Mechanics Of A Central Counterparty (CCP)
CCPs play important roles in the clearing and settlement of transactions. Clearing refers to the processes between the period from trade execution until settlement. Settlement refers to the satisfaction of legal obligations and trade completion.
Functions of a CCP include novation, netting, margining, managing the auction process, and loss mutualization. Auctioning refers to selling off the defaulted member’s trades to the surviving members through an auctioning process. Loss mutualization refers to members’ contributions to a default fund to cover future losses from member defaults.
Other aspects and mechanics of CCPs include:
- Categories of OTC derivatives products: (1) long history of central clearing (e.g., interest rate swaps), (2) short history of central clearing (e.g., index credit default swaps), (3) soon to be centrally cleared (e.g., interest rate swaptions, credit default swaps), and (4) not suitable for central clearing (e.g., exotic derivatives).
- Conditions needed for central clearing: product standardization, lower complexity, and high liquidity.
- Participants: Transacting with CCPs is restricted to clearing members only. Member criteria include admission criteria, financial commitment, and operational criteria.
- Number of CCPs: It is generally not feasible to have a single CCP due to regional differences in trades and requirements, differences in product types, and regulatory reasons.
- Types of CCPs: CCPs could be utility-driven CCP (i.e., focused on long-term stability) or profit-driven CCP (i.e., focused on bottom line). Arguments generally support profit-driven CCPs.
- Failure of a CCP: The potential failure of a large CCP could create a catastrophic event. CCPs must therefore ensure sufficient loss absorption capacity.
Advantages And Disadvantages
Advantages of CCPs include: transparency, offsetting, loss mutualization, legal and operational efficiency, liquidity, and default management.
Disadvantages of CCPs include: moral hazard, adverse selection, separation of cleared and non-cleared products, and procyclicality of margin requirements.
Margining
Margining includes posting both initial margin and variation margin. Margining tends to be more stringent in central clearing than in OTC markets. CCPs set margin requirements based only on the risks of the members’ transactions, and the credit quality of the member is typically not a consideration for initial margin.
Novation and Netting
Novation refers to replacing a bilateral OTC contract with another contract (or contracts) with the CCP, where the CCP is the insurer of counterparty risk. The CCP maintains a “matched book” of trades with no net market risk.
Multilateral offset, or netting, refers to creating a single net obligation between each participant and the CCP from the various bilateral OTC trades (which typically include redundant trades). Netting reduces total risk and minimizes contagion from a member default.
Impact of Central Clearing
By including a CCP in the clearing process, systemic risk can be both reduced and increased. Systemic risk is reduced because counterparty risk is reduced, and transparency and liquidity improve. Systemic risk is increased because higher initial margin during times of stress would heighten market risk, and the failure of a CCP may lead to a catastrophic event.
