This is the third of my series of over-the-counter (OTC) derivative primers. The first two covered the various instruments, and risk management issues. This one covers the basics of bilateral and central clearing. The next post will delve deeper into central clearing mechanics and risk management.

Over-the-Counter (OTC) Derivative Primer: Clearing

By John Kiff

This is the third of my series of over-the-counter (OTC) derivative primers. The first two covered the various instruments, and risk management issues. This one covers the basics of bilateral and central clearing. The next post will delve deeper into central clearing mechanics and risk management.

Clearing is what takes place between initial trade execution and when all of the contract’s legal obligations have been fulfilled. Key clearing functions are illustrated with a $100 million 10-year interest rate swap paying a fixed 5 percent rate against receiving floating-rate payments based on one-year London Interbank Offer Rates (LIBOR). Both payments are made annually in arrears so that payment calculations are made at the beginning of each annual payment period and payments made one year later.

Clearing Basics

The first step in the clearing process is to confirm the terms of the swap contract with both counterparties. This is followed by various transaction and risk management functions throughout the contract’s (10-year) life, unless it is terminated early (see Bliss and Steigerwald, 2006; and Hasenpusch, 2009). These functions include:

• Determining payment amounts at the start of each (one-year) interest period, notifying the counterparties and settling the payments at the end of the period. In the example, if LIBOR is less than 5 percent (e.g., 4 percent), the “fixed payer” makes a payment (and the “variable payer” receives an amount) equal to the difference between the two calculated payments ($1 million = $100 million times 1 percent).
• Daily valuations of all derivative contracts under the specific master agreement (in the case of a bilateral trade) or with the counterparty (in the case of centrally cleared trades) to determine the amounts of collateral to meet margin posting requirements. Also, all posted collateral must be monitored and revalued daily, and haircuts determined and applied.
• Monitoring counterparty creditworthiness and compliance with all the terms of the contracts. This includes determining whether to exercise settlement rights if an event of default or termination occurs, and recovering or making net final payments.
• Keeping relevant records and producing various reports.

For bilaterally cleared contracts, all of these activities are dealt with directly between the two counterparties. Also all of the counterparty risk for all of the OTC derivatives between them is aggregated in a single master agreement. In the case of centrally cleared transactions, all of these activities are done by a central counterparty (CCP) that also guarantees contract performance.

Central Clearing

A central counterparty (CCP) interposes itself between financial contract counterparties, becoming the buyer to every seller and the seller to every buyer and guaranteeing performance of open contracts. By interposing itself between the two clearing members (CMs) to a bilateral transaction, a CCP assumes all the contractual rights and responsibilities.

Novation discharges the original rights and obligations of the buyer and the seller and replaces their contracts with two new contracts with the CCP (see below). The assumption of counterparty risk can also be effected by an “open offer,” in which the CCP interposes itself at the time of the trade.

The figures below show how CCPs impact counterparty risk among four counterparties (A, B, C, and D). The first figure shows the starting configuration. The numbers on the arrows indicate the net replacement costs (e.g., if the contract between A and B were closed out immediately, B would owe A $5). The E(x)’s indicates the maximum counterparty exposures (e.g., E(C) = $10 because it will cost C $10 to replace the contracts with A and D if they both fail). Thus, for example, E(C) = $10 because it will cost C $10 to replace the contracts with A and D if they both fail, etc.

If all of these contracts are novated to a CCP, all of A’s and B’s counterparty risk exposure is eliminated, leaving C and D each with $5 of exposure to the CCP:

Notice that the number of contracts in this system has doubled. However, if the contracts are all identical, multilateral “compression” can be used knock out redundant contracts without changing risk exposures.

For a much more detailed look at these clearing networks, including the impact of indirect clearing see Robert Steigerwald’s Central Counterparty Clearing paper. And for some sharp views on the topic see Craig Pirrong’s Streetwise Professor website.

The next post in this series will delve deeper into central clearing mechanics and risk management.

This primer can be found in the 'Knowledge' section of The OTC Space website, along with a number of other primers and key terms.

Please Note: These are the author’s personal views, and should not be attributed to the International Monetary Fund, its Executive Board, or its management.