Central Counterparty (CCP)

A central counterparty (CCP) is a clearing house that inserts itself into a trade once both sides have agreed terms, so that it faces every seller as their buyer and every buyer as their seller. From that point on, participants no longer carry risk on the firm they dealt with; their exposure is to the CCP. CCPs clear exchange-traded futures and options, standardized over-the-counter derivatives such as interest rate swaps, cash equities, bonds and repurchase agreements.

By standing in the middle, a CCP replaces a web of bilateral exposures with a hub-and-spoke structure, which simplifies risk management, allows offsetting positions to be netted, and concentrates risk in a single, heavily regulated institution.

The legal technique is usually novation: the original contract between the two traders is extinguished and replaced by two new contracts, one between each trader and the CCP. Only clearing members, typically large banks and brokers, face the CCP directly; other firms clear through a clearing member as clients.

Because the CCP is on both sides of every trade, its own market position is flat. Its risk is that a member defaults while owing it money. Positions are also subject to multilateral netting, so a member that bought and sold similar contracts with different firms has only its net position to settle and margin.

A CCP protects itself and its members through several layers:

• Initial margin — collateral posted by each member to cover potential losses on its positions over the time needed to close them out after a default, calculated with statistical models.
• Variation margin — daily, sometimes intraday, payments reflecting gains and losses as positions are marked to market. A shortfall produces a margin call.
• Collateral rules — eligible assets are typically cash and high-quality securities, valued after a haircut.
• Default fund — a pool contributed by all clearing members to absorb losses beyond a defaulter's own margin.
• Default waterfall — the order in which resources are used: the defaulter's margin and default fund contribution, then a tranche of the CCP's own capital, then the other members' default fund contributions, and finally further assessments or recovery tools.

At the Pittsburgh summit in 2009, after the 2008 financial crisis exposed the opacity of bilateral exposures in instruments such as the credit default swap, G20 leaders committed to clear standardized OTC derivatives through CCPs. In the United States this was implemented by Title VII of the Dodd-Frank Act of 2010, with the Commodity Futures Trading Commission and the SEC supervising clearing agencies; in the European Union by the European Market Infrastructure Regulation (EMIR) of 2012, under oversight involving ESMA and national authorities.

Internationally, CCPs are expected to meet the Principles for Financial Market Infrastructures issued in 2012 by the Committee on Payments and Market Infrastructures (CPMI) and IOSCO. These include holding enough financial resources to withstand the default of the largest member, or the two largest for systemically important CCPs active in multiple jurisdictions, and settling cash in central bank money where practical.

Major CCPs include LCH, CME Clearing, Eurex Clearing, ICE Clear and, in US securities, the National Securities Clearing Corporation and the Fixed Income Clearing Corporation, both subsidiaries of The Depository Trust & Clearing Corporation. Some CCPs clear contracts with very large notional amounts in interest rate swaps.

Mandatory clearing concentrates risk. A CCP failure would hit every member at once, so major CCPs are widely regarded as too big to fail, and authorities have developed recovery and resolution regimes for them. Margin calls can also be procyclical: in stress, rising volatility increases margin requirements just as liquidity is scarce, forcing members to raise cash quickly. Critics also question whether CCPs, many of which are owned by profit-seeking exchange groups, hold enough of their own capital in the waterfall.