8
Central Clearing

8.1 EVOLUTION OF CENTRAL CLEARING

8.1.1 Exchange Trading

In derivative markets, many transactions are exchange-traded. An exchange is a central financial centre where parties can trade standardised contracts such as futures and options at a specified price. An exchange promotes market efficiency and enhances liquidity by centralising trading in a single place. The process by which a financial contract becomes exchange-traded can be thought of as a long journey where a critical trading volume, standardisation, and liquidity must first develop.

Exchanges have been used for trading financial products for many years; futures exchanges can be traced back to the nineteenth century (and even further). A future is an agreement by two parties to buy or sell a specified quantity of an asset at some time in the future at a price agreed upon today. Futures were developed to allow merchants or companies to fix prices for certain assets and therefore be able to hedge their exposure to price movements. An exchange was essentially a market where standardised contracts such as futures could be traded. Originally, exchanges were simply trading forums without any settlement or counterparty risk management functions. Transactions were still done on a bilateral basis, and trading through the exchange simply provided a certification through the counterparty being a member of the exchange. Members not fulfilling their requirements were deemed to be in default and were fined or expelled from the exchange.

An exchange can be seen to provide several functions:

Product standardisation. An exchange designs contracts that can be traded where most of the terms (e.g. maturity dates, minimum price quotation increments, the deliverable grade of the underlying, delivery location, and mechanism) are standardised.

Trading venue. Exchanges provide a (physical or electronic) trading facility for the underlying products they list, which provides a central venue for trading and hedging. Access to an exchange is limited to approved firms and individuals who must abide by the rules of the exchange. This centralised trading venue provides an opportunity for price discovery.¹
Reporting services. Exchanges provide various reporting services of transaction prices to trading participants, data vendors, and subscribers. This creates greater transparency of prices.

8.1.2 Evolution of Complete Clearing

The historical development of derivative exchanges led to mechanisms for risk reduction. The first was ‘direct clearing’, meaning that if a party has offsetting positions with the exchange, then they would be offset. For example, suppose party A makes a transaction to buy 100 contracts at a price of $105 and then at a later date executes the reverse position but at a lower price of $102 (Figure 8.1). Rather than a physical exchange of 100 contracts' worth of the underlying together with associated payments of $10,500 and $10,200, netting would be used and settlement would occur based on ‘payment of difference’ (in the example shown, a payment of $300). Payment of difference, rather than delivery, became common in futures markets to reduce problems associated with creditworthiness. Clearly, standardisation of terms facilitates such offset by making contracts fungible.

Direct clearing on exchanges can be seen as similar to netting in over-the-counter (OTC) derivatives (Section 6.3).

Following on from direct clearing, exchanges developed ‘clearing rings’ (Section 6.2.3), whereby three or more counterparties could ‘ring out’ offsetting positions. To achieve the benefits of ‘ringing’, participants in the ring had to be willing to accept substitutes for their original counterparties. In the current OTC derivatives market, portfolio compression (Section 6.2.4) offers a similar mechanism to the historical role of clearing rings.

Even with the use of direct clearing and clearing rings, counterparties are still required to fulfil obligations to each other. This would mean that the default of an exchange member would impose losses on all other members with whom they had trades, despite trading being an anonymous process. The final stage of the historical evolution of risk mitigation at derivatives exchanges was ‘complete clearing’ (which began in 1891), where a central counterparty (CCP) is placed centrally between all counterparties and assumes all such contractual rights and responsibilities, as illustrated in Figure 8.2.

The adoption of central clearing has not been completely without resistance: the Chicago Board of Trade (CBOT) did not have a CCP function for around 30 years until 1925 (and then partly as a result of government pressure). One of the last futures exchanges to adopt a CCP was the London Metal Exchange in 1986 (again with regulatory pressure being a factor). A proposed reason for these resistances is the fact that clearing homogenises counterparty risk and therefore would lead to strong-credit-quality members of the exchange suffering under central clearing compared to the weaker members. The reluctance to adopt clearing voluntarily certainly raises the possibility that the costs of clearing exceed the benefits, at least in some markets. Nevertheless, all exchange-traded contracts are now subject to central clearing. The CCP function may either be operated by the exchange or provided to the exchange as a service by an independent company.

Schematic illustration of direct clearing. — **Figure 8.1** Illustration of direct clearing.

Schematic illustration of complete clearing. The CCP assumes all contractual responsibilities as counterparty to all contracts. — **Figure 8.2** Illustration of complete clearing. The CCP assumes all contractual responsibilities as counterparty to all contracts.

Whilst central clearing became a standard for exchange-traded markets, bilateral OTC derivatives have generally followed a bilateral clearing model. This changed in the late 1990s when SwapClear was set up as part of LCH.Clearnet to centrally-clear interest rate swaps between the major swap dealers.² OTC clearing is now becoming increasingly common as a result of the regulatory changes following the global financial crisis (Section 4.4.1). Centrally-cleared derivatives retain some OTC features (such as being transacted bilaterally) but use the central clearing function developed for exchange-traded derivatives. It is possible to centrally clear an OTC derivative that is not liquid enough to trade on an exchange. However, central clearing does require an OTC derivative to have a certain level of standardisation and liquidity and not be too complex. This means that many types of OTC derivatives will never be suitable for central clearing. Some market participants are not expected to centrally clear due to obstacles such as funding liquidity risk (Section 7.6.2). Nevertheless, it should be noted that a large proportion of the volume of OTC derivatives is transacted in clearable products and by participants suitable for central clearing.

At the current time, there are OTC derivatives that have been centrally cleared for some time (e.g. interest rate swaps), those that have been recently cleared (e.g. index CDSs), and those that are on the way to being centrally cleared (e.g. interest rate swaptions, inflation swaps, single-name CDSs, and cross-currency swaps). Finally, there are of course products that are a long way away and indeed may never be centrally cleared (e.g. Asian options, Bermudan swaptions, and interest rate swaps involving illiquid currencies).

8.1.3 What is a CCP?

A CCP is a particular financial market infrastructure (FMI) that represents a set of rules and operational arrangements designed to allocate, manage, and reduce counterparty risk in a bilateral market. A CCP changes the topology of financial markets by interposing itself between buyers and sellers, as illustrated in Figure 8.3. In this context, it is useful to consider the six entities denoted by D, representing large global banks (‘dealers’). Two obvious advantages appear to stem from this simplistic view. Firstly, a CCP can reduce the interconnectedness within financial markets, which may lessen the impact of an insolvency of a participant. Secondly, the CCP being at the heart of trading can provide more transparency on the positions of the members.

Schematic illustration of (left) the bilateral markets, (right) compared to centrally-cleared markets. — **Figure 8.3** Illustration of bilateral markets (left) compared to centrally-cleared markets (right).

