Central counterparty clearing

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Also see: clearing organization

Central counterparty clearing is the process by which financial transactions are cleared by a single counterparty, generally a well capitalized financial institution such as an exchange. The central counterparty (the exchange's clearing house) becomes a party to every trade, acting as a buyer to every seller and a seller to every buyer. That way, if one trader or firm defaults, other traders and customers are protected.

Central counterparty clearing is a feature of exchange listed products as opposed to the bilateral agreements common in OTC trading, where each party to a trade is at risk that the other party may default.

The central counterparty (CCP) clearing model prevalent in the U.S. futures world is a "vertical" model in which an exchange owns its own clearing house, while the U.S. options industry uses a "horizontal" model (the Options Clearing Corporation (OCC)) in which one clearing utility clears the contracts traded at a number of exchanges.

There are a number of these independent central counterparties; in addition to the OCC, there is LCH in London.

Advantages of Central Clearing, According To The IDCG

Reduces counterparty credit risk

  • Provides Guaranty Fund with financial resources, rules and procedures comparable to existing Clearinghouses
  • Eliminates the need for multiple bilateral credit relationships
  • Eliminates the need for ISDA agreements and ongoing credit risk management of bilateral contracts

Provides transparency not present in the current OTC market structure

  • Includes real-time, normalized pricing data
  • Interest rate curve construction and methodology shared with all participants
  • Potential opportunity for tighter bid/ask spreads

Reduces transaction costs through streamlined back office processes

Creates more efficient markets enabling greater liquidity

  • Operates on fast and efficient electronic platform
  • Facilitates the ability to anonymously trade
  • Attracts new participants

Provides significant benefits due to cleared futures treatment

  • 60/40 tax treatment available where appropriate
  • Bankruptcy protection accorded to segregated funds
  • Regulatory capital requirements mandated by Basel I/II may be reduced or eliminated

References