What is Counterparty Risk in Crypto Explained

By Ehis Ohiwerei

Key Takeaways

  • When we talk about the counterparty, we mean the person or group involved in a transaction with another party. This could be anyone – an individual, a government, a business, or an organization.
  • The entity that sold it will be the counterparty if you purchase anything. On the other hand, the counterparty would be the individual or organization purchasing the item if you were the one selling it.
  • Regardless of what is being traded in a financial transaction, several counterparties may exist. It could be cash, goods, services, or anything else worth it.
  • There are several different counterparties involved while trading securities. Individual investors, liquidity suppliers, scalpers, and fundamental traders are a few of them.

What is a Counterparty?

In finance, “counterparty” refers to the person or party involved in a transaction. However, in the Web3 universe, the counterpart has a specific meaning. It is a protocol similar to a metacoin created by Robert Dermody, Adam Krellenstein, and Evan Wagner back in 2014. The platform is built on the decentralized and open Bitcoin network, including a decentralized exchange (DEX) and token.

Counterparty allows users to buy, sell, and create unique digital assets. Although similar concepts are common now on platforms such as Ethereum and Solana, the launch of Counterparty was a significant milestone at the time. It helped people realize they could use Bitcoin’s technology for more than just currency or a store of value.

Counterparty also paved the way for the global crypto art and collectibles movement, as demonstrated by projects like Spells of Genesis and Rare Pepes, both pioneers of the current NFT craze.

How Does Counterparty Work?

Just like Ethereum token standards establish how specific assets function on its protocol, Counterparty creates the framework that outlines how people can produce unique tokens on the Bitcoin blockchain. These assets are not limited to digital collectibles or tokens. Still, they can extend to anything with a verified level of rarity, even physical items.

Counterparty is comparable to a layer-2 solution for Bitcoin, a platform constructed on top of Bitcoin that inherits the original blockchain’s security but offers additional capabilities. In that regard, it’s like Stacks, another platform based on Bitcoin, to provide smart contract functionality, fueling NFTs and decentralized finance (DeFi) applications.

What is a Counterparty Risk?

Counterparty risk is when one party involved in a transaction fails to fulfill their part of the deal, leading to losses for the other party. This type of risk is common in credit, investment, and trading transactions, as they all require trust that the other party will hold up their end of the agreement. In simple terms, counterparty risk assesses the likelihood that one of the parties will fail to meet their obligations and the severity of the damage if they do.

Read more: What are DeFi Loans Explained

Who can be a Counterparty?

The counterparty can be anyone, and there are few limitations or restrictions on who can fulfill that role. Here are some examples of who can act as a counterparty:

  • Liquidity Providers
  • Individuals
  • Banks
  • Governments
  • Corporations
  • Brokers
  • Any other legal entity

Does Counterparty Risk Exist in Crypto?

The creation of Bitcoin was driven by the desire to eliminate counterparty risk when transacting. Before Bitcoin, an actual digital cash system did not exist. People had to rely on third-party financial institutions to store IOUs for fiat currencies or dollars. Regulators had control over these third parties, which meant they could seize or block funds from being sent to specific payment destinations at any time.

The concept behind Bitcoin is essential that there is no default risk associated with the system. When individuals use crypto, they can be confident that their transactions are either complete or will never happen when they keep bitcoin in their wallets at the primary network layer, where no third party may confiscate the user’s bitcoin or censor their transactions. The decentralization idea, which has grown to be one of the pillars of cryptocurrencies, was created by this concept.

However, some forms of counterparty risk have crept their way back into the Bitcoin ecosystem. This is especially evident in centralized exchanges that allow users to gain access to Bitcoin in the first place. When Bitcoin users hand their Bitcoin over to a custodian-like exchange, counterparty risk is reintroduced into the system. For instance, the exchange could get hacked, leading to the loss of users’ Bitcoin.

Alternatively, they could face other issues that would cause them to default on their obligation to hand over users’ Bitcoin on request. Centralized stablecoins are also exposed to counterparty risks since the issuer needs to collateralize stablecoins by holding the underlying asset. By holding sufficient collateral, the issuer can maintain price stability.