Schematic illustration of a centrally-cleared market including bilateral transactions, directly-cleared transactions, and the positions of non-clearing members who clear through clearing members. — **Figure 8.4** Illustration of a centrally-cleared market including bilateral transactions (dotted lines), directly-cleared transactions (black lines), and the positions of non-clearing members (C) who clear through clearing members (D) (grey lines).

The above analysis is simplistic, and although the general points made are correct, the true CCP landscape is much more complex than represented, as it ignores the following aspects:

Client clearing. Parties that cannot be members of the CCP in question will have to be cleared through a ‘clearing member’. This creates additional complexity regarding operational aspects such as margin transfer and what happens in a default scenario.
Bilateral trades. Not all OTC derivatives are suitable for clearing, and a reasonable population will always remain as bilateral transactions.
Multiple CCPs. There are clearly a number of different CCPs globally that may be implicitly interconnected – for example, via sharing members.

The first two of the above components are illustrated in Figure 8.4.

Central clearing changes the bilateral network to a hub-and-spoke-type system. Whilst this may create greater stability and transparency, it has obvious drawbacks. A CCP at the central hub constitutes a single point of failure. It reduces the possibility for diversification of errors, and a single mistake or failure at the CCP (as opposed to one of its members) has the potential to be catastrophic.

8.2 MECHANICS OF CENTRAL CLEARING

8.2.1 Landscape

Clearing trades obviously has an associated cost. CCPs cover this cost directly by charging fees per trade, and more indirectly by, for example, deriving interest from assets they hold. As FMIs and nodes of the financial system, CCPs clearly need to be resilient, especially during major financial disturbances. This may imply that a utility CCP driven by long-term stability and not short-term profits may be a preferable business model. However, it could also be argued that CCPs will need to have the best personnel and systems to be able to develop advanced risk management and operational capabilities. Moreover, competition between CCPs will benefit users and provide choice. Expertise and competition imply that CCPs should be profit-making organisations. However, this introduces the risk of a possible race to the bottom with respect to certain practices (e.g. margin calculations) that could increase the risk posed by CCPs.

A large number of CCPs will maximise competition, but this too could lead to a race to the bottom in terms of cost and the bifurcation of multilateral offset benefits. Having a small number of CCPs is beneficial in terms of offsetting benefits and economies of scale, but it increases systemic risk linked to CCP failure. Whilst a single global CCP is clearly optimal for a number of reasons, it seems likely that the total number of CCPs will be relatively large. This is due to bifurcation on two levels:

Regional. Major geographical regions view it as important to have their own ‘local’ CCPs, either to clear trades denominated in their own currency or to clear all trades executed for financial institutions in that region. Indeed, regulators in some regions require that financial institutions under their supervision clear certain products using their own regional CCP.
Product. CCPs clearing OTC derivatives have tended to act as vertical structures and specialise in certain product types (e.g. interest rate swaps or CDSs) and thus there is no complete solution of one CCP that can offer coverage of every clearable product (and regulation does not encourage this).

Mandatory clearing can potentially create more systemic risk as large banks are forced to clear only certain standardised transactions. This may have a detrimental effect on net exposure due to the bifurcation or ‘unbundling’ of netting between standard and non-standard contracts (Section 6.4.3). Exemptions for end users and foreign exchange transactions may also create sub-optimal outcomes and the possibility for regulatory arbitrage. The extent of bifurcation depends on how much can actually be practically cleared; for example, the International Swaps and Derivatives Association (ISDA) suggests that this value is approximately 80% for OTC derivatives.³

CCP ownership and operation tends to work broadly via either a vertical or horizontal set-up, with competing coexisting structures. In a vertical structure, the CCP is usually a division of, and owned by, an exchange. The CCP is then essentially tied to the exchange and provides clearing only for products traded on that exchange. This model has generally developed over the years for futures exchanges and arose as the exchanges evolved and developed a central clearing function. Another approach is horizontal, whereby a CCP is separately-owned (typically by its clearing members), has its own financial backing and can, therefore, clear trades across multiple markets and asset classes. Such CCPs generally exist as separate entities. A horizontal set-up is more natural for bilateral OTC derivatives since there is no exchange involved. Regulation appears to favour the increased competition that horizontal clearing allows, with rules calling for CCPs to be ‘open’. For example, the European Commission (EC), under Markets in Financial Instruments Directive (MiFID) II Article 29, proposes to give CCPs access rights to trading venues, which would allow market participants to use a CCP other than the one defined by an exchange or other trading platform. This is seen as important to increase competition between CCPs, thereby reducing costs and improving the quality of clearing services.

Quite a large proportion of the OTC derivatives market will be centrally cleared in the coming years (and indeed quite a large amount is already cleared). This is practical since some clearable products (e.g. interest rate swaps) make up such a large proportion of the total outstanding notional. Although clearing is being extended to cover new products, this is a slow process since a product needs to have a number of features before it is clearable.

For a transaction to be centrally cleared, the following conditions are generally important:

Standardisation. Standardisation of legal and economic terms is key because clearing requires the CCP to be contractually responsible for all cash flows of the product in question. Furthermore, standardisation facilitates offset and compression between identical contracts and makes it easier to replace contracts in the event that a clearing member defaults. For example, prior to 2009, there was a standardisation of CDS contracts – involving changes to standard coupons and maturities – which was a prerequisite to any migration to CCPs.
Complexity. Only vanilla (non-exotic) transactions can be cleared, as they need to be relatively easily and robustly valued on a timely basis to support margin calculations and default management (Section 8.3). Exotic or complex derivatives (even if standardised) create a number of hurdles to central clearing.⁴ Products that are more complex are more subjective to value for variation margin purposes, and initial margin requirements are very difficult to determine. This means that under- or over-margining is likely; the former case leading to excessive risk and the latter to high costs.
Liquidity. Centrally-cleared products need to be liquid for a number of reasons. First, liquidity brings accurate pricing information for variation margin purposes and provides rich historical time-series price data to use to calculate initial margins. Second, liquid products can be more efficiently replaced in default scenarios as illiquid trades will have high bid-offer spreads and may be more likely to be subjected to large risk premiums and negative price moves in turbulent markets. It should be noted that liquidity might be transient, as in many OTC derivatives; liquidity tends to decline over time and yet positions are guaranteed by the CCP for their lifetime.
Wrong-way risk. Ideally, centrally-cleared products would not be subject to wrong-way risk (WWR). This occurs when the default of a counterparty is linked adversely to the value of the underlying contract, which in turn means that the value of the contract will potentially decline rapidly at the time of the counterparty default. These negative implications for default management are therefore quite important. This is a subtle point in relation to CDSs, as these products catalysed the clearing mandate, and yet they are arguably the most difficult to clear centrally due to WWR.
Market volume. There is a significant effort for a CCP to build the relevant processes, models, and systems to be able to clear a given product. If the size of the market for this particular product is not sufficiently large, then clearing may not be beneficial, as the CCP will be unable to recoup the expenditure in the product development process.

