CCPs: Central Clearing of OTC Derivatives

Richard Walker

The core purpose of a central counterparty (CCP) is the management and mitigation of risk. By acting as the buyer to every seller and the seller to every buyer, CCPs reduce counterparty risk, absorb shocks and help to prevent the build-up of excessive risk in the financial system. In addition, CCPs bring efficiencies to market participants by reducing counterparty exposure through the multilateral netting of positions and, in some cases, offering services such as portfolio compression.

As such, CCPs provide an intermediary service in over-the-counter (OTC) markets. A traditional bilateral swap deal requires each party to the trade to assume default risk from the other. Given the long-dated nature of some interest rate swaps, this brings uncertainty in the form of credit risk, an uncertainty that often translates into less liquid and less efficient markets, as each party must factor in the likelihood of aggregate default of all of its trading parties.

However a cleared market, where a CCP intermediates between risk-taking parties and collects sufficient collateral from each to ensure the settlement of all of their swap contracts, significantly reduces bilateral risk. Certainty