Module II·Article II·~4 min read
Central Counterparty (CCP) and Clearing Houses
Clearing, Settlement, and Custody
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Role of the central counterparty in risk management
The central counterparty (CCP) is an organization that becomes the buyer for every seller and the seller for every buyer, taking on counterparty risk. The CCP is a key element of modern financial infrastructure, especially after the lessons of the 2008 crisis.
Mechanism of CCP operation
Novation (substitution) is the central process of the CCP. When two parties enter into a transaction, the CCP "substitutes" itself in the contract: the original deal between A and B is transformed into two deals—A with the CCP and CCP with B. This is called the principle "the CCP stands in the middle." After novation, each participant has exposure only to the CCP, rather than to a multitude of counterparties. This simplifies risk management and reduces systemic interdependence. In the event of a participant's default, the others are protected—the losses are covered by the CCP's resources.
Multilateral netting
Netting (mutual offsetting) is a key advantage of the CCP. Instead of settlements for each transaction separately (gross settlement), the CCP calculates the net position of each participant. If a participant bought 100 shares from one counterparty and sold 80 to another, the CCP will calculate the net obligation—receiving 20 shares. Multilateral netting significantly reduces the volume of settlements and liquidity requirements. According to estimates, netting reduces settlement obligations by 90–99% depending on the market. This frees up capital and lowers operational risks.
CCP risk management
Participation requirements—CCP sets criteria for participants: minimum capital, operational standards, creditworthiness. This ensures the quality of participants and reduces the likelihood of defaults.
Initial margin—the collateral deposited upon opening a position. The size of the margin is calculated based on potential losses under unfavorable market movements. Methodologies include SPAN, VaR, and historical simulations. The margin typically covers 99–99.5% of possible movements over the liquidation period.
Variation margin—daily repricing of positions at market prices (mark-to-market). The loss-making side transfers the variation margin to the CCP, which passes it to the profitable side. This prevents the accumulation of losses and ensures the current status of positions.
Default waterfall
Default waterfall (cascade of protection against default) is the sequence of resources used by the CCP in the event of a participant's default. Typical structure:
(1) margin and collateral of the defaulting participant;
(2) the defaulting participant’s contribution to the default fund;
(3) “skin in the game”—CCP’s own funds;
(4) default fund contributions of other participants;
(5) additional assessments;
(6) residual CCP resources.
Default fund (guarantee fund)—a collective pool of participant funds to cover losses exceeding the margin of the defaulting participant. The size of the fund is calculated to cover the default of the largest participants (usually Cover 1 or Cover 2—one or two largest participants). Properly structured waterfalls create incentives: participants are interested in high-quality risk management, since their default fund contributions are at risk in the event of another participant’s default.
Stress testing and recovery
CCP conducts regular stress testing to assess the sufficiency of resources under extreme scenarios. The tests include historical crises (2008, 2020) and hypothetical scenarios (multiple defaults, extreme volatility).
Recovery plan—a plan of action for the CCP in case the default waterfall is exhausted. Recovery tools include: additional assessments on participants, haircutting of payments (reduction of variation margin), partial tear-up (forced closing of positions), auction (sale of the defaulting participant’s positions).
Resolution—the final measure if recovery is impossible. Special resolution regimes for CCPs provide for regulatory powers, continuity of critical functions, and protection of financial stability.
CCP as systemically significant institutions
After the 2008 crisis, the G20 mandated central clearing of standardized OTC derivatives. This concentrated risks in CCPs, making them “too important to fail.” International standards CPMI–IOSCO “Principles for Financial Market Infrastructures” (PFMI) set requirements for CCPs: risk management, governance, transparency, operational resilience. Regulators conduct assessments of compliance.
Critics point to risk concentration: CCPs become single points of failure. The default of a major CCP could have catastrophic consequences. This requires especially high standards of resilience and oversight.
Leading CCPs in the world
LCH (London Stock Exchange Group)—the largest CCP for interest rate swaps (SwapClear).
CME Clearing—clearing of futures and options in the USA.
ICE Clear—energy and credit derivatives.
Eurex Clearing—European derivatives.
DTCC—clearing and settlement for American securities.
Interoperability between CCPs allows participants to choose a clearing house. This increases competition but creates complexities in managing inter-CCP exposure.
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