Clearing and Settlement of Derivatives

As we can see, the GCM and DCM have a direct relationship with

the clearing house. The DCM can only clear business of an affiliated

company who is a NCM of Eurex whereas the GCM can clear busi-

ness for any NCM.

Customers can have a relationship with the GCM, DCM, an affiliated

NCM of the DCM or any NCM of the exchange.

The Options Clearing Corporation (OCC)

Options Clearing Corporation is the largest clearing organisation in

the world for options and was the first clearing house to receive

an AAA rating from Standard & Poor’s Corporation. Operating under

the jurisdiction of the Securities and Exchange Commission (SEC)

and the CFTC, OCC clears US-listed options, futures and options on

futures on a number of underlying financial assets including stocks,

currencies, stock indexes and interest rate products. The OCC’s

Clearing Membership consists of approximately 130 of the largest

US broker/dealers, US futures commission merchants and non-US

securities firms representing both professional traders and public cus-

tomers. The American Stock Exchange, the Chicago Board Options

Exchange, the International Securities Exchange, the Pacific Exchange

and the Philadelphia Stock Exchange share equal ownership of OCC.

It has in recent years developed and introduced a completely new

clearing system called ENCORE.

The ENCORE has enabled real-time processing capabilities, increased

flexibility by accommodating growth in options volume and new prod-

ucts, and provided secure Internet access to OCC’s customers.

LCH.Clearnet

There are several key stages in the ‘clearing process’ much of which

is generic across clearing houses.

A key stage is when and how the counterparty relationship between

the two parties to the trade on the exchange converts to a relationship

between the clearing house and each of the trade participants. That

stage is often referred to as novation.

Novation

The process of creating the trade in the name of the clearing house

as counterparty to each member is called novation. In this process

the clearing house becomes buyer to every seller of each transaction

40 Clearing and settlement of derivatives

and seller to every buyer of each transaction. At this point, the clear-

ing member has no counterparty risk in the market for their trade

other than with the clearing house. All open positions are only held

with the clearing house and it becomes irrelevant which market

member the trader dealt with originally. Once this process is com-

pleted, the clearing house is in a position to effect settlement of the

two transactions (Figures 3.3 and 3.4).

Settlement takes place between the Members and the clearing

house, not with each other. Counterparty risk between the members

has been removed.

The settlement process on LCH.Clearnet is secured by the use of a

direct debit system, known as the Protected Payment System (PPS).

Protected Payments System

LCH.Clearnet Limited operates PPS for the transfer of funds to and

from Clearing members. A Clearing member is required to maintain a

PPS bank account(s) in London in Great Britain Pounds (GBP) and

for each currency in which it incurs settlements at one of the partici-

pating PPS banks. Different banks can be used for different curren-

cies. Clearing Members are also required to maintain a USD account

at one of the specified banks for PPS in the United States. Any bank

charges arising from the operation of a PPS account are for the

account of the Clearing member. A PPS mandate must be completed,

the original of which is held at the PPS bank and a copy lodged with

LCH.Clearnet Limited.

The role of the clearing house 41

Figure 3.3 Trade Relationship

Figure 3.4 Novation

Member

A

Member

B

Trade

TradeTrade

Clearing

House

Member

B

Member

A

NOVATION