Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

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Clearing, Settlement and Operational Risk

INTRODUCTION

The settlement of exchange-traded derivatives is guaranteed by the clearing house associated with the exchange. The risk of default is greatly reduced by this and by the use of margining procedures. At the time of writing, there is considerable debate on how the default risk on over-the-counter (OTC) derivatives should be managed in future.

However it must not be forgotten that the fall of Barings Bank was largely caused by failings in the operational procedures supporting trading activities in straightforward exchange-traded derivative contracts (see Chapter 1).

This means that banks dealing in derivatives have to put in place stringent controls not just on the more exotic OTC contracts, but also on standard or ‘vanilla’ products, including exchange-traded futures and options. This chapter examines the basic operational procedures relating to clearing and settling derivatives and the associated risks and controls.

RISK MANAGEMENT IN GENERAL

Financial institutions dealing in derivatives face a wide range of risks. Three of the most obvious are market risk, counterparty risk and operational risk.

• Market Risk. Potential losses resulting from changes in market variables such as stock prices, currency rates, bond prices and interest rates. It is also known as price risk.

• Counterparty Risk. Potential losses resulting from the failure of a counterparty to fulfil its contractual obligations, e.g. by settling trades, delivering ...