The Role of CCPs

Just as exchanges facilitate economic activity, financial market infrastructures known as central counterparty clearing houses (CCPs) promote financial stability by providing certainty that a contract will continue to perform if one of the original counterparties defaults – otherwise known as “central clearing”. CCPs therefore operate a comprehensive risk-management framework, including a number of beneficial practices outlined below.

Novation

Once a trade has been agreed by two members, it is assigned to the CCP, which places itself between the two counterparties. The CCP ensures that both counterparties can afford to undertake the trade, and then breaks up the trade into two separate, back-to-back transactions. The CCP remains in the middle, policing the original parties’ willingness to meet their obligations. 

By replacing bilateral exposures with exposures to the CCP, “novation” helps contain defaults and reduces the risk of contagion across the financial system.

Multilateral Netting

As the CCP can therefore stand between all of its members on their cleared trades, it is able to inherently conduct what is known as “multilateral netting”, and sum up the offsetting positions that a participant has across all other market participants to create one overall position. This allows exposures to be smaller than in bilateral markets, and results in only a portion of market risk needing to be settled. 

Margining Practices

In order to guarantee the performance of a trade, the CCP implements strict margining practices. These include the collection of initial margin at the outset of a trade (as well as recalculations to cover potential future losses that could arise if a member defaults before its positions can be closed out). This is in addition to the collection of variation margin, calculated on the mark-to-market prices of a position, on a daily (or intra-daily) basis. The latter can be thought of as daily settlement of outstanding trading losses.

Membership Criteria

CCPs also help maintain strict membership criteria to firms wishing to participate in central clearing. This due diligence ensures that members are solvent and hold sufficient capital, maintain appropriate technical and operational systems and controls (including business continuity measures), possess a fit and proper directorship, and hold all necessary regulatory authorisations, licenses, permissions and approvals.

Default Management 

In the event that any party to a cleared trade does not fulfil their obligations, the CCP has the power to invoke a centralised default management process, in which any outstanding contracts from the defaulting party are hedged, auctioned, transferred, or closed out, providing a reliable level of trade/contract continuation and legal certainty.

CCPs are also advantageous in these situations from the point of view of the end-user, as non-member clients who use intermediaries to clear trades at a CCP are able to “port” their positions from one member to another, allowing them seamless continuance of trading and access to clearing in the event of a member default.

Financial Resources

In the event of a member default wherein either another market participant cannot be found to fulfil the trade, or compensation is required to facilitate a transfer, CCPs can cover losses over and above those covered by margin via prefunded resources collectively known as the “default waterfall”. This includes the defaulting member's contribution to a default fund, the contributions of all clearing members to that default fund and, if necessary, additional recovery tools.

A layer of CCP resources known as “Skin in the Game” can also be included in the waterfall. However, as the name suggests, this is not intended to be a loss absorbing tool, rather a demonstration of the CCP’s alignment of incentives with its participants.

International Standing

Although CCPs existed before 2008, the Global Financial Crisis prompted international standard-setters to mandate central clearing for many standardised OTC derivatives contracts. This was enshrined by national laws such as the Dodd-Frank Act in the United States¹ and European Market Infrastructure Regulation (EMIR) in the EU.

The industry has since made substantial progress, with a notable portion of OTC derivatives having shifted from bilateral to cleared markets. For example, an estimated 76.9% of all interest-rate derivatives are now centrally cleared.² As a result, central clearing has become one of the cornerstones of the modern financial system, reducing systemic risk while supporting the safe and efficient functioning of global financial markets.

¹ In the United States, CCPs have separate legal designations as per the type of product that they clear. CCPs which clear derivatives such as swaps, futures, and options on futures, must be registered as Derivatives Clearing Organizations under the purview of the Commodity Futures Trading Commission (CFTC), while CCPs which clear securities such as bonds, stocks, and equity options, must be registered with the Securities and Exchange Commission (SEC) as Clearing Agencies (CAs). A CCP can function as both types of CCP simultaneously.  

² In the United States, CCPs have separate legal designations as per the type of product that they clear. CCPs which clear derivatives such as swaps, futures, and options on futures, must be registered as Derivatives Clearing Organizations under the purview of the Commodity Futures Trading Commission (CFTC), while CCPs which clear securities such as bonds, stocks, and equity options, must be registered with the Securities and Exchange Commission (SEC) as Clearing Agencies (CAs). A CCP can function as both types of CCP simultaneously.