The Dodd-Frank summary stipulates that swaps and other standardized derivatives contracts must be cleared centrally; and once cleared, must be traded either via a swap execution facility (SEF) or an exchange. This stipulation of using central counterparty (CCP) clearing facility is not a new idea. In fact clearing houses have been put up and were sent on the run to seize the opportunity to offer their services that will help minimize counterparty risks and enhance the transparency. CCP, when used in relation to the Dodd-Frank summary, is an acronym for central counterparty. This is a financial institution acting as a go-between or a mediator between the buyer and seller. During a trading, the CCP steps in to make sure that the seller gets his payment on time, and the buyer gets possession of what he paid for. Using centralized clearing is an ideal way to mitigate counterparty risks, which may also be caused by insufficient collateralization of trades. With CCP clearing being mandated, all OTC derivatives agreements will all be cleared through CCP. The regulators will be the decision-maker as to which derivatives will be eligible for central clearing. They also have the authority to enforce the requirement set forth in the Dodd-Frank summary. This requirement will be one of the market reforms to be implemented in accordance with the Dodd Frank Act of 2010 – that those who want to participate in the over-the-counter derivatives market must use CCP clearing. The CCP will act as the counterparty to each of them. After the trade has been cleared there will be no more bilateral trades and the 2 original traders will not have to face each other. CCP clearing therefore will minimize the counterparty risk. Counterparty risk occurs when one party defaults during the trade. To explain further, CCP will ensure that both parties perform, so that no amount in the contract will be lost. Rather than each party being at risk to one another, both of them have the CCP as a recourse. When CCP is used in clearing a derivatives contract, usually the 2 parties will be required to post collateral in high levels. This can be by way of variation margin and/or initial margin. The collateral will be held by the CCP because it is the intermediary between the two parties. This can avoid the collapse of the buyer when the seller defaults, or vice versa. Clearing and settlement are the 2 main processes done by CCP. Clearing involves identification of both parties’ obligations; settlement occurs when securities and funds have been finally transferred from one to the other. Owing in part to the Dodd-Frank summary, central counterparty clearing is required not only in the US but internationally. Market transactions that were only cleared bilaterally before are cleared now and settled by CCP, including OTC derivatives. Because the CCP bears the credit risk, it benefits both the seller and the buyer. If you are a buyer and you deal with a seller, you bear his credit risk, and he bears yours. When you clear trades using CCP, this institution will hold both your credit risks, which is a much better situation than the previous one. To know more about Dodd-Frank summary or CCP clearing click on the links.
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