Although trusting the other party is a moral issue on the surface, it cannot always be a safe option for concluding a contract. Especially when it comes to financial and economic matters, a misplaced trust may cause other party risk problems! But what exactly is this risk and how can it be prevented? In this article, we will fully answer this question.
What is the counterparty risk?
In short, counterparty risk or transaction risk (counterparty risk), the risk of not fulfilling the obligations of one side of the transaction. This item, which is included in the category of financial risk, may affect any investment. Perhaps for a better understanding of this risk, today’s banking is a suitable example. For example, when a bank offers a loan, it must consider the risk of not being able to repay the installments by the recipient. On the other hand, when a person saves his deposits in the bank, he should consider the possibility of the bank going bankrupt and losing his assets. As a result, in the meantime, both parties will face a topic called counterparty risk.
Of course, counterparty risk is not only related to depositing and lending. In fact, any two-way transaction such as buying securities with the hope of receiving interest, fixed rate for bonds, and any other financial transaction in the world of traditional economy, will include the risk of not fulfilling the obligations of one of the parties.
What is the importance of counterparty risk?
All small and large investors in the financial markets, always at risk Non-fulfillment of obligations of the other party They are facing themselves. Of course, this does not mean that there is an unsolvable error in the world of economics. In fact, fixed income investors, by accepting an acceptable amount of this risk, try to increase their income and gain more profit. As a result, if an investor understands the risks of signing financial contracts and is ready to face them, he will not be exposed to the complete loss of his capital.
Fortunately, in recent years, investors’ awareness of counterparty risk has increased significantly. Although this risk has existed since the beginning of the economy and the need for an agreement between the two sides of a contract, it has never been as obvious and exposed as it is today.
Examples of counterparty risk
The risk of the transaction party may show itself in every small and large contract; But in the history of economics, sometimes this phenomenon has caused very big and influential events. In the following, we have examined two examples of these remarkable events.
Printing dollars and losing support
One of the examples related to this risk occurred in 1944. In this year, a forum titled Bretton Woods (Bretton Woods Conference) decided to use the US dollar as the main global reserve currency. According to the terms of this commitment, the US dollar had to use gold as its backing. In other words, each ounce of gold was considered equal to 35 dollars, and if a non-American country wanted to convert its dollars into gold, it could request the amount of gold it wanted with this formula.
But the main issue started after two decades and from where the American government decided to Printing money without backing took Money printing made the available dollars more than their gold equivalent. As a result, if the countries requested to replace the US dollar with its physical backing according to the initial agreement, the government of this country was not able to provide this amount of gold. For this reason, 27 years after the Bretton Woods conference, the government of this country stopped gold exchanges at the previous rate. This lack of commitment is an example of counterparty risk in international dimensions.
The collapse of the real estate market
In 2008, the real estate market faced a huge shock. Economists consider the cause of this collapse to be the improper management of risks related to collateralized debt obligations, or CDOs. Generally, mortgage loans are converted into CDO securities for investment and are backed by the underlying assets. But by the 2000s, rating agencies had miscalculated, causing banks to overuse these CDOs.
As a result, just when the natural and legal entities of the borrower were no longer able to pay their installments, the banks faced a major financial collapse, which is called The Great Depression Or The Great Recession Be remembered. In this example, the non-commitment of the borrowers to repayment had caused the appearance of the risk of the transaction party in macro dimensions.
Counterparty risk in the world of digital currencies
The emergence of the world of blockchain and digital currencies made investors to a large extent hope to solve the problem of the risk of the trading side. The new economic world, thanks to a distributed and decentralized ecosystem and the absence of third parties to access the assets, created a lot of optimism in this regard. This issue is clearly mentioned in the Bitcoin white paper. In the Bitcoin ecosystem, only miners have the ability to access and block digital assets and change transaction history. But if these people intend to manipulate the ecosystem, their source of income will be at risk before anyone else.
However, sometimes due to the integration of centralized platforms with this area, we see risks in it. The most famous example of counterparty risk in the world of digital currencies Hacking of centralized exchanges related to. In recent years, some exchanges such as FTX and Mt.Gox have been attacked by hackers. The significant growth in the price of digital currencies in recent years has caused hackers to not miss any opportunity to steal these assets, and in the meantime, a centralized exchange is the best option. Attacks by hackers and loss of property will be equal to the impossibility of securing investors’ property and bankruptcy of the exchange.
In the topic of smart contracts, we are facing exactly the same problem. The nature of smart contracts significantly reduces the possibility of risk; But in cases such as Oracle-based contracts, which aim to establish a price dependency between different digital currencies such as Bitcoin and Ethereum, we will have to use a stablecoin or fiat such as the dollar. In this case, due to the entry of the traditional financial world, the risk of the opposite side may show itself.
Fortunately, at present, solutions such as decentralized exchanges and the existence of smart contracts such as the Arwen protocol and the Lightning Blockchain network have been able to prevent hacking and loss of assets to a very high extent. Thanks to these solutions, investors can invest in digital currencies with more confidence than not facing the risk of the other party.
big risk; But predictable
Counterparty risk is an integral part of the economy. In this article, we fully investigated the dimensions of this issue and examined examples of it. Currently, analysts hope that with the development of digital currency blockchain technology, this problem will be forgotten forever; But in the end, to validate this hypothesis, we will have no choice but to wait.
To what extent do you think blockchain networks will be able to solve the risk problem of the transaction side? Share your comments with us and other users of Valex blog.
Written by the risk of the other party: trust is not always responsible! The first time in the blog Valx. appeared.
