How Does Counterparty Risk in a Derivatives Trade Differ When Using a Smart Contract versus a Traditional Contract?

In a traditional derivatives trade, counterparty risk is the risk that the other party will default on its obligations. This risk is typically managed by intermediaries like clearing houses that require collateral (margin).

A smart contract mitigates counterparty risk by locking the required collateral from both parties into the contract from the outset. The contract then automatically executes the settlement based on predefined rules, ensuring that the obligations are met without relying on the counterparty's creditworthiness or the need for a central intermediary.

The risk shifts from counterparty default to the security and correctness of the smart contract's code.