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Mitigating Counterparty Risk in the Credit Default Swap Markets with Central Counterparties: The Whys and Wherefores

Guest post by Jodi Scarlata*

This post discusses key features of a well-designed central counterparty (CCP), aspects particular to a credit default swap (CDS) CCP, and the factors for choosing between multiple CCPs versus a single CCP. For broader discussions of CCP issues, see the 2004 and 2007 reports published by the Bank for International Settlements Committee on Payment and Settlement Systems.

A CCP facilitates standardization and multilateral netting, increases liquidity, and can improve the availability of price information, increasing the ability to value CDS products, and ultimately serves to mitigate risk. A CCP for standardized CDS contracts can reduce operational risks, especially those inherent in over-the-counter trades, such as backlogs of outstanding confirmations and unwinding positions in case of default that can spread across multiple counterparties. In addition, the mutualization of risk among clearing members provided by a CCP reduces hedging costs by eliminating the need for hedging bilateral exposure.

The lack of transparency about the net counterparty exposure in the CDS market can inflate the public perception of counterparty risk. For example, if the market had known in advance that the settlement of Lehman swaps would amount to only $5.2 billion of net funding obligations in the CDS market, according to the Depository Trust and Clearing Corporation, instead of the hundreds of billions in notional that were speculated, the financial markets might not have seen the same degree of turmoil in the fall of 2008. Thus, greater insight into CDS trading activity could reduce the uncertainties characteristic of the recent crisis.

Risk Management: Margining, Collateral, and Membership Requirements

While a CCP mitigates counterparty risk, it also concentrates risk and requires extensive risk management systems. Consequently, a CCP’s risk management processes, internal controls and operational risk procedures, and the adequacy of its back-up financial resources are key to ensuring that risks are contained. In addition, a CCP that clears CDS contracts should conduct stress tests with relevant shocks to its members.

A CCP typically uses margining as an instrument to reduce counterparty credit risk. Initial margin, the amount required to initiate a position, and variation margin, payments for the daily losses and payoffs for daily gains, are required to keep a position open. This allows payment flows to account for intra-day price movements and variation margin changes to account for end-of-day settling up, since variation margin is based on daily mark-to-market pricing; positions are liquidated if variation margin cannot be met. Riskier instruments should incorporate larger margins to account for the greater risk to which the CCP is exposed.

Margin requirements for less liquid instruments should incorporate the potential losses that might occur over a longer liquidation period following a default. Margining requirements should therefore account for risks of a particular product and elements such as sector risk and liquidity risk. The accurate calculation of margin requirements, or even an appropriate range of margin requirements, will be a key challenge to the new CDS CCPs due to the complexities in the pricing of these particular products.

Cash Settlement versus Physical Settlement in a CDS CCP

A CCP can facilitate settlement of contracts after an event of default. For credit derivatives contracts, there has been a decline of physical settlement in favor of cash settlement, and the use of ISDA auction protocols have become standard practice in credit events for the reasons cited below.

A feature of the CDS market is the settlement method in case of default, or credit event. With the occurrence of a credit event, there are two options for the settlement of CDS contracts— physical settlement or cash settlement. A CDS credit event is a default event that results in payments by the protection seller to the protection buyer, concurrent with delivery requirements by the protection buyer. Typical credit events include bankruptcy of the reference entity or its failure to pay with respect to its bond or debt and, for some reference entities, restructuring.

In the case of physical settlement, the protection buyer delivers the debt obligation (the cash instrument) of the reference entity and in return is paid the par value by the protection seller. In cash settlement, the protection seller pays the protection buyer the difference between par value and the market value of the debt obligation of the reference entity. However, the growth of the CDS market has resulted in a much larger notional value of CDS contracts than the outstanding value of the debt obligations. Cash settlement avoids possible failure in physical delivery due to a shortage in deliverable cash instruments.

Keep in mind that the notional amount of single-name CDS far exceeds notional of physical cash bonds and can be potentially distorting. Bank for International Settlements data show CDS notional outstanding of around $57 trillion at end-June 2008 versus a gross market value of underlying securities of only $3.2 trillion for the same period. Further, a physical settlement could result in a short squeeze, as protection buyers purchase bonds to deliver for settlement, bidding up the bond price and thereby offsetting the gains on the CDS protection.

In any case, in light of the concentration of risk in a CCP, a smoothly operating settlement system is crucial for reducing any potential systemic consequences. Central counterparties’ use of cash settlement for CDS contracts would deter market manipulation and help avoid disruption in the settlement process. In March 2009, ISDA initiated its Auction Settlement Supplement and Protocol incorporating cash auctions into standard documentation for settling CDS contracts, i.e., “hardwiring” the ISDA settlement protocol into the contracts. While the ISDA defined protocol provides for both auction and physical settlement, cash settlement can benefit by minimizing price distortions. However, maximizing participation in the industry standard settlement mechanism for all CDS contracts is crucial.

Multiple CCPs versus a Single Central Counterparty

The CDS CCP ventures based in the United States and Europe have engendered some debate as to the optimal number of central counterparties. These currently include CME Clearing, Eurex Clearing, ICE Trust/ICE Clear Europe, and NYSE Liffe/LCH.Clearnet. A single CCP would accomplish the largest reduction in systemic counterparty risk, benefit from economies of scale and a larger pool of counterparties and resource base, and limit opportunities for regulatory arbitrage and competitive distortions. See the recent paper by Duffie and Zhu (“Does a Central Clearing Party Reduce Counterparty Risk?”) for discussion of these points.

