When the counterparty does not honor the agreement: understand the risk you are taking

Why does this matter to you?

In the world of investments, there is a scenario that every trader fears: the other party simply cannot ( or does not want ) to fulfill what they promised. This is what we call counterparty risk, and it is everywhere – from banking transactions to operations in DeFi. Whether you are an individual investor, a financial institution, or even a government, having to deal with this possibility is practically unavoidable.

The central question is simple: how to ensure that those who are supposed to receive the money actually will? And if they do not receive it, what to do? Understanding this risk and knowing how to protect oneself has become essential to maintain the health of the financial system and one’s investments.

What causes counterparty risk?

The root of the problem is insolvency or default. When a counterparty finds itself unable to meet its financial commitments, the reasons can vary widely: inadequate financial management, economic crises, operational failures, legal disputes, or even deliberate fraud. In extreme scenarios, the counterparty simply does not have enough resources to fulfill the agreement.

In practice, risk does not only come from malicious behavior. Often, it is simply the economic reality that changes and the other party is no longer able to meet their commitments.

A concrete example: the case of Alice and Bob

To make it clearer how this works in practice, let's consider a real scenario on a DeFi platform:

Alice decides to lend ETH to Bob through a smart contract. The details are as follows: Bob offers tokens A worth $1,000 as collateral and receives $700 in ETH in return. At first glance, Alice is protected because she has collateral worth 43% more than her loan.

But then comes the market volatility. The price of token A drops drastically – let's say, to $500. Suddenly, the collateral no longer covers even half the value of the loan. If Bob cannot ( or does not want ) to redeem his debt, Alice will be exposed to a significant loss.

Smart contracts generally have protective mechanisms, such as automatic liquidation when the collateral drops to $850. However, even these systems are not fail-proof – liquidation may not happen quickly enough, leaving Alice vulnerable. This is a classic example of counterparty risk in the crypto environment.

How to assess and reduce this risk?

Assessment of payment capacity

The first step is to analyze the financial health of the counterparty. This includes examining credit ratings, financial statements, debt ratios, cash flow patterns, and industry outlook. A high payment capacity means low risk; a weak capacity signals caution.

Don't put all your eggs in one basket

Concentration of exposure to a single counterparty ( or in a small group ) amplifies the risk. The standard recommendation is to limit exposure to about 10% to a single counterparty, although in practice these limits vary depending on the context and the institution.

Diversifying among multiple counterparties is one of the most effective strategies to reduce overall risk.

Well structure your contracts

The agreements must include specific protections: collateral requirements, margin calls, and termination clauses. These provisions create a buffer against potential losses and provide pathways for mitigation in case of issues.

Use collateralization as a shield

Requiring the counterparty to provide assets as collateral (cash, securities, cryptocurrencies) is one of the most direct forms of protection. In case of default, these assets can be liquidated to cover losses.

Constantly monitor

Continuous monitoring of the financial health of the counterparty helps to detect warning signs early. If concerning indicators arise, proactive actions such as reducing exposure, renegotiating terms, or seeking alternative counterparties can prevent greater losses.

Final considerations

Counterparty risk is not something that disappears – it is a permanent aspect of any financial transaction. The key is to recognize it, assess it appropriately, and implement robust protection strategies. In environments like DeFi, where trust is distributed and settlement is automatic, there are still gaps. Active and intelligent management of this risk is what separates cautious investors from inevitable losses.