Other than holding cash, you can't actually hold your own money.
When you give your money to a bank, it's a liability for them to pay back to you.
This is why crypto was invented, to give people custody and responsibility over their money again.
Yet somehow, the people have found a way to run back to the middlemen and inject counterparty risk into crypto.
Counterparty risk in crypto refers to the situation when the third party that manages end-users’ digital a sets does not properly fulfill its contractual obligations.
As a result, users may lose their funds with no chance of recovery.
In the traditional financial industry, practically all financial operations come with some degree of counterparty risk.
Bitcoin and other cryptocurrencies, on the contrary, enable users to take full control over their assets. Yet, the middleman, rent-seekers have found their way back in between crypto and the end-users.
Let’s take a look at both types of financial markets to understand how these risks work and what measures the participants take to avoid them.
For the end users:
When you hold your money in a bank, it’s not your money anymore.
In fact, other than holding cash, there is no way to hold fiat currency in the US in your own digital custody.
Instead, you are trusting a counterparty (the bank) to hold your money and not lose it.
Yet, they lose it all the time in bankruptcies such as the 2008 and 2023 banking crises.
You’ll usually get your money back from the FDIC, however, who will socialize the losses to the entire population.
For the institutions:
When an institution lends money to a user, they expect the terms to be met.
Credit scores help gauge how likely a user is to fulfill their debt obligation.
Despite this, there will never be 100% repayment from the borrowers.
The Liquid Loans protocol solves this problem, as any borrower will be automatically liquidated and the debt repaid in a trustless fashion.
Crypto was invented to get rid of, or at least greatly reduce counterparty risk.
Yet, middlemen have masterfully found their way in between the end users and the products in order to make fees. The end-users have knowingly or unknowingly been compliant throughout the process.
There are 3 main types of counterparty risk in crypto:
There are many ways for counterparty risks in crypto to manifest themselves.
Below, we have listed some of them including real-life examples that took place over the past few years.
Historically, centralized exchanges have always been the most popular option for those who wanted to buy or sell crypto. Integration with traditional fiat payment methods together with user-friendly interfaces provided users with a sense of safe haven.
Indeed, what does one have to fear? How can anything go wrong with a reputable bank-like platform that provides a whole set of convenient tools for managing your crypto assets?
It turned out that it can.
FTX bankruptcy that took place in November 2022 became a real shock for the whole crypto community.
Not only did this reputable platform certified by the US government fall victim to a hack. Once scared users started withdrawing their assets, it was unable to provide a sufficient level of liquidity to meet all the requests. As a result, many people simply lost their money.
So what’s the moral of this story?
That’s right, centralized exchanges carry counterparty risk just like banks and other centralized financial institutions.
Don’t give up your private keys or give your coins away to anybody, not even trusted exchanges.
Another example of crypto counterparty risk is associated with fiat-collateralized stablecoins.
The story is pretty much the same as in the case of centralized exchanges. A single entity mints digital assets and gives them away in exchange for fiat money.
Being highly influenced by external economic conditions, such an entity may fail because of many different factors that it cannot control itself. As a result, its stablecoin may easily lose its peg.
At this, Circle’s USDC losing its peg in March 2023 is one of the most prominent examples.
Following the collapse of Silicon Valley Bank (SVB), the USDC price dropped to the level of $0.91 per coin. It turned out that Circle had a large sum of money invested in SVB, hence the disaster.
It took about three days for USDC to regain its peg. Yet, this event left the crypto community with a bad taste in the mouth.
Finally, users may face counterparty risk in crypto in case of a smart contract vulnerability exploit.
Say, there is a blockchain-based platform that claims to be decentralized. Its founders may have no access to the users’ funds stored safely on a smart contract.
Yet, any vulnerability in this smart contract may turn into severe money losses in case it is discovered by hackers.
Some of the most prominent examples of such exploits include the Beanstalk protocol and the Nomad Bridge losing $181 million USD and $200 million USD correspondingly.
How can companies avoid such situations?
So far, hiring top-notch developers together with external crypto audits has proved to be the best protection.
Luckily, there are now many ways to eliminate counterparty risks in crypto.
In the early years of the blockchain industry, the landscape of decentralized tools was pretty poor. At the same time, their security left much to be desired.
Yet, now the situation has drastically improved.
As the crypto market is more mature, users have a whole plethora of DeFi solutions to choose from. At this, here's what you may do right now to improve the security of your digital assets:
In addition, don’t forget about personal IT security either. Since hackers pay more attention to centralized crypto tools, it doesn’t mean that end-users never emerge in their field of view.
Combine these methods given above with the best security practices. So far this is the best strategy to eliminating counterparty risk and improving your funds’ security.
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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
Kate is a blockchain specialist, enthusiast, and adopter, who loves writing about complex technologies and explaining them in simple words. Kate features regularly for Liquid Loans, plus Cointelegraph, Nomics, Cryptopay, ByBit and more.