Who is a central counterparty

See Diagram 2. It is not possible for all those debtors to seize the claims owed to all these creditors in order to pay the debts which the debtors owe to X.

Enter the central counterparty. The problem of mutuality is solved by the ingenious device of inserting a company, the central counterparty, between the participants and the bankrupt X.

The central counterparty is just an ordinary company whose only business is to act as a central counterparty. Its shares can be owned by the participants who are using the company or the shares can be owned by independent shareholders or by an exchange.

Whenever two participants in the market enter into a contract, e. Thus, if C sells to X in the market, the parties agree with the central counterparty that their single contract is treated as two contracts. The first is between C and the central counterparty under which C sells to the central counterparty.

The second contract is between the central counterparty and X under which the central counterparty sells to X on exactly the same terms. The single contract is turned into two mirror contracts with the central counterparty in the middle.

The set-up is as shown in Diagram 3. The result of this arrangement is that, if X becomes bankrupt, the central counterparty can set off or net against X since all the trades are mutual as between the central counterparty and X. The manifold non-mutual claims on the left are combined into mutual claims on the right.

The effect is that a global set-off by all participants against the bankrupt X becomes possible. The reduction of overall risk in many cases can be simply enormous. The use of a central counterparty therefore makes a lot of sense in terms of making financial markets safer and reducing exposures if one major firm should become bankrupt.

There is a lesser risk of cascade or domino or knock-on insolvencies. The main problem is that there is a gigantic concentration of risk on the central counterparty. All contracts in the particular market go through the central counterparty and so the central counterparty potentially has huge liabilities. If the central counterparty became insolvent, the result could be catastrophic. They really are too big to fail.

Hence the participants have to make sure that this does not happen. For example, the participants have to provide collateral to the central counterparty and banks have to agree to provide loans so that the central counterparty can borrow if it is suddenly short of cash.

These are not fool-proof. Thus collateral can fall in value and banks providing loans can go bust. Systems can fail. But, because the mutualisation of claims results in such a large reduction in exposures, the overall amounts needed to protect the counterparty are very much less. The outstanding amounts of credit default swaps are many times world GDP.

The overall reduction in these risks by the use of a central counterparty could reduce the current exposures by trillions. The amounts involved in foreign exchange and payment systems are so huge that the concentration of risk makes central counterparties less appropriate. As a result and for other reasons the main foreign exchange settlement bank CLS Bank and payment systems adopt different strategies.

Apart from enhanced set-off, these central counterparties have a number of other advantages. Thus traders mainly have to assess only the credit of the central counterparty, instead of the credit of all the other counterparties which they contract with in the market. The traders contract only with the central counterparty. The central counterparty can "match" trades, i. Play What are central counterparties? Convert this page to PDF. Other Quarterly Bulletin Q2 articles. Back to top.

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