Cleared Definition Finance

Cleared derivatives are financial contracts, primarily swaps and futures, that are processed and guaranteed by a clearinghouse. This process introduces a central intermediary, mitigating counterparty risk and promoting market transparency.

Understanding the Need for Clearing

Before the rise of clearinghouses, derivative transactions were typically conducted bilaterally, meaning directly between two parties. This created a significant risk: if one party defaulted on its obligations, the other party would bear the full brunt of the loss. This counterparty risk became particularly apparent during the 2008 financial crisis, highlighting the systemic dangers posed by interconnected bilateral trades.

How Clearing Works

Clearinghouses stand as intermediaries between the buyer and the seller of a derivative contract. Instead of each party being directly exposed to the other, they both have a relationship with the clearinghouse. The process involves several key steps:

• Trade Submission: Once two parties agree to a trade, the details are submitted to the clearinghouse.
• Novation: The clearinghouse steps in, effectively replacing the original buyer and seller. It becomes the buyer to the original seller and the seller to the original buyer.
• Margin Requirements: Both parties are required to post margin (collateral) with the clearinghouse. Initial margin covers potential future losses, while variation margin covers current mark-to-market losses.
• Risk Management: The clearinghouse continuously monitors the positions of its members and adjusts margin requirements as needed to reflect changes in market conditions and potential risks.
• Settlement: At the end of each trading day, the clearinghouse calculates mark-to-market gains and losses and transfers funds between members.

Benefits of Cleared Derivatives

The clearing process offers several significant benefits:

• Reduced Counterparty Risk: The clearinghouse guarantees the performance of the contract, significantly reducing the risk of default.
• Increased Transparency: Clearinghouses provide regulators with access to detailed information on cleared trades, improving market oversight.
• Standardization: Clearinghouses often require standardized contracts, which makes trading and risk management more efficient.
• Improved Liquidity: Clearing can facilitate netting, where offsetting positions are consolidated, reducing the overall volume of transactions and improving liquidity.
• Systemic Risk Mitigation: By centralizing risk management and monitoring, clearinghouses reduce the potential for a single default to trigger a cascade of failures throughout the financial system.

The Clearinghouse as a Central Counterparty (CCP)

Clearinghouses are often referred to as Central Counterparties (CCPs). They play a crucial role in ensuring the stability and integrity of the financial markets. However, CCPs also introduce a new form of risk: concentration risk. If a CCP were to fail, it could have severe consequences for the entire financial system. Therefore, CCPs are subject to stringent regulatory oversight and are required to maintain robust risk management practices.

Conclusion

Cleared derivatives play a vital role in modern finance by mitigating counterparty risk, increasing transparency, and improving market efficiency. While CCPs introduce new complexities and potential systemic risks, their overall impact on the stability and resilience of the financial system is widely considered to be positive. The move toward greater clearing of derivatives, mandated by regulations in many jurisdictions, represents a significant step towards a safer and more transparent financial marketplace.