Central Counterparty (CCP)

Without a central counterparty, each trader is exposed to the risk that the party on the other side fails to pay or deliver. A CCP replaces many bilateral exposures with a single exposure to the CCP, a process called novation.

CCPs manage risk in several ways. They require members to post initial margin when they open positions and variation margin as prices change. They maintain default funds, contributed by members, and their own capital to absorb losses. If a member defaults, the CCP uses these resources, in a set order called the default waterfall, to cover losses.

For example, if a trader holding a large futures position goes bankrupt, the CCP closes or transfers the position, using the trader's margin to cover any loss, so that other traders are not affected.

After the 2008 financial crisis, regulators required many standardised over-the-counter derivatives to be cleared through CCPs. This has reduced counterparty risk, but concentrated it in a small number of CCPs, which are now regulated as critical financial infrastructure.