Clearinghouses and central counterparties explained

A clearinghouse, also called a central counterparty (CCP), is an institution that sits between the two sides of a trade and guarantees that the trade will be completed. Once a clearinghouse accepts a trade, the original buyer and seller no longer face each other. Each faces the clearinghouse. That arrangement replaces a web of bilateral credit relationships with a single, well-capitalized and closely supervised counterparty.

For derivatives, the concept matters because contracts can last for years and can lose or gain a great deal of value before they end. This guide explains how clearinghouses work, how the CFTC supervises them and what risks remain.

In brief

• In the United States, a derivatives clearing organization (DCO) must register with the CFTC before it can clear futures, options on futures or swaps.
• The CFTC describes a DCO as an entity that lets parties replace each other’s credit with the DCO’s credit, and that nets obligations and mutualizes or transfers credit risk.
• Registered DCOs must comply with 17 core principles.
• After the financial crisis, standardized swaps were directed into central clearing.
• Clearing reduces some risks and concentrates others.

What clearing does

Trading and clearing are separate steps. Trading is the moment two parties agree on a price. Clearing is what happens afterward: confirming the trade details, calculating obligations, collecting collateral and settling payments and deliveries.

The key legal step is novation. The CFTC’s description of a DCO says it enables parties to substitute the credit of the DCO for the credit of the parties. In practice, the original contract is replaced by two new ones, one between the seller and the clearinghouse and one between the clearinghouse and the buyer. If one side later fails, the clearinghouse still owes the other side what it was promised, and it manages the failed position under its own rules.

A second function is netting. When a firm has many positions with many counterparties, the clearinghouse can offset gains and losses so that the firm owes or receives a single net amount. This reduces the total flow of money and the amount of collateral needed.

The financial safeguards

A clearinghouse does not eliminate risk by itself. It manages it with layers of protection, often called a default waterfall. The details differ among clearinghouses and are published in their rulebooks.

Membership standards. Only approved clearing members can use the clearinghouse directly, and they must meet financial and operational requirements. Customers access clearing through these members, which are often futures commission merchants or bank affiliates.

Initial margin. Each member posts collateral intended to cover potential losses on its positions if it defaults and the position must be closed out. Margin models estimate how much a position could lose over a closing-out period at a chosen confidence level.

Variation margin. Positions are marked to market, usually at least daily, and members pay or receive cash reflecting changes in value. This prevents losses from accumulating.

Default fund and clearinghouse capital. If a defaulting member’s margin is not enough, the clearinghouse uses its default resources. These typically include contributions from the clearing members and part of the clearinghouse’s own capital. Rules describe the order in which these resources are used and whether surviving members may be asked for additional funds.

Default management. The clearinghouse has procedures to hedge, auction or transfer the defaulting member’s positions and to protect customer property. The CFTC core principles include efficient and fair default procedures.

CFTC registration and the core principles

The CFTC states that a DCO must register before it can clear futures, options on futures or swaps. Registration requirements come from Section 5b of the Commodity Exchange Act and Part 39 of the CFTC’s regulations. The Commission may exempt a DCO from registration for swap clearing if it is subject to comparable, comprehensive supervision in its home country.

To obtain and keep registration, a DCO must meet 17 core principles. According to the CFTC, they cover:

• Financial, operational and management resources, strong risk management and timely settlement under varying conditions.
• Fair eligibility standards for participants and products, protection of member and participant funds, efficient and fair default procedures, and systems security, emergency procedures and disaster recovery plans.
• Effective rule enforcement and dispute resolution.
• Reports the CFTC needs for oversight, business records kept for five years, published rules and procedures, and appropriate information-sharing arrangements.
• Avoiding unreasonable restraints of trade, sound governance and fitness standards, rules to manage conflicts of interest, boards that include market participants, and a well-founded legal framework.

The CFTC also designates certain clearinghouses as systemically important under Title VIII of Dodd-Frank, which brings added prudential standards. Those standards and the Federal Reserve’s role for designated firms are described on the agencies’ websites.

