Central counterparties and market utilities

When Lehman Brothers failed in September 2008, it left behind a huge book of interest rate swaps at the clearing house LCH. LCH closed it out within weeks, inside the margin Lehman had posted. Other members lost nothing. A year later, G20 leaders decided that standard derivatives should be cleared this way.

Every trade that is not settled at once leaves two firms exposed to each other. If one fails before it has paid, the other suffers a loss. This is counterparty riskThe risk that the other side of a trade fails before it has paid everything it owes.. In a market where hundreds of firms trade with each other, it forms a tangled web: one failure can pass losses from firm to firm.

A central counterpartyCentral counterparty: an institution that becomes the buyer to every seller and the seller to every buyer in the trades it clears. (CCP) cuts the web. When two firms agree a trade and send it for clearing, the CCP steps between them by novationReplacing one contract with two: the original trade between two firms becomes two trades, each with the CCP.: the trade is replaced by two, one between the seller and the CCP, one between the CCP and the buyer. The CCP is now the buyer to every seller and the seller to every buyer. It holds no market risk itself, because its two trades cancel out; it holds only the risk that one side fails.

Think of a busy group of friends who keep lending each other money. Instead of tracking dozens of IOUs, they agree that one trusted person will stand behind every loan and keep a single running balance for each of them. That person is the CCP.

Netting. Because every firm now faces the same counterparty, what it owes and what it is owed can be offset into one net figure. This multilateral nettingOffsetting what a firm owes against what it is owed, so only the difference has to be paid. shrinks both the payments and the exposures. In the diagram below, four dealers owe each other $360m across 6 links. Through a CCP they settle $110m across 4: 69% less.

Margin: making the losers pay as they go. The CCP only deals with clearing membersA firm, usually a large bank or broker, that deals directly with a CCP and stands behind its own and its clients' trades., and demands collateral from them:

• Variation marginVariation margin: cash paid every day (or more often) to cover the change in a position's value.: every day, the side whose position lost value pays the side that gained. Losses cannot pile up.
• Initial marginInitial margin: collateral posted up front to cover the loss the CCP could suffer while closing out a defaulter's positions.: collateral posted up front, sized to cover what the CCP could lose in the few days it would take to close out a defaulter's positions, in all but extreme markets.
• Default fundDefault fund: a pool every member pays into, used to cover a defaulter's losses beyond its own margin. contributions: every member pays into a shared pool that covers losses beyond a defaulter's own margin. This is where risk is mutualised: the survivors share what is left of a failure.

The order in which these resources are used is the default waterfallThe fixed order in which resources are used to absorb a defaulting member's losses.: defaulter first, then a slice of the CCP's own capital (its skin in the gameSkin in the game: some of the CCP's own capital, placed in the waterfall to give it a reason to manage risk well.), then the survivors' default fund, then extra calls on the survivors. You will run it in the Try it below.

The catch. A CCP concentrates risk in one place. If a CCP itself failed, every member would be hit at once. That is why CCPs are among the most tightly supervised firms in finance.

Other market utilities. CCPs are one kind of financial market infrastructureFinancial market infrastructure: the systems that clear, settle and record payments and trades. (FMI). Click each one to see what it does.

Netting and the waterfall need only addition, written precisely. For each firm $i$, its net position against the CCP is what it is owed minus what it owes:

The nets always add up to zero, because every payment has a payer and a receiver. The waterfall then takes the loss $X$ through layers of size $R_1, R_2, \ldots$ in order. Each layer pays the smaller of its size and what is left:

These build on the sums of L1.2.01, so they are shown here in full rather than animated.

A member has defaulted. Start with a €400m close-out loss: the defaulter's own resources and the CCP's slice cover most of it, and the survivors pay a little. Then push the loss up until the survivors' fund is used up. Finally, cut the initial margin and see how much sooner the other members are hit.

Northbridge Securities, a made-up clearing member of a euro interest rate swap CCP, fails to pay its variation margin one morning. It has posted €300m of initial margin and €50m to the default fund. The CCP holds €25m of skin in the game. 9 other members have each paid €50m into the default fund. Amounts in € millions.

• Global: the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMI, 2012) set the standard for CCPs, depositories and payment systems. Among them: initial margin must cover potential losses with at least 99% confidence, and the default fund must cover the default of the largest member (the two largest for systemically important CCPs in complex markets). In 2009 the G20 committed to central clearing of standardised OTC derivatives.
• United States: the CFTC supervises derivatives CCPs and the SEC securities CCPs; the most important are designated as systemically important under the Dodd-Frank Act. The SEC has also adopted rules to bring more US Treasury trading into central clearing.
• European Union: EMIR (2012) sets clearing obligations and CCP rules; a 2021 regulation adds recovery and resolution plans for CCPs. ESMA supervises the largest non-EU CCPs serving EU firms.
• United Kingdom and Asia-Pacific: the Bank of England supervises UK CCPs. In Japan, Hong Kong, Singapore and Australia, securities regulators and central banks oversee them together.
• Banks: Basel rules give lower capital charges for trades cleared through a CCP that meets the PFMI, a strong reason for banks to clear.

Margin, collateral and clearing for derivatives return in L1.7.11, and counterparty credit risk in later levels.

• Through novation a CCP becomes buyer to every seller and seller to every buyer, replacing a web of exposures with a hub.
• Multilateral netting cuts the amounts that must be paid and the exposures firms carry.
• Variation margin settles losses daily; initial margin covers the cost of closing out a defaulter.
• The default waterfall runs: defaulter's margin and fund contribution, CCP capital, survivors' default fund, then assessments.
• CCPs, depositories and payment systems are market utilities, supervised closely under the PFMI.

Counterparty risk

The risk that the other side of a trade fails before it has paid everything it owes.

Central counterparty (CCP)

Central counterparty: an institution that becomes the buyer to every seller and the seller to every buyer in the trades it clears.

Novation

Replacing one contract with two: the original trade between two firms becomes two trades, each with the CCP.

Clearing member

A firm, usually a large bank or broker, that deals directly with a CCP and stands behind its own and its clients' trades.

Netting

Offsetting what a firm owes against what it is owed, so only the difference has to be paid.

Variation margin

Variation margin: cash paid every day (or more often) to cover the change in a position's value.

Initial margin

Initial margin: collateral posted up front to cover the loss the CCP could suffer while closing out a defaulter's positions.

Default fund

Default fund: a pool every member pays into, used to cover a defaulter's losses beyond its own margin.

Skin in the game

Skin in the game: some of the CCP's own capital, placed in the waterfall to give it a reason to manage risk well.

Default waterfall

The fixed order in which resources are used to absorb a defaulting member's losses.

Central securities depository

Central securities depository: the institution that records who owns which securities and transfers them at settlement.

FMI

Financial market infrastructure: the systems that clear, settle and record payments and trades.