Remember that social studies project from middle school? The teacher split the class into groups. You landed in a team of slackers, nobody did their part. In the end, you were left holding the bag as the project started to crumble. This was the first time you experienced counterparty risk.
Nearly all financial instruments carry counterparty risk. When you engage in a contract with another group (“party”) you always face the risk of the other side failing to meet their obligations. Stocks, bonds, derivatives and options all carry this risk because there is always a chance that the other side will default. In such a scenario a company may file for bankruptcy.
There is a spectrum to risk. Investors can rely on various ratings and figures to help them gauge where an investment falls on this scale. However, even this system can breakdown. The most recent and painful example was the 2008 financial crisis. Well-respected rating agencies like Moody’s, Fitch and S&P all gave the highest possible rating (AAA) to mortgage-backed securities made up of subprime loans. These wildly optimistic ratings were not just a failure of the agency’s rating models. In many cases bond issuers paid the agencies. Some have highlighted this practice as an example of collusion. Investors, misled by these ratings, lost billions.
So, where is the market today?
Some believe today’s stock market is characterized by heightened counterparty risk given the outsized valuations amid constantly rising stock prices. Recently, The World Bank showed that the total U.S. stock market is valued at 150% of annual gross domestic product. This figure is far north of the historical measurement. Moreover, the figure bears an uncomfortable resemblance to the state of the market in 2000 prior to a sharp drop in values. What does an investor do? Where do they go?
Gold offers a rare departure from this inherent problem in investing because it carries no counterparty risk. When you own the physical asset of a rare, precious metal, you own something that isn’t in the hands of rating agencies. There is no threat of unscrupulous CEOs or backroom dealings that leave the investor out in the cold.
As we’ve discussed before, it’s important for investors to remember that counterparty risk does not go away when you own gold ETFs. “Physical gold is a tangible asset. Paper gold is a financial instrument,” astutely remarks Business Insider. They continue, “You must rely on another party – known to you or not- to make good on the investment. With a gold ETF, you are dependent upon, among other things, management prowess, fund structure, chain of custody, operational integrity, regulatory oversight and delivery protocols.” That’s a long list for an investor seeking a haven investment.
If there’s one party you want to skip once and awhile it’s the counterparty.
Some measured exposure to counterparty risk is an acceptable characteristic of a diverse portfolio. However, all investors need to ask themselves if they’re comfortable with all of their holdings being subject to this darker side of the market.