Cleared swaps

What Is Cleared Swaps?

Cleared swaps are derivatives contracts that are processed and guaranteed by a central counterparty (CCP). In the realm of financial markets, a swap is an agreement between two parties to exchange future cash flows based on a predetermined notional principal amount. When a swap is "cleared," it means that a CCP steps in between the original buyer and seller, becoming the legal counterparty to both sides of the transaction. This mechanism fundamentally alters the counterparty risk profile of the trade, enhancing market stability and efficiency. Cleared swaps represent a significant portion of the global derivatives market, especially following regulatory reforms aimed at mitigating systemic risk.

History and Origin

The widespread adoption of cleared swaps is largely a direct consequence of the 2008 financial crisis. Prior to the crisis, the vast majority of swaps were traded bilaterally over-the-counter (OTC), exposing financial institutions to significant and often opaque counterparty risk. The collapse of Lehman Brothers and the near-collapse of AIG, heavily involved in OTC credit default swaps, highlighted the interconnectedness and systemic vulnerabilities of this market.

In response, the Group of Twenty (G20) leaders, in September 2009, mandated that all standardized OTC derivatives should be centrally cleared. This global initiative aimed to enhance transparency, reduce systemic risk, and improve market resilience. In the United States, this mandate was enshrined in the Dodd-Frank Act of 2010. The Commodity Futures Trading Commission (CFTC) began implementing mandatory clearing for certain interest rate and credit default swaps in March 2013, requiring swap dealers and active market participants to submit these transactions to a central counterparty for clearing.⁶, ⁷ This marked a significant shift in the structure and regulation of the derivatives market.

Key Takeaways

• Cleared swaps are derivatives transactions processed through a central counterparty (CCP), which becomes the legal buyer to every seller and the legal seller to every buyer.
• The primary purpose of central clearing is to mitigate counterparty risk and enhance financial stability.
• Post-2008 financial crisis regulatory reforms, such as the Dodd-Frank Act, mandated central clearing for many standardized swaps.
• CCPs manage risk through various mechanisms, including initial margin requirements, daily mark-to-market valuations, and default funds.
• Cleared swaps generally offer increased transparency and netting benefits compared to their uncleared counterparts.

Interpreting Cleared Swaps

When a swap is cleared, the original two parties to the trade no longer face each other directly. Instead, they each face the CCP. This setup transforms bilateral credit exposures into exposures to a single, highly capitalized entity whose core function is risk management. The CCP standardizes trade terms, nets positions, and manages potential defaults of its clearing members. This process improves market efficiency by reducing the need for individual participants to assess and manage the creditworthiness of every single counterparty they trade with. For market participants, cleared swaps provide greater certainty regarding trade execution and settlement, especially in volatile market conditions.

Hypothetical Example

Consider two hypothetical parties, Company A and Company B, entering into an interest rate swap with a notional principal of $10 million. Company A agrees to pay a fixed interest rate of 3.0% annually, and Company B agrees to pay a floating rate (e.g., SOFR + 100 basis points).

1. Agreement: Company A and Company B agree on the terms of the swap.
2. Submission to CCP: Instead of trading directly, both companies (or their clearing members) submit the swap details to a CCP.
3. Novation: The CCP "novates" the original trade. This means the single bilateral contract is legally replaced by two separate contracts:
   • One contract between Company A and the CCP (Company A pays fixed, CCP pays floating).
   • One contract between Company B and the CCP (Company B pays floating, CCP pays fixed).
4. Margin and Collateral: Both Company A and Company B are required to post initial collateral (margin) with the CCP to cover potential future losses. This margin is calculated based on the risk of their positions.
5. Daily Mark-to-Market: Each day, the value of the swap is re-evaluated based on market movements. If the swap's value changes, leading to a loss for one party, that party will receive a variation margin call from the CCP to cover the loss, while the other party receives a payment.
6. Default Management: If, for example, Company A defaults, the CCP steps in. It uses Company A's posted margin and contributions to a default fund to cover any losses from unwinding Company A's position, thereby protecting Company B from direct exposure to Company A's default.

Through this process, the CCP acts as a shock absorber, significantly reducing systemic risk in the financial system.

