What happens after a counterparty defaults on a derivative trade?
"The answer is in your question: derivatives are contracts so are enforced in the same way as any other contract.  If the counterparty refuses to pay immediately they will, in the first instance be billed by any intermediary (Prime Broker etc.) that facilitated the contract. If they still refuse to pay the contract may stipulate that a broker can ""net off"" any outstanding payments against it or pay out using deposited cash or posted margins. The contract will usually include the broker as an interested party and so they can, but don't need to, report a default (such that this is) to credit agencies (in some jurisdictions they are required to by law). Any parties to the trade and the courts may use a debt collection agency to collect payments or seize assets to cover payment. If there is no broker or the counterparty still has not paid the bill then the parties involved (the party to the trade and any intermediaries) can sue for breach of contract. If they win (which would be expected) the counterparty will be made to pay by the legal system including, but not limited to, seizure of assets, enforced bankruptcy, and prison terms for any contempts of court rulings. All of this holds for governments who refuse to pay derivatives losses (as Argentina did in the early 20th century) but in that case it may escalate as far as war. It has never done so for derivatives contracts as far as I know but other breaches of contract between countries have resulted in armed conflict. As well as the ""hard"" results of failing to pay there are soft implications including a guaranteed fall in credit ratings that will result in parties refusing to do business with the counterparty and a separate loss of reputation that will reduce business even further. Potential employees and funders will be unwilling to become involved with such a party and suppliers will be unwilling to supply on credit. The end result in almost every way would be bankruptcy and prison sentences for the party or their senior employees. Most jurisdictions allow for board members at companies in material breach of contract to be banned from running any company for a set period as well. edit: netting off cash flows netting off is a process whereby all of a party's cash flows, positive and negative, are used to pay each other off so that only the net change is reflected in account balances, for example: company 1 cash flows netting off the total outgoings are 3M + 500k = 3.5M and total incomings are 1.2M + 1.1M + 1.2M = 3.5M so the incoming cash flows can be used to pay the outgoing cash flows leaving a net payment into company1's account of 0."
"I experimented with Lending Club, lending a small amount of money in early 2008. (Nice timing right - the recession was December 2007 to June 2009.) I have a few loans still outstanding, but most have prepaid or defaulted by now. I did not reinvest as payments came in. Based on my experience, one ""catch"" is lack of liquidity. It's like buying individual bonds rather than a mutual fund. Your money is NOT just tied up for the 3-year loan term, because to get good returns you have to keep reinvesting as people pay off their loans. So you always have some just-reinvested money with the full 3 year term left, and that's how long it would take to get all your money back out. You can't just cash out when you feel like it. They have a trading platform (which I did not try out) if you want your money sooner, but I would guess the spreads are wide and you have to take a hit when you sell loans. Again though I did not try the trading platform. On the upside, the yields did seem fine. I got 19 eventual defaults from 81 loans, but many of the borrowers made a number of payments before defaulting so only part of the money was lost. The lower credit ratings default more often obviously, only one of 19 defaults had the top credit score. (I tried investing across a range of credit ratings.) The interest rates appear to cover the risk of default, at least on average. You can of course have varying luck.  I made only a slight profit over the 3 years, but I did not reinvest after the first couple months, and it was during a recession. So the claimed yields look plausible to me if you reinvest. They do get people's credit scores, report nonpayment on people's credit reports, and even send people to collections. Seems like borrowers have a reason to pay the bill. In 2008 I think this was a difference compared to the other peer lending sites, but I don't know if that's still true. Anyway, for what it's worth the site seemed to work fine and ""as advertised"" for me. I probably will not invest more money there for a couple reasons: However as best I could tell from my experiment, it is a perfectly reasonable place to put a portion of your portfolio you might otherwise invest in something like high-yield bonds or some other sub-investment-grade fixed income. Update: here's a useful NY Times article: http://www.nytimes.com/2011/02/05/your-money/05money.html" A derivative is a financial instrument of a special kind, the kind “whose price depends on, or is derived from, another asset”.  This definition is from John Hull, Options, Futures and Other Derivatives – a book definitely worth to own if you are curious about this, you can easily find old copies for a few dollars. The first point is that a derivative is a financial instrument, like credits, or insurances, the second point is that its price depends closely from the price of something else, the mentioned asset. In most cases derivatives can be understood as financial insurances against some risk bound to the asset. In the sequel I give a small list of derivatives and highlight the assets and the risk they can be bound to.  And first, let me point out that the definition is (marginally) wrong because some derivatives depend on things which are not assets, nor do they have a price, like temperature, sunlight, or even your own life in the case of mortgages.  