The Role of Central Counterparties in Financial Crisis Recovery

Author Name: 
Marcus Zickwolff, Executive Director and Head of Trading & Clearing System Design, Eurex Group

While the financial crisis caused massive fallout on the bilaterally traded over-the-counter (OTC) side, exchange-traded and centrally cleared derivatives escaped with barely a scratch. Since then, growing clearing volumes point to centralised clearing becoming one of the major growth areas of the financial market. The crisis exposed inefficiencies as large segments of the market were neither standardised nor automated – despite the speed of global trading activity and the increased complexity of transactions. This was not seen to be a problem in a bull market but, when the credit crisis rapidly unfolded, users of bilateral transactions were scrambling to pick up the pieces. OTC market participants and regulators alike have realized that clearing houses offering central counterparty services (CCP) provide practical solutions that the market desperately needs: transparency, neutrality and efficiency enabling the mitigation of counterparty risk.

In their statement after the meeting in Pittsburgh in September 2009, the Leaders of the G20-Nations called for sweeping changes to improve OTC derivatives markets: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the Financial Stability Board (FSB) and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.” [1]

As 90% of global derivatives volume is purportedly being conducted in the OTC markets, it is clear why regulators are concerned. Governments and regulators, especially in Europe and the US, have pushed for legislation forcing users of OTC contracts to clear their OTC business via an approved clearing house offering central counterparty services (CCP). As a result of the crisis, in July 2009 the European Commission issued a report requiring the central clearing of standardised OTC derivatives and it is thought that this will be put into practice by 2011. Meanwhile, similar steps are being taken with the preparation of US legislation that would require the clearing of standardised OTC derivatives, and implementation is expected by late 2010. Finally Committee on Payment and Settement Systems (CPSS) and IOSCO are reassessing their recommendations for CCPs – it started with amendments for clearing OTC derivatives and now they launched a comprehensive review of their existing standards for market infrastructures, e.g. central counterparties.

In 2001, central counterparty organizations from Asia, the Americas and Europe founded the non-profit organization CCP12 to promote clearing and risk management best practices, support the development of global standards and liaise with regulators. At the time of the 2008 market events, major clearing organizations that make up the CCP12 reinforced their initiatives in the over-the-counter market to facilitate needs and mitigate the inherent risks. They serve as a model to the industry.

The Role of a Central Counter Party (CCP)

A clearing house acts as a central counterparty when it interposes itself, directly or indirectly, between counterparties in order to assume their rights and obligations, acting as the direct or indirect buyer to every seller and the direct or indirect seller to every buyer.


The most common, but by no means only, legal process to achieve this is called “novation”, in which two new contracts are created – between the CCP and the buyer, and the CCP and the seller – to replace the single, original contract between the two parties thus, transferring counterparty risk to the clearing house.

A clearing house that offers central counterparty services establishes and records obligations arising from trading on a marketplace (securities exchanges, derivatives exchanges, et cetera) and ensures that those obligations are processed according to the relevant rules. This may involve interfacing with a local or international central securities depository (CSD), or similar settlement facility, to ensure that the trades are settled. It may also imply netting of those trades and of subsequent settlement payments for the benefit of efficient risk management and operational efficiency. Another aspect is that CCPs enable anonymous trading by offering guaranteed settlement, which increases the efficiency of a marketplace.

To summarize, CCPs increase market safety and integrity by:

  • Mitigating and management of counterparty risk
  • Mitigating liquidity & operational risks
  • Addressing information asymmetries
  • Reducing complexity and increasing efficiency

Moving OTC traded derivatives from bilateral settlement to clearing via a CCP is the most effective way of reducing the described systemic risk inherent in the global OTC segment.

Mitigating and Management of Counterparty Risk

The origination of bilateral counterparty risk in the OTC segment is on the one hand the most obvious and critical weaknesses that needs to be addressed for the creation of an improved financial environment. As examples like Lehman and AIG have shown, the risk of a renowned counterparty with global exposure failing is far from theoretical. Therefore, CCP risk management capacities for mitigating and managing counterparty risk are essential contributions to the safety of the global financial marketplace. In the first place, CCPs reduce the probability of a counterparty defaulting due to the novation process. On the other hand they manage and minimize the implications of a possible default by different means.

Central clearers have put effective lines of defence in place ensuring multilevel security so they are well protected against default. So, following novation, which is usually handled automatically, each market participant only needs to be concerned with the counterparty risk of the CCP. This reduction in the complexity of counterparty relations significantly reduces costs for those involved.

All CCP clearing members usually require a clearing license, which is only issued and upheld if certain prerequisites are fulfilled (e.g. minimum levels of equity capital, compliance with technical specifications to ensure that transactions are properly recorded, booked and monitored). Thereby the CCP establishes minimum quality standards for its members and regularly monitors the solvency and capabilities of its members.

Once they are accepted, clearing members must also meet collateral requirements as specified by the Rules and established margining methodology of the CCP as part of the standard requirements for membership. The CCP calculates the change in value of the positions of its members at the very minimum on a daily basis – sometimes even intraday or real-time. Should losses be incurred, the respective members must post additional collateral. CCPs set their margin requirements at levels that are expected to cover estimated market moves of normal market conditions for the interval between the time of last collection of margin and transfer or close-out of positions.

During the risk management process the CCP nets all offsetting open derivatives contracts of each trading party across all other trading parties. Such multilateral netting decreases the gross risk exposure – to a much higher degree than in the OTC segment which utilizes only bilateral netting. Therefore, the CCP’s own risk is reduced and is manageable by means of appropriate margins and capital deposits designed to prevent damages which arise as a result of any member’s default burdening the CCP. The CCP therefore closely regulates and monitors admission for its central clearing offering on an ongoing basis.

