Outline how a derivative transaction is cleared.
The idea
Clearing a derivative follows a sequence. The trade is executed and the terms matched or confirmed, then submitted to the clearing house. Through novation the original contract is replaced by two contracts, one between the clearing house and each side, so the clearing house becomes buyer to every seller and seller to every buyer. Initial margin is posted when the position opens. Variation margin is exchanged each day as the position is marked to market, and at expiry cash or the asset is settled through the clearing house. Parties that are not clearing members reach the clearing house through a clearing member that guarantees their performance. Until novation takes effect the original counterparties are still exposed to each other. Exam point: novation is the step that swaps bilateral risk for risk against the clearing house.
Formulas
Daily variation margin on a cleared position
VM = V(t) − V(t − 1)
- V(t)
- the mark-to-market of the position at the end of day t
- V(t − 1)
- the mark-to-market at the end of the previous day
A positive result is received and a negative one paid. Margin follows the change in value, not its level, and initial margin stays posted on top.
A practice question
In clearing a derivative transaction, what is the effect of novation?
- The original contract stays in place and the clearing house acts only as a record keeper of the tradeWhy not: Describes a trade repository's role; novation actually replaces the contract.
- The two parties net all their trades against each other and settle only the single net amountWhy not: Confuses novation with bilateral close-out netting.
- The original contract is replaced by two contracts, each with the clearing house - correct
- The transaction is split into a series of smaller contracts that are each priced at market valueWhy not: Invents a decomposition of the contract; novation changes the counterparty, not the contract's size.
Novation makes the clearing house the buyer to every seller and seller to every buyer, which converts bilateral risk into risk against the clearing house.
A harder one
A pension fund is not a member of the clearing house. How is its cleared swap handled?
- Through a clearing member, which guarantees its performance and collects its margin - correct
- The fund deals directly with the clearing house, which treats it exactly like a clearing memberWhy not: Ignores membership: only clearing members face the clearing house directly.
- The clearing member acts as agent only and takes no responsibility if the fund fails to performWhy not: Wrongly says there is no guarantee; the clearing member is liable to the clearing house for client trades.
- The fund's bank guarantees the trade to the original dealer, so no margin is posted to anyoneWhy not: Describes a bilateral credit line; cleared trades require margin to the clearing member and clearing house.
Clients access a CCP through clearing members, who guarantee client trades and pass on the margin they collect.
The hardest tier
Two parties execute an OTC swap in the afternoon and submit it to a CCP for clearing at the end of the day. Which statement about the period between execution and acceptance is correct?
- The CCP guarantees the trade from the time of execution, so there is no bilateral exposure at any pointWhy not: Assumes novation is instant; the CCP only takes over after it accepts the trade.
- The trade has no legal effect until clearing, so neither party can have any exposure to the otherWhy not: Confuses acceptance with legal existence; the trade is binding, so exposure exists until novation.
- Until the CCP accepts and novates the trade, the original counterparties remain exposed to each other - correct
- Exposure is nil because initial margin is always posted at execution to the other partyWhy not: Initial margin is posted to the CCP or clearing member after acceptance, not bilaterally at execution.
Novation takes place on acceptance. Before then the parties face each other, which is why CCPs use fast acceptance windows and pre-trade credit checks.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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