A list of some of the significant CCPs is shown in Table 8.1. One of the most significant players in OTC derivative clearing is LCH Ltd, the first CCP to clear significant amounts of OTC transactions through SwapClear, which is dominant in the interbank interest rate swap market. Other important OTC clearing CCPs include ICE (Intercontinental Exchange) – which offers clearing for some CDSs through ICE Clear Credit – the Chicago Mercantile Exchange (CME), and Eurex.

8.2.2 Novation

A key concept in central clearing is that of contract novation, which is the legal process whereby the CCP is positioned between buyers and sellers. Novation is the replacement of one contract with one or more other contracts. Novation means that the CCP essentially steps in between parties to a transaction and therefore acts as an insurer of counterparty risk in both directions. The viability of novation depends on the legal enforceability of the new contracts and the certainty that the original parties are not legally obligated to each other once the novation is completed. Assuming viability, novation means that the contract between the original parties ceases to exist and they, therefore, do not have counterparty risk to one another.

Table 8.1 Some significant central counterparties.

US and Canada	CME Clearing US
	ICE Clear Credit
	LCH Ltd
	Int'l Derivatives Clearing Group (IDCG)
Europe	CME Clearing Europe
	ICE Clear Europe
	LCH Ltd
	Eurex Clearing AG
	LCH.Clearnet SA
	NASDAQ OMX (Sweden)
Australia	ASX Clear
Brazil	BM&FBovespa
Hong Kong	HKEx Clearing
Japan	Japan Securities Clearing Corporation (JSCC)
Singapore	Singapore Exchange Ltd (SGX)

Typically, the CCP guarantees the transaction from the point at which it is ‘matched’, and the CCP becomes the ‘buyer to the seller and seller to the buyer’. Clearing members may therefore not need to make a counterparty risk assessment of their original bilateral counterparty. In an electronic trading environment, clearing may provide anonymity as buyers and sellers need not know each other's identity.

Because it stands between market buyers and sellers, the CCP has a ‘matched book’ and bears no net market risk. It does take the counterparty risk, which is centralised in the CCP structure. Put another way, the CCP has ‘conditional market risk’, since in the event of a member default, it will no longer have a matched book. A CCP will have various methods to return to a matched book, such as holding an auction of the defaulting member's positions. CCPs also mitigate counterparty risk by demanding financial resources from their members that are intended to cover the potential losses in the event that one or more of them defaults.

8.2.3 Multilateral Offset and Compression

A major problem with bilateral derivatives trading is the proliferation of overlapping and potentially-redundant contracts, which increases counterparty risk and adds to the interconnectedness of the financial system. Such redundancy is a natural consequence of the many users and banks in the market and their different objectives and business models.

A primary advantage of central clearing is multilateral offset. This offset can be in relation to various aspects such as cash flows or margin requirements. In simple terms, the multilateral offset is as illustrated in Figure 8.5. In the bilateral market, the three participants have liabilities marked by the directions of the arrows. The total liabilities to be paid are 180. In this market, A is exposed to C by an amount of 90. If C fails, then there is the risk that A may also fail, creating a domino effect. Under central clearing, all assets and liabilities are taken over by the CCP and can offset one another. This means that total risks are reduced: not only is the liability of C offset to 60, but also the insolvency of C can no longer cause a knock-on effect to A, since the CCP has intermediated the position between the two.

Schematic illustration of multilateral offsetting afforded by central clearing. — **Figure 8.5** Illustration of multilateral offsetting afforded by central clearing.

Note that methods such as portfolio compression (Section 6.2.4) can create multilateral offset effects such as netting. However, portfolio compression requires actual transactions (or cash flows) to be eliminated, whereas the multilateral effects at a CCP are more general. For example, if two transactions almost offset one another (such as by having slightly different reference rates or maturities), then portfolio compression may not be possible, but the CCP will still see the net market risk position as being small, leading (for example) to lower initial margin requirements. Put another away, a CCP can compress risk, whereas bilateral compression can only compress objective quantities such as cash flows.

Whilst the above representation is generally correct, it ignores some key effects: the impact of multiple CCPs, the impact of non-cleared trades, and even the impact on non-derivatives positions. These aspects will be discussed in Chapter 10.

Cleared trades can still make use of portfolio compression services. It may seem that compression of cleared trades is less relevant, as compression aims not to change the market risk characteristics of portfolios and would not (for example) be expected to lead to a reduction in margin requirements. Despite this, there are clear benefits of reducing the number of trades and the total notional cleared by a given CCP relating to efficiency, including:

initial margin requirements (since, for example, some CCPs impose multipliers for large portfolios);
regulatory capital (in particular the leverage ratio, as discussed in Section 13.4.6);
operationality (e.g. cash flow payments and reporting);
computation burden (e.g. for margin calculation); and
simplification of the auction process (fewer trades to close out).

Compression services are therefore complementary to central clearing. An illustration of the impact of compression on clearing is given in Figure 8.6. This shows the total notional outstanding and the compressed notional for interest rate swaps cleared by the SwapClear service, together with the compressed notional that has been essentially removed. Note that, whilst there is a steady increase in notional cleared, the notional outstanding is almost constant.

Bar chart depicts the SwapClear compression. — **Figure 8.6** Illustration of SwapClear compression.⁵

Compression such as that shown in Figure 8.6 is gradually being expanded to cover more products and counterparties.⁶ As noted in Section 6.2.4, more advanced compression approaches are also being developed, such as blended-rate compression, which enables the compression of any number of positions with varying fixed rates but the same remaining cash flow dates.⁷

8.2.4 Margin and Default Funds

The advent of complete clearing (Section 8.1.2) led to CCPs requiring both variation and initial margins (Section 7.2.3) as the primary defence against the insolvency of a clearing member. Historically, centrally-cleared markets have tended to impose standard and tighter margin requirements compared to bilateral markets, although the incoming BCBS-IOSCO bilateral margin requirements (Section 7.4) are reducing this gap.

Generally, CCPs require variation margin to be transferred on a daily (and sometimes intradaily)⁸ basis and must usually be in cash. Initial margin requirements may also frequently change with market conditions and must be provided in cash or liquid assets (e.g. treasury bonds). They are calculated to high confidence levels (at least 99%) and cover the time period over which it would be anticipated to be necessary to close out the portfolio of a defaulted clearing member.

