CCPs come up when derivatives are sent for clearing and when margin posted to a CCP is managed. How a firm deals with a CCP also depends on whether it is a clearing member or uses one.

How a central counterparty changes a trade

A central counterparty replaces the trades among many market participants with trades in which it is the counterparty to each of them1. It becomes the buyer to the seller and the seller to the buyer, so it ensures that outstanding trades are performed2. The replacement of one trade by two trades, novation, and the difference between cleared and uncleared trades are covered in Cleared vs Bilateral Trades.

When a CCP becomes the counterparty, two things follow. The first is that it can reduce risk to participants. Trades with different counterparties can be offset as trades with the CCP (multilateral netting), and the CCP can impose more effective risk management on participants2. Netting across markets greatly reduces the volume to be settled, and in theory participants can trade without considering each other's credit risk3.

The second is that risk is concentrated in the CCP. A CCP normally holds open positions (unsettled trades) with its participants, so it may incur losses against them when market prices move. When a participant defaults, prices also keep moving until the CCP has hedged, transferred or closed out the defaulting participant's trades4. A CCP therefore prepares with resources contributed in advance, such as margin and a default fund.

How clearing members and customers connect to a CCP

Below, a party that trades directly with a CCP and takes part in clearing is called a clearing member. The materials of Japan Securities Clearing Corporation (JSCC) call it a clearing participant. A customer that is not a clearing member asks a clearing member to clear and uses the CCP through that member. The PFMI call a party that participates directly in a CCP a direct participant, and a party that uses it through a direct participant an indirect participant5. PFMI Principle 19 expects a CCP to identify, monitor and manage the material risks that arise from such tiered participation6. The party responsible to the CCP for performing a customer's obligations is the clearing member, which is a direct participant7.

CustomerVia a memberMemberDirectCCPRequestCustomer tradesCustomer marginGains and losses
Figure 1Relationships among the CCP, clearing members and customers
Figure description

A customer asks a clearing member to clear. The clearing member submits the customer's trades and margin to the CCP separately from its own. The CCP pays and receives gains and losses with the clearing member as its direct counterparty.

To protect customers, a CCP keeps customers' positions and margin separate from the member's own. In JSCC's clearing of credit default swaps (CDS) and interest rate swaps, the clearing member's own positions and margin and its customers' positions and margin are managed separately, and customers' positions and margin are kept apart in an account for each customer8. For listed derivatives, customers' positions and margin are managed either in an account that pools several customers (an omnibus account) or in an account for each customer8.

If a clearing member defaults, its customers can also move their positions and margin to another clearing member. In JSCC's clearing of listed derivatives, CDS and interest rate swaps, the defaulting clearing member's consent is not required, but the receiving clearing member must accept the transfer8. PFMI Principle 14 expects a CCP to have such rules on segregation and portability9. The supervisory guidelines of the Financial Services Agency (FSA) also have points of focus to the same effect10.

Margin and the default fund prepare for a member's default

The financial resources a CCP takes from members are of two broad kinds2. One is initial margin and variation margin. JSCC takes margin as collateral so that losses from a member's default are covered by that member. Variation margin is the gain or loss from revaluing outstanding trades at the latest prices (mark-to-market), which is paid and received with the member at least once a day. Initial margin is designed to cover possible future losses (potential future exposure) under normal market conditions at a level that covers losses in at least 99 cases out of 100 (a confidence level of 99% or higher)11.

The other is the default fund. The default fund is a pool of resources, in addition to margin, that members deposit in advance in anticipation of several members defaulting. For CDS, interest rate swaps, over-the-counter Japanese government bond (JGB) transactions, cash market transactions, index futures and others, JSCC sets the required amount of the default fund on the assumption that the two largest clearing members (including their affiliates) default. The default fund contributions of members other than the defaulting member may also be used to cover losses12.

On the order in which losses are covered, JSCC's basic approach is to cover them first with the defaulting clearing member's resources (margin and similar), and then with the resources of non-defaulting clearing members (the default fund and similar). To preserve the CCP's incentive to manage risk appropriately, however, JSCC covers losses with its own resources before it uses those of non-defaulting clearing members13. The PFMI call such a series of resources that cover a CCP's losses a waterfall. A waterfall may include the defaulting participant's initial margin and contribution to the default fund, part of the CCP's own funds, and non-defaulting participants' contributions to the default fund14.

Consider a hypothetical example in which a member defaults and closing out its trades produces a loss of 1 billion yen. The amounts differ from one CCP arrangement to another, so the figures serve only to explain the order.

Order Resource that covers the loss Amount covered (billion yen) Cumulative (billion yen)
1 The defaulting member's margin and default fund contribution 0.7 0.7
2 The CCP's own contribution 0.1 0.8
3 The default fund of non-defaulting members 0.2 1.0

In this example the third resource is used, so part of the loss reaches non-defaulting members as well. Because of the default fund, a member may bear a loss from the default of a member it did not trade with. On the other hand, if the first resource alone covers the loss, the other members bear nothing.

The FSA's supervisory guidelines require a CCP to state clearly, in its business rules and similar documents, its authority to collect additional amounts and the allocation method when a loss exceeds the resources contributed in advance15.

