Central Clearing Parties: What they are and why we need them - Part 1

G-20 Leaders Vote for CCPs: What are they?

In September 2009, as the financial crisis was starting to slowly recede, the leaders of the twenty largest economies of the world (the G-20) met in Pittsburgh. At the end of their summit, they issued a communiqué of nearly 9000 words. Somewhere in the middle of the statement, the following sentence appeared:

All standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. 

This was a very big deal. It represented a commitment to overhaul the infrastructure of derivatives markets by requiring traders to use central clearing parties, or CCPs, for short. What is a CCP? And why would something so arcane surface in a statement issued by Presidents and Prime Ministers?

To understand all of this, we can start with a simple financial transaction. Imagine that you wish to purchase 100 shares of Apple stock. At current prices, this will cost you something like $50,000. Well, there needs to be a mechanism for you to transfer the money to the person with the shares, and for them, in turn, to transfer ownership of the shares to you. These payment and settlement functions are handled by a series of intermediaries, including banks, securities firms and a clearinghouse. All in all, the system works because the buyer and seller are confident that they will receive what they expect.

Now consider a derivatives transaction – one involving a futures contract, an option or a swap. These differ from the stock purchase in a very important way: they all entail promises to make payments on some future date, under some conditions. That is, they involve transfers of funds in the future that are often contingent on the state of the world at the time. How do we ensure that the two sides of the transaction – the long and short, the buyer and seller – get what they are promised? 

Prior to the crisis, most derivatives contracts were traded over the counter. That is, buyers and sellers made bilateral arrangements based on previously negotiated contracts. These contracts would specify things like how much collateral each party had to provide to guarantee that they would meet the payment obligations when the derivative came due. They also specify what happens in the event that one of the parties went bankrupt.

The alternative to bilateral transactions is trading through a central counterparty.  Sometimes called a clearinghouse, the CCP sits between the buyer and seller of every derivatives contract.  That is, it buys the contract from the seller and sells the same contract to the buyer.  The CCP is perfectly hedged, so long as the two parties to the transaction remain solvent and can make the requisite payments when the contract comes due.  To ensure itself against the possibility of default, the CCP demands collateral to clear each trade and requires the posting of margin as the value of the derivative changes over time.  Finally, to handle the possibility of losses, the CCP will hold capital and have a loss-sharing agreement with its trading members.