What services does a CCP provide?
A CCP centralises counterparty risk management and ensures a safe and controlled post-trade process.
A CCP adds value when there is counterparty risk i.e. the possibility that a trading party could become unable to fulfill its obligations, and when there is market risk i.e. the possibility that the price may have moved unfavorably if a trade has to be replaced after a trading party's default.
A CCP can, through multilateral netting, introduce operational efficiencies by reducing the number of transactions to be settled and capital efficiencies by reducing the value of obligations to be settled.
The use of a CCP ensures a safe and controlled post-trade process. In markets where an electronic order book matches buyers and sellers, the use of a CCP gives trading firms the assurance that they are protected regardless of which counterparty the electronic trading system matched them with. A CCP also preserves the anonymity of the trading parties vis-à-vis each other.
The CCP ensures that it can meet its obligations by collecting sufficient collateral from each trading party to be used to cover any losses incurred if the collateral-giving party defaulted and the CCP had to replace the trade at the prevailing market price. The CCP calculates collateral requirements based on each member’s exposures and open obligations.
A CCP centralises counterparty risk management. It protects all customers through contract; a CCP’s rulebook defines legally binding obligations and rights over all customers, and the procedures when there is a customer default. The customers of a CCP are usually referred to as participants or members to reflect the rule-based nature of the CCP service. In many jurisdictions, there is specific legislation that ensures a CCP can exercise its rights in order to give legal certainty to the centralised risk management.
A side benefit derived from CCPs is the facilitation of multilateral netting, whereby numerous sales and purchases of the same asset by the same party are netted down into a single obligation to settle against the CCP, instead of many obligations to settle against many different trading parties. CCPs thus help to increase liquidity in a market. In markets where settlement costs are high, market participants could consider the cost and operational benefits of multilateral netting to be one of the main values of a CCP.