How Does Counterparty Risk Differ between Custodial and Non-Custodial Exchanges?

On a custodial exchange, counterparty risk is concentrated on the exchange itself. If the exchange becomes insolvent or suffers a security breach, users can lose their funds because the exchange holds their assets.

For non-custodial exchanges, the risk is shifted from a central entity to smart contracts. While this eliminates the risk of the exchange failing, it introduces smart contract risk, where a bug or exploit in the code could lead to a loss of funds.

Users do not face the risk of the exchange itself being a failing counterparty.