Prevention is better than cure; the more robust a CCP’s users, the more robust the CCP. A CCP’s fundamental protection is to set suitable minimum thresholds for the financial health of the participants it will accept, and diligently monitor changes – where necessary ceasing to serve a participant who no longer meets requirements.

A trading venue needs to maximise liquidity via maximum participation. Trading firms that choose to outsource clearing or do not meet a CCP’s minimum threshold can use an intermediary to access the CCP, called a General Clearing Participant (GCP) or General Clearing Member (GCM). The GCP/GCM stands behind the obligations of all its customers and is the legal contracting party with the CCP.

A CCP typically aims to always have sufficient liquid collateral and resources on hand to cover potential losses when needed. The collection process needs to be certain and timely, so that the collateral required is already in the possession of the CCP when it’s needed. Default procedures need to be clear and enforceable: there must be no legal risk to its ability to use a defaulter’s collateral to cover losses.

Furthermore, in the event that the defaulter’s collateral is insufficient to cover losses in extremely volatile markets, the CCP must have additional resources available so that its financial condition is not jeopardised and it can continue to meet its obligations to other users.

The additional resources are usually a combination of loss sharing amongst remaining users, a CCP’s own capital, and sometimes a guaranteed amount of available funds provided by the CCP’s parent. All CCPs in Europe have a loss sharing mechanism contributed to by all users, variously called a clearing fund, guarantee fund or default fund. The CCP’s rule book gives it the right to use the fund to cover close-out losses that exceed the collateral collected from a defaulter.

CCPs also need to manage legal risk, operational risk, settlement risk, and liquidity risk. To read more about CCP risk management and EuroCCP’s approach and processes, Click Here.

There is currently no minimum or common risk management standard among CCPs operating in the EU. Each CCP is regulated by its home-market regulator.

A CCP’s risk management approach should be assessed in its entirety and in the context of its business model. Trying to compare one single aspect of a CCP’s risk management approach with another CCP could lead to wrong conclusions. For example, a CCP that has a lower threshold for the financial health of its customers might have a larger parent guarantee. A parent guarantee which appears solid might vanish if the CCP changed ownership. A CCP which uses a small, limited amount of its equity capital before deploying additional resources might not materially alter the loss-sharing obligations of its participants.

Many CCPs separate margin into two types: variation margin and initial margin. Variation margin captures actual changes in the value of the open obligations after a fresh mark-to-market of the prices, usually at the end of each trading day. Initial margin mainly captures potential further price changes in the interval between the last mark-to-market and the point of actual close out of the position; the more volatile the price and the longer the expected time required to close out the position, the higher the amount of initial margin. CCPs typically have additional components of the margin requirement.

The frequency and timing of margin collection varies by CCP.

To accomplish an equivalent level of risk mitigation, a market participant on its own would need to:

• Assess the credit quality of each firm it trades with – difficult to achieve in an electronic execution environment;
• Go through an intermediary (with additional costs and risks) if it desired anonymity to protect its investment strategy;
• Ensure legally enforceable bilateral netting through novation (if used);
• Bilaterally settle with multiple counterparties with the associated operational risks;
• Calculate and exchange sufficient (and significantly more) collateral with each trading party to guard against replacement cost risk;
• Ensure its rights to use the collateral received from the other parties (who may reside in different jurisdictions) are legally enforceable in the event of the other’s bankruptcy;
• Retrieve from the administrators the collateral that it has posted to the bankrupt party.

Moreover, a market participant on its own would not benefit from multilateral netting, which reduces liquidity risk and capital requirements through lower values of net obligations to be settled, and reduces operational costs from fewer bilateral settlements.

There are some financial institutions which have an operational workflow similar to a CCP, such as inter-dealer brokers. An inter-dealer broker stands in the middle of every trade executed to provide anonymity to the parties that trade. Each party relies on the inter-dealer broker to honour the obligations. But the similarity stops there. An inter-dealer broker typically does not collect collateral from its customers, and takes the risk that a customer might default when it is then left to honour the trade to the remaining customer and be exposed to market risk if the price has moved adversely in the meantime. Inter-dealer brokers settle trade-by-trade without the risk management and operational efficiency benefit of bilateral or multilateral netting.

Certain banks offer a “clearing bank” service to trading firms, which is a form of post-trade, back office outsourcing and is not a central counterparty service. The clearing bank provides value-added services to the trading firm to ensure smooth settlement on the due date, such as lending securities when the customer fails to deliver, or advancing credit to the trading firm for securities purchased. These clearing bank value-added services involve risk taking and are typically not offered by a CCP.