What The Crypto Carnage Can Teach You About Counterparty Risk

Sometimes it takes something pretty drastic to wake us up to the reality of a situation. Getting puffed out walking up the stairs can give us the kick we need to get fitter and healthier. A particularly terrible day at the office can force us to dust up the CV and start looking for other jobs.

Or in the case of our finances, the near-collapse of an entire market segment can make us think twice about the stability of the companies we hand our cash over to.

What are we referring to here? We’re talking about FTX, crypto in general and the importance of understanding counterparty risk.

What is counterparty risk?

As with many things in the finance sector, it’s a fairly complex sounding term which is used to describe something that is pretty fundamental.

Counterparty risk is the probability that the company or organisation you give money to will default on their obligations.

So when you give some money to a bank or financial institution to hold for you, you get a return back in the form of interest. However, there is a chance that they will go bankrupt, and you could lose some or all of your money.

That’s counterparty risk.

Crypto and counterparty risk

Generally speaking, counterparty risk becomes more relevant the wealthier you are, and gains more attention when the economy is volatile. Investors were happy to take big risks for big returns without worrying about it prior to 2008. When the financial crash came, all of a sudden they became a lot more interested in the financial stability of their banks and investment firms.

We’ve seen something similar play out in crypto, but on a more extreme scale.

With eye-watering ‘interest rates’ on offer (sometimes as high as 18%, supposedly ‘low risk’) from various exchanges and platforms, investors have been piling money in as an alternative to rock bottom bank interest rates.

As we’ve seen in the case of companies like Celsius and FTX, it’s been, at best, totally mismanaged, and at worst, an outright scam.

There’s a reason the rates on offer have been so high, and that’s because the counterparty risk is just as high too. Of course this is difficult for investors to understand, with the well-funded crypto companies doing a very good job at portraying an image of trust and professionalism.

The reason counterparty risk is so much higher in the crypto space is because there are no rules. At least, not in the same are rules for the mainstream finance sector. There’s no regulation on digital assets. Companies like FTX can create a currency out of thin air, assign it a value and use that made up asset as security for loans.

There’s no FCA or SEC looking through the books to make sure the accounting is up to scratch. There are no disclosure requirements for the companies to stick to. Supposedly, outright fraud is still punishable, but amongst the spaghetti bowl of linked intermediaries and sub accounts it is incredibly difficult to ascertain the line between illegal and simply inept.

How to manage counterparty risk

So handing over your money to a three year old crypto startup based in the Bahamas, run by a group of people all under the age of 30 living together in a mega mansion and allegedly regularly taking amphetamines turns out to be a bad idea.

Noted.

But back in the real world, is counterparty risk really something to be concerned about? If so, how do you manage it?

Understand the counterparty’s financial position

It’s always worthwhile knowing and understanding the stability of the company who you’re placing your money with. In the mainstream financial system, this is far easier to ascertain than in the crypto world.

Banks and regulated investment funds have very strict and specific requirements that they need to meet in order to continue to do business in major economies like the US, the UK and throughout Europe.

Given that almost all of these companies are publicly traded, they also need to report  quarterly and provide a breakdown of their assets and liabilities, plus other details such as their profit margins and liquidity ratios.

Not only that, but in the aftermath of the 2008 financial crisis, major legislation has been passed to limit the chances of a similar event occurring again. Banks are required to hold a far greater level of capital to secure their lending and business practices, as well as undertaking stress testing to ensure that they could remain solvent in the event of a similar event.

These international standards, known as the Basel Accords, have so far proven to be a major benefit in improving the stability of the global banking system.

You don’t necessarily have to do all of this research yourself, but it’s important to have the conversation with your financial advisor to make sure that they do it on your behalf for your investments.

When it comes to the banking you do personally, you also have an additional layer of protection within the traditional financial system.

The Financial Services Compensation Scheme

In the UK there’s an added layer of protection for savers. The UK government’s Financial Services Compensation Scheme (FSCS) provides individual protection for up to £85,000 per financial institution, should they go bust.

So if you have £60,000 in a bank account and that bank goes under, the UK government will reimburse you your £60,000, or any shortfall amount that you’re unable to to claim back from the bank.

If you had £100,000 with that same bank, the FSCS would cover only up to the first £85,000, meaning you’d lose the rest.

