IOUs on the Blockchain: Unpacking Counterparty Risk in Crypto

The concept of IOUs (I owe you) is not new to finance, but its significance has come to light in the cryptocurrency and decentralized finance (DeFi) space. An IOU represents an informal acknowledgment of debt, where one party owes a specific amount to another without the legal structure of a formal bond or promissory note.

When you deposit funds into a bank, for example, you don't own cash; you have an IOU from the bank promising to return that amount on demand. The same principle applies in crypto, where exchange balances are IOUs from the exchange, and users who hold their assets in non-custodial wallets have direct ownership.

The collapse of FTX in November 2022 highlighted the risk associated with holding funds in custodial exchanges. Customer balances were essentially worthless when FTX became insolvent because they were IOUs that could not be honoured.