Counterparty risk is a concern in crypto trading, where the possibility of one party failing to meet its obligations can result in losses. This guide will discuss the types of counterparty risks and how you can mitigate them.

What Is Counterparty Risk?

Counterparty risk measures how likely one of the parties in a financial agreement is unable or unwilling to fulfill their contractual terms.

Counterparty risk is prevalent in banking and the financial markets as they require some level of trust that transacting parties will honor their end of the bargain. Counterparty risk also exists in crypto trading and decentralized finance. 

How Does Counterparty Risk in Crypto Occur?

Counterparty risk occurs in crypto despite the aim of blockchain technology to eliminate counterparty risk when transacting.

Initially, Bitcoin was designed to replace traditional trust-based payment models with a peer-to-peer network underpinned by trustless cryptographic proofs to allow users to transact directly without involving third parties. 

However, using custodial exchanges to trade bitcoin exposes you to counterparty risks. When buying or selling bitcoin through an exchange, the exchange acts as a trusted third party to facilitate the transaction and maintain custody of your assets. 

Counterparty risk can occur if an exchange is hacked and funds are stolen, or if the exchange is facing insolvency, or could default on its obligations to return your funds. 

Counterparty risk also happens in decentralized finance (DeFi), where DeFi applications deploy smart contracts instead of counterparties for transactions between parties. Counterparty risk can occur when other counterparties exploit vulnerabilities in the smart contract code to renege on their obligations.

Types of Counterparty Risks in Crypto

Let’s take a look at the types of counterparty risks you may face in the crypto markets.

  • Centralized exchange risks – Crypto exchanges act as intermediaries and custodial services for crypto trading. However, these organizations can experience security breaches, mismanagement, and insolvency, posing serious third-party risks to users.
  • DeFi protocol risks – Vulnerabilities in DeFi protocol technology can lead to counterparty risk arising when using features such as cross-chain bridges and oracles. Cross-chain bridges facilitate the transfer of digital assets across chains like Ethereum to Solana. Oracles facilitate the sharing of real-world data to the blockchain networks. In both cases, any flaws in the protocol can lead to hacks and loss of funds, making it impossible to complete a transaction. 
  • Crypto Lending risks – Crypto lending platforms can expose users to counterparty risk when they rehypothecate collateral and over-leverage, resulting in the loss of customer funds.
  • OTC desks – OTC desks play a critical role in the crypto ecosystem as large players want to access liquidity outside exchanges. However, despite typically being large organizations, there are counterparty risks if any of the counterparties associated with the OTC Desk defaults on a trade.

How to Mitigate Counterparty Risks

There are several ways in which counterparty risks can be mitigated to avoid any negative impact.

  • The first is to conduct operational due diligence on the counterparty involved in a transaction to minimize the risk of error. Evaluate their reputation, security, and adherence to regulatory compliance. 
  • Audit the smart contract code if you transact through smart contracts. A professional audit reduces the risk of coding errors and minimizes any counterparty risk. 
  • Invest your crypto holdings in a well-balanced portfolio to reduce the blow of a single counterparty failure, as you can recoup your losses from other ventures.
  • Trade with counterparties that employ the use of multisig wallets. Multisig wallets require multiple authorizations from all parties, reducing the likelihood of funds being misappropriated, thus reducing your counterparty risk. 

Wrapping Up

While measures like over-collateralization in DeFi lending reduce counterparty risk, crypto traders and investors still face a degree of counterparty risk in most areas of the crypto asset markets. Therefore, it’s important to be aware of the different types of counterparty risks and take appropriate risk management measures the mitigate them.