Lesson 5 of 5 · All lessons in this module
  1. What a derivative is and how a contract is built
  2. Firm commitments, contingent claims and why derivatives are used
  3. Derivative underlyings: equities, rates, currencies, commodities, credit
  4. OTC and exchange-traded derivative markets
  5. Central clearing and central counterparties

Lesson 5 of 5 · 12 min

Central clearing and central counterparties

Since 2008 most OTC derivatives must be cleared through a central counterparty, which keeps OTC flexibility for end users while handling credit risk the way exchanges do, at the cost of concentrating risk in the CCP.

In short

  • After the 2008 crisis, regulators introduced a central clearing mandate for most OTC derivatives.
  • A central counterparty (CCP) takes on the counterparty credit risk between the original parties and provides clearing and settlement.
  • Steps: (1) dealers execute the trade on a swap execution facility (SEF); (2) trade details go to the CCP; (3) the CCP novates the trade, replacing it with identical trades in which the CCP faces each side.
  • End users keep OTC customization with their dealer; trades between dealers are cleared like ETDs, gaining transparency, standardization and risk reduction.
  • The downside is centralization and concentration of risk in CCPs, a systemic concern that needs strong safeguards.

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