A Brief Introduction to Client Clearing


Marion Morris.jpg


Marion Morris

FinTrU Associate

Wednesday 11 November 2020

Following the Lehman Brothers default of 2008 and the market turmoil that ensued, the complex and opaque web of privately traded over-the-counter (OTC) derivatives were identified as a contributing factor to the crisis. As bilateral markets fell into disarray, exchange traded derivatives (ETD) markets continued to operate. Central Counterparties (CCPs) were able to act quickly to manage their own risk, winding down and transferring the multiple positions and client accounts worth trillions of dollars in Lehman’s portfolio of which they had carriage.


Due to the performance of CCPs during the Lehman default, client clearing took centre stage in the financial reform of global markets and mandatory clearing was introduced to address the systemic importance of derivatives contracts in a push to reduce counterparty risk.[1] Following the 2009 Pittsburgh summit, the G-20 commitments were announced and it was agreed amongst the G-20 leaders that: “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”[2]


The key purpose of client clearing is to provide certainty to market participants that their traded contracts will be settled. A clearing house acts as a central counterparty, stepping in once a trade has been executed to create a contract between the CCP and each clearing member, essentially becoming the buyer to every seller and the seller to every buyer. Market participants who are not direct members of a clearing house must have their trades cleared through a clearing member.


The clearing member contractually faces the clearing house and must respond to all requirements and liabilities on behalf of its clients to include posting margin to cover the risks associated with their side of the trade, from execution through to settlement. Market participants who are not direct clearing members are generally known as clients, hence the term client clearing. There are two main types of clearing model which have been distinguished in the market: in the US, the “agency” model is most commonly used and the “principal-to-principal" model, illustrated in the diagram below, is the most commonly used for clearing client transactions in Europe.


By placing themselves between buyers and sellers, CCPs have become crucial risk managers, detangling complex trading relationships in the derivatives markets. In order to carry out this role, CCPs have rule books with established processes to ensure that their clearing members can meet their obligations. Additionally, clearing members are required to post initial margin throughout the life cycle of a derivatives contract, with CCPs having control of the types of collateral to accept to satisfy such initial margin obligation. CCPs also perform mark-to-market calculations daily, paying out variation margin (VM) to clearing members with net gains on their positions and collecting VM from clearing members with net losses.


In order to alleviate the risk from a potential clearing member default, clearing members are required by CCPs to contribute to a mutualised guarantee fund that can be drawn upon to cover the losses from a clearing member default that exceeds the defaulter’s own financial resources at the CCP.[3] CCPs also carry out routine stress testing to establish what would happen in the scenario of a clearing member default.

Legislation was introduced in order to bring into effect the commitments announced following the Pittsburgh summit, in a bid to improve transparency and reduce the risks associated with the derivatives market. In the US, reform was introduced through the Dodd-Frank Act which requires standardised OTC derivatives trades to be cleared at a CCP. In the EU, the European Market Infrastructure Regulation (EMIR) was introduced which includes the obligation to centrally clear certain classes of OTC derivatives contracts though CCPs. For non-centrally cleared OTC derivatives contracts, EMIR establishes risk mitigation techniques. Several key components of central clearing introduced through EMIR include:

  • Segregation – under EMIR, CCPs are required to segregate collateral held to ensure a clearing member can distinguish between positions and assets held for its clients and those held for itself. Articles 39(2) and 39(3) establish that, as a minimum, CCPs must offer both individual client segregation and omnibus client segregation. Where an individual account is selected, the client’s assets and positions are held in an account segregated from assets and positions held for other clients. Where a client opts for an omnibus account, their assets and positions are segregated from the clearing member’s own account but commingled with other clients’ assets and positions. Clients must be particularly careful when selecting an account type: individually segregated accounts come with higher fees, however, in selecting an omnibus account, clients must be prepared to cover shortfalls from other clients in that account.

  • Porting of positions – in the event of a clearing member’s default, CCPs are required to have portability rights in place so that clients can, if necessary, transfer their positions to another clearing member rather than having to close out their positions. This could potentially prevent the market scenario that unfolded following the Lehman Brothers collapse and help prevent one default from spreading contagion to the entire market. 

  • Transaction reporting – in order to have a clearer overview of the market, regulators now require all counterparties to report details of their transactions to trade repositories, irrespective of whether they are cleared or not. A template delegated reporting agreement was published by the International Swaps and Derivatives Association (ISDA) and the Futures Industry Association (formerly known as FIA: the Futures and Options Association) and further reporting obligations were introduced outside EMIR through the introduction of Markets in Financial Instruments Directive II (MiFID II).

Client clearing documentation was also reformed and, following the introduction of EMIR and MiFID II, ISDA and the FIA developed an industry standard addendum which sits with the ISDA Master Agreement. An addendum was also created that sits with the FIA’s standard exchange traded derivatives clearing agreement. 

Due to their unique position, CCPs, and client clearing in general, have been at the forefront of regulators minds since the Lehman Brothers default, in an attempt to prevent a financial crisis like that of 2008 happening again.  Despite the many advantages of client clearing, there is growing concern that risk has now been concentrated within CCPs and a number of clearing members, with the assumption that they are too big to fail. The results of a 2017 study spanning over 15 jurisdictions in Europe, Asia and North and South America found that the largest 20 clearing members (as measured by contributions to CCPs prefunded financial resources) accounted for around 75% of all such contributions from a total of 307 clearing members.[4]   


This concern that client clearing, rather than acting as a solution, has in fact become a source of systemic risk, was illustrated in an article published by the Federal Reserve Bank of Chicago which found that:

“Various national authorities, international standard setters, and market participants have argued that, unchecked, the consolidation within the clearing industry which has left derivatives contracts concentrated among a few large CCP clearing members, could be a source of systemic risk.” [5]

One solution under discussion with regards to this growing concern is the encouragement of those that meet CCP membership requirements to become direct clearing members themselves. It is noted, however, that this solution comes with obstacles and whilst much reform has taken place since the 2008 financial crash, what is becoming apparent is that further reform is required in the clearing space.


[1] https://fia.org/events/clearing-day-%E2%80%93-introduction-derivatives-clearing

[2] G20 Leaders Statement: The Pittsburgh Summit, September 24-25, 2009, Pittsburgh

[3] Federal Reserve Bank of Chicago, Economic Perspectives, Vol.43, No. 3, 2019 “The Concentration of Cleared Derivatives: Can Access to Direct CCP Clearing for End-Users Address the Challenge?” by Nahiomy Alvarez 

[4] Basel Committee on Banking Supervision et al., 2017, p.2

[5] Federal Reserve Bank of Chicago, Economic Perspectives, Vol.43, No. 3, 2019 “The Concentration of Cleared Derivatives: Can Access to Direct CCP Clearing for End-Users Address the Challenge?” by Nahiomy Alvarez

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