Central Clearing

A Central Clearing Counterparty (CCP) is an entity that interposes itself between the two counterparties in a financial transaction. After the parties have agreed to a trade, the CCP becomes the buyer to every seller and the seller to every buyer. In doing so, the CCP can reduce counterparty credit and liquidity risk exposures through netting. It also provides standardised and transparent risk management.

Central clearing fundamentally potentially alters the linkages and exposures in the financial system and has important implications for securities lending markets. It replaces bilateral trading exposures between market participants with a centralised network of exposures between clearing participants and the CCP.

A central counterpart combines the exposures to all clearing members on its balance sheet. If all clearing members can meet their obligations, the CCP runs regularly matched books. However, if a participant defaults, it assumes the rights and obligations of the failed clearing participant, and instead of being subject to multiple exposures to a range of counterparties, each market participant maintains just a single trading exposure to the CCP.

ISLA follows developments in this field with keen interest as the reduced Risk Weighted Asset (RWA) profile of exposure to a CCP can be attractive to market participants who themselves have RWA exposure as a business binding constraint within the existing bi-lateral trading world.

In 2012, the EU adopted the European Market Infrastructure Regulation (EMIR), with the aim of increasing transparency in the over-the-counter (OTC) derivatives markets, mitigating credit risk, and reducing operational risk. The regulation introduced reporting requirements on derivative trades, alongside a clearing obligation for standardised OTC derivatives. The framework is currently being reviewed, with negotiations expected to finalise under the upcoming legislature.