How Is Collateral Used to Manage Counterparty Risk in Bilateral OTC Derivative Trades?

In bilateral OTC trades, collateral is used to secure the obligations of the counterparties. The party that is "out-of-the-money" (i.e. has a negative market value in the contract) is required to post collateral, typically cash or high-quality government bonds, to the other party.

This collateral amount is adjusted daily based on the mark-to-market value of the derivative. If a party defaults, the non-defaulting party can seize the collateral to cover its losses, thus reducing its direct financial exposure to the defaulter.