An important distinction with the FSCS is that it’s based on each banking group rather than banking brand. So for example, subsidiaries of the NatWest Group include Coutts, RBS and NatWest. This means if you had accounts with all of them, you will only have protection for a total of £85,000 across all three banks.

Many other countries have similar schemes, such as the Federal Deposit Insurance Corporation (FDIC) protection in the United States or the Hong Kong Deposit Protection Board.

The FSCS technically applies to investments as well, but in reality it doesn’t really provide protection in the same way. Here’s why.

Who actually holds your money?

An important step in assessing counterparty risk is knowing who actually holds your money. In the case of a bank, that’s usually pretty easy. With investments, it’s a bit different.

Take Rosecut, for example. We manage investments on our clients behalf, but we don’t actually hold that money on our balance sheet. The funds are passed from you, directly into specific investment assets and funds.

When the funds are invested into ETFs, stocks and bonds, counterparty risk doesn’t apply. Say you’re investing money into NatWest stock. You could still lose it all if NatWest were to go bankrupt, but this is investment risk, not counterparty risk.

When you’re investing, you are accepting the potential risk of losing your money as compensation for the potential long term returns. Investing in a company and depositing money with a company are two very different things, and it’s important to understand the difference.

So yes, technically the FSCS applies to investment accounts, but the true application of this is very narrow. Most commonly it’s there to protect any funds held in cash on an investment platform.

For example, if an investment portfolio is worth £250,000 and there is 5% of the holdings in cash, that means there is £12,500 cash sitting in a bank account designated to that investor. It’s that amount which is protected under the FSCS.

There are some edge cases where the protection is more relevant, such as Structured Deposits, but these are pretty niche and not widely used.

What Happens If Your Investment Platform or Financial Advisor Goes Bust?

As an investor, you have a significant amount of protection from counterparty risk for your investments in the UK.

When a client decides to do business with us at Rosecut, it’s important to understand that this is an advice based relationship. We provide investment and strategy advice, which includes a range between which we can move your money into different assets. It means we can shift your equity component from US stocks to Uk stocks or from stocks to cash, but we never actually handle our clients' money.

At no point in the process do our clients' investment funds sit on the Rosecut balance sheet, meaning there is no counterparty risk with Rosecut. 

When you invest with Rosecut, the funds are transferred directly to one of the 3 custodian banks we use. This is different to opening an account with a regular bank, because the assets don’t sit directly on the bank's balance sheet and by law it must be kept segregated.

So for example if you had transferred £200,000 to Barclays for investment and Barclays went bankrupt, your funds would be protected. If that £200,000 was simply sitting in a retail Barclays bank account, they wouldn’t be (outside of the FSCS limit).

This is the same for when the funds are invested into various ETFs, stocks, bonds and other assets. These assets are held by the investment platform, but on your behalf. If the platform goes bust, they aren’t able to use your assets as security for any of their own liabilities.

All of this regulation creates a huge level of protection from counterparty risk.

In the event of the failure of your investment platform or financial advisor, a new one would be appointed, and your investment funds would remain in the markets the whole time.

Steps you can take to manage counterparty risk

By now hopefully you’ve got a better understanding of what counterparty risk is and how you can manage it within your own finances. Here is a summary of what you need to do to make sure that some guy with an afro living in the Bahamas isn’t able to walk off with your funds.

• Review the investment platforms you use and ensure they are all authorised and regulated by the government body in the country they’re in. In the UK, that’s the FCA, in the US it’s the SEC.

• For any assets in an unregulated asset class, such as crypto and NFTs, or other alternatives like whisky, assess whether this is money you could afford to lose. There’s nothing wrong with investing in high risk assets, as long as you understand there is a chance you could lose everything you invest.

• Calculate how much you have allocated to each bank you hold cash with. If this is below £85,000 per financial institution in the UK, that’s great. If not, consider spreading your assets across multiple banks.

• We don’t advise holding large amounts of cash for long periods of time. However, if you find yourself holding a large amount of cash for a specific reason, for example after selling a business and while you’re looking for reinvestment opportunities, you can also consider NS&I. 

These are deposit products offered by HM Treasury, which means they are fully protected by the government, even for amounts above £85,000. Some NS&I accounts allow you to hold up to £2 million. 

If you’d like a comprehensive review of your current level of counterparty risk, get in touch. We can review and assess your current asset allocation and provide recommendations on changes that can help secure your assets.