Cleared derivatives

Cleared derivatives are financial contracts, such as futures contracts, options contracts, and swaps, whose transactions are processed and guaranteed by a central counterparty (CCP). This clearing process is a critical component of modern derivatives markets, designed to mitigate counterparty risk and enhance market stability. When a derivative transaction is cleared, the CCP interposes itself between the buyer and the seller, becoming the buyer to every seller and the seller to every buyer. This novation effectively replaces the bilateral credit exposure between the original trading parties with two separate exposures to the CCP. The CCP then manages the risk associated with these positions through various mechanisms, including the collection of collateral and margin, thereby reducing the potential for default risk and its ripple effects across the financial system.

History and Origin

The concept of clearing dates back centuries, with early forms used for bank check clearing in the 18th century and later adopted by financial exchanges in the latter part of the 19th century. For derivatives, organized clearinghouses emerged alongside the formalization of futures markets. For instance, the Chicago Board of Trade (CBOT), established in 1848, initially relied on direct bilateral settlements.¹⁵ However, as trading volumes grew and the need to manage counterparty risk became more apparent, the CBOT, like other exchanges, introduced more sophisticated clearing mechanisms, eventually leading to the interposition of a clearing entity.¹⁴ This evolution aimed to reduce instances where parties might default on their obligations due to price fluctuations, thereby ensuring the integrity of the contracts.¹³

The importance of robust clearing systems for derivatives was dramatically underscored during the 2008 global financial crisis. The widespread use of uncleared, over-the-counter (OTC) derivatives among major financial institutions contributed to a lack of transparency and significant interconnectedness, exacerbating systemic risk when firms like Lehman Brothers collapsed.¹²,¹¹ Many of Lehman's derivatives were bilateral, OTC agreements, and the confusion and rush to terminate these contracts following its bankruptcy filing added to the financial stress.¹⁰ This event highlighted the need for greater transparency and centralized risk management in the derivatives markets.

Key Takeaways

Cleared derivatives are financial contracts guaranteed by a central counterparty (CCP).
The CCP interposes itself between buyers and sellers, mitigating counterparty risk through novation.
Risk management by CCPs involves collecting collateral and margin from participants.
Central clearing enhances market stability and transparency by reducing systemic risk.
The 2008 financial crisis underscored the critical need for central clearing in derivatives markets.

Interpreting Cleared Derivatives

In the context of derivatives markets, the term "cleared derivatives" signifies a level of risk mitigation and standardization. For market participants, trading cleared derivatives implies that their exposure is to a highly regulated and capitalized central counterparty rather than directly to their original trading partner. This arrangement provides significant protection against the default risk of an individual counterparty. From a broader market perspective, the prevalence of cleared derivatives contributes to overall market stability by concentrating and managing counterparty credit risk efficiently. It also allows for greater transparency of positions and exposures within the financial system, aiding regulators and market participants in assessing risks more effectively.

Hypothetical Example

Consider two hypothetical parties, Company A and Company B, who wish to enter into a futures contract for 1,000 barrels of crude oil.

Agreement: Company A agrees to buy 1,000 barrels of oil at $80 per barrel for delivery in three months, and Company B agrees to sell.
Trade Submission: This agreement is submitted to a CCP.
Novation: Upon acceptance, the CCP legally interposes itself. Now, Company A has a contract to buy 1,000 barrels from the CCP, and Company B has a contract to sell 1,000 barrels to the CCP. The original bilateral relationship is extinguished.
Margin Requirements: Both Company A and Company B are required to post initial margin with the CCP as a good-faith deposit to cover potential losses from price movements.
Daily Mark-to-Market: Each day, as the price of crude oil fluctuates, the contracts are marked to market. If the price moves against a party, they may be required to post additional variation margin. For example, if the price drops to $78, Company A (the buyer) would incur a theoretical loss, and the CCP would collect funds from Company A and pay Company B.
Settlement: At the expiration of the contract, Company A fulfills its obligation to the CCP by paying $80,000, and the CCP ensures Company B receives $80,000. The entire settlement process is guaranteed by the CCP, removing the need for Company A and Company B to trust each other directly.

