How Is Counterparty Risk Mitigated in Smart Contract-Based Derivatives?
Smart contract-based derivatives mitigate counterparty risk by removing the need to trust a central counterparty. Instead, trust is placed in the code of the smart contract, which is transparent and executes automatically.
These contracts require parties to lock collateral into the contract upfront. The smart contract then manages this collateral, automatically liquidating positions if they become undercollateralized.
This ensures that obligations are met without relying on the solvency or honesty of the trading partner.
Glossar
Collateralization
Meaning ⎊ Collateralization is the act of pledging an asset or pool of assets to secure a financial obligation, such as a loan, a margin trade, or a derivative position.
Transparency
Principle ⎊ Transparency in a public blockchain context means that all transactions, contract code, and network activity are openly recorded and auditable by any participant.
Derivatives
Instrument ⎊ Derivatives are financial instruments whose value is intrinsically linked to, or "derived" from, an underlying asset, benchmark, or rate.
Counterparty Risk
Exposure ⎊ Counterparty risk represents the potential loss incurred when a trading partner defaults on their contractual obligations.
Blockchain
Architecture ⎊ A blockchain represents a distributed, immutable ledger system, fundamentally designed to record transactions across a network of computers.