Hence, a CCP is in a better position than any counterparty of a bilateral transaction to absorb the default of a clearing member. By specifying the requirements for clearing members’ margining and collateral, CCPs are able to reduce the risk of a defaulting member affecting others. Eventually, all clearing members form default fund, which facilitates the mutualization of potential losses.

Addressing Information Asymmetries

Participants in a bilateral environment are not able to gain as comprehensive a picture of their counterparties’ derivatives trading risks as CCPs are, since their knowledge is limited to their own positions vis-à-vis their counterparties. Understandably, the effects of this uncertainty on market confidence in periods of market turmoil can be devastating. By contrast, CCPs are uniquely poised to swiftly understand the positions of all market participants which they serve as a central counterparty and are in a stronger position for managing risks for a clearing member in distress. This may necessitate increasing collateral and – if needed – unwinding open positions. Well-established CCP processes for unwinding the positions of a defaulting member further foster market confidence.

For this reason, some market participants questioned the orderly functioning of OTC markets during the recent crisis and the value of traded assets. The introduction of clearing houses into the mix promises to correct these asymmetries because only the clearing house knows which counterparty is on the other side of a trade. This anonymity may encourage increased trading activity on the part of both buy-side and sell-side users.

Reducing Complexity and Increasing Efficiency

A CCP reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing minimum financial and operational criteria as well as margin and collateral requirements for its members, centralizing the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral). CCPs address operational risks by means of adequate auditing procedures (i.e. compliance with technical infrastructure requirements) that ensure the necessary operational know-how of their current and potential members.

Using CCPs actually requires less regulatory capital from clearing members due to CCPs’ capacity to mutualize losses through the use of default funds. Analyses suggest a remarkable cost advantage if there is no equity capital cost due to the zero capital weighting. On the other hand, higher collateral cost results from the precautionary measures taken by CCPs as compared with typical OTC derivatives trading– such as higher quality requirements for eligible collateral and overall level of  collateralization required. However these are partially offset by equity capital savings.

CCPs Showing Resilience in Crisis

In recent history, CCPs globally have proved themselves to be robust over a set of market-wide events including extreme price volatility and participant defaults.

This has included historic events such as the 1987 stock market crash as well as more recent events such as the sub-prime credit crisis. The resilience of CCPs in times of extreme price volatility and market turmoil is enhanced by the fact that CCPs are only exposed to clearing participant default, not to market risks or losses of their clearing participants which fall short of causing the default of those participants.

In terms of participant events, major global CCPs have skilfully managed the crises that involved such as Drexel Burnham Lambert (1990), Barings (1995), Griffin (1998), Enron (2001), Refco (2005) and Lehman Brothers[2] (2008). In all cases, major global CCPs coped with these default events by closing-out or transferring the positions of the defaulters, without impacting other participants, and within the margin and other financial resources available to them. Anecdotally, the certainty about counterparty creditworthiness provided by CCPs also helped market activity to continue despite (and recover from) these events.

Participants of CCPs internationally have themselves proved robust in recent years against defaults of large clients such as LTCM (1998) and Amaranth (2006).

Due to the increasing demand for clearing and the ongoing interconnection of the global financial markets, it makes sense that the institutions that are active in these markets exchange relevant information and act in concert. Hence leading clearing houses formed CCP12, whose mission is to foster dialogue and information sharing on areas of mutual interest and concern as well support the development of standards and promote best practices in CCP risk management.

The Future for CCPs

The pivotal role of CCPs in an improved financial environment requires a careful assessment of potential implementation options. Market participants are already incentivized to use CCP clearing: it allows potential regulatory capital savings and reduces their counterparty risk for the benefit of market integrity and safety.

While a CCP effectively mitigates and manages counterparty risk, it also consolidates counterparty risk within the derivatives market at a single point. Thus, regulators need to ensure that effective supervision and crisis management mechanisms continue to be in place for CCPs. Because of its global nature, the derivatives markets run the risk of regulatory arbitrage with CCPs competing based on their risk management and margining approaches. Therefore, regulatory efforts are needed to help ensure a level playing field among CCPs and to avoid detrimental effects on the integrity of CCPs and the cleared markets. Since one of the roles of a CCP is to serve as a safety net, the institutional independence and irrevocable nature of default activities of any CCP in an improved financial environment must be guaranteed to avoid conflict of interests and legal uncertainties. In addition, clearing houses would benefit from further legal and regulatory clarity to protect client funds.

For further questions and dialogue please visit or contact Marcus Zickwolff at

[1] Source: Leaders Statement – The Pittsburgh summit September 24-25 2009,

[2] The collapse of US investment bank Lehman Brothers in late 2008 precipitated a oneday fall of around five per cent in major equity market indices, and falls of around 10 per cent in major banking stocks. During this time CCPs around the world inherited Lehman Brothers’ securities market positions as the bank defaulted on its obligations. Despite the massive market turmoil, CCPs unwound, hedged, liquidated, and transferred millions of positions and client accounts worth trillions of dollars, providing stability and certainty to already fragile markets. More information is available in a separate CCP12 paper Central Counterparty Default Management and the Collapse of Lehman Brothers on

About Marcus Zickwolff

Marcus Zickwolff is responsible for the design and implementation management of the Eurex® system for trading and clearing of derivatives as well as of the CCP system for clearing of securities and the central Risk Engine system. Having joined the IT Section of Deutsche Terminbörse (DTB) in 1992, he worked since 1997 with Deutsche Börse AG as Head of the Xetra® Market & Product Development Dept. From 2003 Marcus led the groupwide System Design Dept within the Eurex Group. He is Secretary of EACH (the European Association of Central Counterparty Clearing Houses) and Chairman of the Executive Committee of CCP12 (the Global Association of Central Counterparties).