But before going in this list, let me go through the remaining points of your question. What is the basic idea and concept behind a derivative? As already noted, in most cases, a derivative can be understood as a financial insurance compensating from a risk of some sort.  In a classical insurance contract, one party of the contract is an insurance company, but in the broader case of a derivative, that counterparty can be pretty anything: an insurance, a bank, a government, a large company, and most probably market makers. How is it really used, and how does this deviate from the first point? Briefly, how does is it affecting people, and how is it causing problems? An important point with derivatives is that it can be arbitrarily complicated to compute their prices.  Actually what is hidden in the attempt of giving a definition for derivatives, is that they are products whose price Y is a measurable function of one or several random variables X_1, X_2, … X_n on which we can use the theory of arbitrage pricing to get hints on the actual price Y of the asset – this is what the depends on means in technical terms.  In the most favorable case, we obtain an easy formula linking Y to the X_is which tells us what is the price of our financial instrument. But in practice, it can be very difficult, if at all possible, to determine a price for derivatives. This has two implications: Persons possessing sophisticated techniques to compute the price of derivatives have a strategic advantage on derivatives market, in comparison to less advanced actors on the market. Organisation owning assets they cannot price cannot compute their bilan anymore, so that they cannot know for sure their financial situation. They are somehow playing roulette. But wait, if derivatives are insurances they should help to mitigate some financial risk, which precisely means that they should help their owners to more accurately see their financial situation! How is this not a contradiction? Some persons with sophisticated techniques to compute the price of derivatives are actually selling complicated derivatives to less knowledgeable persons.  For instance, many communes in France and Germany have contracted credits whose reimbursements have a fixed interest part, like in a classical credit, and a variable interest part whose rate is computed against a complicated formula involving the value of the Swiss frank at each quarter starting from the inception of the credit.  (So, for a 25 years running credit of theis type, the price Y of the credit at its inception depends on 100 Xs, which are the uncertain prices for the Swiss frank each quarter of the 25 next years.)  Some of these communes can be quite small, with 5.000 inhabitants, and needless to say, do not have the required expertise to analyse the risks bound to such instruments, which in that special case led the court call the credit a swindling and to cancel the credit.  But what chain of events leads a 5.000 inhabitants city in France to own a credit whose reimbursements depends on the Swiss frank?  After the credit crunch in 2007 and the fall of Lehman Brothers in 2008, it has begun to be very hard to organise funding, which basically means to conclude credits running long in time on large amounts of money.  So, the municipality needs a 25 years credit of 10.000.000 EUROS and goes to its communal bank.  The communal bank has hundreds or thousands of municipalities looking for credits and needs itself a financing.  So the communal bank goes to one of the five largest financial institutions in the world, which insists on selling a huge credit whose reimbursements have a variable part depending on hundred of values the Swiss frank will have in the 25 next years. Since the the big bank has better computation techniques than the small bank it makes a big profit.  Since the small bank has no idea, how to compute the correct price of the credit it bought, it cuts this in pieces and sell it in the same form to the various communes it works with.  If we were to attribute this kind of intentions to the largest five banks, we could ask about the possibility that they designed the credit to take advantage of the primitive evaluation methods of the small bank. We could also ask if they organised a cartel to force communal banks to buy their bermudean snowballs. And we could also ask, if they are so influent that they eventually can manipulate the Swiss frank to secure an even higher profit.  But I will not go into this.  To the best of my understanding, the subprime crisis is a play along the same plot, with different actors, but I know this latter subject only by what I could read in French newspapers. So much for the “How is it causing problems?” part. What is some of the terminology in relation to derivatives (and   there meanings of course)? Answering this question is basically the purpose of the 7 first chapters of the book by Hull, along with deriving some important mathematical principles.  And I will not copy these seven chapters here! How would someone get started dealing in derivatives (I'm playing a     realistic stock market simulation, so it doesn't matter if your     answer to this costs me money)? If you ask the question, I understand that you are not a professional, so that your are actually trying to become the one that has money and zero knowledge in the play I outlined above. I would recommand not doing this.  That said, if you have a good mathematical background and can program well, once you are confindent with the books of Hull and Joshi, you can have fun implementing various market models and implementing trading strategies. Once you are confident with this, you can also read the articles on quantitative finance on arXiv.org. And once you are done with this, you can decide for yourself if you want to play the same market as the guys writing these articles. (And yes, even for the simplest options, they have better models than you have and will systematically outperform you in the long run, even if some random successes will give you the feeling that you do well and could do better.) (indeed, I've made it a personal goal to somehow lose every last cent of my money) You know your weapons! :) Two parties agree today on a price for one to deliver a commodity to the other at some future instant.  