Academic journal article Chicago Fed Letter

Clearing and Settlement of Exchange Traded Derivatives

Academic journal article Chicago Fed Letter

Clearing and Settlement of Exchange Traded Derivatives

Article excerpt

Derivatives are a class of financial instruments that derive their value from some underlying commodity, security, index, or other asset. Futures and options are common forms of derivatives. This article explains how clearing and settlement systems for exchange traded derivatives work.

Because of its role in fostering a sound financial system, the Federal Reserve Bank of Chicago has taken a keen interest in clearing and settlement systems for derivatives products, in particular, the risk-management, banking, and payment systems that support such clearing and settlement systems. The Seventh Federal Reserve District is home to over half a dozen exchanges and four systemic ally significant clearing organizations, or central counterparties (CCPs) ,1 As these markets have grown, their potential systemic implications for the nation's financial system have similarly increased. Previous Chicago Fed Letter articles have explained the concepts of clearing and settlement in general,2 and the settlement o f f o r e ign e x c h ang e c ? n t r ac t s in p articular.3 This Chicago Fed Letter expands upon the general clearing theme, discussing specifically how derivatives CCPs' margining4 and settlement systems work and how they affect payment and settlement systems and foster public confidence in organized markets and the financial system in general.

Derivatives

Derivatives are financial contracts that are traded on organized exchanges or in the over-the-counter (OTC) market - a decentralized market model where market participants find other market participants to trade with. As is the case with derivatives in general, futures and options derive their value from the current or expected market value of an underlying commodity, security, index, or financial instrument or from the occurrence or magnitude of an event. For example, a futures or options contract based upon the expected value of a foreign currency versus the dollar would be directly affected by changes in the "spot" (or current) foreign exchange rate between the two currencies, the prevailing and anticipated interest rates of both currencies, and other economic indicators that capture economic growth or relevant international capital flows. Similarly, a futures or options contract based on a commodity like corn would be based on the amount of corn currently in storage; anticipated corn crop yields; and anticipated demand for corn, e than ol, and other corn byproducts.

Exchanges versus the OTC market

Exchanges provide a forum for attracting interested buyers and sellers. Trade intermediaries solicit clients and assume the financial risk of those clients. Some OTC instruments, notably certain standardized interest rate swaps and credit default swaps,5 are eligible to be cleared by one or more CCPs, even though the contracts were bilaterally negotiated in the OTC market and not on an exchange. Unlike securities, where settlement occurs in three business days or fewer, derivatives instruments are financial contracts that are often outstanding for weeks and even years. Derivatives contracts are revalued daily and eventually mature or are liquidated. To address the continuing financial risk throughout the life of derivatives contracts, all derivatives exchanges are associated with one or more CCPs that guarantee financial performance among all clearing members.6

Derivatives CCPs

A derivatives CCP guarantees the financial performance of its clearing members.

At the time that a trade matches,7 the CCP becomes the buyer to the selling clearing member and the seller to the buying clearing member. In this way, clearing members do not need to make a credit assessment of the other clearing members or their clients. In an electronic trading environment, clearing provides valuable anonymity; buyer and seller (and buying clearing member and selling clearing member) rarely know (or need to know) each other's identity.

In order to guarantee the performance of all clearing members, a derivatives CCP collateralizes, or "margins," the financial performance exposure that the CCP has to each of its clearing members. …

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