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 high-profile historical examples.
What's counterparty-risk?
First, a counterparty is a third-party — a person or an organization that isn't you. In the case of financial services, potential counterparties can include banks, custodians, brokers, exchanges, and similar entities. As a result, you're exposed to counterparty risk when you trust 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 textbook counterparty risk. Now, local financial authorities usually provide insurance for some amount of the deposits. However, it's worth checking if that applies to your bank, how much, and under what conditions.
Reducing counterparty risk therefore requires limiting the control counterparties might have over your money. This is one of the main motivations for self-custody. Like having cash sitting 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 remove every risk though, as there's lots of ways you could mismanage your storage solution.
However, counterparty risk has been and remains a major 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 to illustrate the threat.
Enron Bankruptcy, 2001
Up until 2001, Enron was an energy company with various financial transactions involving counterparties, including banks, investors, and other entities. Many of the company's 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 make sure 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 Enron declared bankruptcy, the company's various counterparties faced significant losses, which is a prime example of counterparty-risk.
Lehman Brothers, 2008
You might have heard of this one. Lehman Brothers and its collapse is considered the first domino to fall as the 2008 financial crisis and credit crunch took hold. The company was a major financial institution that engaged in various transactions with banks, hedge funds, and other financial firms.
Lehman Brothers was borrowing money and securities, with the promise of repaying its counterparties back. When the company failed to repay, the risk these counterparties were exposed to 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. 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 yourself against counterparty risk
When the banks collapsed and received eye-watering bailouts, Satoshi Nakamoto was inspired to launch Bitcoin. Being decentralized and built around the novel and immutable technology of blockchain, the asset was designed to minimize the need to rely on trusted third-parties – and therefore to minimize counterparty risk.
Self-custody allows you to further shield yourself from counterparty risk when trading and transacting with cryptocurrencies. Through self-custody, you remain in control of storing and managing your digital assets and the private keys used to access them. Self-custody provides an alternative to leaving your assets on a centralized exchange, for example, where the security of your crypto is in the hands of a third-party.
We recommend learning more about self-custody and how to apply it to your own assets, so you can take full control of your crypto. Start with our insightful guide to self-custody here.
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