The collapse of the FTX empire easily stands out as one of the most gruesome events in the crypto world of all time. And although the dust is yet to settle, there is already a lot to unpack. For one, the ongoing crisis underscores the risks of participating in the crypto market. Specifically, it brings to the fore the prevalence of something known as counterparty risk in the crypto space and how there is little or no regulatory protection against it. In this article, we’ll explore counterparty risk in the digital asset space and why it remains one of the biggest threats to crypto holders.
Counterparty risk explained
Counterparty risk is the possibility that one of the parties involved in a transaction might fail to fulfill its end of the bargain, thereby causing the other party to incur losses. This type of risk is prevalent in credit, investment and trading-based transactions as they all require some level of trust that counterparties will fulfill their contractual obligation.
Simply, counterparty risk is a measure of how likely one of the parties is to default on their side of the bargain and how big the damage is if they do.
Does counterparty risk exist in crypto?
Interestingly, the concept that birthed Bitcoin stemmed from the need to eliminate counterparty risk when transacting.
Satoshi Nakamoto, in the Bitcoin whitepaper published 14 years ago, explained that eliminating intermediaries was the ideal solution to the weaknesses of trust-based payment models. To achieve this, Satoshi introduced a peer-to-peer network anchored by trustless cryptographic proof that entails users to transact directly without requiring third parties. Notably, this model eliminates the need for centralized entities. As such, the parties know for a certainty that transactions, thanks to the Bitcoin network, either finalize or never occur – there are no in-betweens. This model birthed the decentralization mantra that has since become one of the bedrocks of cryptocurrency.
However, the trust-based model has found its way into the heart of the crypto market. You could even argue that the present crypto realm was built on the back of centralized crypto companies. Notably, decentralized exchanges account for just 18.2% of all spot-trading volume, according to research carried out by Citigroup. This means that centralized exchanges, which operate intermediate processes for executing trades, storing coins and initiating transactions, account for the remaining 82.8% of spot-trading volume.
Apart from crypto exchanges, the other services that are susceptible to counterparty risks include crypto lending platforms, custodial wallet providers, crypto card services and centralized stablecoins.
In the case of centralized stablecoins, the issuer needs to collateralize stablecoins by holding the underlying asset. By holding sufficient collateral, the issuer is able to maintain price stability. For instance, companies issuing U.S. dollar-pegged coins need to hold an appropriate amount of US dollars to collateralize their digital assets.
In essence, the crypto economy is not immune to the problems inherent in the trust-based transactional model Satoshi warned us about 14 years ago. For what it’s worth, the trust-based model remains central to the success of cryptocurrency and, judging by the events of the past few weeks, also its potential downfall. Having centralized entities control a significant share of the crypto market ultimately exposes crypto users to counterparty risks.
Why are crypto exchanges susceptible to counterparty risk?
Since exchanges are the major gateways to the crypto market, new and experienced crypto participants often deposit their funds with them. Users trust that these exchanges will have plenty of coins available whenever any user initiates a withdrawal. Unfortunately, as FTX's collapse has shown, this trust has cost many people their crypto wealth if the exchange misappropriates customer funds and cannot cover withdrawals. Another concern for customers of centralized exchanges face is a security hack that exposes users' coins to theft.
Whatever the reasons may be, the common denominator is that users are at risk of losing their funds permanently. If this proves to be the case, the affected exchange or service provider has defaulted in its contractual obligation to process withdrawals when due.
Unfortunately, there is little or no crypto regulatory framework designed to protect users from such risks. This has, in a way, emboldened unregulated exchanges, knowing fully well that they only need to locate their businesses in jurisdictions where the legal repercussions for losing users' funds are non-existent or lenient.
The Bahamian government has begun to investigate Sam Bankman-Fried and other executives of FTX and Alameda Research. That said, while it is possible the culprits are held accountable and face criminal charges, this does not guarantee that users will recover any missing funds.
How to avoid counterparty risk
Confirm the validity of the crypto exchange
If you would rather stick to your favorite centralized exchange then you ought to carry out due diligence. It is worth mentioning that the most important trait the ideal exchange has to offer is transparency. There has been a widespread call for exchanges to offer proof-of-reserves, which would show they have enough assets to offset any liabilities.
Opt for self custody
Although the recent FTX scandal has forced popular exchanges to take proactive steps to enable a more transparent ecosystem, the fact remains that users are still leaving a lot to chance as regards their safety. As such, the best bet for crypto participants is to opt for self custody – the act of utilizing non-custodial services and solutions such as a software wallet like MetaMask or a cold storage solution like Ledger or Trezor wallets.
Decentralized solutions are not as susceptible to counterparty risks as centralized alternatives, as they usually do not require users to deposit coins in third-party wallets.
Beware of defi solutions susceptible to counterparty risks
It is important to note, while decentralized finance limits counterparty risks to an extent, other elements within the DeFi space still expose risks that stem from the possibility of counterparties failing to fulfill their end of the deal. This is especially true for DeFi solutions that rely on oracles. These solutions include decentralized stablecoins (such as Magic Internet Money) and decentralized betting platforms. In both examples, the protocols require off-chain data to function optimally.
In a case where data providers erroneously or intentionally supply wrong information into the blockchain, users are bound to lose funds. And so, it is not just enough to opt for non-custodial solutions, users also have to ensure that the protocols they opt for are unsusceptible to oracle-based counterparty risks.
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