Clearing Mechanics

Abstract This chapter examines the different methods used by central counterparties (CCP) for effecting a ‘counterparty substitution’ between a CCP and its clearing members. CCPs are able to interpose themselves between the members of the clearing system and assume their obligations through the contractual mechanisms of novation and open offer. A ‘novation’ involves the termination of an earlier contractual agreement that was entered into between two counterparties and a substitution with a new agreement and a new counterparty. Conversely, in an ‘open offer’, a contractual agreement is created between each counterparty and the CCP at the moment that the counterparties agree to enter into a particular transaction so that there is never a contract between the two counterparties. The counterparty substitution process is a critical stage in the clearing procedure because it is the main mechanism for ensuring that the CCP is able to act as the main counterparty and ‘principal’ for settling the outstanding obligations arising from the derivative contracts that have been executed by the system’s participants, irrespective of whether they have entered into these transactions on a regulated derivatives exchange or over-the-counter (OTC). The chapter analyses the clearing mechanism from a legal perspective and focuses mainly on common law jurisdictions as many of the large CCPs are based in the United Kingdom.