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FRM Exam Part I · Exchanges and OTC Markets

Central Clearing and Central Counterparties (CCPs) Explained

Updated 11 October 2026 · Fact-checked

A central counterparty (CCP) steps between buyer and seller through novation, becoming the buyer to every seller and the seller to every buyer. It controls counterparty risk using initial margin, daily variation margin, a default fund and its own capital, used in a set order called the default waterfall.

Understand Central Clearing and Central Counterparties (CCPs)

In a bilateral trade, each side carries the risk that the other fails to pay. In a web of many trades, one default can spread to others. Central clearing replaces that web with a hub.

Novation is the legal step that makes this work. The original contract between A and B is cancelled and replaced by two new contracts: A faces the CCP, and the CCP faces B. A and B no longer have exposure to each other. Each has exposure only to the CCP. The CCP holds a matched book, so its net market position is zero while all members perform.

The CCP protects itself with layers of resources. Variation margin (VM) is paid daily to reflect the change in market value of positions. It settles gains and losses, so exposure does not build up. Initial margin (IM) is collateral posted at the start of the trade and adjusted as risk changes. It covers the potential loss in the close-out period (often a few days) after a member defaults, to a high confidence level. IM is a buffer against future moves. VM is a payment for moves that already happened.

If a member defaults and its margin is not enough, the CCP uses a default waterfall. A typical order is: the defaulter's initial margin, then the defaulter's default fund contribution, then the CCP's own capital (often called skin in the game), then the default fund contributions of the surviving members, then further tools such as assessments on members. Exact order and tools vary by CCP, so learn the principle: defaulter pays first, then the CCP, then the survivors.

CCPs reduce systemic risk through multilateral netting, daily margining, transparency and standardised default procedures. They also concentrate risk. A CCP becomes a single point of failure, which is why regulators set standards for CCP margin, capital and recovery. Clearing is also mandated for many standardised OTC derivatives after the 2007-2009 crisis.

Key formulas to remember

Novation result
A ↔ B becomes A ↔ CCP ↔ B
The CCP is the buyer to every seller and the seller to every buyer. Its net position is zero.
Variation margin
VM = change in mark-to-market value of the position since the last settlement
Paid or received daily. The side with a loss pays. It is not a deposit that is returned.
Multilateral netting
Net exposure to CCP = Σ gains and losses across all trades with the CCP
Netting works across all of a member's cleared trades in the same netting set, so the CCP exposure is lower than the sum of bilateral gross exposures.
Initial margin purpose
IM ≈ potential loss over the margin period of risk at a high confidence level
Usually calculated with a VaR-type or scenario-based model. It rises when volatility rises.
Default waterfall order (typical)
Defaulter IM → defaulter default fund → CCP own capital → survivors' default fund → other loss-allocation tools
State this as typical, not universal. The defaulter's own resources are always used first.

How to solve Central Clearing and Central Counterparties (CCPs) questions

Most CCP questions test either a margin calculation or the order in which resources absorb a default loss. Use the same method each time.

  1. 1Identify what is asked: novation, margin type, netting benefit, or default waterfall loss allocation.
  2. 2Write down the positions and each member's mark-to-market value at the start and end of the period.
  3. 3For margin, separate the two: compute VM from the price change, then treat IM as a separate buffer given in the question.
  4. 4Apply the sign rule: a loss means paying VM, a gain means receiving VM.
  5. 5For a default loss, list the layers in waterfall order with their sizes.
  6. 6Subtract each layer from the loss in turn until the loss is fully absorbed. Stop when the remaining loss is zero.
  7. 7Check the answer: total resources used must equal the loss, and no layer can be used beyond its size.
  8. 8Choose the option that matches your result, and remove options that mix up IM and VM.

Quickest way: Layer-by-layer waterfall subtraction

When to use it: Use when a question gives a default loss and several pools of resources and asks how much falls on a given layer.

  1. Write the layers in order from the first loss layer to the last.
  2. Subtract the first layer from the loss, floor the remainder at zero.
  3. Repeat down the list until the remainder is zero.
  4. The answer is what the asked layer absorbs, which is the smaller of its size and the remaining loss at that point.

