Central Counterparty
Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile than their underlying asset. This can lead to credit risk, in particular counterparty risk, those situations where one party to a trade loses a big sum of money and is unable to honor its settlement obligation. In a safe trading environment, the parties to a trade need to be assured that their counterparty will honor the trade, no matter how the market has moved. This requirement can lead to messy arrangements like credit assessment, setting of trading limits and so on for each counterparty, and take away most of the advantages of a centralised trading facility. To prevent this, a clearing house interposes themselves as counterparties to every trade and extend guarantee that the trade will be settled as originally intended. This action is called novation. As a result, trading firms take no risk on the actual counterparty to the trade, but on the clearing corporation. The clearing corporation is able to take on this risk by adopting an efficient margining process.
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