Counterparty risk is the likelihood of a party defaulting on its obligation in a transaction.
The risk-free illusion
Everything in life involves risk. Everything.
What matters is how you manage it: mitigate or eliminate.
Counterparty risk must be taken especially seriously because, even if you believe the likelihood of default to be low, the possibility of severe and permanent loss is introduced into the equation.
Buying government bonds with a guaranteed nominal return works because the risk can be hidden in real terms. The is also the remote possibility that the issuer defaults (something that has only ever happened to Germany, Greece, Lebanon, Argentina, Sri Lanka, Croatia, Brazil, Ukraine, Russia, The Philippines, Poland, Panama, Turkey, Ghana, Kenya, Vietnam, Japan, Hungary, Spain, Romania, Australia, Chile, etc.)
What you choose to store your value in is equally important. Because not all forms of money are created equal. Perhaps a good time to revisit this concept from Nik Bhatia's book Layered Money.
"If you have Bitcoin on an exchange or custodian, you don't have bitcoin." —Stephan Livera
Bear in Mind
Bitcoin is digital bearer money that can be transacted peer-to-peer without a third party to mediate the exchange. This also means that it can be self-custodied, eliminating counterparty risk entirely.
Yes, risk of permanent loss still exists (remember: everything involves risk!), but it's a factor that is within your control. The option exists to employ a personalized self-custody scheme that fits your needs, objectives, and value being secured.
And unlike other bearer instruments (i.e., cash or gold), the costs of storing and securing it do not scale with the amount held. Billions of dollars of value can be stored in a sequence of 12 words on a single piece of paper (although inadvisable).
The important thing here is that self-custoding your bitcoin holds the entire system to a higher standard: wiping out the fractional-reserved and over-leveraged players in bear markets and cementing the on-ramps and service providers that do not require rehypothecation as part of their business model.
As always, practice safe stacks.
"The riskiest way to use financial systems is to assume counterparty risk doesn't exist just because you haven't been burned... yet." —Lopp