Cleared derivatives are derivative contracts that have been submitted to a central counterparty (CCP), which becomes the buyer to every seller and the seller to every buyer. Each original party then faces the clearing house, not the other party, and the clearing house manages the risk of default through margin and a pool of shared resources.
All exchange-traded derivatives, such as futures and listed options, are cleared as a matter of course. The term is used mainly to distinguish cleared from uncleared contracts within over-the-counter (OTC) derivatives, which are negotiated privately. Since the financial crisis of 2007 to 2009, a large share of the over-the-counter market, above all interest rate swaps, has moved into clearing houses.
Background to mandatory clearing
Before the crisis, most over-the-counter derivatives were held bilaterally, often with little collateral. When Lehman Brothers failed and American International Group required a rescue in 2008, the web of exposures between dealers proved opaque and hard to unwind. In 2009 the G20 leaders agreed that standardised over-the-counter derivatives should be cleared through central counterparties, traded on electronic platforms where appropriate and reported to trade repositories.
The commitment was implemented in the United States by the Dodd-Frank Act, with rules made by the Commodity Futures Trading Commission (CFTC) and the securities regulator, and in the European Union by the European Market Infrastructure Regulation, known as EMIR, adopted in 2012. Other major jurisdictions followed. Regulators decide which classes of contract must be cleared, based on standardisation, liquidity and the availability of reliable pricing. The main classes covered are interest rate swaps in major currencies and index credit default swaps. Exemptions apply to smaller counterparties and, in many cases, to non-financial companies hedging commercial risk.
How clearing works
After two parties execute a trade, it is submitted to the clearing house. On acceptance, the original contract is replaced by two contracts with the clearing house through novation. The process is described under central counterparty clearing.
Only a clearing member deals directly with the clearing house. Other firms, including most asset managers, pension funds and smaller banks, gain access as clients of a member, an arrangement called client clearing. The member guarantees its clients' obligations and passes margin between them and the clearing house.
Risk is managed through several layers:
- Variation margin. Positions are revalued at least daily, and losses are paid in cash to the clearing house, which passes them to the party with the corresponding gain; see variation margin.
- Initial margin. Each party posts initial margin to cover the potential loss if its position had to be closed out over several days.
- Default fund. Members contribute to a default fund that absorbs losses beyond a defaulter's own margin and contribution.
- The clearing house's own capital. A tranche of its capital is used before the contributions of surviving members.
The order in which these are used is called the default waterfall. When a member fails, the clearing house hedges and auctions its portfolio and transfers its clients to other members, as set out under default management.
Advantages
Central clearing replaces many bilateral exposures with a single exposure to a well-resourced, closely supervised entity. Multilateral netting reduces the total amount at risk: a firm's positions with many counterparties in the same product offset one another at the clearing house. Margin is collected daily under consistent rules, so losses cannot accumulate unnoticed. Cleared positions are easier to value, report and terminate, and services such as trade compression remove redundant contracts.
Bank capital rules reinforce the incentive. Exposures to a qualifying central counterparty attract low capital charges, while uncleared trades carry higher charges and, for larger firms, mandatory margin under a bilateral collateral agreement.
Risks and criticism
Clearing does not remove risk; it concentrates it. A handful of clearing houses now stand at the centre of the global derivatives market, and the failure of one would be a systemic event. Regulators have therefore set international standards for their resilience, required recovery plans and created resolution regimes for them.
Margin has its own effects. Initial margin requirements rise when markets become volatile, and variation margin must be paid in cash, often within hours. Episodes such as the market turmoil of March 2020 and the stress among United Kingdom pension funds in September 2022 showed that sudden margin calls can force firms to sell assets and so amplify price moves.
Other concerns include the limited number of banks offering client clearing, since capital and leverage rules make the service costly to provide, and the question of how losses should be shared between a clearing house's owners and its members. Location is also contested. Much euro-denominated swap clearing takes place in London, and the European Union has introduced requirements for its firms to maintain active accounts at clearing houses within the Union.
Operations
Cleared trades follow a standard lifecycle: execution, affirmation, submission, acceptance, daily margining, and eventual maturity, termination or compression. Positions and collateral are reconciled daily between client, member and clearing house, and all trades are subject to trade reporting. Client collateral is held under segregation models that offer different levels of protection and cost. These processes form a large part of derivative lifecycle management.