What is counterparty risk?

Counter party risk is the risk to you if the other people or entities that are involved in a contract don’t hold up their end of the bargain. In the world of cryptocurrency, counterparty risk does come into play in specific circumstances.

An explanation of counterparty risk.

An example of this is with decentralized finance (Defi) protocols that have admin keys. These admin keys allow developers to modify or replace the smart contracts underpinning the protocol, including making adjustments to user balances. This adds couterparty risk as users of the protocol are at the mercy of the people who control the admin keys 🔑. Ideally you want to use Defi protocols that are non-custodial i.e. they have no admin keys.

Another example of counterparty risk is in crypto assets that are tied to real-world commodities or Government-issued fiat currencies. These assets are dependent upon a company holding enough of a given currency or commodity to “back” the digital currency in circulation. The risk inherent to such a model is that the company issuing the digital asset may not actually own or control the real-world asset to back the digital counterpart. This class of cryptocurrencies, known as stablecoins, are particularly susceptible to counterparty risk as stablecoins achieve relative “price stability” by holding as collateral the underlying asset in question. Stablecoins that are backed by US Dollars illustrate this risk, as the company issuing the coin may not actually have the US Dollars on hand sufficient to back the digital asset. Ideally you want to use algorithmic stable coins 🪙 that are able to hold their pegs better.

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