What Is Counterparty Risk & How To Mitigate It
There’s been a lot of buzz around the most recent events surrounding QuadrigaCX. For those of you who aren’t aware – QuadiragCX is a Canadian Bitcoin Exchange that have recently lost access to their customers funds. The entire incident is all rather suspicious, but we will not be diving into that drama over here. You can simply google “Quadriga Scam” to find out more. In this post, however, I want to discuss the risks that people tend to ignore when dealing with exchanges like QuadrigaCX.
Specifically I want to talk about Counterparty Risk.
In usual Mango-style, we’re going to break this concept down piece by piece. To understand what is Counterparty Risk, we first need to discuss precisely what is “Counterparty".
What is a 'Counterparty' ?
A counterparty is the person or organisation on the other side of a financial transaction. If you make a financial deal with someone, then the person on the other side of the deal is the counterparty. Here are a few examples of counterparties:
If you loan money to a friend, then your friend is the counterparty (Credit Risk)
If you put money in the bank, then the bank is the counterparty
If you deposit money into a broker (or exchange), then the broker is the counterparty
Whenever you engage in a financial transaction with a counterparty, you are exposing yourself to Counterparty Risk.
What is Counterparty Risk?
Alright, so what is Counterparty Risk? Counterparty risk is the risk that you are bearing incase the person on the other side of the transaction cannot fulfill their end of the deal
Counterparty Risk is the risk that the counterparty defaults or goes bankrupt.
In the previous section we listed a few examples of counterparties. In each one of those cases, you were also bearing Counterparty Risk. Let’s use those same examples when pertaining to Counterparty RIsk:
You lend money to a friend and he cannot pay you back
You put money in a bank, and the bank goes insolvent (due to bank-run, financial collapse etc)
You deposit money into an exchange, and the exchange gets hacked or loses all your funds.
By now, you’re seeing that it’s all pretty straightforward. Whenever you engage in a transaction with another party (counterparty), you are bearing the risk that the other party may not be able to deliver when the time comes to fulfill their end of the transaction
Difference Between Counterparty Risk & Credit Risk
I’ve received this question a few times now: What is the difference between counterparty risk and credit risk?
Counterparty risk is actually a subset of Credit RIsk.
So essentially – Counterparty risk is a form of Credit Risk. Credit Risks typically refers to the risk you assume when the counterparty cannot payback a loan (for example when you buy bonds).
Real Examples of Counterparty Risk
So, now we understand what Counterparty Risk actually is. But let’s go over a few examples how bad Counterparty Risk can get. A lot of people have lost a lot of money because they didn’t take counterparty risk seriously enough. Here are a few recent examples of counterparty risks that took a bad turn:
The Flash Crash of EUR/CHF: Several brokers actually went broke overnight on this one. In 2011, the Swiss National Bank (SNB) put a price floor on the EUR/CHF pairing. Essentially, they pegged the EUR/CHF at atleast 1.2 in an effort to facilitate cheap exports. This caused a lot of traders to take advantage of the price floor.
However, after a series of events – the SNB suddenly removes the price peg and the exchange rate dropped by 20% within the first minute. This caused a massive flash-crash. Traders not only lost their entire balance, but their accounts actually went into the negative! They owed more than they actually had.
The Mount Gox Hack: Mt. Gox was a major cryptocurrency exchange back in the day. In 2014, it suddenly suspended all trading without any clear explanation other than “maintenance”. Apparently, a security breach/hack caused the exchange to go insolvent. They soon announced bankruptcy and closed trading altogether. Traders who had their funds in there lost everything.
Death Of QudrigaCx CEO: This is the most recent event/example of counterparty risk at its truest form. QuadrigaCX is a Canadian Cryptocurrency Exchange. A few weeks ago, the CEO of the exchange dies while on vacation in India (apparently!). It was then uncovered that he was the only one who could access all the customer funds in the exchange. Furthermore, his laptop could not be found after his death – making it impossible to access the cryptocurrency which was stored in a secure cold wallet. Almost $150 million dollars of customer funds have been lost. Some people lost their entire life savings.
How To Mitigate Counterparty Risk
While Counterparty Risk can be a scary thought, there are several ways to mitigate counterparty risk. Taking the appropriate steps to mitigate these steps will keep your finances in tact even if a Black Swan event takes place.
Divide your funds among Banks that insure your money: Most banks provide deposit insurance on a your money up to a certain amount. You can reduce your counterparty risk exposure by placing your money in several different banks. This will ensure the most coverage.
Don’t send your entire trading account to an exchange: If you’re a trader, it may be in your best interest to trade with only a portion of your funds and leverage the rest. For example you can send 20% of your account to the exchange, and keep the 80% in your bank. With a 5x leverage, you can trade the same amount while still protecting yourself in case the exchange goes down. If you’re looking for an good cryptocurrency exchange that allows for leverage trading, we recommend Deribit
Credit Checks & Deposit Requests: If you’re renting out your apartment, or loaning money – it’s best to do credit checks on the counterparty. If you’re a landlord you can ask for security deposits. Banks and credit card companies do a credit check on your financial history for this very reason – to reduce their counterparty risk. They will assess their counterparty risk when dealing with you as a counterparty, and accordingly offer you an interest rate. Landlords do the same and ask you for a security deposit. The interest rate and deposit rate will cover any losses that they may incur in case you don’t fulfill your end of the deal (i.e payback credit card, and not damage property)
Conclusion: What Is Counterparty Risk?
When we engage in any sort of trade/ transaction with a counterparty, it’s more often a means to an end. In the process of achieving that end we often forget to account for counterparty risk.
The rules & regulations that govern many counterparties ( banks, exchanges, businesses) usually evoke the feeling of safety and reliability amongst many of us. And while the crash of banks, exchanges and business is improbable, it is still possible.
Given that our world is highly reliant on counterparties for the purpose of trades and transactions, we can’t eliminate counterparty risk entirely. However, we can mitigate counterparty risk by doing the following: (limited to the scope of examples in the post)
For those who are “banked” – Do not put all of your eggs in one basket. Divide your funds among Banks that insure your money
For those of you who trade – Crypto, Forex etc – Don’t send your entire trading account to an exchange. Change the narrative around margin trading and use it to mitigate counterparty risk.
loaners/landlords – Do a Credit Check, or ask for a Deposit Request
In short, always think of a means to protect your wealth in the case of a black swan event. Black Swan events are notorious for taking you for everything you’ve got and more.
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