Clearinghouses for Over-the-Counter Derivatives

This paper focuses on a little-known, but long-standing financial market risk management institution known as a clearinghouse. It is also referred to as a “central counterparty clearinghouse” or “CCP.” Clearinghouses are used for the back-office processing of several types of financial instruments, including securities, repurchase agreements, and both exchange-traded and over-the-counter (OTC) derivatives. As highly-connected, core nodes of the payment, clearing, and settlement (PCS) systems of financial markets, they are critical institutions. Although frequently referred to as the “plumbing” of financial markets, PCS systems are more akin to being the “central
nervous system.” Trade clearing – and clearinghouses – comes into play after a trade is agreed to (contracted) and prior to its final settlement. In the case of securities, this clearing window is generally short (1-3 days), but it can be quite lengthy in the case of OTC derivatives (potentially decades!).4 Importantly, the time between the execution of a derivatives trade and its final settlement is “essential to the contract…the fundamental economic purpose of a derivatives transaction involves the reciprocal obligations of the parties over the life of the contract.” Therefore, OTC derivative counterparties potentially confront significant counterparty credit risk (the risk of a party’s default or insolvency prior to final settlement). Herein lies the problem for which clearinghouses are seen to be the “cure.”

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