Role of Central Clearing

Clearing Houses play a key role in the stability and integrity of markets by managing clearing risk. Clearing risk covers:

1. Credit risk of counterparties
2. Market Risk
3. Liquidity Risk
4. Systemic Risk

Futures clearing operations record all transactions and document delivery from sellers to buyers. A clearing operation (at CME Group it’s known as the Clearing House) plays the role of third party to every futures transaction after the trade clears.
 

This means the Clearing House first ensures that the buyer and seller are in agreement as to price, quantity, and expiration month of an order. Then, the Clearing House assumes the obligation of the seller against the original seller and of the buyer against the original buyer. It is as if the seller had sold to the Clearing House and the buyer had bought from the Clearing House. This practice ensures the integrity of all trades.

Specifically, a central clearing house supports the overall strength of the balance sheet of each party by multi-lateral netting of all transactions, thus reducing credit exposure (the net market value of the transaction at the time of potential default) and the probability of counterparty default.

Multilateral transaction netting reduces credit exposures that typically exist in the absence of clearing. In effect, multilateral netting allows clearing members to offset their net liabilities with some members against their net claims to other members. Thus, the benefits of multilateral netting tend to increase the clearing house’s participation. Furthermore, the margining procedures typically used by clearinghouses have the effect of eliminating current exposures (or collateralizing them) on a daily basis and reducing potential future exposition.
 

As the central clearing counterparty, clearinghouses guarantee the proper settlement of transactions effected by their members and, sometimes, by a member’s clients. By assuming this role, they expose themselves to the clearing risk representing the potential replacement cost that clearinghouse would have to bear if one of the counterparties of a trade is unable to fulfill it liabilities in excess of its margin deposits:

The clearing risk is a specific risk, which combines:
1. Credit risk: counterparty’s inability to meet its liabilities
2. Market risk: market shifts between the time a transaction is executed and the time it is cleared
3. Liquidity risk: not having funds available upon demand
4. Systemic risk: overall credit pressures in system

Details: CME Clearing Overview