State what a central counterparty (CCP) is and outline how central clearing works.
The idea
A central counterparty (CCP) is an institution that steps between the two sides of a trade and becomes the buyer to every seller and the seller to every buyer, guaranteeing performance to its clearing members. Only members face the CCP directly, and other firms clear through a member that stands behind their trades. Each day the CCP values positions, collects variation margin from members whose positions lost value and pays it to those whose positions gained, holds initial margin against future losses, and keeps a default fund for extreme cases. Its book is matched, so it carries no directional market risk until a member defaults. The usual error is to say clearing removes counterparty risk. Clearing instead concentrates and mutualises it. The exam point is that the CCP's risk is credit risk on members.
A practice question
Which description best defines a central counterparty (CCP)?
- An entity that becomes the buyer to every seller and the seller to every buyer of cleared contracts and guarantees their performance to its members. - correct
- A trading venue that matches buy and sell orders from many participants and publishes prices, without taking on any obligation to perform the trades once they are matched.Why not: Confuses a CCP with an exchange or trading venue; a venue matches orders, a CCP guarantees performance.
- A bank that lends cash to clearing members so that they can meet their margin calls.Why not: Confuses a CCP with a liquidity provider; a CCP interposes itself between trade parties.
- A trade repository that records contracts for regulators but takes on no obligations under them.Why not: Confuses clearing with reporting; a repository records data but does not guarantee any contract.
A CCP interposes itself between the two sides of each cleared trade, becoming counterparty to both and guaranteeing performance. A venue only matches orders and a repository only records trades.
A harder one
A dealer executes an interest rate swap on an electronic platform and then submits it to a CCP for clearing. Which statement correctly separates the roles of the two?
- The platform guarantees performance and collects margin, and the CCP's role is limited to matching the orders.Why not: Reverses the roles; matching is the venue's job and guarantee is the CCP's.
- The two are the same legal entity by definition, so a swap cannot be traded on one and cleared at another.Why not: Assumes trading and clearing are always integrated; OTC swaps are routinely traded on one venue and cleared at a CCP.
- The CCP sets the price at which the swap trades and publishes it to the market, and the platform only records the executed result for regulatory reporting purposes afterwards.Why not: Attributes price formation to the CCP; the CCP only values and clears contracts already agreed.
- The platform provides price discovery and matching; the CCP, once it accepts the trade, guarantees performance and manages margin for it. - correct
Trading and clearing are separable functions: the venue discovers the price and matches counterparties, whereas the CCP takes on the post-trade counterparty role and risk management.
The hardest tier
A CCP clears one futures contract. Members' net positions in USD million of notional (long positive, short negative) are A +30, B +20, C -35 and D -15. Member A defaults and the CCP has not yet hedged or auctioned the position. Ignoring margin, the CCP's loss if the futures price then falls 3% is closest to:
- USD 0.9 million - correct
- USD 1.5 millionWhy not: Applies the 3% to the CCP's long legs against C and D (USD 50 million) and ignores its offsetting short leg to B.
- USD 3.0 millionWhy not: Applies the 3% to the gross of all four members' positions (USD 100 million) although the book was matched before default.
- USD 0.6 millionWhy not: Uses only member B's USD 20 million instead of the CCP's net unmatched position.
The CCP is short 30, short 20 to B, long 35 to C and long 15 to D. Without A, it is long 50 and short 20, a net long of 30. A 3% fall costs 30 x 0.03 = USD 0.9 million.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Central Clearing
- Account for novation as it applies in central clearing.
- Explain multilateral offset, compression and netting, illustrating each with a case.
- Outline how margin and default funds are applied and estimated under central clearing.
- Discuss the exposures a CCP bears and how it controls them.
- Show a loss waterfall at work through illustrations.
- Account for the ways losses are absorbed and the default of one or more CCP members is handled.
- Contrast clearing done bilaterally with clearing done through a central counterparty.
- Contrast the initial margin and default fund contributions asked of clearing members, with respect to how losses are covered, what clearing costs and the moral hazard created.
- Outline the strengths and weaknesses of central clearing.