How to become a clearing member

A party that wants to become a clearing member applies to the CCP for qualification and receives its approval. JSCC sets qualification requirements in the form of acquisition standards and maintenance standards. The thinking is that, because a CCP bears the credit risk of each counterparty, it requires high creditworthiness of clearing members17.

After approval, the CCP keeps monitoring its members. JSCC continuously checks financial condition, management structure and operational execution structure. It reviews financial condition through reports from monthly to annual and through news and market information (share prices, CDS and bond spreads). It also reviews the operational execution structure by whether daily cash payments, securities deliveries and collateral deposits are made by their deadlines. When it finds that a requirement is not met, it can instruct improvements to the operational execution structure or positions. It can also suspend all or part of the assumption of obligations and the bearing of obligations, or revoke the qualification17.

PFMI Principle 18 expects a CCP to set and publish participation requirements that are objective and based on risk. This is to reconcile fair and open access with reasonable risk-related requirements for the CCP's financial soundness1819.

How JSCC, LCH and CME differ

JSCC, LCH Limited and CME differ in the products they clear and in the authority that issues the license, authorization or registration on which each rests as a CCP. The following table sets out the differences among the three CCPs.

CCP Country Products Regulatory basis
Japan Securities Clearing Corporation (JSCC) Japan Exchange-traded products, over-the-counter derivatives (CDS and interest rate swaps), over-the-counter JGB transactions, listed commodity derivatives A license for financial instruments obligation assumption services (January 2003) and a permission for commodity transaction obligation assumption services (July 2020)20
LCH Limited UK (London) Over-the-counter interest rate, inflation, currency, equity and commodity derivatives, repos and others, including listed interest rate derivatives Authorization as a central counterparty by the Bank of England (June 12, 2014)21
Chicago Mercantile Exchange, Inc. (CME Clearing) US Futures, options and swaps A derivatives clearing organization registered with the US Commodity Futures Trading Commission (CFTC)22

In July 2020, JSCC merged with Japan Commodity Clearing House and extended its clearing to commodity markets2023. The permission for commodity transaction obligation assumption services came with this merger. The FSA, the Ministry of Agriculture, Forestry and Fisheries, and the Ministry of Economy, Trade and Industry regulate and supervise it20.

It has also received recognition and exemptions from overseas authorities. In October 2015, the US CFTC exempted it from registration as a derivatives clearing organization under the US Commodity Exchange Act for interest rate swap clearing. In April 2015, the European Securities and Markets Authority (ESMA) recognized it as a third-country CCP in the European Union. As a result, US clearing members and EU financial institutions can meet their clearing obligations in their own countries or regions through clearing at JSCC20.

LCH Limited is a UK CCP authorized by the Bank of England, located in London. The authorization is dated June 12, 2014, and it had been recognized as a clearing house since November 22, 2001. The authorization covers, in a table updated on March 1, 2023, over-the-counter interest rate derivatives (June 12, 2014), inflation derivatives (March 27, 2015), and currency, equity and commodity derivatives, among others2124. The Bank of England's list also shows LCH SA of France as a separate CCP.

CME is the clearing division of Chicago Mercantile Exchange, Inc. (CME Clearing), which clears futures, options and swaps. It is a derivatives clearing organization registered with the CFTC, and under Title VIII of the Dodd-Frank Act the CFTC is its supervisory agency. A Federal Reserve Board document lists CME among the eight institutions designated as financial market utilities (shown as updated on January 29, 2015)22. The Bank of England recognized CME on May 24, 2024 as a non-UK CCP that may provide clearing services in the UK25.

How margin is calculated, how the default fund works and the order in which losses are covered differ between CCPs, and between the clearing services within one CCP. JSCC builds a loss-coverage arrangement for each clearing service so that a loss in one service does not reach the others13.

The risk of a CCP itself and the PFMI

Because a CCP takes on participants' defaults, its own safety affects the whole market. If a CCP's soundness is not ensured, not only the stability of its business but also the soundness of the whole financial system may be harmed (systemic risk). A CCP therefore concentrates on financial instruments obligation assumption services and their ancillary business, and in principle may not engage in other business26.

Effective risk management by the CCP and adequate financial resources are the precondition for the CCP to reduce risk to participants2. Adding financial resources whose losses are shared in common makes it easier for a CCP to prepare for defaults in extreme conditions, but it also strengthens the links among participants. The PFMI call for a balance between financial resources separated by participant, such as margin, and resources shared in common27. JSCC checks at least once a day, by stress testing, whether its loss-coverage resources are sufficient13.

The PFMI principles that concern CCPs include credit risk (Principle 4), margin (Principle 6), and participant-default rules and procedures (Principle 13). They also include segregation and portability (Principle 14), access and participation requirements (Principle 18), and tiered participation arrangements (Principle 19)28. The principles as a whole are covered in Overview of Market Infrastructure. The FSA's supervisory guidelines also expect a CCP to disclose information regularly in line with the PFMI29.