This is a classical future contract, it can be modified in every imaginable way, usually by embedding options.  For instance one party could have the option to choose between different delivery points or delivery days. Two parties write today a contract allowing the one party to buy at some future time a commodity to the the second party.  The price is written today, as part of the contract.  (There is the corresponding option entitling the owner to sell something.)  Unlike the future contract, only one party can be obliged to do something, the other jas a right but no obligation. If you buy and option, your are buying some sort of insurance against a change of price on some asset. This is the most familiar to anybody.  Credits can come in many different flavours, especially the formula to compute interests, or also embed options.  Common options are early settlement options or restructuration options. While this is not completely inutitive, the credit works like an insurance.  This is most easily understood from the side of the organisation lending the money, that speculates that the ratio of creanciers going bankrupt will be low enough for her to make profit, just like a fire insurance company speculates that the ratio of fire accidents will be low enough for her to make a profit. This is like a mortgage on a financial institution.  Two parties agree that one will recive an upfront today and give a compensation to the second one if some third party defaults. Here this is an explicit insurance against the unfortuante event, where a creancier goes bankrupt. One finds here more or less standard options on electricity. But electricity have delicious particularities as it can practically not be stored, and fallout is also (usually) avoided. As for classical options, these are insurances against price moves. A swap is like two complementary credits on the same amount of money, so that it ends up in the two parties not actually exchanging the credit nominal and only paying interest one to the other — which makes only sense if these interests are computed with different formulas. Typical example are fixed rate vs. EURIBOR on some given maturity, which we interpret as an insurance against fluctuations of the EURIBOR, or a fixed rate vs. the exchange ratio between two currencies, which we interpret as an insurance against the two currencies decorrelating. Swaps are the richest and the most generic category of financial derivatives.  The off-the-counter market features very imaginative, very customised insurance products. The most basic form is the insurance against drought, but you can image different dangers, and once you have it you can put it in options, in a swap, etc.  For instance, a restaurant with a terrasse could enter in a weather insurance, paying each year a fixed amount of money and becoming in return an amount of money based on the amount of rainy day in a year. Actually, this list is virtually without limits! It's a debt derivative.  Credit default swaps are contracts drawn up on a specific issue of a bond (in the case of single-name), or on a basket/index of a class of bonds (in the case of credit default index swaps/CDX).  When it comes to derivatives you would have to look at the underlying instrument.  For example, options on AAPL common stock are equity derivatives.  Forwards on corn or wheat are commodity derivatives.  Interest rate swaps where the floating leg is pegged to LIBOR are debt/rates derivatives. Investors already can trade their assets - simply tokenizing a bond is unlikely to make it more liquid.  The key to liquidity is having a willing counterparty who wants to buy/sell what you are looking to sell/buy.  Because debt can be structured in a myriad of ways, markets for some bonds will be extremely thin, with limited buyers and sellers.  I don't see how tokenization will solve that problem. To add to this, that risk is really only a problem if you don't have the cash flow to service the debt. If the surplus dips but your ultimately profitable on whatever trade you made, you're okay. If you default, you're not okay.  Volitility relative to loan term effectively. The day trader in the article was engaging in short selling.  Short selling is a technique used to profit when a stock goes down.  The investor borrows shares of a stock from someone else and sells them.  After the stock price goes down, the investor buys the shares back and returns them, pocketing the difference. As the day trader in the article found out, it is a dangerous practice, because there is no limit to the amount of money you can lose. The stock was trading at $2, and the day trader thought the stock was going to go down to $1.  He borrowed and sold 8,400 shares at $2.  He hoped to buy them back at $1 and earn $8,400 profit.  Instead, the stock went up a lot, and he was forced to buy back the shares at $18.50 per share, or about $155,400.  He had had $37,000 with E-Trade, which they took, and he is now over $100,000 in debt. As I understand it, it was a mark to market loss. Which means that JPM has booked an unrealized loss while some hedge funds have booked unrealized gains. Now over the next few months as JPM tries to unwind he trades, these losses will be realized. You should watch Margin Call and follow Demi Moore's lead.  Do you figure out what derivatives to buy or just calculate how much exposure the firm has and tell someone else?   Can you potentially go to jail because of your job or is losing your job the worst that can happen?