Counterparty risk is the risk involved when one party to a contract or financial transaction is unable to meet its obligations.
In investing, this risk is usually related to the other party in the transaction not being able to pay up.
For example, if you purchase a bond and the issuer of that bond defaults on their interest payments, you as the bondholder are at risk of losing money.
If you buy Bitcoin and hold it on an exchange that goes belly up, you may lose your Bitcoin, and there has been plenty of examples of exchanges doing just that (e.g., Celsius, Mt. Gox, quadrigacx).
How does this happen?
In short, it comes down to flawed corporate strategy, human error, or bad luck.
Things can happen that are out of our control – like a global pandemic – which can lead to overleveraged businesses failing and not being able to meet their financial obligations.
When this happens on a large scale, it can have a ripple effect throughout the economy and markets, leading to losses for investors.
How do I protect myself from counterparty risk?
When it comes to Bitcoin, the best way to avoid counterparty risk is by, first, using self-custody. This simply means holding your Bitcoin in a cold wallet, with no third party between you and your funds.
However, one must keep in mind that holding your Bitcoin in a cold wallet requires you to take on the responsibility of securing your private keys.
This means that if you lose your keys, there is no customer service line you can call to get them back – you are completely on your own.
There are several ways for you to minimize this risk, by using multi-sig wallet that requires more than one key to sign a transaction.
We will get into multi-sig in a different post, but generally speaking, they are beneficial because they require more than one person to sign off on a transaction, making it much harder for someone to steal your Bitcoin.
What’s next?
If you do choose to use an exchange or online wallet, make sure to do your due diligence and make sure they let you withdraw your Bitcoin to a hardware wallet that is in your full control.
This will minimize the risk of you losing your Bitcoin if something happens to the exchange.
You should also keep in mind that even if you take all the precautions in the world, there is always some degree of risk involved – that’s just the nature of investing.
The key is to make sure you are comfortable with the amount of risk you are taking on and to always do your own research before investing in anything.