Notes

  1. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "「清算機関」の機能" (The functions of a clearing house). ↩

  2. Committee on Payment and Settlement Systems of the BIS and Technical Committee of the International Organization of Securities Commissions, "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 1.13 (pages 11–12) (in Japanese). The English original is CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), which uses the same paragraph numbers. ↩ ↩2 ↩3 ↩4

  3. Japan Securities Clearing Corporation, "JSCCとは" (in Japanese), "JSCCの役割" (The role of JSCC). ↩

  4. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.4.14 (page 56) (in Japanese). ↩

  5. "金融市場インフラのための原則" (provisional Japanese translation), paragraph 3.19.1 (page 146) (in Japanese). ↩

  6. "金融市場インフラのための原則" (provisional Japanese translation), the text of Principle 19 (page 4 of the summary) (in Japanese). ↩

  7. "金融市場インフラのための原則" (provisional Japanese translation), paragraph 3.19.9 (page 149) (in Japanese). ↩

  8. Japan Securities Clearing Corporation, "リスク管理 分別管理・勘定移管" (Risk management: segregation and portability, in Japanese; shown as of April 14, 2023), "顧客ポジション・証拠金の分別管理" (Segregation of customer positions and margin) and "ポジション及び証拠金の移管" (Transfer of positions and margin). ↩ ↩2 ↩3

  9. "金融市場インフラのための原則" (provisional Japanese translation), the text of Principle 14 (page 3 of the summary) (in Japanese). ↩

  10. Financial Services Agency, "清算・振替機関等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Clearing and Settlement Institutions, etc.; the English title is an unofficial translation; in Japanese), III-3-6, "(1) Significance" and "(2) Main points of focus". ↩

  11. Japan Securities Clearing Corporation, "リスク管理 証拠金" (Risk management: margin, in Japanese; shown as of December 18, 2024), main text. ↩

  12. Japan Securities Clearing Corporation, "リスク管理 清算基金" (Risk management: default fund, in Japanese; shown as of September 21, 2021), main text. ↩

  13. Japan Securities Clearing Corporation, "リスク管理 損失補償" (Risk management: loss coverage, in Japanese; shown as of October 1, 2026), main text. ↩ ↩2 ↩3

  14. "金融市場インフラのための原則" (provisional Japanese translation), paragraph 3.4.17 (pages 57–58) (in Japanese). ↩

  15. Financial Services Agency, "清算・振替機関等向けの総合的な監督指針" (in Japanese), III-3-5, "(2) Main points of focus". ↩

  16. Japan Securities Clearing Corporation, "免許・認証取得状況" (Status of licenses and recognitions, in Japanese), "日本の規制当局からの免許取得状況" (Licenses from Japanese regulators). The notice is the FSA notice on capital adequacy ratios, which sets the criteria, under Article 14-2 of the Banking Act, for judging whether a bank's capital is adequate in light of its assets; the provision is Article 270-8, paragraph 1. ↩

  17. Japan Securities Clearing Corporation, "リスク管理 清算参加者管理" (Risk management: clearing participant management, in Japanese; shown as of March 31, 2026), main text. ↩ ↩2

  18. "金融市場インフラのための原則" (provisional Japanese translation), the text of Principle 18 (page 4 of the summary) (in Japanese). ↩

  19. Financial Services Agency, "清算・振替機関等向けの総合的な監督指針" (in Japanese), III-3-1-2, "(1) Significance". ↩

  20. Japan Securities Clearing Corporation, "免許・認証取得状況" (in Japanese), "日本の規制当局からの免許取得状況" (Licenses from Japanese regulators) and "海外の規制当局からの認証等の取得状況" (Recognitions from overseas regulators), the entries for the US and the European Union. ↩ ↩2 ↩3 ↩4

  21. Bank of England, "Who are we?", "UK CCPs", the entry for LCH Limited (shown as updated on July 23, 2026). ↩ ↩2

  22. Board of Governors of the Federal Reserve System, "Designated Financial Market Utilities", the list of designated institutions and the entry for "Chicago Mercantile Exchange, Inc.". ↩ ↩2

  23. Japan Securities Clearing Corporation, "JSCCとは" (in Japanese), "沿革" (History). ↩

  24. Bank of England, "Table 1: Classes of financial instruments covered by LCH Limited's authorisation" (shown as updated on March 1, 2023). ↩

  25. Bank of England, "Who are we?", "Recognised non-UK CCPs", the entry for Chicago Mercantile Exchange (shown as updated on July 23, 2026). ↩

  26. Financial Services Agency, "清算・振替機関等向けの総合的な監督指針" (in Japanese), III-4-2, "(1) Purpose". The limit on business is Article 156-6, paragraph 2 of the Financial Instruments and Exchange Act. ↩

  27. "金融市場インフラのための原則" (provisional Japanese translation), footnote 54 to paragraph 3.4.18 (page 58) (in Japanese). ↩

  28. "金融市場インフラのための原則" (provisional Japanese translation), the list of principles (pages 1–4 of the summary), Principles 4, 6, 13, 14, 18 and 19 (in Japanese). ↩

  29. Financial Services Agency, "清算・振替機関等向けの総合的な監督指針" (in Japanese), III-3-8, "(2) Main points of focus". ↩