This is often called default risk.
Counterparty risk is the risk that a counterparty will fulfill its obligation in a financial transaction. This can be based upon the instrument trades such as with a derivative or extend to the institution and, in some cases, systemic level.
Instruments that have counterparty risk:
The financial system works takes a number of steps to size up this risk. Credit score and bond ratings are two examples of attempts to provide investors (and lenders) with a quantified assessment of the risk situation.
Solvency
One of the biggest headline grabbers is when a financial institutions goes up. Companies such as Bear Stearns, Lehman Brothers, Long Term Capital Management, and MF Global all made news when they went under.
In the cryptocurrency industry, such names as Celsius, FTX, and Signature Bank also garnered a lot of attention through their failures.
The common denominator in all this is investors lost billions of dollars. They were caught when the insolvency of these entities was exposed.
Counterparty risk, in this regard, starts with the question will the entity be there to complete the financial obligation it has? In these examples the answer was no.
Regulation
Governments take steps to ensure confidence in the financial system. When dealing with money, finance, and the economy, trust is a vital factor. When it is lost, things can spin out of control.
Banks runs are a prime example of what can take place when trust is lost. If the solvency of a bank is questioned, depositors can be overrun with fear. The result is many people rushing to the different branches to pull their money. Under fractional reserve banking, this is a problem as banks do not keep deposits as vault cash.
The result of large numbers of people seeking to get their cash pushes the financial institution into a liquidity crisis. Without access to the money, the obligations are unfulfilled.
Regulation is the solution according to governments. Great pains are taken to write laws for financial institutions to follow. Regulatory bodies are also established to monitor the standing of these different companies and alert the public when things are questionable.
Another aspect is regulatory bodies also step in due to a lack of compliance. When these entities run afoul of the regulations, penalties can be assessed. This can include fines, suspensions, and, in some cases, jail time.
The track record of regulation at reducing counterparty risk is spotty at best. Financial institutions fail all the time in spite of being heavily regulated. At time, this is simply due to business practices that do not align with the market. Others are caused by fraud, poor risk management, and greed.
Insurance
Many seek to reduce counterparty risk by taking out some form of insurance against the financial activity that is being engaged upon.
An example of this is how the deposits in the United States are insured up to the amount of $250,000. During the Great Depression, as part of the Banking Act of 1933, the Federal Deposit Insurance Corp. or FDIC was established. This is a form of insurance that banks are required to have as a means of protecting depositors. The idea is that people should feel safe putting their money in banks, at least up to this level, since it is insured.
It is a situation that does not always work as planned. What we have here is simply moving the counterparty risk.
The Great Financial Crisis ended up with everyone at the door of AIG. This is where the United States Treasury had to step in and prevent collapse. It is also an example of where the insurance failed.
AIG sold credit default swaps. These typically apply to bonds but also are used for other securitized debt, such as mortgage backed securities (MBS). During the leadup to the Great Financial Crisis, the latter was rated on part as US Treasuries. This caused financial institutions throughout the whole banking, or Eurodollar, system to accept these as collateral.
Problems arose when the liquidity with some of the MBS dried up and institutions started to have difficulty valuing their funds. Suddenly, many questioned the true value of these things.
Under this scenario, a bank run resulted. Instead of depositors running to banks, it was the banks running around to be made good on the collateral.
Since AIG was the backstop since it was the insurer, its insolvency became a problem. The counterparty risk associated with the specific MBS was shifted to the ability (or inability) of AIG to pay in the credit default swaps it issued.
Insurance is worthless if the company providing it cannot make the payment.
Financial Products
This concept extends to many financial products. Some carry risk simply in how they are designed.
Credit default swaps carried additional risk since they are not traded on exchanges. Instead, this is a transaction between two parties. Anytime there is a bilateral trade, each party is taking a risk of the ability (or desire) of the other party to fulfill the obligation.
Annuities can also fall into this category. This is a fixed income instrument sold by insurance companies. They are considered low risk investments since there is no speculation involved. Where the risk enters is the solvency of the insurance company issuing the annuity. If that company is forced into bankruptcy, the annuity is likely worthless.
Blockchain
Cryptocurrency seeks to alter the counterparty risk discussion.
From the standpoint of money, this is designed to remove the risk associated with central banks, governments, and commercial banks. Bitcoin was introduced by Satoshi Nakamoto after the GFC as a means for people to remove themselves from a monetary system with so much counterparty risk.
The idea was to shift that to a decentralized blockchain where "code is law". As long as the mining spread out and no group was able to achieve a 51% attack, trust could be maintained in a trustless system.
A case could be made this addresses the currency issue. When we move to the financial product level, there is still great question. Many companies that are involved in cryptocurrency presented the same (or greater) risk than traditional ones. In this sense, DeFi is no different than TradeFi.
Individuals are still dependent upon the intermediaries. If they fail, which we saw on a number of occasions, money is lost. This could be a situation where DeFi was not truly decentralized. This is something the industry will have to address in the coming years.
Hive Backed Dollar (HBD)
The stablecoin market within cryptocurrency is being exposed as to offering counterparty risk in a few different ways.
Tokens such as Tether and USDC are backed by centralized institutions. This means there is a risk associated with the decisions they make. That, in turns, means the backing (reserve) carries risk as evidenced by Circle putting funds in Silicon Valley Bank. Finally, there is the risk of the application that individuals use to stake.
The Hive Backed Dollar (HBD) offers something different. This is a base layer coin meaning it is produced by the blockchain. There is also a way for coin holders to stake without going through an application or company. It is the process of moving it to the savings offered by the blockchain, which pays a interest. Since the blockchain is decentralized, the risk is associated with the blockchain continuing to run.
Here we see counterparty risk associated with a central backing or company removed from the equation.
Other aspects of DeFi can also bring this forward.