STSM125010 - Financial markets: central counterparties: what is a central counterparty

A central counterparty (CCP) is an organisation that acts as an intermediary between the two parties to a securities transaction. Trades on most major stock exchanges go through a CCP. The seller of a security sells to the CCP who simultaneously sells to the buyer. This means that if one party defaults then the CCP will absorb the risk. This eliminates both the risk of direct financial loss through a default and the risk of indirect loss through having to unwind the trade.

The benefits to an exchange of using a CCP include:

• Reduced risk - reduces counterparty risk for its members defaulting on a transaction, leaving them to trade freely with each other.
• Increased market liquidity - enhances market liquidity as a contract can be closed out with any of its counterparties.
• Decreased settlement costs - reduces its members’ settlement costs by netting payments and receipts across contracts and exchanges.