If margins are sufficient, then the central clearing follows the so-called ‘defaulter-pays’ approach, where a clearing member contributes all the necessary funds to pay for their own potential future default. Achieving this within every possible scenario is impractical, though, because it would require very high financial contributions from each member, which would be too costly. For this reason, the purpose of financial contributions from a given member is to cover losses to a high level of confidence in a scenario where they would default. This leaves a small chance of losses not following the defaulter-pays approach and thus being borne by the other clearing members.

Another basic principle of central clearing is that of loss mutualisation, where losses above the resources contributed by the defaulter are shared between CCP members. The most obvious way in which this occurs is that CCP members all contribute to a CCP ‘default fund’,⁹ which is typically used after the defaulter's own resources to cover losses. Since all members pay into this default fund, they all contribute to absorbing an extreme default loss. Losses wiping out a significant portion of the default fund of a CCP are obviously intended to be unlikely.

Note that, in a CCP, the default losses that a member incurs are not directly related to the transactions that this member executes with the defaulting member. Indeed, a member can suffer default losses even if it never traded with the defaulted counterparty, has no net position with the CCP, or has a net position with the CCP in the same direction as the defaulter (although there are other potential methods of loss allocation that may favour a member in this situation, as discussed in Section 10.2.4).

8.2.5 Clearing Relationships

Only clearing members can transact directly with a CCP. Becoming a clearing member involves meeting a number of requirements and will not be possible for all parties.Generally, these requirements fall into the following categories:

Admission criteria. CCPs have various admission requirements, such as credit rating strength and requirements that members have a sufficiently large capital base.
Financial commitment. Members must contribute to the CCP's default fund. Whilst such contributions will be partly in line with the trading activity, there may be a minimum commitment, and it is likely that only institutions intending to execute a certain volume of trades will consider this default fund contribution worthwhile.
Operational. Being a member of a CCP has a number of associated operational requirements. One is the frequent posting of (liquid) margin, and others are the requirement to participate in fire drills that simulate the default of a member, and auctions in the event that a member does indeed default.

The impact of the above is that large global banks and some other very large financial institutions are likely to be clearing members, whereas smaller banks, buy-side and other financial firms, and other non-financial end users are unlikely to be direct clearing members. Large regional banks may be members of only a local CCP so as to support domestic clearing services for their clients.

Institutions that are not CCP members – so-called non-clearing members (‘clients’) – can clear through a clearing member. Although there are different set-ups, the general rule here is that the client effectively has a direct bilateral relationship with their clearing member and not the CCP. Whilst the position of clearing members to their clients is still bilateral, they will – to a large extent – mirror CCP requirements in their bilateral client relationships – for example, in relation to margin-posting.

Clients will generally still have to post margin but will not be required to contribute to the CCP default fund. Clearing members will charge their clients (explicitly and implicitly) for the clearing service that they provide, which will include elements such as the subsidisation of the default fund. Note also that clearing members often require more margin from their clients than is required by CCPs. Clearing members can also potentially earn returns on excess margins received (above those required by the CCP) to compensate them for the clearing service they provide and the additional risk they take in doing this. On the other hand, they must consider the cost of ‘client clearing’ in terms of capital requirements and the leverage ratio (Section 13.6.4).

The client clearing set-up is illustrated in Figure 8.7. Note that clients can have a clearing relationship with more than one clearing member, as shown. One reason for this is that clients may wish to ‘port’ their portfolio to a different clearing member. Indeed, this is the aim in a default scenario so as to provide continuity for the clients. However, the ability to achieve portability depends on the precise set-up for client clearing. In this respect, what is important is the way in which margin posted by the client is passed through to the clearing member and/or the CCP, and how it is segregated. Depending on the manner of segregation, it is possible for the client to have a risk to the CCP, their clearing member, or their clearing member together with other clients of their clearing member. In general, there are two broad account structures used for client clearing:

Omnibus segregation. This refers to segregation between the account of the clearing member (the ‘house account’) and those of their clients (the ‘omnibus account’). Typically, the margin in a house account can be used to cover the losses of a client of that member, but not vice versa. This means that a client is not exposed to losses from their clearing member's own portfolio. However, all assets in an omnibus account can be used to meet the obligations of a defaulted client(s). This means that the clients have a risk to their clearing member and even other clients of their clearing member (this is sometimes known as ‘fellow customer risk’). Note that fellow customer risk requires the default of a clearing member and one or more of their other clients, as the client defaults are otherwise the responsibility of the clearing member.

Figure 8.7 Illustration of the client clearing set-up where a client (C) accesses a CCP through one or more clearing members (CMs).
Individual segregation. In this case, client accounts are segregated individually so that they cannot be used to cover the losses of other clients. This is a safer set-up as it protects against clearing member risk and fellow customer risk but is more expensive.

There are a number of other aspects that are important, such as whether or not margin is segregated by value, or if the actual assets are segregated and if the segregation is physical or just legal.¹⁰ Other differences can relate to whether the omnibus margin is posted on a net or gross basis and what happens to any excess margin.

8.3 CCP RISK MANAGEMENT

8.3.1 Overview and Membership Requirements

A CCP stands between buyers and sellers and guarantees the performance of trades. In a centrally-cleared market, counterparty risk is centralised within the CCP that is legally obliged to perform on the contracts it clears. There is consequently no need for the original counterparties to monitor one another in terms of credit quality, as they are only exposed to the overall credit quality of the other members.¹¹ This clearly puts the emphasis on the operation and resilience of the CCP itself.

In order to perform counterparty risk mitigation, a CCP actually performs a number of related functions:

Multilateral offset. Due to the centralisation of trades, a CCP can provide netting and/or compression benefits for trades that originated with different counterparties.
Loss absorbency. A CCP will collect both variation and initial margins from its members to cover potential default losses. It will also hold default fund contributions from its members to cover possible extreme losses in excess of margins. Initial margins and default funds will be driven by factors such as volatility, correlation, and the size of the cleared portfolio.
Default management. A CCP will manage a member default. This may include hedging and auctioning the underlying positions, allocating any losses in excess of the margins held, and transferring or ‘porting’ (Section 8.2.5) client trades to solvent clearing members.

In order to manage the risk that they take, CCPs have a number of mechanisms to ensure their continuity and resilience against counterparty and liquidity risks.

CCPs employ membership requirements to ensure clearing members do not bring undue risk to the CCP (although such restrictions should, on the other hand, not be anti-competitive). In general, membership requirements are based around:

Creditworthiness. The probability of default of the clearing member, as assessed by external or internal methods.
Liquidity. The ability of the member to meet liquidity requirements, such as the need to meet margin calls at short notice.
Operationality. The ability to adhere to the CCP rules, such as those pertaining to auctions.

CCP members will also face requirements over the minimum capital base, default fund contributions, and default management participation.

8.3.2 Margin

Unlike a bank, which relies largely on capital to absorb losses, margin is the primary defence for a central counterparty.

