(Part of my undertaking to read Chapter 2 of books in my library.)
This book was published in 2014, so there will be some contents that are out of date. A lot of activity has occurred in the central counterparties regulatory world recently.
Many derivatives contracts, such as options, and futures, are traded on an exchange. In an exchange, derivatives contracts are standardised. Standardisation leads to efficiency and tradeability.
While originally, contracts where traded on an exchange where the exchange served merely as a witness, and not a counterparty to the trade. If a trading party did not live up to the contract, the exchange would fine them or even expel them.
Only approved firms and individuals may trade in an exchange.
Exchanges facilitate margining and netting between trade counterparties, which reduce the magnitude of risk for each side.
There are 3 forms of clearing: direct clearing, ring clearing, and complete clearing. Direct clearing is where each party delivers their contract obligations to the other. If there are offsetting trades, often the practice is to just net the difference, a practice called "netting", or "payment of difference". Ring clearing is an expansion of direct clearing to more than two parties. The parties must agree to join the ring. If A must pay B, who must pay C, then C can receive the payment directly from A. The exchange itself is not a participant other than an enforcer of rules. A disadvantage of rings is that a quality counterparty may be replaced by one that has lower credit quality. Not everyone in the ring benefits. Complete clearing extends and improves the ring by placing the exchange as a central counterparty to all parties. A party no longer has to worry about the credit rating of their counterparty; the exchanges assumes the rights and responsibilites of the counterparty.
Of course, if an exchanges assumes the obligations of a party, it must protect itself from exposures arising from an insolvent party. Two ways to mitigate the exposure is through the practice of initial margins and variation margins. In addition to margins, a method of loss sharing is also implemented. One practice is requiring all members to make share purchases.
There was resistance to this concept early one: firms with high quality rating felt they lost their advantage over lower quality firms because a firm's credit rating became irrelevant. The counterparty service can be provided by the exchange, or be provided by another firm offering that service for the eschange.
All derivatives market clearing service became standardised and used central clearing until OTC's arrived on the scene.
To be continued...
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