The post-crisis clearing mandate

Before 2008, many swaps were bilateral. Counterparty exposures were large and hard to measure. The Dodd-Frank reforms directed standardized derivatives into central clearinghouses. In its overview, the CFTC says clearinghouses stand between the parties to a trade and absorb the risk that a counterparty defaults.

The Commission determines which classes of swaps must be cleared, and parties can use exceptions where the statute allows, such as for qualifying commercial end users. Swaps that are not cleared remain subject to margin rules. The effect has been to move a large share of standardized interest rate and credit index swaps through a small number of clearinghouses.

Concentration and the “too big to fail” question

Clearing reduces the risk of a chain of failures in bilateral markets, but it concentrates risk in a few institutions. A large clearinghouse may be the main hub for a particular product. If it failed, the consequences for markets could be severe. For this reason, regulators focus on stress testing, margin model validation, liquidity resources, governance and recovery and resolution planning.

Debates continue about how much capital clearinghouses should hold themselves, how procyclical margin may be during volatile periods, and how to handle the end of a recovery plan if a clearinghouse cannot be saved. Reasonable observers disagree, and policy papers from the CFTC, the Federal Reserve, the Bank of England and international standard setters present different views.

Customers and segregation

Retail and institutional customers usually reach clearinghouses through a futures commission merchant. CFTC rules require that customer funds be segregated from the firm’s own funds, and that cleared swaps customer collateral be handled under a separate legal framework in the bankruptcy code, often described as legal segregation with operational commingling. These rules aim to protect customers if their broker fails, and to allow positions to be transferred (ported) to another clearing member.

Reading a clearinghouse rulebook

Each clearinghouse publishes its rules, and the CFTC posts rule filings and approvals on its website. A reader who wants to understand a particular clearinghouse should look for a few items: who may become a clearing member and what capital is required; how margin is calculated and how often it can change; the order of resources used in a default; what happens to customer positions if a member fails; and the clearinghouse’s recovery tools if its resources run low. Public disclosures under international standards, often called principles for financial market infrastructures, give a standardized summary and are published on clearinghouse websites.

Changes to those rules are not made informally. A registered clearinghouse generally must file rule changes with the CFTC, either for approval or on a self-certification basis, and the Commission can stay or review them. That process means that a margin increase announced by a clearinghouse during a volatile week has usually been prepared under rules already on file.

Common misconceptions

“A clearinghouse guarantees every investor against loss.” It guarantees performance of cleared trades to its members within its rules. It does not protect investors from market losses.

“Clearing means exchange trading.” The two are distinct. A swap can be cleared without being traded on an exchange, and some venues trade uncleared swaps.

“Clearinghouses are run by the government.” Most are private companies, often owned by exchange groups or members, but registered with and supervised by regulators.

“Margin is a fee.” Margin is collateral, held to cover risk and returned when positions are closed, subject to gains and losses.

A worked example

Two firms trade a futures contract. Firm A buys and Firm B sells. Both are customers of clearing members. When the trade is submitted, the clearinghouse becomes the counterparty to each clearing member. Both members post initial margin. The next day the price rises, so Firm A’s position gains and Firm B’s loses. B’s clearing member pays variation margin to the clearinghouse, which passes it to A’s clearing member.

Suppose Firm B’s clearing member then fails to pay. The clearinghouse uses B’s member margin first, then its default fund and capital according to its rulebook, while it works to close out or transfer the positions. Firm A is paid what it is owed because the clearinghouse stands behind the trade.

FAQ

What is the difference between a clearinghouse and an exchange?

An exchange is where trades are matched. A clearinghouse handles what comes after: guaranteeing, netting and settling. Some exchange groups own both, but they are legally and functionally separate.

Is every clearinghouse registered with the CFTC?

A clearinghouse that clears futures, options on futures or swaps for US customers must register or be exempt. The CFTC publishes a list of registered DCOs.

What are core principles?

They are statutory standards that DCOs must meet to be registered. There are 17, covering risk management, default procedures, governance and recordkeeping, among others.

What happens if a clearing member defaults?

The clearinghouse follows its default rules, using the member’s margin, then default resources, and manages or transfers its positions.

Does clearing remove counterparty risk?

It reduces bilateral counterparty risk and concentrates it in the clearinghouse, which is why regulators supervise clearinghouses closely.