A central clearing counterparty (CCP), also referred to as a central counterparty, is a
financial institution
Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...
that takes on
counterparty credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
between parties to a transaction and provides
clearing and
settlement
Settlement may refer to:
*Human settlement, a community where people live
*Settlement (structural), the distortion or disruption of parts of a building
* Closing (real estate), the final step in executing a real estate transaction
*Settlement (fin ...
services for trades in
foreign exchange
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...
,
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
,
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. A CCP reduces the
settlement risk
Settlement risk is the risk that a counterparty (or intermediary agent) fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security ...
s by
netting
In law, set-off or netting are legal techniques applied between persons or businesses with mutual rights and liabilities, replacing gross positions with net positions. It permits the rights to be used to discharge the liabilities where cross cla ...
offsetting transactions between multiple counterparties, by requiring
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
deposits (also called "
margin
Margin may refer to:
Physical or graphical edges
*Margin (typography), the white space that surrounds the content of a page
*Continental margin, the zone of the ocean floor that separates the thin oceanic crust from thick continental crust
*Leaf ...
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.
[https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2013/central-counterparties-what-are-they-why-do-they-matter-and-how-does-the-boe-supervise-them.pdf?la=en&hash=3D7AFAEA1E84FAAEC803D92D02BD069E8D5F4943 ] 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.
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
Novation, in contract law and business law, is the act of –
# replacing an obligation to perform with another obligation; or
# adding an obligation to perform; or
# replacing a party to an agreement with a new party.
In international law, no ...
.
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 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.
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
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the ...
.
[
]
History
Post financial crisis of 2007–08
In the wake of the financial crisis of 2007–08
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
the G20
The G20 or Group of Twenty is an intergovernmental forum comprising 19 countries and the European Union (EU). It works to address major issues related to the global economy, such as international financial stability, climate change mitigation, ...
leaders agreed at the 2009 Pittsburgh summit that all standardised derivatives contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties (CCPs). In the United States, as part of the Obama financial regulatory reform plan of 2009
Barack Hussein Obama II ( ; born August 4, 1961) is an American politician who served as the 44th president of the United States from 2009 to 2017. A member of the Democratic Party (United States), Democratic Party, Obama was the first Af ...
, pressure has been placed on traders of derivatives such as credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
s (CDS) to make their trades on an open exchange with a clearinghouse. In June 2009, Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
official Alfred Kohn mentioned that the largest CDS dealers were working on an exchange, and that only regulatory approval rather than legislation would be required. In March 2010, the Options Clearing Corporation
Options Clearing Corporation (OCC) is a United States clearing house based in Chicago. It specializes in equity derivatives clearing, providing central counterparty (CCP) clearing and settlement services to 16 exchanges. Started by Wayne Luth ...
(OCC) stated that it was moving forward in backing equity derivatives. In Europe, the European Market Infrastructure Regulation
The European Market Infrastructure Regulation (EMIR) is an EU regulation aimed at reducing systemic counterparty and operational risk and thereby prevent future financial system collapses. Its focus is regulation of over-the-counter (OTC) deriv ...
mandated central clearing. It is estimated that almost half of all outstanding interest rate swap transactions are centrally cleared. The systemic importance of CCPs is expected to increase further as the central clearing of standardized over-the-counter (OTC) derivatives becomes mandatory in line with commitments made by G20 leaders following the crisis. The Financial Stability Board reported in April 2013 that, as at the end of February 2013, around US$158 trillion of interest rate swaps and over US$2.6 trillion of OTC credit derivatives were centrally cleared, representing 41% and 12% respectively of total outstanding notional amounts.
Securities (US)
DTCC's subsidiary the National Securities Clearing Corporation (NSCC) clears broker-to-broker trades using its Continuous Net Settlement (CNS) System. This has acted as a CCP, long before the term was coined. In order to deal with the default of a member broker, as happened with Drexel Burnham
Drexel Burnham Lambert was an American multinational investment bank that was forced into bankruptcy in 1990 due to its involvement in illegal activities in the junk bond market, driven by senior executive Michael Milken. At its height, it was a ...
and Lehman Brothers
Lehman Brothers Holdings Inc. ( ) was an American global financial services firm founded in 1847. Before Bankruptcy of Lehman Brothers, filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Gol ...
, DTCC has a guarantee fund to which all broker members contribute. It also has rules to handle the gains and losses from a defaulting broker. The guarantee fund ensures that settlement can be completed. A defaulting member's contribution to the fund, along with any other assets held by the depository, are used to absorb any losses at the time of default.
The options market, with its Options Clearing Corporation
Options Clearing Corporation (OCC) is a United States clearing house based in Chicago. It specializes in equity derivatives clearing, providing central counterparty (CCP) clearing and settlement services to 16 exchanges. Started by Wayne Luth ...
(OCC), also acts as a central clearing counterparty. Its rules stipulate a five-step "waterfall" in dealing with a member's default:[
#The margin deposits of the suspended firm
#Clearing fund deposits of the suspended firm
#Clearing fund deposits of non-defaulting firms
#OCC retained earnings
#Clearing fund assessments
In order to access the viability of its funds, the OCC carries out a firm-wide default test annually. In addition, the firm performs smaller, limited scope defaults throughout the year. Results are reported to its Enterprise Risk Management Committee.]
Europe
LCH.Clearnet, the result of a merger between the London Clearing House and Clearnet, acts as a CCP for a wide variety of financial products, from equities and commodities to credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
s and interest rate swap
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations wit ...
s.
Asia
Asian countries have addressed the needs of their derivative markets by forming CCPs. Shanghai Clearing House, formed in 2009, acts as a CCP for a wide range of financial products in China.
See also
* Central securities depository A central securities depository (CSD) is a specialized financial organization holding securities like shares, either in certificated or uncertificated ( dematerialized) form, allowing ownership to be easily transferred through a book entry rather t ...
* Clearing (finance)
In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. This process turns the promise of payment (for example, in the form of a cheque or electronic payment request) into ...
* Swap Execution Facility
References
Further reading
The Economics of Central Clearing: Theory and Practice
ISDA Discussion Papers Series Number One - May 2011
* R Cont (2015
The end of the waterfall: default resources of central counterparties
Journal of Risk management in Financial Institutions, Henry Stewart Publications.
Central counterparties: what are they, why do they matter and how does the Bank supervise them?
Bank of England, Quarterly Bulletin, Q2 2013
Central counterparty clearing: History, innovation, and regulation
Chicago Fed
Deloitte, 19 June 2017
Central Counterparties Risk Assessment and News Services
External links
Central Counterparties
ESMA
Central Counterparties and Trade Repositories (non-EU)
ESMA
{{Authority control
Securities (finance)
Financial markets
Securities clearing and depository institutions
Systemic risk
Settlement (finance)