Impossible Finance — “The Counterparty-Free Asset”
XRP is a public, counterparty-free asset native to the XRP Ledger[i]
One of the many ideas propagated to sell cryptocurrencies is the idea of a counterparty-free asset. The general idea is that if there is no “counterparty” who can fail to pay you back what is owed, an asset is inherently less risky and generally better than old fashioned financial assets such as bonds, shares and bank deposits. However, does this in anyway make economic sense? Do even the words “Counterparty-free asset” make literal sense or are we dealing with another example of Impossible Finance?
The strict definition of a counterparty is, the other party taking part in a financial transaction. You are exchanging dollars for yen and agree a trade. Your counterparty is the party selling you yen in exchange for your dollars. In capital markets the term counterparty is often used in a narrower way. A large financial institution may be in the FX business. When they sell foreign exchange to existing bank account holders, the other side of the transaction would be more commonly referred to simply as a “client”. The concept that the other party in a financial transaction is a client brings lots of obligations in most jurisdictions about treating them fairly. When trading with a market counterparty such as another bank it is “buyer beware”, both parties need to keep their wits about them and there is little concept of fairness.
Given the meanings applied to counterparty in the world of conventional finance it curious to say the least, to have an asset described as “counterparty-free”. Financial assets do not have counterparties. There will generally be a counterparty in a trade to buy or sell an asset but the asset itself does not have a counterparty. Instead of counterparties financial assets have “issuers”. Does this semantics even matter? An asset with there is no risk of the issuer failing to meet its obligations must be a good thing?
Issuers sell securities such as bonds and shares that imposes a variety of legal obligations on them in relation to the owners of the securities. These can relate to obligatory payments for bonds and generally optional payments (dividends) and ownership rights in relation to equities. Securities may be bought when initially issued via an underwriter or later bought from a third party in what is the essentially the second hand markets of stock exchanges, trading desks and electronic trading platforms.
If you buy a bond (that has an issuer), engage in a capital markets trade (with a counterparty) or make a loan/deposit (to what is termed an “obligor”) the common risk is actually called “credit risk”. This is the risk of not get paid funds contractually owed to you. With a classic cryptocurrency such as Bitcoin, Litecoin or XRP (aka Ripple) owning the asset gives you no rights whatsoever of any kind. No ownership rights such as shares, no rights to receive funds and there is certainly no “counterparty”. But the ownership of a financial asset does not involve a counterparty either. You may as well refer to a cryptocurrency as a banana-free asset because there are no bananas involved (apologies if I have unknowingly libelled the issuers of Bananacoin). Perhaps cryptocurrency promoters are simply using language imprecisely because of a lack of understanding of real-world finance and actually meant a “credit-risk free asset”.
Surely it must be a good thing to have a credit risk free asset? Some classes of investment have no direct credit risk. If you physically own commodities, property, shares there is no real credit risk, just the risk that the value of the asset of fluctuates up and down, mostly depending on supply and demand. This is called market risk. Even financial assets where there is credit risk will typically be subject to market risk as well. Owning a bond exposes you to the risk the issuer goes bust but it always exposes to the risks that overall interest rates move up or down affecting the relative value of the bond as well multiple other factors influencing market sentiment. Market risk can just as easily, perhaps more easily, wipe out your investment as credit risk. So being free of credit risk does not mean you have a safe investment or even a good investment.
Credit risk is in fact not an inherently bad thing. If a financial asset has credit risk, it means your asset is someone else’s liability i.e. someone is legally obliged to pay you what they promised. A financial asset that does not have intrinsic value like property or commodities and does not have someone who is legally obliged to pay your money in the future is an extremely strange thing. An asset without being a liability, something whose base value is zero. As we have seen over the decade of the cryptocurrency madness and the millennia of investment bubbles and scams, fools can rush into an asset class for a period, no matter how worthless or corrupt it is. Giving worthless (or grossly over-hyped) assets a tradeable price but not a real value. Typically, during that period between the madness starting and the bubble completely bursting (or the organisers being imprisoned) assets without inherent value or an issuer/obligor tend to fluctuate wildly, if not insanely in price.
So, what is the verdict on a counterparty-free asset? A clear case of Impossible Finance and as meaningful as selling banana-free assets, unless of course you don’t like bananas.
