The blockchain and its distributed ledger technology has moved far beyond the cryptocurrency world. Businesses far and wide are taking advantage of peer-to-peer value transfer with exceptional fault tolerance. Because every participant gets an exact copy of the same data, this allows for almost real-time transfer of information or assets without having to go through an intermediary. However, there is a degree of blockchain liquidity risk associated with distributed ledger technology. It often has to do with counterparty risk.
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What Is Liquidity?
A simple way to explain liquidity in commercial or interpersonal transactions is this. How easy is it to convert an asset into cash? And how easy is it to do so without affecting its market value? In the world of traditional finance this can be an issue with real estate, stocks, fine art, or other collectables. Part of the liquidity issue has to do with how big the market is for a given asset. Another part has do to with the buyer paying what they promised when the time comes to pay. In the stock market this is called counterparty risk. It is handled by an intermediary who guarantees the transaction and makes payment even when one of the parties defaults on their obligation.
Who Handles Blockchain Counterparty and Liquidity Risk?
Intermediaries in traditional finance commonly protect the parties in a deal or transaction against counterparty risk. They typically are involved in resolving disputes. No matter what the terms of a smart contract are, someone on the other side of the world may not pay according to the terms of the contract when payment is due. There is no counterparty risk entity within the blockchain system to help resolve disputes. There is no entity in the blockchain system to insure contracts against loss in such situations. Folks like the Bank of International Settlements have warned of this risk in the blockchain system.
The Blockchain Helps Manage Risks
In many cases, use of blockchain technology reduces or even eliminates business risk. IBM explains the risk reduction benefits of blockchain technology. A simple but very important benefit is the reduction of paperwork and therefore the reduction of errors in an accounting system. When everyone gets the same information throughout the network, small but critical errors do not seep in and create recurring problems. The risk of fraud is virtually eliminated in a system in which data is copied to multiple locations so that one person cannot change one record to order to steal money or modify critical information.
How Can You Manage Blockchain Liquidity and Counterparty Risks?
Counterparty and liquidity risks have been around ever since people have made agreements to buy and sell things. The Romans said, let the buyer beware (emptor caveat). In the current era we often say that if a deal is too good to be true is very likely not true and not a good deal. Blockchain technology along with cryptocurrencies allow us to do business with anyone, anywhere in the world. It does not allow us to vet them. In other words, before entering into a business arrangement with another party it is wise to carry out a background review of the company, individual, or other entity. As a rule blockchain technology is of no help in doing this. Common sense is very often the best guide along with the willingness to walk away from a deal that you cannot be absolutely sure of.
SlideShare Version – Blockchain Liquidity Risk