What Is a Central Counterparty Clearing House (CCP) in Trading? (2024)

A central counterparty clearing house (CCP) is an entity that facilitates trading in European derivatives and equities markets. Typically operated by the major banks in each country, CCPs are a crucial part of these markets, reducing the counterparty, operational, settlement, market, legal, and default risks for traders.

A CCP is a particular type of clearing house. While the latter also facilitates trading, CCPs take an additional step and must agree to the terms before they clear the transaction. In the U.S., the equivalent of a CCP is a derivatives clearing organization (DCO) or derivatives clearinghouse. These are regulated by the Commodity Futures Trading Commission (CFTC) and include the Options Clearing Corporation and Chicago Mercantile Exchange Clearing.

Understanding a Central Counterparty Clearing House (CCP)

Central counterparty clearing houses (CCPs) perform two main tasks as intermediaries in transactions: clearing and settlement. As counterparties to the buyers and the sellers, CCPs guarantee the terms of a trade—even if one party defaults on the agreement. CCPs bear the lion's share of the buyers' and sellers' credit risk when clearing and settling market transactions.

The CCP collects money from each buyer and seller to cover potential losses incurred by failing to follow through on an agreement. In such cases, the CCP replaces the trade at the market price. Monetary requirements are based on each trader’s exposure and open obligations.

How a Central Counterparty Clearing House (CCP) Works

To protect privacy, CCPs shield the associated traders’ identities from one another. CCPs also protect trading firms against default from buyers and sellers who are matched by an electronic order book and whose creditworthiness is unknown. In addition, CCPs reduce the number of transactions that are being settled. This helps smooth operations while reducing the value of the obligations, which helps money move more efficiently among traders.

What Are Derivatives Clearing Organizations (DCOs)?

DCOs are critical players in keeping commodities and derivatives markets in the U.S. stable and trustworthy. As defined by the CFTC, a DCO is an entity that enables parties to substitute the DCO's credit for their own through novation (the legal substitution of one party for another in a contract). Think of them as financial middlemen who solve a crucial problem—they bring trust to a system where trades are done without credit checks or most often without even knowing who the other party is. When two people make a deal involving derivatives, a DCO ensures everyone holds up their end of the bargain.

They do this by becoming a stand-in for both parties, taking on the responsibility for making the deal go through even if one side can't or won't pay up. This process, which the CFTC oversees, helps reduce risk and brings far more trading into the market.

DCOs are particularly important in the derivatives market, where they must register with the CFTC before providing clearing services for futures contracts, options on futures, or swaps. DCOs must meet stringent regulations to protect market participants and maintain market stability.

To obtain and maintain registration, DCOs must follow 17 "core principles" established in the Commodity Exchange Act. They cover a wide range of operational and risk management requirements, such as the following:

1. Maintaining adequate financial, operational, and managerial resources
2. Implementing the appropriate risk management procedures
3. Ensuring prompt settlement under very different market circ*mstances
4. Protecting member and participant funds
5. Establishing efficient and fair default procedures
6. Having robust safeguards and disaster recovery plans

DCOs must maintain complete records, publish their rules and operating procedures, and participate in information-sharing agreements. These requirements promote transparency and allow for effective oversight by regulators.

The CFTC may exempt a DCO from registration for clearing swaps if it determines that the DCO is subject to comparable, comprehensive supervision by authorities in its home country. This provision recognizes the global nature of derivatives markets while ensuring consistent standards across borders.

Blockchain Technology, Cryptocurrency Trading, and CCPs

CCPs have long been a cornerstone of risk management in European and U.S. financial markets (the latter through DCOs). As blockchain technology and cryptocurrencies reshape the financial landscape, CCPs are adapting to this new paradigm while also changing their traditional models.

In traditional markets, CCPs act as intermediaries between buyers and sellers, guaranteeing trades even if one party defaults. This system has proved effective in mitigating counterparty risk and enhancing market stability. However, the decentralized nature of blockchain technology has suggested a possible advance over the CCP model, blockchain proponents have argued.

In 2015, clearinghouses from several nations joined forces to create a Davos-formed think tank, the Post Trade Distributed Ledger Group (PTDLG), which studies how blockchain technology can be used for clearing, settling, and recording securities trades. The group, which in 2018 began collaborating with the Global Blockchain Business Council, now includes around 40 financial institutions worldwide (though it claims far more in "ambassador" and other roles).

Blockchain's inherent features are said to provide transactions with immutability, transparency, and near-real-time settlement. Having these would seem to eliminate the need for CCPs in some markets. Smart contracts, for instance, automatically execute trades and transfer assets without intermediaries. This has led some crypto enthusiasts to argue that blockchain could make CCPs obsolete.

But let's not get ahead of ourselves. While blockchain can streamline many processes, it can't perform all the risk management functions of CCPs. For example, CCPs handle collateral management, netting of positions, and default management procedures—tasks still notional in blockchain-based systems.

