How Do Smart Contracts Eliminate Counterparty Risk in Financial Derivatives?

Smart contracts eliminate counterparty risk by holding collateral or margin in an escrow-like mechanism on the blockchain. The contract code dictates the automatic execution or settlement of the derivative based on predefined conditions, removing human discretion.

Since the funds are locked and the rules are immutable, neither party can default or fail to honor the agreement. This mechanism ensures that the financial obligations are met instantly and trustlessly upon trigger.

This is a major advantage over traditional Over-The-Counter (OTC) derivatives.