Central counterparty clearing

A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.

CCPs "mutualize" (share among their members) counterparty credit risk in the markets in which they operate.[1] A CCP reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the creditworthiness of the member firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit. CCPs require a pre-set amount of collateral — referred to as ‘initial margin’ — to be posted to the CCP by each party in a transaction. The first line of defense is collateral provided by the defaulting member. CCPs typically adjust initial margin demands in response to changes in market conditions. For instance, a CCP may increase initial margin requirements in response to high price volatility. Variation margin is the second line of defense against fluctuation in the prices of securities pledged as collateral. If those prices fall, the member must deposit a corresponding amount of cash, and if those prices go up, the member may withdraw a corresponding amount of cash. This is done either on a daily basis or sometimes more frequently. For some financial products, members’ net payment obligations to or from the CCP are settled on a daily basis (or more frequently if there are large movements during the course of the day) to prevent the build-up of large exposures.[2] The advantages of a central counterparty clearing arrangement are greater transparency of the risks, reduced processing costs, and greater certainty in cases of default by a member.[3] Once a trade has been executed by two counterparties, it is submitted to a clearing house, which then steps between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. For example, a trade between member firm A and firm B becomes two trades: A-CCP and CCP-B. This process is called novation.

As the CCP concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized[4] in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting. Guarantee funds are capitalized with collateral from the member firms and own capital, called 'skin-in-the-game' of the CCP. [5] [6] In the event of a settlement failure, the defaulting firm may be declared to be in default and the CCP's default procedures utilized, which may include the orderly liquidation of the defaulting firm's positions and collateral. In the event of a significant clearing firm failure, the CCP may draw on its guarantee fund in order to settle trades on behalf of the failed clearing firm.

Nonetheless, it is possible that, in extreme circumstances, CCPs could be a source of systemic risk.[7][8]

CCPs have a trade association representing them called CCP Global.

  1. ^ Rehlon, Amandeep; Nixon, Dan. "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF). Bank of England. Retrieved 1 April 2017.
  2. ^ Amandeep Rehlon; Dan Nixon web (2013), "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF), Bank of England, retrieved 24 April 2023
  3. ^ Steigerwald, Robert S. (2013), "Central Counterparty Clearing" (PDF), Understanding Derivatives—Markets and Infrastructure, Federal Reserve Bank of Chicago: 12–26, retrieved 2017-03-29
  4. ^ "Primer: Derivative Instruments". Financial Policy Forum Derivatives Study Center.
  5. ^ Cont, Rama (2015), "The end of the waterfall: default resources of central counterparties", Journal of Risk Management in Financial Institutions, 8, Henry Stewart Publications, SSRN 2588986, retrieved 2020-12-09
  6. ^ Priem, Randy (2018). "CCP recovery and resolution: preventing a financial catastrophe". Journal of Financial Regulation and Compliance. 26 (3): 351–364. doi:10.1108/JFRC-03-2017-0032. S2CID 158726414.
  7. ^ Cite error: The named reference BIS2015 was invoked but never defined (see the help page).
  8. ^ Purring, Craig (May 2011). "The Economics of Central Counterparty Clearing: theory and Practice" (PDF). ISDA Discussion Papers (1): 12.