What is Counterparty Risk in Crypto and How Can True DeFi Mitigate It

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.

Key Takeaways

• Blockchain and crypto currencies were invented to get rid of middlemen, yet they have crept back in.
• In TradFi, end-users trust that banks and other institutions will not lose their money. Banks trust that users will pay back loans. 
• Centralized credit scores lack transparency and therefore, are prone to manipulations.
• Counterparty risk in crypto can be found in both centralized exchanges, fiat-backed stablecoins, and smart contracts with admin keys and governance.
• To avoid these risks, users should rely on truly decentralized solutions and store their funds in a non-custodial way.

What is Counterparty Risk?

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.

Counterparty Risk in Traditional Finance

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.

Counterparty Risk in Crypto

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:

1. Centralized Exchanges - These exchanges hold your coins for you. They help convert fiat to crypto and vice versa while charging you fees throughout the process. They are notorious for losing customers' deposits and going bankrupt. 
2. Smart Contracts with Admin Keys and Governance - Admin keys and governance allow the developers to change the rules of the contract at any time. These should be avoided as they are ‘fake defi’
3. Fiat-Backed Stablecoins: These coins such as USDC, have admin keys which allow tokens to be frozen and blacklisted, as well as potentially under collateralization with their fiat reserves. 

Examples 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.

Centralized Exchange Bankruptcies

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. 

Failures of Fiat-Backed Stablecoins

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.

Smart Contract Failures

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.

How To Mitigate Counterparty Risk in Crypto

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:

• Use true DeFi tools. For example, platforms such as Liquid Loans enable their users to conduct immutable governance-free operations within all the DeFi tools from self-custodial wallets.
• Avoid CEXes and other centralized solutions. Start using decentralized exchanges instead. The good news is that ever since UniSwap introduced liquidity pools in 2020, DEX trade volume has significantly increased.
• Check the results of security audits. If the tool you’ve chosen is truly decentralized, check if its code has passed any external audits, if these audits have revealed any vulnerabilities, and if these issues have been fixed.

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.