Variation margining clearly requires timely and reliable price data for all cleared derivatives and, where price data is not directly available, market-standard valuation methods. Such methods may sometimes need to evolve with market practice, a good example being the move from Libor to overnight indexed spread (OIS) discounting for interest rate swaps.¹² Typically, only cash is accepted as variation margin, as it is seen – directly or indirectly – as settlement (Section 7.2.6). Variation margin and settlement amounts from clearing members' other clearing activities in a single currency may be netted, resulting in a single payment or receipt per day. Usually, there is no netting of different currencies for variation margin purposes.

Initial margin is intended to cover potential close-out losses in the event of a default by that clearing member. Typically, it is calculated using different scenarios for possible price movements over an assumed close-out period (MPoR or liquidation period), such as five days. Initial margin exists for the life of the trade and can be increased or reduced depending on market conditions and the remaining risk.

Unlike variation margin, initial margin need not necessarily be in cash. Acceptable types of margin in this context may include cash in major currencies, government treasury securities, and government agency securities. The general aim of initial margin is that, after the application of haircuts, the CCP is not exposed to significant credit, market, and liquidity risks. Securities must be sufficiently liquid, such as having price data available on a frequent basis and having low credit risk.

CCPs will hold large amounts of margin. This offers a possibility for income to balance the interest rates that CCPs may contractually agree to pay. Most CCPs will pay interest to clearing members on excess cash deposited as initial margin. Typically, this may be set at a level with respect to a short-term deposit rate such as FedFunds minus 10 basis points (bps).¹³ Since CCPs will pay interest rates on some margin received, they need to generate a return on the margin they hold. However, margin also needs to be invested extremely carefully so as to avoid creating additional risk for the CCP. CCPs may, therefore, deposit margin with central banks, commercial banks, or reverse repos, or invest it in other assets with very low credit and liquidity risks.

8.3.3 Default Scenarios and Margin Period of Risk

The main risk faced by a CCP is a default by one of its clearing members. This will lead to an unmatched book due to the contingent market risk that the CCP faces, since it will still have to pay variation margin to non-defaulters who have made a valuation gain (that would have been otherwise offset by variation margin received from the defaulting counterparty).

A CCP has greater authority and control over this process than a typical counterparty in a bilateral OTC trade. CCPs have general rights in relation to declaring a clearing member in default and subsequently managing the risk of that member's portfolio. These rights include suspension of trading, closing out positions, transferring client positions, and liquidating securities held as margin. In a default scenario, the CCP typically neutralises its exposure through a combination of the following:

Macro-hedging. This aims to minimise the exposure of the portfolio to major risk factors (e.g. interest rate sensitivity) with liquid transactions. Such hedges reduce the market risk that the CCP faces. The ‘default management group’ has the discretion to apply relevant market risk macro-hedges in the manner they consider optimal.
Auctions. After the above, the CCP auctions the portfolio amongst other clearing members by sub-portfolio (e.g. currency). The default management group has the discretion to split the portfolio into sub-portfolios in the manner they consider optimal, with the macro-hedging ensuring that they do not have significant directional risks. Surviving CCP members will submit two-way prices for sub-portfolios, and the member bidding the best price will win a given portfolio. Clearing members may have strong incentives to participate in an auction in order to collectively achieve a favourable working out of a default without adverse consequences (such as being exposed to losses through default funds or other mechanisms). There may also be individual incentives to clearing members bidding in the auction, such as any resulting losses being allocated to losing bidders first before winning bidders are affected. It should be noted that the macro-hedges executed in the previous step should be helpful in the auction process because the portfolios auctioned will be the defaulter's trades together with the macro-hedges. Since these will have less sensitivity to market moves, it should be easier for clearing members to put in reasonable bids, even in volatile markets.

A CCP also benefits from a default management group made up of key personnel from the CCP together with senior traders from member firms who may be seconded on a revolving basis. Such traders can help with tasks such as the macro-hedging of the portfolio.¹⁴

In order to maximise the efficiency of a potential auction, the default management process is practised via periodic (e.g. twice a year) ‘fire drills’, where clearing members submit prices. New CCP members will also be required to take a ‘driving test’ to show that they can deal with the operational requirements posed by the auction. These operational requirements revolve around the ability to process, price, and bid on relatively large portfolios of trades in a short timescale (a few hours).

Client positions are most-efficiently ported to a surviving clearing member. Indeed, clients may have agreements with backup members in place, specifically for such a purpose. However, porting requires the surviving clearing member to accept the portfolio and the associated margin in question. This in turn will depend on the way in which client margin has been charged and segregated. In the event that porting is not possible, the client trades (of the defaulted member) will be managed in the default process together with the defaulted member's own portfolio. The client's initial margin will be used to cover any losses, depending on how this is segregated (see Section 8.2.5).

In the aftermath of the Lehman Brothers bankruptcy in 2008, SwapClear reported that 90% of their Lehman risk was neutralised (macro-hedged) in one week and all 66,000 trades were auctioned within three weeks. The events were hailed as a success and required only around a third of the initial margin, with the rest being returned to the Lehman administrators.¹⁵ The more recent Nasdaq example (discussed later in Section 10.1.3) was a less successful operation, where a substantial part of the default fund was required.

Based on the above description, the MPoR for a CCP is illustrated schematically in Figure 8.8, which can be compared to the MPoR in a bilateral market depicted previously in Figure 7.17. CCPs can be seen to reduce the MPoR by making daily and potentially also intradaily collateral calls in cash only (no settlement delays). They also have full authority over all calculations (no disputes allowed) and ensure that members can adhere to the operational requirements of posting margin, and that they guarantee to post on behalf of clients if necessary.

CCPs can also close out positions more quickly than in bilateral markets, as they can declare a member in default without any external obstructions and aim to then invoke a swift and effective default management process thanks to a privileged position with respect to bankruptcy law. This privileged position should enhance the CCP's ability to deal with a default in an efficient manner. For example, in a bilateral market the methodology for closing out trades and the macro-hedging of the positions of a defaulted counterparty prior to close-out may be challenged by the bankruptcy administrators, as discussed in Section 6.3.5.¹⁶ The MPoR for a CCP is therefore defined by the following three periods:

Schematic illustration of the margin period of risk for a CCP. — **Figure 8.8** Illustration of the margin period of risk (MPoR) for a CCP.

No action. The ‘pre-default’ period (from when the clearing member last posted margin until remedial action is taken) will likely be shorter than in bilateral markets, since CCPs can declare members in default more easily and with less chance of legal challenges.
Macro-hedging. The CCP may first seek to neutralise key sensitivities of the underlying portfolio via macro-hedges, which will be quite fast as the underlying hedges will be liquid. This should cause the overall risk of the portfolio to drop significantly, although the portfolio will still be subject to basis risks and bid-offer costs.
Auctions. The CCP will then arrange and hold one or more auctions to trade out of the underlying portfolio. During this time, the risk will gradually drop to zero as successful auctions are completed, although the CCP may be exposed to costs in auctioning the positions.