The resulting concentration of operational risk would necessitate strong risk management processes and oversight. The U.S. approach is to allow for multiple CCPs, allowing market forces to determine the optimal number of CCPs in order to assure clearing services are provided efficiently. However, there are concerns that such an approach will be a “race to the bottom,” as each CCP fights for market share by economizing on risk management procedures, and lowering margining requirements and contributions to a guarantee fund. (A guarantee fund compensates nondefaulting participants from losses suffered in the event of another participant’s failure to meet its obligations to the CCP.)

From a cross-border perspective, the systemic importance of a single CDS central counterparty for a domestic economy might lead authorities toward retaining the CCP under national regulatory and supervisory oversight for the ability to control or mitigate the impact on domestic financial stability. National authorities might be reluctant to oversee a global entity where jurisdictional disputes may arise. Nevertheless, a global CDS CCP would mitigate the most overall counterparty risk. Thus, if a global CDS CCP is not established, then the development of separate CCPs should provide for the crossborder coordination of regulatory and supervisory frameworks to avoid regulatory arbitrage. These frameworks should ensure that linkages and clearing mechanisms are established across CCPs, without constraining the use of multiple-currency transactions. At present, there are various legislative, regulatory, and market proposals outstanding to deal with counterparty clearing organizations, which may affect issues such as the standardization and documentation of credit default swaps, and the responsibilities of counterparties and clearinghouse members, amongst others.


* Jodi Scarlata is a Senior Economist at the IMF. These are her personal views, and should not be attributed to the IMF, its Executive Board, or its management.


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Mitigating Counterparty Credit Risk in OTC Markets: The Basics

By John Kiff*

A central counterparty (CCP) reduces systemic counterparty credit risk by applying multilateral netting. This post discusses key tools of over-the-counter (OTC) counterparty credit risk mitigation, including netting and the collateralization of residual net exposures, and explains how a CCP reduces systemic counterparty risks. A follow-up post by one of my IMF colleagues (Jodi Scarlata) will delve deeper into the particulars of CCPs for credit default swaps.

An OTC contract is exposed to counterparty default risk prior to the contract’s expiration while it has a positive replacement value. In the absence of bilateral closeout netting, the maximum loss to a defaulted counterparty is equal to the sum of the individual contracts’ positive replacement values. The figure below shows two bilateral contracts. A owes B $5 on one contract, and is owed $10 from B on the second one. A faces a $10 loss if B defaults. This all assumes that the counterparties have signed a master agreement with the appropriate closeout provisions that covers both transactions. If they had not, B could “cherry pick” A by defaulting on its obligation to pay the $10, but insisting that A still pay the $5. In this case, A loses $15.


Closeout netting aggregates all exposures between the counterparties, under a default, and contracts with negative values can be used to offset those with positive values. Hence, the total exposure associated with all contracts covered by the particular master agreement is reduced to the maximum of the sum of the replacement values of all the contracts and zero. A loses $5 if B defaults. The exposure can be further reduced by requiring counterparties to post collateral (cash and highly-rated liquid securities) against outstanding exposures, usually based on the previous day’s valuations.

For more detail on OTC derivative collateral and netting practice see Bliss and Kaufmans’ “derivatives and systemic risk” paper. For surveys of OTC derivative counterparty credit risk exposure management practices, including collateral policies, see “new developments in clearing and settlement arrangements for OTC derivatives” by the Bank for International Settlements Committee on Payment and Settlement Systems, and “counterparty credit exposure among major derivatives dealers” by the International Swaps and Derivatives Association. Best practice guides can be found in the 2005 and 2008 reports by the Counterparty Risk Management Policy Group.

The second figure shows contracts across four counterparties, all of whom have bilateral closeout netting master agreements with each other applies. The numbers on the arrows indicate the net bilateral flow (A, B, C and D, clockwise from the top left corner), and the subscripted “E” indicates the maximum counterparty exposure for the counterparty. Thus, ED = $10, because both A and B owe D $5. Each counterparty faces a maximum counterparty default-related loss of either $5 or $10. C loses $10 if both A and D fail, and D is vulnerable to the simultaneous default of A and B. Hence, A and B should each provision against $5 of potential counterparty credit losses, and C and D should each provision for $10, for a total of $30, even though the maximum potential loss among all four is only $10.



Multilateral netting, typically operationalized via “tear-up” or “compression” operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk. In this case, it could eliminate four contracts, and eliminate all A’s and B’s counterparty credit risk exposure, and leave C and D with $5 of maximum potential individual losses. The third figure shows the two possible post-netting configurations. The leftmost configuration eliminates the circular BACB flow, and replaces the BDC flow with a more direct BC flow. The rightmost configuration just needs to eliminate the circular BADC flow. Using such tearup operations, TriOptima’s TriReduce service eliminated about $30 trillion notional of credit default swap contracts in 2008.


A sound CCP takes the multilateral netting principle a step further, and reduces the likelihood of knock-on failures by requiring the participants to post margin, and by loss sharing among other clearinghouse members. Other typical arrangements include capital funds comprised of clearing member contributions and accumulated profi ts and transaction fee rebates. All of this will be covered in more detail by Jodi, but see also Bliss and Steigerwalds’  “derivatives clearing and settlement: A comparison of central counterparties and alternative structures”).



* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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