Counterparty Risk and How to Minimize It
You’ll often hear people talk about government bonds as a “risk-free” asset. That’s because you’re guaranteed to get your money back – as long as the government exists and remains solvent. Since governments rarely just disappear or default on their debt, there is an extremely low likelihood you will lose your investment in a government bond.
But that likelihood isn’t zero. Therefore it is not truly a “risk-free” asset.
In fact, government bonds share one characteristic with most investment assets; they come with some level of counterparty risk.
What exactly is counterparty risk?
In a nutshell, it is the risk that a person or institution on the other side of a transaction might not fulfill its obligation.
Consider government bonds. When you buy a bond, you assume the government will pay interest and return your invested money at the end of the bond’s term. But a government could be overthrown, or it could accumulate so much debt that it can’t repay all of its bondholders. That’s the counterparty risk.
Most investment transactions come with some degree of counterparty risk. When a company issues stock, that company could go bankrupt. That’s counterparty risk. Even government-issued fiat currency has counterparty risk. People who have old Zimbabwe banknotes know this to be true.
Gold and silver have no counterparty risk.
In fact, if you own physical gold or silver, there is no other party involved. No counterparty means no counterparty risk. Precious metals don’t depend on any people or institutions to give them value. Nothing behind gold and silver can fail to render them valueless. In a nutshell, gold and silver are liquid under all market conditions.
Gold and silver are tangible assets that you can hold in your hand. They can be bought and sold all over the world. Their value is recognized globally. While the price of gold or silver may fall, it will never fall to zero. Precious metals can’t default on their payments, they can’t commit fraud, and they can’t go bankrupt.
When I say gold and silver have no counterparty risk, it’s important to remember that I am talking about physical gold and silver that remains in your possession. If you buy a gold or silver ETF (paper gold and silver), you assume that the issuer of the ETF has the physical metal to back the paper on hand. It may or may not, and that introduces counterparty risk.
You also take on counterparty risk when you store your gold and silver with a third party. It is possible for that third-party storage entity to commit fraud, get robbed, or be destroyed by an act of god. While the counterparty risk introduced by storing your gold and silver with a third party is relatively low, it does exist. You have to weigh that risk against the risk of storing large amounts of metal in your home. You can find reliable third-party storage options HERE.
In a world fraught with counterparty risk, holding physical gold and silver as part of your investment portfolio will help you hedge against that risk.