In the wake of the financial crisis and in response to the G20 commitment to provide global financial stability, regulators around the world are increasingly looking to central counterparty (CCP) clearing houses as a way to mitigate counterparty risk in the market. Proposals in both the U.S. Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) stress the importance of having over-the-counter (OTC) derivative transactions cleared through CCPs.

Central counterparty clearing refers to the process by which financial transactions are cleared by a centralized counterparty. Through a process called “novation,” the CCP becomes the seller to the buyer and the buyer to the seller. A clearing house usually provides the CCP service and manages the counterparty default risk by leveraging its built-in risk management mechanisms, such as margins or default funds contributed by its clearing members.[1]

Initially devised as a mechanism to reduce transaction costs by calculating members’ net obligations to post margins and settle contracts, the role of the CCP has expanded over time. Since the financial crisis, the importance of CCPs in providing financial stability through their risk management arrangements cannot be overstated.

CCPs have long been used by derivatives exchanges and a few securities exchanges. In recent years, they have been introduced into more securities markets, including cash markets and OTC markets, becoming an integral part of the financial market infrastructure. For example, repurchase agreements, also known as repos,[2] an important financial instrument used to provide funding for dealers and banks, can now be cleared through several clearing houses in Europe, the United States and Canada.

Given this rising demand for CCP clearing, many clearing houses are seizing the opportunity to build out their clearing business. For example, CME Clearing Europe plans to launch real-time, open-access clearing for OTC financial derivatives, including interest rate swaps (IRS), foreign exchange (FX) and credit default swaps (CDS). In Asia, Hong Kong Exchanges and Clearing (HKEx) plans to expand into providing clearing services for OTC derivatives to support the global regulatory initiatives.

For financial institutions new to CCPs, understanding the services that a CCP can provide and the differences among various CCPs can be daunting. For example, the European Association of CCP Clearing Houses (EACH) consists of 23 members. Each member offers different services, currencies and products, and has different requirements for participation.

This series of blogs about central counterparty clearing will explain some of the differences and key attributes of CCPs, how financial institutions can participate in a CCP, and what the future holds for these entities. Next week, the CCP blog series will look at the history of CCPs and explain how they are organized.

What changes have you seen in central counterparty clearing? Join the discussion. 

[1] An important concept of CCP is risk mutualisation. The clearing members share the default risk of other clearing members, which provides strong incentives for the clearing members to monitor the clearinghouse’s risk management practice.

[2] Repos are the sale of securities together with an agreement for the seller to buy back the securities at a later date.