Clearinghouse

The economic substance of clearing is novation. Once a bilateral trade is matched and accepted for clearing, the original contract between the two counterparties is legally extinguished and replaced by two contracts, each facing the clearinghouse. Neither party retains any claim on the other; each now has an obligation to, and a claim against, the central counterparty alone.

This has three consequences a candidate should be able to state. Credit assessment collapses to a single name: participants need only evaluate the clearinghouse and their own clearing member. Contracts become fungible, so a long futures position can be closed by selling an identical contract to anyone, since both legs face the same counterparty and net to zero. And exposures across a member's book can be netted, dramatically reducing the gross notional that must actually be settled.

Initial margin is a performance bond sized to cover the expected worst-case move in a position over the period required to close it out, typically estimated from historical or simulated price distributions at a high confidence level. It is posted at trade inception and returned when the position is closed, adjusted for gains and losses.

Variation margin is the settlement of the day's price change. At the end of each session the clearinghouse sets an official settlement price and marks every open position to it. Accounts with losses pay cash into the clearinghouse; accounts with gains receive it. Because the clearinghouse's book is flat by construction, the payments net exactly. If an account's balance falls below the maintenance margin level, a margin call requires the holder to restore the balance to the initial margin level, not merely to the maintenance threshold. Failure to meet the call permits the position to be liquidated.

All exchange-traded derivatives, futures and listed options, clear through an affiliated clearinghouse; clearing is what makes the standardised contract tradable at all. In over-the-counter markets, the picture changed after 2008. Regulatory reforms in the United States and Europe mandated central clearing for standardised interest rate swaps and index credit default swaps, pushing a large share of a formerly bilateral market onto central counterparties such as LCH SwapClear and ICE Clear Credit.

Access is tiered. Only clearing members face the clearinghouse directly; end users clear indirectly through a member, who guarantees the client's obligations and holds client collateral in segregated accounts. Non-cleared OTC derivatives remain, and are now subject to bilateral margin requirements designed to remove the collateral advantage of avoiding clearing.

Be able to explain novation and its effect on counterparty credit exposure, distinguish initial from variation margin by purpose and timing, and compute an account's balance across several trading days including the point at which a maintenance margin breach triggers a call and the amount required to cure it. Futures margin questions are frequently arithmetic exercises disguised as concept questions.

Equally testable is the contrast between cleared and non-cleared instruments. Forwards are customised, bilateral and settled at maturity, so credit exposure accumulates over the contract's life; futures are standardised and marked daily, so exposure is reset each session. Recognise also that clearing transforms credit risk rather than deleting it: what remains is concentrated exposure to the central counterparty itself, plus a daily liquidity demand for cash variation margin that can bind precisely when markets are stressed.