Central counterparty clearing
Central counterparty clearing (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.
CCPs "mutualize" (share among their members) counterparty credit risk in the markets in which they operate. A CCP reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the member firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit. The advantages of a central counterparty clearing arrangement are greater transparency of the risks, reduced processing costs, and greater certainty in cases of default by a member. Once a trade has been executed by two counterparties, it is submitted to a clearing house, which then steps between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. For example, a trade between member firm A and firm B becomes two trades: A-CCP and CCP-B. This process is called novation.
As the CCP concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting. Guarantee funds are capitalized with collateral from the member firms. In the event of a settlement failure, the defaulting firm may be declared to be in default and the CCP's default procedures utilized, which may include the orderly liquidation of the defaulting firm's positions and collateral. In the event of a significant clearing firm failure, the CCP may draw on its guarantee fund in order to settle trades on behalf of the failed clearing firm.
Post financial crisis of 2007–08
In the wake of the financial crisis of 2007–08 the G20 leaders agreed at the 2009 Pittsburgh summit that all standardised derivatives contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties (CCPs). In the United States, as part of the Obama financial regulatory reform plan of 2009, pressure has been placed on traders of derivatives such as credit default swaps (CDS) to make their trades on an open exchange with a clearinghouse. In June 2009, Federal Reserve official Alfred Kohn mentioned that the largest CDS dealers were working on an exchange, and that only regulatory approval rather than legislation would be required. In March 2010, the Options Clearing Corporation (OCC) stated that it was moving forward in backing equity derivatives. In Europe, the European Market Infrastructure Regulation mandated central clearing.
DTCC's subsidiary the National Securities Clearing Corporation clears broker-to-broker trades using its Continuous Net Settlement (CNS) System. This has acted as a CCP, long before the term was coined. In order to deal with the default of a member broker, as happened with Drexel Burnham and Lehman Brothers, DTCC has a guarantee fund to which all broker members contribute. It also has rules to handle the gains and losses from a defaulting broker. The guarantee fund ensures that settlement can be completed. A defaulting member's contribution to the fund, along with any other assets held by the depository, are used to absorb any losses at the time of default.
- The margin deposits of the suspended firm
- Clearing fund deposits of the suspended firm
- Clearing fund deposits of non-defaulting firms
- OCC retained earnings
- Clearing fund assessments
In order to access the viability of its funds, the OCC carries out a firm-wide default test annually. In addition, the firm performs smaller, limited scope defaults throughout the year. Results are reported to its Enterprise Risk Management Committee.
LCH.Clearnet, the result of a merger between the London Clearing House and Clearnet, acts as a CCP for a wide variety of financial products, from equities and commodities to credit default swaps and interest rate swaps.
Asian countries have addressed the needs of their derivative markets by forming CCPs. Shanghai Clearing House, formed in 2009, acts as a CCP for a wide range of financial products in China.
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