For example, the SwapClear management of the Lehman Brothers default was described as follows:¹⁷

Upon default (Monday 15 September 2008), the default management group was formed from member firms (on a rotating basis), who seconded pre-assigned and experienced traders to work alongside LCH.Clearnet's risk management team.
The default management group applied macro-hedges to neutralise market risk on the defaulter's portfolio, with all participants adhering to strict confidentiality rules throughout the process.
The risk positions were reviewed daily, and further hedges were executed in response to changing market conditions.
From Wednesday 24 September to Friday 3 October, the competitive auctions of the five (currency-specific) sub-portfolios were successfully completed.

The above process lasted for three weeks, but the majority of the risk was hedged well before this. Like the MPoR for bilateral markets, it is therefore important to consider the MPoR used in risk models as a metaphorical parameter, since risk decays gradually during the CCP default management process. For OTC derivatives, CCPs generally use a value of five business days compared to the minimum 10 days used in bilateral markets (Section 7.2.3). This five-day period forms the basis of CCP initial margin calculations discussed in the Chapter 9.¹⁸

8.3.4 The Loss Waterfall

In the event of a clearing member default, the member's initial margin and default fund contributions are available to the CCP to cover costs arising from macro-hedging and the auction. In case the initial margin and default fund contributions prove insufficient, and/or the auction fails, the CCP has other financial resources to absorb and/or other mechanisms to allocate losses. In general, a ‘loss waterfall’ defines the different ways in which resources will be used. A typical loss waterfall is represented in Figure 8.9.

The first components of the loss waterfall are the defaulter-pays resources and include the initial margin and default fund contribution(s) of the defaulter(s).¹⁹ After this, there is typically a ‘skin-in-the-game’ equity contribution from the CCP. This gives the CCP some incentive to avoid losses beyond the defaulter-pays resources.

Schematic illustration of a typical loss waterfall defining the way in which the default of one or more CCP members is absorbed. — **Figure 8.9** Illustration of a typical loss waterfall defining the way in which the default of one or more CCP members is absorbed.

If the resources above are completely depleted, then the remaining default fund of the CCP is used to absorb losses. This is now a survivors-pay approach, as this forms the collective contribution of all clearing members, who now stand to make a loss. The allocation of losses in the default fund may be pro rata, or use other rules that in turn may incentivise clearing members to bid proactively in the auction (e.g. by allocating losses to winning bidders last). This is discussed in more detail in Section 10.2.3.

Losses wiping out a significant portion of the default fund of a CCP are clearly envisaged to be exceptionally unlikely. However, if this does happen, then there are other methods for absorbing losses that depend on the CCP in question. These are summarised below and discussed in more detail in Section 10.2.4.

Rights of assessment. This represents an unfunded obligation to contribute additionally to a default fund that has been depleted by losses. Typically, such a recapitalisation will be invoked if a significant fraction (e.g. 25%) of the default fund is used. If this right were unlimited, then the CCP would be unlikely to fail (unless all its clearing members did so). However, this would create siginificant moral hazard and unlimited exposure for clearing members. Furthermore, it might destabilise markets as members would be required to contribute to default funds at the worst possible time. For these reasons, rights of assessment are generally capped in terms of the maximum amount in a given period.
Variation margin gains haircutting (VMGH). This is probably the most common alternative loss-allocation concept (ISDA 2013b). The idea of VMGH is that losses made by a defaulting clearing member can be balanced by ‘haircutting’ the corresponding gains that must (due to the matched book) have been made by other clearing members. This means that clearing members whose positions have increased in value since the default will not receive the full margin to cover their gain, whilst those owing money to the CCP will still be required to pay in full. An interesting feature of this is that it mimics the economics of a bilateral market. Note also that a clearing member subject to VMGH may not have made an overall profit as their gains may be offset by losses associated with bilateral trades or those at another CCP (or they may be client trades). If a CCP can auction a defaulter's portfolio at mid-market prices, then VMGH is guaranteed to work, as the losses from the defaulter must be matched by equivalent gains for other CCP members. The obvious reason why VMGH may fail in practice is if the CCP has to close out at a significant premium to mid-market prices.
Tear-up. If the resulting exposure cannot be neutralised via an auction, then one other option is for the CCP to ‘tear up’ unmatched contracts with surviving clearing members. The aim of the tear-up is to return a CCP to a matched book by terminating opposite trades to those of the defaulter (these could represent the original bilateral trades or just any that are suitable). All other contracts (possibly the vast majority of the total contracts cleared) could remain untouched. The major difference with tear-up compared to VMGH is that the CCP is not exposed to any risk premium in auctioning transactions. Tear-up could be partial or full; in the latter case, the CCP will obviously not fail, but the clearing members will be left with losses and the market risk that the CCP was unable to neutralise.
Forced allocation. A method similar to tear-up is forced allocation, whereby clearing members are obliged to accept certain portfolios at prices determined by the CCP. This has a similar effect, since instead of tearing up an existing trade, a CCP might impose the reverse trade on a member. However, a forced allocation may be more random as any member can be allocated positions, whereas tear-up requires a member to have the appropriate trades in their portfolio. Furthermore, unlike tear-up, it would not be possible for a clearing member to pass on the impact of forced allocation to its clients.

It is also important to note that a CCP can impose losses on its members via the default fund, without being close to actually failing itself. The recent Nasdaq example (Section 10.1.3) illustrates this clearly. Note also that the default losses that a member incurs are not directly related to the transactions that they executed with the defaulting member. Indeed, a member can suffer default losses even if it never traded with the defaulted counterparty or has no net position with the CCP.

Some loss-allocation methods are theoretically infinite – i.e. the CCP would never fail, but would rather impose any level of losses on its clearing members to be able to continue to function itself. Not surprisingly, these allocation methods (e.g. tear-up or forced allocation) are fairly severe and may even cause surviving clearing members to fail.

Assuming loss allocation is finite, the remaining capital of the CCP would then be used to cover losses. At this point, assuming losses persist, the CCP will fail unless it receives some external liquidity support (via a bailout from a central bank, for example). Some CCPs may have other components in the waterfall – for example, lines of credit with banks and financial guarantees provided by insurance companies. Having such liquidity ‘on tap’ is costly, but this cost may be justified since CCPs could be very exposed in the event of a large negative asset price move, or the default of a clearing member and possible withdrawal of other clearing members.

