Counterparty Risk and its Impact on DeFi
Counterparty risk refers to the situation where one of the parties in a financial transaction fails to fulfill their commitments. In the traditional market, stocks, bonds, and derivatives carry counterparty risk. In addition, the delivery risk is considered in trading any physical goods or resources.
Summary:
- When centralized financial technologies fail, banks, local authorities, or judicial courts can intervene and, in most cases, remedy the situation. When decentralized finance fails, there is little to no accountability or redress.
- Getting hacked, losing users’ assets, or being confronted with other circumstances that would cause the exchange to default on its responsibility to hand over its customers’ assets on demand are all instances of counterparty risk.
- Even multibillion-dollar exchanges must rely on inefficient, delayed, and costly liquidity sources with considerable counterparty risk.
- Types of counterparty risks in DeFi include adverse selection and principal-agent conflict.
- FLUID is poised to become the liquidity aggregator of the future with a blockchain-based frictionless solution that uses the best-in-class MPC wallet, providing the highest throughput, ultra-low latency, ultra-low-cost, and zero counterparty risk.
Underestimation of counterparty risk led to the 2008 financial crisis. Banks lent mortgages to subprime borrowers who couldn’t pay off the loan, triggering adverse market events. The traditional finance system is centralized and aims to mitigate counterparty risk by introducing regulations through governments and institutions, and that is why, in 2008, many of the accountable parties for the crash faced jail and hefty fines.
It is a slightly different situation in the cryptocurrency markets. Although blockchain networks are fixed ledgers that can’t be maliciously altered, counterparty risk is still present in many aspects of the cryptocurrency industry. Moreover, the industry is still very underdeveloped, leaving a lot of space for any type of fraud or inefficiencies.
Counterparty Risk Exists in Cryptocurrency
Infrastructure and applications built on a blockchain technology base are emerging at an astronomical pace in 2022. Users can trade, store and stake their funds on hundreds of platforms. However, those platforms can differ in their architecture, such as centralized, decentralized, or hybrid structures, and can all be compromised due to the lack of cybersecurity best practices. Even with the best cybersecurity framework in place, platforms are still at risk and this is why cybersecurity teams in crypto need to be monitored 24/7.
Blockchain technology cannot be altered, but the applications built on blockchain technology are vulnerable to cyberattacks – a typical attack is a reentrancy attack, which occurs when a function makes an external call to another untrusted contract. The untrusted contract then calls back to the original function in an attempt to drain funds.
Since crypto’s inception, there have been countless hacks attempted on centralized and decentralized exchanges. In 2014, hackers stole over 850,000 BTC from Mt.Gox, a centralized exchange worth $460M. There are also innumerable examples of hacks and rug pulls for decentralized exchanges, which is a practice of fraud where an organized cell pumps up the price of a token and sells as many of the tokens as possible against the AMM liquidity pool before their price drops to damaging numbers. Conversely, regulation forbids these types of malpractices in the traditional finance world, and accountable parties are investigated and dealt with accordingly by local law enforcement.
When it comes to liquidity aggregation and counterparty risk, there are several aspects of the process that could impact counterparty risk, such as the quality of security of the counterparty platform we are trading against, the smart order router architecture, and the settlement solutions.
Counterparty Risk in Smart Contracts and DeFi
The automated nature of smart contracts can eliminate some of the transaction risk points where counterparty risk still exists. Blockchain technology allows smart contracts to work without the need to trust any party except the smart contract itself. Therefore, the security of a smart contract is a vital component when it comes to counterparty risk in DeFi.
Types of Counterparty Risks in DeFi
In DeFi, there are several forms of counterparty risks. Adverse selection and principal-agent conflict are two of the most typical prevalent cases in DeFi.
Adverse Selection: Adverse selection describes a situation wherein sellers have more information about a product’s quality than buyers or vice versa. In other words, it’s a situation in which asymmetric information, also known as information failure, is used.
Interest rates are transparent, open-source, and substantiated on the borrower side. Moreover, since the lending code is immutably stored on the blockchain, the methodology described perfectly translates to the final product. On the lending side, the present state of DeFi means that only overcollateralized loans can be made; adverse selection becomes purely a function of accurate collateral value, which is less of a concern when assets are liquid.
Principal-Agent Conflict: The principal-agent dilemma is a conflict in priorities between a person or organization and the representative authorized to act on their behalf. An agent may operate in a way that is not in the principal’s best interests. This conflict originates from a misalignment of incentives between those who invest in the platform, such as liquidity providers or lenders, and those who control it.
In this situation, a few active investors influence most platforms’ governance with high governance token stakes that have an aligned, long-term interest to support best practices for the platform’s health, much like the shareholders of a big firm. While many platforms transfer all risk to end-users, for example, by offering to exchange tokens without serving as a counterparty, others may take on some risk to ensure the platform’s long-term viability.
To better align objectives, a principal-agent problem may necessitate modifying the incentive structure, enhancing data flow, or both.
How does FLUID help?
Post-crisis laws need to be centrally cleared or bilaterally minimized using approved regulatory methods to limit counterparty risk. However, smart contracts and distributed ledger technologies may provide an easier answer.
The ability of exchanges and liquidity nodes to source liquidity across blockchains effectively, compliantly, and transparently remains a critical concern as the virtual asset, and the token market expands into a multi-trillion-dollar business. Today, even large multibillion-dollar exchanges rely on inefficient, delayed, and costly liquidity sources with considerable counterparty risk.
FLUID was created to disrupt these inefficient and opaque virtual asset liquidity providers with a blockchain-based frictionless solution that replicates institutional level liquidity aggregation in the global FX markets using best-in-class MPC wallet overlaid with blockchain technology. FLUID will achieve this by implementing mature A.I. and Machine Learning technologies into practice that the team developed in the past.
FLUID is also deploying a solution to address the issue of order cancellation in cross-exchange transaction execution, removing counterparty risk.
The capacity to do so opens up new win-win prospects for exchanges, liquidity nodes, and other pools of cross-chain liquidity, including increased operational efficiency, lower costs, increased capital utilization, improved end-user experiences, and new product development frontiers.
