What Role Does Collateral Play in Mitigating OTC Counterparty Risk?

Collateral, typically in the form of cash or highly liquid securities, is exchanged between OTC counterparties to secure the derivative exposure. This collateral acts as a financial buffer, ensuring that if one party defaults, the non-defaulting party can seize the collateral to cover any losses.

Regular exchange of this collateral, known as variation margin, ensures that the exposure is covered in real-time, drastically reducing the potential loss from a counterparty default.