There's also the problem that the financial industry has already been through a run of blockchain ventures that didn't pan out. As a Financial Times headline put it in late 2023, the "case for blockchain in financial services" has been "dented by failures." Here are a couple of examples:

• B3i (Blockchain Insurance Industry Initiative): This consortium of 15 insurance and reinsurance companies aimed to use blockchain to reduce inefficiencies in premium and claims settlement. However, B3i ceased operations and filed for insolvency in July 2022 because of challenges in gaining industrywide adoption and scaling its blockchain structure.
• we.trade: A blockchain-based trade finance platform backed by 12 major banks, including Deutsche Bank AG (DB), HSBC Holdings PLC (HSBC), and Banco Santander S.A. (SAN), also entered insolvency in 2022. Despite its promise to streamline international trade transactions, even its own members were unconvinced, and the group fell apart because they wouldn't fund it.
  

In addition, while most DCOs have steered clear of unproven technologies, CCPs elsewhere in the world haven't been as patient.

The ASX Blockchain Debacle: A Cautionary Tale

The early 2020s failure of the Australian Securities Exchange (ASX) blockchain project serves as a stark warning about the risks of adopting unproven technologies in critical financial infrastructure. It's worth looking at the debacle for that reason. Here's a brief timeline of events:

1. 2017: ASX contracts with tech firm Digital Asset (DA) to create a blockchain-based ledger for its new Clearing House Electronic Subregister System (CHESS).
2. 2020: The project is internally rated as "red," indicating material risks to timely delivery. An email from Digital Asset to ASX noted that "there was a risk of continued delays to the delivery of code ... and that this would put additional pressure on future milestones," according to ASIC.
3. December 2021: DA revised its timeline to deal with the software issues, but ASX rejected it since it had already published its plan with the earlier dates.
4. February 2022: Instead of reckoning with the problem, ASX publicly states the project is "on track for go-live" and "continuing to progress well," according to the Australian Securities and Investments Commission (ASIC).
5. Mid-July 2022: After nearly seven years and about $250 million invested, ASX terminates the project.
6. August 2024: ASIC brings a suit against ASX for allegedly making false and misleading statements about the project.

The Australian regulator said the case illustrates the dangers of overpromising on blockchain capabilities in complex financial systems. It also warned about the financial consequences and loss of trust that can come from pursuing trendy technologies without a thorough evaluation.

ASIC Chair Joe Longo said that ASX's claims over the years that its CHESS system was on track "go to the heart of trust in the integrity of our markets." "Companies and market participants rely on what the ASX says about its operations to make their own decisions and investments," he said.

ASIC, which has been busy bringing cases related to crypto fraud, pump-and-dump schemes, and scams involving major players in the Australian markets, has clearly tired of financial executives continually speaking of the promise of crypto and blockchain while hiding problems, if not outright scams. Between the summer of 2023 and 2024 alone, it brought suits in 615 cryptocurrency cons.

Europe's Leap Into Blockchain-Based Clearing Operations

ASX is not the only CCP looking to blockchain for greater efficiencies and the other promises of the technology. Euroclear, one of the largest in Europe, has been partnering with Paxos, a blockchain infrastructure company, to develop a blockchain-based platform for settling gold trades. The platform, Euroclear Bankchain, has completed pilot programs and has been processing settlements.

In addition, Euroclear has been working since 2021 on a central bank digital currency (CBDC) with the Banque de France while working out how to bring to the market blockchain-based settlements for government bonds. In March 2024, Euroclear also bought a major stake in IZNES, a regulated international platform for subscriptions and redemptions of shares of European funds. These efforts indicate that Euroclear is continuing to explore and develop blockchain-based clearing and settlement structures rather than abandoning them​.

SIX, the Swiss stock exchange operator, has the SIX Digital Exchange (SDX), which uses blockchain technology to offer trading, settlement, and custody services for digital assets. SDX leverages the blockchain for real-time settlement and the simultaneous transfer of ownership. This setup mirrors the role of a CCP by providing central clearing for digital asset trades on its platform. In 2024, SDX, the World Bank, and the Swiss National Bank issued the first Swiss Franc (CHF) digital bond by an international issuer, totaling CHF 200 million. This seven-year bond will settle using the SNB's wholesale CBDC, with coupon and redemption payments made in tokenized CHF on the SDX platform.

The US's More Measured Approach to Blockchain and Clearing

Meanwhile, U.S. clearing institutions like the Depository Trust & Clearing Corporation (DTCC) that are working on blockchain-based systems are notable for their more circ*mspect approach. For example, DTCC has been using blockchain additional projects first, including its "Smart NAV" pilot project for publishing mutual fund asset information. In 2022, DTCC went live with its "Project Ion," a blockchain-based alternative settlement platform. This platform uses distributed ledger technology. Most importantly, though, it's designed to work alongside DTCC's existing systems, which remain authoritative for any cleared transactions.

As the integration of blockchain and traditional finance continues, it's likely we'll see hybrid models emerge. This could combine the efficiency and transparency of blockchain with the risk management expertise of CCPs. As the ASX debacle shows, while blockchain may offer potential benefits in particular, its application in core clearing and settlement functions is still just a promise on the horizon, not a proven technology.

