What does a clearing house actually do?

A clearing house — formally a central counterparty, or CCP — is the institution that makes it possible to trade a derivative with a stranger. It does three things, in a strict order.

1. Novation — one trade becomes two

You buy a futures contract from a firm you have never heard of. The moment the trade is matched, the CCP legally replaces it with two contracts: you and the CCP, and the CCP and the seller. The original agreement between you ceases to exist.

Everything else follows from this. You no longer need to assess the seller's creditworthiness, because you are not facing them. You can close your position by trading with a completely different party, because there is nobody to release you from an obligation. And the CCP is now perfectly balanced — every long it faces is matched by a short — so it has no market risk at all. Its only exposure is that a member fails.

2. Margin — making sure the failure is small

Because a member failing is the CCP's whole risk, it manages that one thing relentlessly, with two kinds of margin:

• Initial margin — collected upfront, sized statistically to cover a large adverse move over the time it would take to close out a defaulter's position (a common calibration is a move exceeded on only about 1% of occasions over a one-to-several-day window). This is the deposit that creates leverage, as the previous lesson showed.
• Variation margin — the daily cash settlement of gains and losses. This is the important one: it means no unpaid obligation is ever allowed to accumulate. A member's loss must be funded within hours, not at maturity.

Between them, a default exposes the CCP to roughly the move over the days it takes to close the book out — instead of years of accumulated value, as in the bilateral world. That is a buffer sized to a confidence level, not a cap, and the worked example below runs straight through it.

3. The default waterfall — who pays, in what order

If a member fails anyway, the CCP closes out its positions and absorbs the loss through a published, ordered sequence. Every major CCP uses the same shape:

1. The defaulter's own initial margin.
2. The defaulter's contribution to the mutualised default fund.
3. The CCP's own capital tranche — its "skin in the game", deliberately placed ahead of surviving members so that the CCP's incentives are aligned with theirs.
4. The surviving members' default fund contributions — the loss becomes mutualised.
5. Further assessments and recovery tools — additional calls on members, and, in extremis, allocation mechanisms defined in the rulebook.

Worked example. A member defaults and closing out its book costs $180 million:

The failure is absorbed by the defaulter's own resources, the CCP's capital and $10m of the $900m mutualised default fund. The loss does reach surviving members — that is the fourth layer doing its job — but for just over 1% of the buffer, the fifth layer is never called, and no customer is touched at all. That is the design working.

The honest caveat

A CCP does not delete risk; it concentrates it. Hundreds of bilateral exposures become one enormous node that must not fail. The waterfall has been tested: in September 2018, a single trader defaulted on Nordic power futures at Nasdaq Clearing, and the loss burned through his margin and default-fund contribution and then consumed Nasdaq's own €7 million junior tranche and roughly €107 million of the roughly €166 million mutualised fund, which surviving members had to replenish. One trader, two thirds of a clearing house's mutualised buffer. The structure held — and it was closer to its limit than most participants had assumed.

The waterfall does not cover you. A clearing house faces its clearing members, not their customers. A retail futures account is a customer of a broker that is a member or clears through one; the margin sits in a segregated account at that broker, and the segregation and porting rules protect it, not the default fund. When the broker MF Global failed on 31 October 2011, its customers found a shortfall in segregated funds of about $1.6 billion (the bankruptcy trustee's figure), and the clearing houses did not make it good. Ask where your margin is held and under which segregation regime before asking how strong the CCP is.

Where the two worlds now meet

After 2008, the G20 agreed at Pittsburgh in 2009 that standardised OTC derivatives should be centrally cleared, reported to trade repositories, and — where not cleared — subject to higher capital requirements. Mandatory margin on non-cleared trades came later, through the G20's 2011 Cannes commitment and the BCBS-IOSCO standards built on it. That commitment became Dodd-Frank in the United States and EMIR in the European Union. The result is today's landscape: exchange-traded derivatives cleared as they always were, the standardised part of the OTC market now cleared too, and a genuinely bespoke remainder still bilateral but collateralised and reported.

Try it now

1. Find the rulebook or risk disclosure of any major clearing house and locate its published default waterfall. Confirm the five layers appear in the order above, and note where its own capital sits.
2. Rerun the worked table with a close-out loss of $400 million. How deep does it go, and how much of the mutualised fund is consumed?
3. In one sentence, state what a CCP replaces counterparty risk with. If your answer is "nothing", reread the caveat — the correct answer is a name, and it is the CCP.