When centralized entities control a significant share of the crypto market, crypto users are ultimately exposed to counterparty risks. Other services susceptible to counterparty risks include crypto lending platforms, custodial wallet providers, and crypto card services.

How is Counterparty Connected to Ethereum?

The Emblem Vault, launched in September 2020, is a wallet that supports both NFTs and fungible tokens across various blockchains. It allows collectors to wrap their Bitcoin-based assets, such as Rare Pepes and Spells of Genesis Cards, as native ERC-721 tokens on the Ethereum blockchain through the vault. This move increases the exposure of Counterparty projects and simplifies trading for users who may find Counterparty confusing or daunting.

What Cryptocurrencies Have Counterparty Risk?

Assets tied to physical commodities or government-issued currencies are vulnerable to counterparty risk. This risk arises when a company that issues a digital asset doesn’t own or control the underlying asset to back the digital counterpart, leading to user losses. This risk is exceptionally high for stablecoins, which aim to maintain a stable value by holding collateral assets.

For example, stablecoins backed by the US dollar could be at risk if the company issuing the coin doesn’t have enough USD reserves to back the digital assets. In Exodus, some stablecoins that have counterparty risk include TrueUSD (TUSD), USD Coin (USDC), Paxos (PAX), Binance USD (BUSD), Gemini Dollar (GUSD), DAI, and Tether USDT. It’s essential to be aware of counterparty risk when dealing with digital assets to avoid losing money in the long run.

Why are Crypto Exchanges Susceptible to Counterparty Risk?

Cryptocurrency exchanges serve as the primary entry points for new and experienced investors in the crypto market. Many trust that these exchanges have enough funds to fulfill user withdrawals. However, when an exchange like FTX goes bust, customers’ confidence in them can quickly turn into losses for users who cannot withdraw their funds. The risk of centralized exchanges being hacked is another primary concern for users.

In either case, the result is that the user’s funds can be permanently lost, which means that the affected exchange or service provider has failed to fulfill its contractual obligations to its users. Unfortunately, no regulatory framework is in place to protect crypto investors from such risks.

Consequently, unregulated exchanges may take advantage of this lack of regulation, knowing they can set up shop in jurisdictions where the legal repercussions for losing users’ funds are minimal or non-existent.

Counterparty Risks in Smart Contracts and DeFi

The automated and self-executing nature of smart contracts offers a potential solution to the problem of counterparty risk in financial transactions. By eliminating the need for trust in third-party intermediaries, smart contracts can significantly reduce the chances of fraud or default.

The security of smart contracts is a critical factor in ensuring the trustworthiness of DeFi platforms, as the smart contract is the sole authority governing the transaction. Therefore, it is essential to ensure that smart contracts are secure and reliable to mitigate any potential counterparty risk.

Types of Counterparty Risks in DeFi

Here are the types of counterparty risks that can occur in DeFi, explained in simple terms:

Adverse Selection

This happens when one party has more information about a product’s quality than the other, leading to an information imbalance. In DeFi, interest rates are transparent and substantiated, which means borrowers can’t hide information. However, lenders can only offer overcollateralized loans, meaning the collateral should be worth more than the loan. This can help mitigate the risk of adverse selection.

Principal Agent Conflict

This is a conflict of interest between an individual or organization and the representative acting on their behalf. In DeFi, this can happen between investors and the platform’s controllers. Some investors may control the platform’s governance more than others, leading to misaligned incentives.

While many platforms transfer all risk to end-users, some platforms may take on some risk to ensure the platform’s long-term viability. It is crucial to have high governance token stakes with a long-term interest in supporting best practices for the platform’s health.

What are the Counterparty’s Biggest Projects?

