What is counterparty-risk and how can you protect yourself from it?
In crypto you'll often hear about counterparty-risks and how Bitcoin was built to mitigate them. But can you explain in simple terms what they are and why they matter? Here's our best shot at explaining it all, with some (scary!) historical examples.
What's counterparty-risk?
First things first: a counterparty is a third-party, someone else than you. In the case of financial stuff, potential counterparties will often be banks, custodians, brokers, exchanges, and the like. So you are exposed to some level of counterparty-risk when you are trusting a counterparty with some form of access to your money.
For example, if a bank files for bankruptcy, its customers will often lose parts of their deposits – that's straight on counterparty risk. Now, local financial authorities usually provide insurance for some amount of the deposits. But it's worth checking if that applies to your bank, how much, and under what conditions!
Limiting counterparty-risk, therefore, requires limiting the control counterparties might have over one's money. This is one of the main motivations for self-custody. Like having cash sit in a personal safe, storing crypto in a self-custodial wallet does away with counterparty-risk, since you're the only person responsible for the funds' safety. That doesn't take away all risks though, as there's lots of ways you could mismanage your storage solution.
Yet, counterparty risk has been and remains a massive issue in the history of money. It's arguably one of the main motivations of crypto's existence in the first place! You might think concerns are overblown, so here are some recent examples of counterparty-risk.
Enron Bankruptcy, 2001
Up until 2001, Enron was an energy company with various financial transactions with counterparties, including banks, investors and other companies.
Most financial transactions included derivatives, swaps, and structured finance products, which were used to manage risk and generate profits.
The counterparties often relied on Enron's financial strength to ensure it would meet its obligations. But little did they know, Enron's accounting firm Arthur Andersen LLP embellished and misrepresented Enron's financial health, which caused Enron to declare bankruptcy in 2001.
After they declared bankruptcy, their various counterparties faced significant losses. These companies' exposure to Enron carried what's the very definition of counterparty-risk.
Lehman Brothers, 2008
You might have heard of this one. Lehman Brothers was the bank the collapse of which kicked off the 2008 financial crisis and the credit crunch. They were a large financial institution that engaged in various financial transactions with banks, hedge funds and other financial firms.
They were borrowing money and securities, with the promise of repaying their counterparties back. When they failed to repay, the risk these counterparties were exposed with Lehman Brothers materialized and led to significant losses.
Cyprus Banking Crisis, 2013
In 2013, Cyprus banks were engulfed in a financial crisis triggered by issues related to the Greek sovereign debt. But with this type of risky exposure, if Greece defaulted on its debt, it could lead to massive losses for the Cyprus Banks. This could make it difficult for the banks to repay their creditors, including depositors and other banks, creating a counterparty risk.
In 2012, the value of Greek bonds held by Cyprus banks plummeted, leaving Cyprus in financial peril, with limited capital and high debt to pay back its depositors. To prevent Cyprus Banks from collapsing, the European Union and the International Monetary Fund provided a bailout package to Cyprus. Some depositors with accounts over a certain amount had to take a loss, which led to protests up and down the country. The depositors had multiple layers of counterparty risk, ranging from the health of the Cyprus banks themselves, to the sustainability of their investments (in this case, Greek sovereign bonds).
How to protect oneself against counterparty risk?
When a bank collapses and bailouts inspired Satoshi to launch bitcoin, which was designed to minize the need to rely on trusted third-parties – and therefore to minimize counterparty risk. Beyond Bitcoin, crypto allows taking self-custody of one's funds and can be a solution to minimize part of one's exposure to counterparty risk.
Here is our guide about self-custody, read on to figure out if it might be a solution for you!
NOTHING IN THIS ARTICLE IS A SOLICITATION TO BUY OR SELL DIGITAL ASSETS. OKX DOES NOT ENDORSE ANY PARTICULAR DIGITAL ASSET OR STRATEGY. DIGITAL ASSETS HOLDINGS INVOLVE A HIGH DEGREE OF RISK, CAN FLUCTUATE GREATLY ON ANY GIVEN DAY, AND MAY EVEN BECOME WORTHLESS. YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING OR HOLDING DIGITAL CURRENCIES IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. OKX DOES NOT PROVIDE LEGAL, TAX, INVESTMENT, OR OTHER ADVICE. PLEASE CONSULT YOUR LEGAL/TAX/INVESTMENT PROFESSIONAL FOR QUESTIONS ABOUT YOUR SPECIFIC CIRCUMSTANCES.