Common mistakes in Central Clearing and Central Counterparties (CCPs)

  • Treating initial margin and variation margin as the same thing.

    Both are collateral, and both are called margin.

    Fix: IM is a buffer against future losses after a default. VM settles gains and losses that have already occurred, daily.

  • Thinking novation means the CCP guarantees nothing is lost.

    The CCP is described as a counterparty to everyone, so it looks risk-free.

    Fix: Novation moves credit risk to the CCP. The CCP still depends on margin, its capital and member contributions. It can fail.

  • Using surviving members' default fund contributions before the defaulter's own resources.

    The default fund is called mutualised, so students assume it is first.

    Fix: Defaulter pays first: its IM, then its own default fund contribution. Mutualised funds come later.

  • Assuming VM is returned at the end of the trade.

    Students confuse VM with a deposit.

    Fix: VM is a payment that transfers value. IM is the collateral that is returned if there is no default.

  • Saying central clearing removes systemic risk.

    Reducing bilateral exposures sounds like eliminating risk.

    Fix: It reduces and reshapes risk but concentrates it in the CCP. Use the words reduce and concentrate.

Worked examples

Example 1

A clearing member has a cleared position that loses value by USD 4.0 million today. The member has posted initial margin of USD 6.0 million. How much variation margin must it pay today, and what happens to its initial margin if it does not default?

Show the solution
  1. Variation margin equals the change in mark-to-market value.
  2. The position lost USD 4.0 million, so the member pays USD 4.0 million.
  3. Initial margin is not used to pay daily losses when the member performs.
  4. The USD 6.0 million IM stays with the CCP as a buffer, though it may be recalculated if risk changes.

Answer: The member pays USD 4.0 million in variation margin. Its USD 6.0 million initial margin stays posted as a buffer.

Example 2

A clearing member defaults and the CCP faces a loss of USD 95 million after close-out. Resources: defaulter's initial margin USD 40 million, defaulter's default fund contribution USD 10 million, CCP own capital USD 15 million, survivors' default fund contributions USD 100 million. Using the typical waterfall order, how much is taken from the survivors' contributions?

Show the solution
  1. Start with the loss of USD 95 million.
  2. Defaulter's initial margin absorbs USD 40 million. Remaining loss = 95 − 40 = USD 55 million.
  3. Defaulter's default fund contribution absorbs USD 10 million. Remaining = 55 − 10 = USD 45 million.
  4. CCP own capital absorbs USD 15 million. Remaining = 45 − 15 = USD 30 million.
  5. Survivors' contributions are available up to USD 100 million, so they absorb the remaining USD 30 million.

Answer: USD 30 million is taken from the survivors' default fund contributions.

Exam tips

  • Memorise the waterfall order and the principle behind it: the defaulter pays first, then the CCP, then the survivors.
  • In options, look for words that signal the margin type: daily settlement of gains and losses means VM, buffer for close-out means IM.
  • Expect conceptual questions on what novation changes: counterparty identity and legal exposure, not the economics of the trade.
  • Remember the trade-off: CCPs reduce bilateral counterparty risk and improve netting, but concentrate risk and create procyclical margin calls in stress.
  • Read the loss and resource numbers carefully, and check that your layers add up to the loss before choosing an answer.

Practice questions from Exchanges and OTC Markets

Central Clearing and Central Counterparties (CCPs) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Central Clearing and Central Counterparties (CCPs): frequently asked questions

What is novation in central clearing?

Novation replaces the original contract between two parties with two contracts, each with the CCP. After novation, neither original party faces the other. Each faces the CCP.

What is the difference between initial margin and variation margin?

Initial margin is collateral posted up front to cover potential future losses if a member defaults. Variation margin is a daily payment that reflects gains and losses in the position's market value. IM is a buffer, VM is a settlement.

How does a CCP reduce counterparty risk?

It takes over each trade through novation, nets positions across members, and collects daily variation margin so exposures do not build up. It also holds initial margin and a default fund to absorb losses if a member fails.

What is the CCP default waterfall?

It is the order in which resources absorb a defaulting member's losses. A typical order is the defaulter's margin and default fund contribution, then CCP capital, then surviving members' contributions, then other tools. Details differ across CCPs.