Central Counterparty Clearing and Systemic Risk Regulation

In this chapter, we discuss a special form of financial market infrastructure — the central counterparty clearing house (or CCP). Central clearing involves the substitution of a CCP as the common counterparty to all cleared trades, typically by means of novation or an equivalent legal mechanism. As a result, the clearing house becomes a principal to all cleared trades — making it, in effect, the “buyer to every seller” and “seller to every buyer”. We discuss some of the legal dynamics, risk implications, and liquidity enhancing properties of this defining characteristic of central clearing.In the wake of the recent financial crisis, the heads of state of some of the world's largest economies agreed on a broad program of regulatory reform, including fundamental changes to the regulation of over-the-counter (OTC) derivatives markets. In particular, the Group of Twenty (G-20) leaders agreed to require all “standardized” OTC derivatives to be centrally cleared. That mandate is a focal point of the program of regulatory reform for OTC derivatives markets and contributes to the systemic importance of CCPs. We consider some arguments for and against the clearing mandate in this chapter and discuss ongoing regulatory efforts to mitigate systemic risk in the financial system.