Counterparty has supported a variety of exciting projects since its inception. Some of these projects include:

  • Spells of Genesis: The first-ever blockchain trading card, FDCARD, was released on Counterparty in March 2015. Developers later used it in Spells of Genesis, a strategic blockchain card game. Players can collect and trade assets called ORBs to build strong decks on the Bitcoin blockchain and test them against opponents.
  • Phockheads: One of the first digital collectibles, Phockheads were brought to Counterparty after being inactive on Namecoin, an early blockchain platform. They can now be traded and collected on the Counterparty platform.
  • HODLpet: This was the first “living creature” hosted on the Bitcoin blockchain. It’s similar to an online Tamagotchi, collectively nurtured by a community of HODLers. Added features include NFT artwork drops by notable artists and a playable NFT card game.
  • Rare Pepes: These are meme pictures built on the first Pepe the Frog design by Matt Furie. In September 2016, the first batch of Rare Pepes was issued and made available for purchase and exchange using XCP or Bitcoin. Counterparty’s lively market still operates where collectors may buy unique and uncommon cards.
  • Bassmint: This is a new cryptographic music directory and label on Counterparty. It was created by a group of artists, musicians, and technologists in the Bitcoin community. Artists can mint their music, have it curated on Bassmint, and get paid in Bitcoin directly by fans.

What are the Factors That Influence Counterparty Risk?

Recently, efforts have been made to reduce users’ risk when trading on exchanges. One way to achieve this is through smart contracts like those in the Lightning Network and the Arwen Protocol.

These smart contracts help limit the counterparty risk users face while trading on exchanges. With such solutions in place, exchanges can become non-custodial, and this helps reduce the risk of a central point of failure. Decentralized exchanges like Bisq are another solution that helps address the issue of a single point of failure.

How to Avoid Counterparty Risk

To reduce counterparty risk, choosing reliable counterparties is crucial. The more secure the counterparty involved in a transaction, the lower the chances of them breaking the contract.

To put the transaction in proper perspective, it is necessary to understand the market positions of both parties involved, including your organization. Here are some new wordings for the list of items:

Check the Credibility of the Crypto Exchange.

If you prefer a centralized exchange, doing some research first is essential. Look for an exchange that is transparent and open about its operations. Many call for exchanges to prove they have enough assets to cover their liabilities, so watch for this.

Consider Self Custody

Despite recent efforts by some exchanges to improve transparency, relying on them entirely for your safety is still risky. It’s safer to use self-custody solutions like software wallets like MetaMask or hardware wallets like Ledger or Trezor. Decentralized options like these are less prone to counterparty risks as they do not require users to deposit their coins in third-party wallets.

Final Thoughts on Counterparty Risks in Crypto

Counterparty is a highly secure platform built on Bitcoin’s already secure infrastructure. This means that the assets on the Counterparty platform are safe and are not likely to get lost or require external storage servers. The global network of miners and node operators also provides added security to the platform. Since Counterparty is well-established, it has remained relevant by supporting various projects and initiatives, much like Bitcoin’s role in the broader cryptocurrency ecosystem.

Frequently Asked Questions

What is a Counterparty?
A counterparty refers to the other party involved in a trade or transaction, whether an individual, a business, the government, or other organization. Counterparty risk is the risk that the other party will not fulfill their end of the deal.
What is a Counterparty in Crypto?
Counterparty is a digital currency based on the Bitcoin blockchain for peer-to-peer financial trading. It was founded in 2013 by Adam Krellenstein, Evan Wagner, and Robby Dermody. Counterparty has a mobile wallet, bitcoin-aware smart contracts, a decentralized exchange, custom-named assets, and is open source.
Which Crypto Exchanges Have Counterparty Risk?
Centralized exchanges that hold your coins introduce counterparty risk, as they control your private keys and may need more funds to cover every depositor.
Does Bitcoin Have Counterparty Risk?
Bitcoin is based on a "trustless protocol," where the blockchain ensures that no one needs to know the identity of their counterparty in any transaction. As a result, there is no credit or counterparty risk.
How Does Blockchain Reduce Counterparty Risk?
Blockchain technology allows smart contracts to operate without trusting any party except the smart contract itself. This means the security of a smart contract is crucial to reducing counterparty risk in decentralized finance (DeFi).
What is Counterparty Risk in Crypto Explained

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What is Counterparty Risk in Crypto Explained

By Ehis Ohiwerei - min read
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