Much of the attention paid by the public to financial markets is typically directed at pre-trade – when orders go into an order book to be filled – or trading itself. Occasionally however attention shifts to post-trade, or what happens after a trade has been agreed. Now is one of those times, with the US’s move to T+1 settlement slated for next year.
Central clearing (as opposed to bilateral clearing) is typically used in exchange-traded markets, where trades are standardised and easily replicable. Bilateral clearing in contrast usually occurs in over-the-counter (OTC) markets where trades are highly customised and not easily standardised. One of the main actors in central clearing is the central clearing house, or central counterparty (CCP). CCPs are regulated entities, typically operated by infrastructure providers such as exchanges or independent clearing organisations. As such, they’re required to maintain sufficient financial resources.
CCPs stand between the buyer and seller in a trade. In order to do so, they make use of a legal concept called ‘novation.’ Novation is when a single contract between two parties is replaced by two contracts: one between the buyer and the CCP, and the other between the seller and the CCP (see figure below). In this way, the CCP can simultaneously face both parties to a trade and ensure that each side is meeting its obligations.
Clearing is the process by which the CCP performs three principal functions:
Successful completion of these steps ensures settlement can occur in a timely and efficient manner, reducing the risk of default and promoting confidence in the financial system.
Central clearing grew more prevalent after the financial crisis of 2008. Prior to the crisis, many derivatives trades were conducted bilaterally between two parties without the involvement of a central clearinghouse. In bilateral clearing, each party assumes the counterparty risk of the other and settlement is performed directly between the parties. This means that if one party to a trade defaults, it could have a domino effect, impacting other parties and potentially leading to a systemic crisis. In response, regulatory reforms were introduced to prevent this from happening, one aspect of which was the promotion of central clearing for standardised derivatives through CCPs. By inserting themselves between counterparties, CCPs effectively mutualize and manage the counterparty credit risk.
It’s worth noting that while CCPs help mitigate certain risks, they also carry their own, such as the concentration of risk within the CCP itself. For this reason, regulators set standards for how clearinghouses must operate, including capital requirements, risk management practices and operational procedures.
In sum, by ensuring that settlement can occur in a timely and safe manner, central clearing boosts efficiency and helps promote confidence among market participants, making it a critical piece of our financial market infrastructure.
Besides buying or selling single options, there are many other possible strategies that involve positions in multiple options simultaneously, as well as combining options with positions in the underlying assets.
The Options Basics Explainer introduced the concepts of call and put options, strike price, expiry, and long or short positions in an option contract. This page looks in more detail at option pricing.
What is an ETF? An ETF – or exchange traded fund – is a fund formed by a basket of underlying instruments that can be traded on the exchange. ETFs are often (but not always) tracking an index and following the index methodology, providing investors a low-cost and efficient way to invest in an index without having to buy all the underlying constituents.
What are options? An option is a type of derivative contract that gives the holder the right to buy or sell the underlying asset at a predetermined price – the exercise or strike price – at or before a certain date. Options exist on a wide variety of underlying assets, like single stocks, indices, ETFs, bonds, currencies, commodities. These contracts can serve as tools to protect a portfolio against potential losses or to express an opinion about the direction of the market.
What do long/short positions in put options mean? In the simplest terms, there are four positions an investor can take in options: buying call options (long call), selling/writing call options (short call), buying put options (long put), and selling/writing put options (short put).
The Option Greeks are a collection of variables that measure the sensitivity of option prices to changes in underlying factors. Mathematically, they are derivatives of components of option pricing models. Each factor has a Greek letter assigned to it, hence the name ‘Greeks’.
