Securities clearance and settlement is a highly paper–intensive and cumbersome process, prone to risk and human error. Each transaction between brokers was handled separately. Paper confirmations of the trade was exchanged by hand or post. Information technology has transformed these clearing and settlement operations. Two parallel systems exist for clearing and settling derivatives: bilateral and central counter party (CCP) clearing and settlement. Most OTC derivatives are settled bilaterally, that is, by the counter parties to each contract. Risk management practices, such as collateralization, are also dealt with bilaterally by the counter parties to each contract. In contrast, most exchange-traded derivatives and some OTC derivatives are cleared and settled through a CCP.
In the case of centrally cleared derivatives markets, the original contract entered into by two counter parties is automatically replaced by two contracts, each of which arises between one of the original counter parties and the
central counter party. A Central Counter party (CCP) is an entity that stands between transacting counter parties (a seller vis–a–vis the original buyer and a buyer vis–a–vis the original seller) to guarantee execution of the transaction. Thus, the original transacting parties substitute their contractual relationships with each other with contracts with the CCP. Central Counter party Clearing has become popular in Europe, not just in derivatives markets, where, due to the high risk involved, it has been common for decades, but also in equities markets.
Even though clearing and settlement has traditionally been an arrangement between two contractual parties, regulators have introduced a host of rules because of the potential systemic risk of transactions clearing. This is the case with Capital Adequacy Directive III (known as CAD III) introduced by the European Union which like the Basel II Capital Accord have identified credit risk, market risk and operational risk are the three main sources of risk in the area of post trade operations. This has prompted to start exploring ways to minimize these risks (counterparty risk). Some of the most significant losses from derivatives activities stemmed from operational failures. The collapse of Barings Bank and Daiwa Bank Ltd. in 1995 and more recent troubles at Allfirst Bank in 2002 are just a few examples. In each of these cases, derivatives traders circumvented risk-management controls and the institutions suffered significant, sometimes bringing down the entire institution.