Central clearing interposes a central counterparty (CCP) between the two original parties to a derivatives trade. Instead of Bank A and Client B being directly exposed to each other, the CCP becomes the buyer to Bank A and the seller to Client B. Neither party faces the credit risk of the other — both face the CCP, which is designed and capitalised to withstand defaults.

Why central clearing was mandated

Before the 2008 financial crisis, most OTC derivatives were cleared bilaterally: each bank managed its own exposure to each counterparty. When Lehman Brothers failed, its counterparties suddenly faced complex, uncertain exposures on thousands of bilateral trades. The process of unwinding those trades took years and created significant losses.

Post-crisis, G20 leaders and financial regulators mandated central clearing for standardised OTC derivatives — vanilla interest rate swaps, CDS indices, and others. The 2009 Pittsburgh summit committed to the clearing mandate as a cornerstone of post-crisis reform. In the UK and EU, EMIR (European Market Infrastructure Regulation) gave the mandate legal force.

How the CCP manages risk

A CCP requires each clearing member to post Initial Margin (IM) — a buffer of collateral calculated to cover the potential future loss from closing that member's position if they default. It also collects Variation Margin (VM) daily: the daily mark-to-market change of each position, keeping the CCP's exposure to any member current.

If a clearing member defaults, the CCP uses the defaulting member's margin to close out their positions in an orderly way. If losses exceed the margin, a 'default waterfall' of additional resources stands behind it.

LCH SwapClear and the major CCPs

LCH SwapClear, operated by the London Stock Exchange Group, clears the vast majority of vanilla interest rate swaps globally. For equity derivatives, ICE Clear and Eurex Clearing are major CCPs. For CDS indices, ICE Clear Credit is the primary platform.

How clearing members manage their margin obligations, how the default waterfall is structured, and the regulatory framework governing CCPs are explored in depth in Market Mechanics — the complete plain-English guide to how a bank's markets business works.