CLEARING 101: What is a CCP?
CLEARING 101: What is a CCP?
A Central Counterparty (“CCP”) is a Financial Market Infrastructure that interposes itself between counterparties to contracts traded in financial markets, becoming the buyer to every seller and the seller to every buyer and thereby guaranteeing the performance of open contracts. It is a critical entity that ensures the smooth running of any financial system.
To have a full understanding of the importance of a CCP, let us create an example below:
For a trade to take place, there will always be a buyer and a seller in the market (kindly note that this can be a financial market or even a commodities market).
Let us assume Investor A is a seller while Investor B is a buyer. For the transaction to be completed, Investor A needs to deliver the security sold and receive payment while Investor B has a payment obligation and needs to receive the security purchased.
However, for advanced financial products like Futures (A type of Derivatives), the delivery date for the traded contract is in the future. Because delivery is set in the future, unforeseen circumstances could emerge to make it difficult for either Investor B to pay or for Investor A to deliver the traded item. This is called Counterparty Risk. The risk is that one party to the trade could fail to fulfill his/her obligation.
If counterparty risk is left without control, many market participants are directly exposed to each other. If they fail to fulfill their obligations, it could lead to a huge financial crisis similar to what happened across major markets in 2008. This is one of the problems NG clearing solves as a Central Counterparty.
Without a CCP like NG clearing, it is difficult to effectively monitor the concentration of counterparty risk. It is also difficult to put risk mitigation measures in place to protect the market. A crisis could spread across the financial system as there is no institution absorbing the risk and stabilizing the market.
Therefore, NG Clearing as a CCP is crucial for the smooth running of advanced financial products like derivatives. For every transaction, rather than having participants exposed to each other, they are exposed to one institution – NG Clearing, the Central Counterparty (CCP).
Using our example, the CCP comes between Investor A and Investor B. That is, the CCP buys the contract from Investor A (the Seller) and sells the contract to Investor B (the Buyer). The CCP becomes the buyer to the Seller and the Seller to the buyer. This process is known as Novation.
The implication of this is that even if circumstances make it difficult for Investor A or Investor B to fulfill their part of the bargain, the CCP will step in to fulfill the obligation, ensuring the transaction is completed.
For NG Clearing to manage counterparty risk and stabilize the market, we take margins and collaterals from market participants as buffers for when they are unable to meet their obligations. We also utilize robust risk monitoring and management systems to manage the complex risk associated with the derivatives market. This makes it is easier to manage the concentrated risk as well as put measures in place to safeguard the market against unforeseen circumstances. This helps in improving stability and integrity while offering market participants new opportunities to invest in sophisticated financial products like Derivatives.
As the first CCP in West Africa, we are paving the way for Nigeria’s derivatives market, through world-class, technology-enabled clearing and settlement services as well as robust risk market systems. You can read more about NG Clearing on our website www.ngclearing.com