Note that none of the above methods allow a CCP to use the initial margin of non-defaulting members. Initial margin haircutting has been suggested as a possible means to allocate losses (Elliott 2013), but it has not been used in practice and may not be allowed by regulators.²¹ Hence, initial margin contributions are – in theory – risk free, since they do not appear in the loss waterfall. On the other hand, since other loss-allocation methods (such as tear-up) are potentially infinite,²² this may be of limited consolation to a surviving clearing member.

8.3.5 Comparing Bilateral and Central Clearing

Table 8.2 compares bilaterally- and centrally-cleared markets. Only standardised, non-exotic, and liquid products can be cleared. CCPs allow for multilateral netting, which is potentially more efficient than bilateral netting (and portfolio compression) in bilateral markets. CCPs impose strong margin requirements on their members (although regulation in bilateral markets is becoming stricter in this respect). An important feature of central clearing is a centralised default management auction process compared to the more uncoordinated bilateral equivalent. In bilateral markets, costs arise mainly from capital costs (although the introduction of initial margin is changing this), whereas in centrally-cleared markets the major costs for loss absorbency are initial margin (and default fund contributions for clearing members), as capital requirements are generally quite low (see Section 13.6).

Table 8.2 Comparing bilaterally- and centrally-cleared OTC derivative markets.

	Bilateral	Centrally cleared
Counterparty	Original	CCP
Products	All	Must be standard, vanilla, liquid, etc.
Participants	All	Clearing members are usually large dealers Other margin-posting entities can clear through clearing members
Netting	Bilateral netting agreements and portfolio compression	Multilateral netting (including compression)
Margining	Bilateral, bespoke arrangements dependent on credit quality Regulatory rules being introduced (Section 7.4)	Full collateralisation, including initial margin enforced by CCP
Close-out	Bilateral	Coordinated default management process (macro-hedges and auctions)
Loss absorbency cost	Mainly capital	Mainly initial margin (and default fund)

8.4 INITIAL MARGIN AND DEFAULT FUNDS

8.4.1 Coverage of Initial Margin and Default Funds

Initial margin is generally expected to provide coverage to a high degree of confidence (e.g. 99%) in the event that a clearing member defaults. However, initial margin breaches are clearly possible. Indeed, in the event that initial margin is insufficient, losses may be extremely high. For example, Bates and Craine (1999) estimated that, following the 1987 crash, the expected losses conditional on a margin call being breached increased by an order of magnitude.

The role of the default fund is to absorb extreme losses not covered by margins, as illustrated qualitatively in Figure 8.10. The distribution of losses is likely to be very heavy-tailed, meaning that if the margin is breached, then very large losses are possible. In order to provide coverage of these improbable but potentially large losses, an amount far beyond the initial margin is required. This is the classic problem of insurance and can only be mitigated by a pooling of risk. The default fund is therefore shared amongst the CCP members. The loss mutualisation inherent in the default fund is a key point since it spreads extreme losses from the failure of a single counterparty across all other clearing members. This has the potential to ameliorate systemic problems, but it also creates other risks. The size of the default fund is quantified via stress scenarios in relation to member defaults and related market conditions (Section 8.4.3).

Graph depicts the relationship between initial margin and default fund. — **Figure 8.10** Representation of the relationship between initial margin and default fund.

8.4.2 Default Fund Versus Initial Margin

The default fund is a key component of clearing. Since it is mutualised, it provides a much higher coverage of losses than initial margin, which avoids the cost of clearing being prohibitive (since in reality paying for one's own default in all possible scenarios is not practical). Hence, the contribution to a default fund may seem reasonably small compared to initial margin requirements but will provide much greater loss absorbency due to mutualisation.

In order to understand this, consider the split of initial margins (IM) and default funds (DF) shown in Figure 8.11. In all three cases it is assumed that each of the five CCP members contributes one unit to the CCP, and the resources available to absorb the default of one member are shown. Smaller initial margins and correspondingly-larger default funds are cheaper but increase moral hazard, as there is more chance of default fund losses and less chance of the defaulter-pays approach being followed.

Schematic illustration of the comparison of different choices of initial margin and default fund proportions. — **Figure 8.11** Comparison of different choices of initial margin and default fund proportions.

Another consideration is that non-clearing members do not contribute to the default fund of a CCP. This means that clients only contribute directly to the risk of their own portfolio via the initial margin that the CCP imposes on its clearing members (which in turn will likely be imposed on the clients). Hence, default funds mutualise not only the default of clearing members but also the default of their clients. The related point is that large default funds and smaller initial margins will disincentivise clearing members from providing portability (the transfer of client positions from one clearing member to another; see Section 8.2.5). Without enough initial margin, this becomes difficult, especially since the clearing member accepting the positions may have to pay more into the CCP default fund. The balance in choice of default funds is summarised in Table 8.3.

Putting more financial contributions into initial margins generally incentivises better behaviour, whereas putting more into default funds provides greater overall loss absorbency and therefore makes clearing cheaper at the expense of moral hazard.

8.4.3 Default Fund Coverage

Losses hitting the default fund are supposed to be uncommon, in line with the high level of confidence used for calculating initial margin. To some extent, this has indeed been the case: for example, LCH reports seven defaults during its history and all of these defaults have been managed within the initial margin of the defaulter, and therefore without any impact on other clearing members or markets.²³

That said, when CCP default funds are required, losses can potentially be large. For example, in 1987, the Hong Kong Futures Exchange made losses that dwarfed the associated default fund (see Section 10.1.2). A more recent example is the default fund losses at Nasdaq (Section 10.1.3). The potential for such losses may be considered to increase, as CCPs in the future will be larger and will have to take on more complex and risky financial products compared to the past.

Clearly, the default fund has the role of making clearing cost-effective by using loss mutualisation to cover potential tail risk over the initial margins. However, working out the appropriate size of the default fund is difficult due to the very fact that it is covering risk arising from extreme events. Calculating the potential exposure above initial margins is plagued by problems such as fail tail behaviour, complex interdependencies, and WWR. The actual probability of a CCP exhausting its default fund is impossible to quantify with any accuracy, as it is likely linked to events involving the default of one or more clearing members together with extreme market movements and illiquidity.

Table 8.3 Summary of the strengths and weaknesses between higher and lower initial margins and default funds.

	Higher initial margin Lower default fund	Lower initial margin Higher default fund
Cost	Higher	Lower
Client clearing	Clients pay for their own risk via initial margin Promotes portability	Clients do not pay for their own risk directly Portability difficult
Moral hazard	Lower	Higher

For the above reasons, CCPs are typically required to calibrate the size of the total default fund qualitatively via pre-defined stress tests. This may then be allocated to clearing members in a relatively simplistic way, such as pro rata with initial margins (maybe averaged over a time period) or based on the total size of positions (potentially also subject to a floor). The total default fund size is typically framed in terms of the number of defaults a CCP can withstand (usually one or two). Default fund contributions are not updated as frequently as initial margins – for example, monthly.

