How does central clearing of OTC derivatives work, and what role does a CCP play in reducing counterparty risk?

Central clearing interposes a Central Counterparty (CCP) between the original buyer and seller of an OTC derivative. Instead of bilateral credit exposure, both parties face the CCP, which manages risk through a structured default waterfall.

How Novation Works

When a trade is submitted for clearing:

1. Original bilateral trade between Party A and Party B is novated
2. The CCP becomes the buyer to every seller and the seller to every buyer
3. Party A now faces only the CCP; Party B faces only the CCP
4. The original credit exposure between A and B is eliminated

Margin Framework

The Default Waterfall

If a clearing member defaults, losses are absorbed in this order:

1. Defaulter's initial margin — first line of defense
2. Defaulter's default fund contribution — second buffer
3. CCP's own capital ("skin in the game") — typically 25% of required capital
4. Non-defaulting members' default fund contributions — mutualized losses
5. CCP's remaining capital and recovery tools — assessments, variation margin haircutting

Example: Clearview Derivatives Clearing

Ashford Capital holds a $200 million notional interest rate swap cleared through Clearview CCP. Ashford posts $8 million in initial margin and $3.2 million to the default fund. Daily, Clearview calls variation margin — if the swap moves $500,000 against Ashford, that amount must be wired by 10 AM the next business day.

Does Clearing Eliminate Counterparty Risk?

No — it concentrates and manages it. The CCP itself becomes systemically important ("too important to fail"). Risks include:

• Wrong-way risk — if many members default simultaneously
• Liquidity risk — CCP must liquidate defaulter's portfolio quickly
• Concentration risk — a few large CCPs clear most global derivatives
• Procyclicality — margin calls increase during stress, exacerbating liquidity strain

For deeper analysis of clearing mechanics, visit our FRM Part I course.