What Happens When a Counterparty Defaults in a Smart Contract-Based Derivative Agreement?

In a smart contract-based derivative, a "default" is typically a situation where a position becomes undercollateralized. The smart contract is programmed to automatically handle this event without manual intervention.

When the collateral value drops below a certain threshold, a liquidation event is triggered. The smart contract allows a third-party liquidator to repay the debt and claim the collateral, often at a discount.

This automated process ensures that the position is closed before it becomes a loss for the protocol, effectively preventing a traditional default scenario.