Cryptocurrency Exchanges and Their Claims to CCP-Like Practices

Some exchanges have long been asserting to develop their own CCP-like structures in the cryptocurrency space. For example, since 2018, Binance, one of the largest crypto exchanges, has had what it says is a secured emergency fund for its users, which acts as a type of insurance fund to protect users in case of large-scale breaches or hacks—a function that's said to be like the default funds maintained by traditional CCPs.

However, that's hardly the case: estimates put the amount traded each year on Binance at $1.5 trillion; the company said in August 2024 that assets in its CCP-like fund were valued at $1 billion, the same as in 2022. For comparison, LCH, which clears about the same value each year, has about six times as much in its backup funds, which aligns with regulatory and International Swaps and Derivatives Association and other international clearing best practices.

Moreover, many of the claims in the crypto space to have robust protections aren't true at all. For example, FTX, the major cryptocurrency exchange founded by the since-convicted Sam Bankman-Fried, rapidly grew into a multi-billion-dollar enterprise, not least on the back of its claim to insure at least part of its users' deposits. After it collapsed in November 2022 due to fraud, misuse of customer funds, and a liquidity crisis, its bankruptcy exposed significant gaps in oversight and governance within the crypto industry, leading to widespread investor losses and a slew of criminal proceedings.

A significant element in the FTX meltdown was its claim to have a fund that functioned similarly to a CCP, designed to protect against systemic risk within the platform. This fund, labeled on the exchange as the "FTX Insurance Fund," was said to be able to cover losses in cases where large-scale liquidations occurred that couldn't be fully absorbed by the market. The idea was to create a buffer to prevent cascading failures within the platform, similar to how a CCP acts as a backstop in traditional financial markets.

However, FTX’s approach to providing such protections was, in the end, criminal. In 2023, FTX's cofounder, Gary Wang, testified that the amount displayed to investors as in the fund was taken from a random number multiplied by the daily volume on the exchange. Not even a fraction of that number was ever stored away. The difference between a CCP operating under strict regulatory oversight and crypto exchanges' claims to mirror such investor protections is stark and profound:

1. Regulatory framework: Many crypto exchanges operate in a regulatory gray area (or lawless zone), often with minimal external supervision.
2. Transparency and accountability: CCPs are subject to rigorous transparency requirements, including detailed financial disclosures and operational reports. Crypto exchanges—FTX only stands out as the most costly example—lack this, making it impossible for users to assess the actual state of their risk management practices.
3. Risk management practices: CCPs employ sophisticated, time-tested risk management techniques, including robust margin requirements and default management procedures. Crypto exchanges often claim to have similar protections, but as the FTX case demonstrated, these claims can be grossly exaggerated or entirely fabricated.
4. Governance and oversight: CCPs and DCOs have strong governance structures, including independent boards and risk committees. Many crypto exchanges lack even the most minimal separation of those who own the exchange and those performing any typically "independent" functions.
5. Capital requirements: CCPs and DCOs are required to maintain substantial capital reserves to cover potential losses. Crypto exchanges may claim to have similar reserves, but these claims are unverifiable without proper regulation and auditing.
   

Pros and Cons of CCPs

Central Counterparties (CCPs) offer significant benefits in trading by mitigating counterparty risk. They act as intermediaries, ensuring that both parties meet their obligations and reducing the risk of default. This structure enhances market stability and confidence, making trading more efficient and secure.

However, CCPs also present certain risks and limitations. One of the main concerns is the concentration of risk. Since CCPs centralize counterparty risk management, any failure or disruption in a CCP could have widespread impacts on the entire financial system, potentially leading to systemic risk.

Another limitation of CCPs is their operational and compliance burden on market participants. Companies must follow stringent regulations and uphold robust risk management protocols, which can demand considerable resources. These requirements can also limit market access for smaller participants, potentially reducing market liquidity and diversity. That said, it's unlikely these markets would have a fraction of their participants without the trust built by these regulations and risk management standards. The rise and fall of various crypto ventures shows the value of such robust requirements.

Moody’s Rating Methods for Central Counterparty Clearing Houses

Moody’s Investors Service rates CCPs worldwide. In its periodic reports, Moody’s evaluates how a CCP is meeting its clearing and settlement obligations and how much money will likely be lost if a trader defaults on an obligation. The CCR report factors in the following considerations:

• A CCP’s management capabilities for obligation defaults and related protections
• A CCP's business and financial basics
• A CCP's operating environment
• A CCP's quantitative measurements and qualitative issues, which Moody’s uses when determining a given CCP’s creditworthiness

The Bottom Line

CCPs act as intermediaries in the clearing and settlement of trades, particularly in derivatives markets. Unlike traditional clearing houses, which focus on settling trades between the original parties, CCPs have the additional role of becoming the counterparty to both sides of a trade through a process known as novation. To manage risks, CCPs maintain emergency or default funds, which are designed to cover extreme scenarios such as the default of several major clearing members simultaneously.

These funds come from member contributions, scaled according to the risk they bring to the CCP. While CCPs and traditional clearing houses share the goal of reducing settlement risk, CCPs have a more active and risk-intensive role because they assume counterparty risk. In the U.S., many CCPs are registered as DCOs with the CFTC, meaning they must meet stringent regulatory standards specific to derivatives markets.