How Does a Clearing House Mitigate Counterparty Risk in a Derivatives Trade?
A clearing house mitigates counterparty risk through a process called novation, where it legally substitutes itself as the buyer to every seller and the seller to every buyer. This means the original parties no longer bear the risk of the other party defaulting; their counterparty is now the financially secure clearing house.
Furthermore, the clearing house requires both parties to post margin, which acts as collateral to cover potential losses from adverse price movements, creating a financial buffer against default.
Glossar
Counterparty Risk
Exposure ⎊ Counterparty risk represents the potential loss incurred when a trading partner defaults on their contractual obligations.
Clearing House
Settlement ⎊ A clearing house, within cryptocurrency and derivatives markets, functions as an intermediary between buyers and sellers, mitigating counterparty risk through a process of novation ⎊ replacing original trade agreements with new ones directly with the clearing house.
Financial Buffer
Reserves ⎊ A financial buffer, within the context of cryptocurrency, options trading, and derivatives, represents a strategically allocated pool of capital designed to mitigate adverse market movements and operational risks.
Financial Derivatives
Stewardship ⎊ Involves engineering these contracts to explicitly manage or incentivize positive externalities, such as climate risk exposure or carbon credit valuation.