On Counterparty Risk

They say that there’s no such thing as a deal without Counterparty Risk. Investopedia defines this as:

the likelihood or probability that one of those involved in a transaction might default on its contractual obligation.

Generally this concept applies to contracts between consenting parties. However, there are a few less-intuitive examples that conceivably fit under this umbrella which I find interesting and thought-provoking. Together, the following 9 scenarios prove that you can never eliminate risk.

(1) Walking down the street

Risks:

  1. Acts of God such as being mauled by a bear or hit by a meteor.
  2. Human error or judgment in a lose-lose scenario, such as someone losing control of their car and swerving to hit you (MIT).
  3. De facto theft, such as you get charged with trespassing and fined, your credit gets docked because they didn’t inform you about the fine, and it takes years to challenge the damages in court.
  4. The State doesn’t enforce property rights: they decide to repossess your property (without due process), declare that what you believed was your property isn’t actually yours, or sell you off into slavery.
  5. Crime, terrorism, civil conflict, and war.

(2) You hold assets at home under your mattress

Including money, jewelry, and artwork.

Risks:

  1. The physical items get burned in a fire.
  2. You get robbed or forced to reveal the assets’ locations to a robber.

(3) You insure your property

Risks:

  1. The insurance company goes bankrupt.
  2. The insurance company refuses to pay by unilaterally declaring your case isn’t covered by the contract; the State doesn’t force the company to pay out (or it takes years to go through trial).

(4) You store your property in a vault

Risks:

  1. The State can confiscate it legally.
  2. Theft by the vault owner or a third-party robber.
  3. The vault closes and it takes years to repossess your property.

(5) You entitle your assets to a bank

Including storing your money in a checking/savings account.

Risks:

If your assets are above the FDIC insurance limit:

  1. You may be subject to either lose the money completely or a bail-in (Cyprus).

If your assets are below the FDIC insurance limit:

  1. The bank may close and it takes years to repossess your property (SVB, SVB).

  2. The FDIC goes bankrupt.

Also:

  1. A private third-party may enforce a lien against your property, and the bank may comply to give it up without your consent.

  2. The State may decide to re-value what your assets are worth (via a CBDC).

  3. Theft by the bank.

  4. The bank refuses to give the paper dollars to you (Australia).

(6) Subscription services

Reminiscent of the phrase “You’ll own nothing and be happy.”

Risks:

  1. You “purchased” a movie on a streaming service and can no longer access it because your account was suspended.
  2. A company deactivates your devices on a whim (Maryland, US).
  3. Your bank account gets frozen (Canada).
  4. Police can commandeer your smart phones (France).

(7) You are an W-2 employee of a company

Risks:

  1. The company refuses to pay you on time (which is de facto theft since it’s effectively a mandatory loan with a zero interest rate).

(8) You contract with another party

This is the standard definition of “counterparty risk.”

Risks:

  1. The other party refuses to uphold their end of the agreement while you upheld yours.
  2. The other party defaults on a bond or options agreement you purchased from them.

(9) You buy a house

This may be an example of risk, not necessarily counterparty risk.

Risks:

  1. The housing market crashes.
  2. The house was a lake-front property on a man-made lake held up by a dam which breaks, draining the lake and devaluing the home (Michigan, US).
  3. Your homeowners insurance company decides to cancel your contract because you live in too inhospitable of an area.

(10) You own a credit card

Risks:

  1. You can’t pay your bills on time because the internet/electricity went out.
  2. You can’t legally buy assets (such as gold or stocks) with a credit card.
  3. Your bank arbitrarily cancels your oldest card, thus reducing your average credit history and lowering your credit score.
Written on July 10, 2023