Practical Applications

Cleared swaps are integral to modern financial markets, appearing in various capacities:

• Risk Mitigation: They are a core component of systemic risk management strategies for major financial institutions. By centralizing counterparty exposures, CCPs reduce the potential for cascading defaults across the financial system. The Federal Reserve, among other global regulators, emphasizes the role of central clearing in enhancing financial stability.⁵
• Regulatory Compliance: For many standardized interest rate swaps and credit default swaps, central clearing is a regulatory requirement in major jurisdictions, including the United States and Europe. Firms that do not qualify for specific exceptions must clear these transactions through a derivatives clearing organization (DCO).⁴
• Market Liquidity and Efficiency: Central clearing can improve market liquidity by providing a standardized and secure environment for trading. It allows participants to focus more on price discovery and less on bilateral credit assessment. This has contributed to significant growth in cleared swap volumes, with European cleared swap volume hitting records.³
• Portfolio Management: Large institutional investors, such as pension funds and asset managers, utilize cleared swaps for hedging interest rate risk, managing currency exposures, or gaining synthetic exposure to certain assets, benefiting from the reduced counterparty risk and streamlined operational processes.

Limitations and Criticisms

While cleared swaps offer significant benefits, they also present certain limitations and have faced criticisms:

• Concentration Risk: By centralizing risk, CCPs themselves become large, interconnected entities whose failure could have catastrophic systemic consequences. Some argue that this shifts, rather than eliminates, systemic risk, concentrating it in a few critical financial market utilities.² This concern about the potential for too-big-to-fail CCPs has led to calls for robust regulatory reform and enhanced oversight. The Federal Reserve Bank of San Francisco, for example, has discussed the "ugly" side of CCPs, acknowledging the concentration of risk.¹
• Procyclicality of Margin Calls: In times of market stress and heightened volatility, CCPs may issue large and frequent margin calls. While necessary for risk management, these calls can exacerbate liquidity pressures on clearing members and, by extension, the broader financial system, potentially forcing asset sales into falling markets.
• Complexity and Cost: The operational requirements for clearing swaps can be complex and costly, particularly for smaller market participants. This includes the need for direct or indirect access to a CCP, posting collateral, and adapting to standardized processes.
• Scope of Clearing: Not all swaps are standardized enough to be centrally cleared, particularly highly customized or illiquid trades. This leaves a significant portion of the market still operating on a bilateral, uncleared basis, which retains the original counterparty risk challenges.

Cleared Swaps vs. Uncleared Swaps

The distinction between cleared swaps and uncleared swaps lies primarily in how counterparty risk is managed.

While both involve swaps as financial instruments, cleared swaps introduce a robust institutional layer—the CCP—to manage systemic risk, whereas uncleared swaps rely on direct, bilateral agreements and credit assessments between the trading parties. The regulatory landscape post-2008 has actively pushed for the migration of suitable trades from the uncleared to the cleared environment.

FAQs

What is a Central Counterparty (CCP) in the context of cleared swaps?

A Central Counterparty (CCP) is a financial institution that interposes itself between the two counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. For cleared swaps, the CCP takes on the credit risk of both parties, ensuring the completion of trades even if one party defaults.

Why did central clearing of swaps become mandatory?

Central clearing became mandatory for many swaps following the 2008 financial crisis. The crisis exposed the immense and opaque counterparty risk in the bilateral OTC derivatives market, which contributed to systemic instability. Regulators mandated clearing to reduce this risk, increase transparency, and improve overall market resilience.

What types of swaps are typically cleared?

Generally, standardized and liquid swaps are subject to mandatory clearing. This primarily includes certain classes of interest rate swaps and credit default swaps. More bespoke or illiquid swaps may remain uncleared due to the challenges of standardizing them for CCP processing.

What happens if a party to a cleared swap defaults?

If a party to a cleared swap defaults, the Central Counterparty (CCP) manages the default process. The CCP uses the defaulting party's posted margin and contributions to a dedicated default fund to cover any losses from closing out or porting the defaulted positions. This mechanism prevents the default of one firm from directly impacting its trading counterparties, thereby containing systemic contagion.