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February 22, 2010

Cover Sidebar: OTC Derivative Clearing, a Different Business

Clearing, which is the process covering everything from execution to settlement, is usually straightforward when it is simply cash for a security transaction. But that's not the case in over-the-counter derivative contracts.

They cover a lot of ground. They run the range from the plain vanilla credit default swap to collateralized debt obligations packaged as securities. The latter can be a package of subprime mortgages. Credit default swaps are one of a number privately negotiated OTC derivative contracts. They are a kind of insurance against a possible default. They are vital for both many private and public institutions.

OTC derivative contracts also potentially pose far more risk than someone not having the cash to pay for a trade in a day or two.

That's because OTC derivatives are usually dated contracts that are tied to the performance of any underlying index or security over years. So counterparty risk rises dramatically. That's because there is usually a much longer period between execution and settlement than there is in a normal stock for cash clearing and settlement.  

 

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