Practical Applications

Cleared derivatives are fundamental to the functioning of modern financial markets, appearing in several key areas:

Risk Management: Corporations and financial institutions utilize cleared derivatives to hedge against various financial risks, such as interest rate fluctuations, currency movements, or commodity price volatility. By using a CCP, they transfer bilateral counterparty risk to a centralized entity, enhancing the reliability of their hedging strategies.
Market Efficiency: The standardized nature and central clearing of these instruments facilitate greater liquidity and efficiency in trading. Exchange-traded derivatives, by their nature, are typically cleared, benefiting from transparent pricing and efficient execution.
Regulatory Compliance: Following the 2008 financial crisis, global policymakers introduced significant regulation aimed at increasing the use of central clearing for standardized derivatives. For instance, the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States mandated clearing for many standardized swaps through derivatives clearing organizations (DCOs) registered with the Commodity Futures Trading Commission (CFTC).⁹,⁸,⁷ This regulatory push seeks to reduce systemic risk by ensuring that a larger proportion of derivatives transactions are subject to robust risk management practices.⁶
Capital Efficiency: Central clearing can lead to more efficient use of capital for market participants due to multilateral netting of positions and reduced gross exposures, which can lower capital requirements compared to bilateral, uncleared trades.⁵,⁴

Limitations and Criticisms

While central clearing significantly reduces counterparty risk and enhances market transparency, it is not without limitations or criticisms. One primary concern is the concentration of risk. By interposing itself, a CCP becomes a single point of failure; if a CCP were to fail, the consequences could be catastrophic for the entire financial system.³ This concentrates systemic risk within a few critical institutions, necessitating stringent oversight and robust recovery and resolution plans for CCPs.

Another limitation relates to the costs associated with clearing, including initial and variation margin requirements, which can tie up capital that might otherwise be used for other investments or business operations. While designed to mitigate risk, these costs can affect market liquidity, particularly during times of stress when margin calls may increase.

Furthermore, not all derivatives are suitable for central clearing. Highly customized or illiquid products traded in the OTC derivatives market often lack the standardization required for efficient clearing by a CCP. Mandating clearing for such products could either stifle innovation or create inefficient market structures. The 2008 financial crisis highlighted how the complex, uncleared OTC derivatives market exacerbated the crisis due to a lack of transparency and interconnectedness, yet it also underscored the difficulty of retrospectively imposing clearing on highly bespoke instruments.²,¹,

Cleared Derivatives vs. OTC Derivatives

The primary distinction between cleared derivatives and OTC derivatives lies in their settlement and risk management structure. Cleared derivatives are standardized financial contracts where a central counterparty (CCP) becomes the legal counterparty to both sides of the transaction through a process called novation. This structure significantly reduces counterparty risk for the original trading parties, as their exposure shifts from each other to the CCP. Cleared derivatives are typically exchange-traded derivatives, or standardized OTC products that have been mandated for clearing due to their widespread use and systemic importance.

In contrast, OTC derivatives are customized financial contracts traded directly between two parties without the interposition of a CCP. While this allows for greater flexibility in terms of contract terms and conditions, it exposes the parties to the direct credit risk of their counterparty. If one party defaults, the other faces potential losses. Historically, the opacity and interconnectedness of the OTC market, particularly among large financial institutions, contributed to systemic vulnerabilities, which was a key driver for post-crisis regulatory reforms advocating for increased central clearing.

FAQs

What types of derivatives are typically cleared?

Many standardized futures contracts, options contracts, and certain classes of swaps (like interest rate swaps and credit default swaps) are commonly cleared. Regulatory mandates, such as those introduced after the 2008 financial crisis, have increased the types of OTC derivatives that must be centrally cleared if they meet certain standardization criteria.

Why is central clearing important for derivatives?

Central clearing is important because it significantly reduces counterparty risk by interposing a financially robust central counterparty (CCP) between trading parties. This enhances financial stability, improves transparency in the market, and provides greater security for participants by guaranteeing trade settlement.

Do all derivatives have to be cleared?

No, not all derivatives are required to be cleared. Highly customized or illiquid over-the-counter (OTC) derivatives that do not meet the standardization criteria set by regulators are often traded bilaterally without central clearing. However, there has been a global regulatory push to mandate central clearing for as many standardized derivatives as possible to mitigate systemic risk.

What happens if a central counterparty (CCP) fails?

While rare, a CCP failure would be a significant event for the financial system. CCPs are designed with multiple layers of defense, including participant margin, default funds, and capital, to absorb losses. Regulators also impose strict requirements for their resilience and have frameworks for their recovery and resolution to prevent a systemic collapse.