How exchanges reduce counterparty risk
Derivatives exchanges are probably the most efficient way for market participants to eliminate their respective counterparty risk. They achieve this results through the combination of four main processes.
1. Derivatives exchanges act as central counterparties, meaning that traders in a contract do not face each other; they both face the exchange.
Exchanges are financial institutions of very high capitalization. More, they also have the power to establish their own rules (“self-regulated organizations“, or SROs), as well as the power to enforce these rules or to have them enforced.
2. Derivatives exchanges reduce the amounts at risk with variation margins (see Futures and Margins)
3. Derivatives exchanges require market participants to have a solid financial capacity.
Individual traders who do not meet these strict requirements must trade through a clearer, a solid financial backer, which will guarantees its payments.
4. The closing-out mechanism protects exchanges against default. The clearers and the members (traders) bear all the risks. (See Closing out mechanism)
Thanks to these processes, derivatives exchange guarantee their market participants they will receive their gains… or to be immediately liquidated and sued for the monies.