OTC Derivatives Clearing: How Does It Work and What Will Change?

New over-the-counter (OTC) derivatives regulations have been proposed in both the U.S. and the E.U., which once finalized will affect how market participants trade, provide margin with respect to and settle OTC derivatives.  The new regulations will have an impact on the liquidity, transparency and pricing for these products and a key component of both regimes will be the central clearing of certain standardized swaps.  If a market participant wishes to engage in a swap that is of a type that the applicable regulator has determined must be cleared, the swap must be submitted to a clearinghouse for clearing unless an exception applies.  While certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed by the U.S. Congress last year will become effective on July 16, 2011, most key provisions are expected to be finalized by the end of 2011.  In Europe, the new derivatives regulations proposed by the European Commission are still pending.  OTC derivatives clearing will therefore soon become a reality for most market participants in the U.S. – including many hedge funds – as well as foreign market players trading these products with U.S. counterparties.  In a guest article, Fabien Carruzzo and Joshua Little, Senior Associate and Associate, respectively, at Kramer Levin Naftalis & Frankel LLP, describe the clearing process, how hedge funds and other market participants will trade and access clearing and what will change from the current bilateral trading model.  Carruzzo and Little also address margin requirements and how trades and margin are protected in the event of default by a dealer (clearing member).  Finally, the authors provide a general overview of the documentation governing contractual relationships among market participants.

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