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A derivative is a contract between two parties, where the value is driven primarily by the price of some underlying physical “thing” like oil, gold, or a stock. The best known derivatives are futures (where you are buying with an execution/delivery date in the future), options (the right but not obligation to buy or sell), and swaps (exchange of two cash streams). Even a sports bet can be thought of as a derivative, as the value is based on something else.

Using the sports analogy, let’s say you want to buy Pats/Colts (i.e., buy the Pats, sell the Colts). The spread is 7, so you would pay $7 and receive in dollars the difference in the score.

Collateralization is a process where the two parties to the contract “settle up” the current value on a daily basis (this is called “marking to market”). In the betting example, you paid $7 to enter into the contract, but the current market value is $7, so I would “post” that amount back to you.

Then, later in the day, ESPN breathlessly reports that Tom Brady has a hangnail, and the spread falls to 3 points. That means your contract is only worth $3 by current reckoning, so you need to return $4 of the collateral I posted.

On Saturday, Andrew Luck sees a GEICO ad and gets really mad, and guarantees a win, causing the spread to go to 2. Now your contract is only worth $2, and you return another $1 of collateral to me.

Then on Sunday, the Colts get Gronked and lose by 18. The contract settles at $18, and since I’ve already posted $2 I need to pay you $16. (I really hope I haven’t screwed up the math somewhere.)

Of course, if I only have $10, then I can’t pay, and you don’t get your money. This is called counterparty credit risk. If my buys and sells are mostly balanced, it’s not much of a problem, but if my position gets too directional I can be exposed. Alternately, if I have very directional risk facing a counterparty who goes under, then we can start to see contagion.

Enter the central counterparty. After you and I make the initial bet, we agree to amend the contract (”novate”) so that the CCP sits in between us, i.e., your long Pats/short Colts position is against the CCP, and my offsetting position is against the CCP. So the CCP is net flat. Two additional bits of information: we will each post a little bit of extra collateral to the CCP (so on day 1, instead of getting the full $7, maybe you only get to hold $5, and instead of posting just $7, maybe I have to post $9, so the CCP holds net $4); and, if I go under, the other market participants are not affected (for the most part — there will be some market disruptions due to the need to “replace” the risk that evaporated, to restore balance to the system).

Hope that helps.

Yes, that helps somewhat. I'm going to read it over, slowly, at least three times today. I won't even look for errors, your numbers get the give-and-take across. It does sound like a bit of a Monopoly game, where I buy a derivative on say a hotel on Boardwalk according to a present value, but the price of that hotel fluctuates day to day, and I give or get money accordingly. That would really mess up the game, especially if people had the means to manipulate the value of a hotel on Boardwalk.

How could a derivative not be subjected to cheating? If I wanted to lower that spread on a Pats game, I'd start a well placed rumor that Tom Brady couldn't play in that game....(etc)

This really shouldn't be allowed; it does sound like gambling where insider knowledge and manipulation win the day.