The CPSS-IOSCO (2012) principles require that a CCP should ‘maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions’. This is typically known as a Cover 1 requirement. Additionally, it is stated that:

In addition, a CCP that is involved in activities with a more-complex risk profile or that is systemically important in multiple jurisdictions should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions.

This is known as a Cover 2 requirement.

As an example of a CCP following the guidance above, the SwapClear default fund is ‘sized to cover the default of the largest two SwapClear Clearing Members (in line with the principles outlined by CPSS-IOSCO) using an updated set of extreme, but plausible, theoretical and historical stress test scenarios that are tailored specifically for the interest rates market’.²⁴

The apparent ‘two largest default’ requirement above is potentially quite significant. For example, Heller and Vause (2012) studied dealers and estimated that CCP default funds may need to be about 50% larger to cover losses that could arise from the default of the two most important interest rate swap or CDS dealers, rather than just the single most important dealer. However, it is not surprising that OTC CCP default funds are viewed as needing to be more resilient. They would only be hit during a serious crisis when one or more clearing members had failed. It follows that the failed clearing members would quite likely be large, systemically-important financial institutions and that financial markets would be extremely turbulent at this point. Furthermore, since the failed counterparties are likely to be members of several CCPs, the chance of this causing a severe systemic disturbance is high. Only very large default funds can guarantee the financial integrity of CCPs and provide the necessary confidence and stability to prevent a major crisis in such a situation.

8.5 IMPACT OF CENTRAL CLEARING

8.5.1 Advantages and Disadvantages of Central Clearing

CCPs offer many advantages and potentially offer a more transparent, safer market where contracts are more fungible and liquidity is enhanced. The following is a summary of the advantages of a CCP:

Transparency. A CCP may face a clearing member for a large proportion of its transactions in a given market and can, therefore, see concentration that would not be transparent in bilateral markets. If a member has a particularly extreme exposure, the CCP is in a position to act on this and limit trading. These aspects may, in turn, disperse panic that might otherwise be present in bilateral markets due to a lack of knowledge of the exposure faced by institutions.²⁵
Multilateral offset. As mentioned above, the risk of contracts transacted between different counterparties but cleared through a CCP can be offset. This increases the flexibility to enter new transactions and terminate existing ones, and reduces costs.
Loss mutualisation. Even when a default creates losses that exceed the financial commitments from the defaulter, these losses are distributed throughout the CCP members, reducing their impact on any one member. Thus, a counterparty's losses are dispersed partially throughout the market, making their impact less dramatic and reducing the possibility of systemic problems.
Legal and operational efficiency. The margining, netting, and settlement functions undertaken by a CCP potentially increase operational efficiency and reduce costs. CCPs may also reduce legal risks in providing centralisation of rules and mechanisms.
Liquidity. A CCP may improve market liquidity through the ability of market participants to trade easily and benefit from multilateral netting. Barriers to market entry may be reduced.
Default management. A well-managed central auction may result in smaller price disruptions than the uncoordinated replacement of positions during a crisis period associated with the default of a clearing member.

For the past century and longer, clearing has been limited to listed derivatives traded on exchanges. Bilateral OTC markets have been extremely successful, and their growth has been greater than that of exchange-traded products over the last two decades. The trouble with clearing OTC derivatives is that they are more illiquid, long-dated, and complex compared to their exchange-traded relatives.

Despite the obvious advantages, the mandatory central clearing of OTC derivatives is not without criticism. The following is a summary of the disadvantages of a CCP:

Moral hazard. This is a well-known problem in the insurance industry. Moral hazard has the effect of disincentivising good counterparty risk management practice by CCP members (since all the risk is passed to the CCP). Parties have little incentive to monitor each other's credit quality and act appropriately because a third party is taking most of the risk.
Adverse selection. CCPs are also vulnerable to adverse selection, which occurs if members trading OTC derivatives know more about the risks than the CCP itself. In such a situation, firms may selectively pass these riskier products to CCPs that underprice the risks. Obviously, firms such as large banks specialise in OTC derivatives and may have superior information and knowledge on pricing and risk than a CCP. Anecdotal evidence on this point is already apparent, with market participants aware that different CCPs are cheaper, for example, when clearing pay-fixed and receive-fixed interest rate swaps.
Bifurcations. The requirement to clear standard products may create unfortunate bifurcations between cleared and non-cleared trades. This can negate the benefit of multilateral offset and increase costs.
Procyclicality. Procyclicality refers to a positive dependence on the state of the economy. CCPs may create procyclicality effects by, for example, increasing margin requirements (or haircuts) in volatile markets or crisis periods. The greater frequency and liquidity of margin requirements under a CCP (compared with less uniform and more flexible margining practices in bilateral OTC markets) could also aggravate procyclicality.

CCPs perform a number of functions, such as netting, margining, transparency, loss mutualisation, and default management. Another important point to note is that some of these functions can be achieved via other mechanisms. For example, trade compression can facilitate greater netting benefits, bilateral markets can (and do) have margining mechanisms, and trade repositories can provide greater transparency.

8.5.2 Will Mandatory Clearing Kill Credit Value Adjustment?

Since CCPs ultimately mitigate counterparty risk, there is an obvious question as to whether the clearing mandate – and the associated bilateral margin requirements (Section 7.4) – will lead to a gradual reduction in credit value adjustment (CVA) – and other related components, such as funding value adjustment (FVA) and capital value adjustment (KVA) – to levels that are much less relevant than they have been historically.

To answer the above question, it is important to realise that counterparty risk, funding, and capital issues (CVA, FVA, KVA) predominantly arise from non-margined OTC derivatives with end users (see Section 5.2.5). Since such end users will be exempt from the clearing mandate, they will not move to central clearing except on a voluntary basis. Since most such end users find it difficult to post margin, such voluntary clearing (or bilateral margin posting) is unlikely.

To see this in practice, referring to the breakdown of a bank's CVA previously shown in Figure 3.4 shows that only about 15% of the CVA comes from exposures to banks and ‘other financial institutions’. This is the CVA that would likely be more significantly reduced from clearing and bilateral initial margin posting. The other 85% of the CVA comes from exposure to corporates and governments who are exempt counterparties, most of whom would be unable/unwilling to centrally clear. Hence, the uncollateralised bilateral transactions that are most important from an xVA perspective will likely persist as such.

It is also important to note that central clearing and other changes, such as the incoming bilateral collateral rules, may reduce components such as CVA in certain situations, but will also increase other components (e.g. most margin value adjustment, which arises from funding initial margins, as discussed in Chapter 20). Hence, it will become even more important to consider xVA holistically to understand the balance of various effects. There will also be a growing need to assess the impact of CVA on a central counterparty, which is not yet common practice.