10.2 Central Clearing

Central Clearing

FMP–6 zooms in on the institution that FMP–5 introduced: the central counterparty (CCP). GARP expects you to explain how clearing works, why regulators pushed it after the crisis, and what new risks appear when counterparty risk is concentrated in a few infrastructures.

CCP Mechanics

Lifecycle of a cleared trade (simplified):

1. Execution — parties agree on economic terms (on exchange or OTC platform).
2. Novation / registration — the CCP becomes buyer to the seller and seller to the buyer.
3. Margining — initial margin is calculated (often portfolio-margined within eligible product sets); variation margin flows as prices move.
4. Default management — if a clearing member defaults, the CCP uses that member’s IM, then default-fund contributions (and further waterfall steps) while hedging, auctioning, or transferring positions.

Clearing members (futures commission merchants / clearing brokers) face the CCP. Many end clients clear through a member as customers, not as direct CCP members.

Exact waterfalls vary by CCP and jurisdiction; exam questions test the logic of “defaulter pays first, then mutualization,” not every rulebook line.

Bilateral Versus Centralized Clearing

Bilateral: each pair of counterparties manages credit with CSAs, credit limits, and capital. The network is a dense graph—Dealer A faces B, C, D, …

Centralized (CCP): the network becomes a star. Members face the CCP; the CCP faces members. Multilateral netting collapses offsetting positions across the membership.

Netting comparison (numeric sketch)

Three dealers each have offsetting positions that form a circle: A is owed 10 by B, B owed 10 by C, C owed 10 by A. Bilateral gross credit marks look like 10 + 10 + 10 = 30 of one-way receivables in the system. With a CCP and full multilateral netting of these identical offsets, net positions can collapse toward zero system exposure (before considering other trades). Real books are messier, but the multilateral benefit is the point.

Advantages and Disadvantages of CCPs

Advantages

• Multilateral netting lowers aggregate exposures
• Standardized IM/VM and daily mark-to-market reduce unpaid MTM buildup
• Transparent default management and position transfer tools
• Reduced interconnectedness among dealers for cleared products
• Potentially lower capital versus equivalent uncleared bilateral risk (rule-dependent)

Disadvantages / new risks

• Concentration: CCP failure or severe stress is systemic
• Procyclicality: IM rises in volatility spikes, forcing deleveraging (“margin spiral”)
• Liquidity risk: VM calls demand cash (or liquid collateral) exactly when funding is scarce
• Moral hazard / adverse selection: if membership or product eligibility is weak, risk migrates into the CCP
• Loss of customization: bespoke hedges may remain uncleared and thus differently regulated

OTC Regulatory Initiatives

Post-GFC reforms (G20 agenda and implementing regimes such as Dodd-Frank / EMIR-style frameworks) targeted OTC derivatives with a package:

1. Clearing mandates for standardized, liquid OTC derivatives where a CCP is available
2. Margin rules for uncleared derivatives — VM generally required; IM phased in by notional size
3. Trade reporting to trade repositories
4. Higher capital on remaining bilateral exposures and on exposures to CCPs (though CCP exposures often receive preferential treatment versus raw bilateral)
5. Trading venue / electronic execution requirements for some products

The policy bet: push risk into resilient, margined, netted CCP structures; make leftover bilateral risk expensive and collateralized.

Margin Comparison: Cleared Versus Uncleared

Worked IM intuition

Suppose a portfolio’s 5-day 99% expected shortfall on cleared swaps is estimated at $20 million and the CCP’s IM model targets that horizon. IM ≈ $20 million (plus add-ons). The same portfolio uncleared might face SIMM IM of a similar order plus no access to multilateral netting against other dealers’ offsets—so total system IM across dealers can be higher even if pairwise SIMM looks “fair.”

Netting Comparison and Market Impact

Bilateral netting helps each pair. Multilateral netting helps the system. Compression cycles further cancel redundant contracts.

Market impacts of widespread clearing:

• Dealer balance sheets: lower counterparty RWA on cleared flow, but higher liquidity needs for IM/VM
• Client clearing: clients need clearing brokers; concentration among a few FCMs creates client access risk
• Pricing: cleared vs uncleared basis (including funding valuation adjustment effects in dealer pricing)
• Product migration: standardized products clear; exotic risk may concentrate in uncleared books

CCP Risks

CCPs are risk managers, not risk-free utilities.

Recovery and resolution planning for CCPs matters because tearing up contracts or haircutting variation margin in extreme recovery can redistribute losses onto participants.

Member Versus Non-Member (Client) Risks

Clearing members contribute to default funds, face CCP margin calls directly, may be assessed for replenishment, and operationally guarantee client performance to the CCP.

Non-member clients typically:

• Post margin to their clearing broker (who posts to the CCP)
• Face broker default risk (depending on segregation and portability)
• Do not usually contribute directly to the CCP default fund (the member does)
• Depend on portability—the ability to move positions to a backup clearer if their FCM fails

Mini vignette

A hedge fund clears IRS through FCM X. X defaults. If positions are portable and collateral is properly segregated, the fund may transfer to FCM Y with limited loss. If segregation is incomplete or no backup clearer will take the book in a stress week, the client can face frozen collateral and close-out losses—even though the original swap counterparties were “replaced” by the CCP at the member level.

Synthesis

Central clearing is a risk transformation: from opaque bilateral webs to CCP-centric stars with better netting and margin discipline—and new concentration, liquidity, and mutualization risks. Exam answers should name which risk fell and which rose. If asked whether CCPs eliminate systemic risk, the precise answer is no: they reshape it and, if well designed, make it more manageable and transparent.