What it means
When a trade is cleared, the original contract is replaced by two contracts with the clearing house, a process called novation. The buyer's counterparty becomes CDCC and so does the seller's, which means neither needs to assess the other's creditworthiness.
CDCC is a subsidiary of the group that operates Canada's derivatives exchange and is supervised as a financial market infrastructure. Central clearing matters because derivatives create obligations that stretch into the future, and a failure by one large participant can cascade through the market.
A clearing house concentrates and manages that risk using membership standards, margin collected from both sides, a default fund contributed by members and a defined order in which those resources are used. The same arrangement also allows offsetting positions to be netted, which reduces the cash that has to move.
The mechanics a finance team deals with are margin calls. Initial margin is collected when a position is opened and is sized to cover a plausible adverse move before the position could be closed out, while variation margin is settled against daily price changes so that losses do not accumulate.
A clearing member that fails to meet a call can have its positions closed out. Clearing also changes how derivatives appear in the accounts and in treasury planning.
Margin posted is an asset held with the clearing house rather than an expense, but it is restricted cash, so a hedging programme that looks cheap on paper can be demanding on liquidity. Treasurers therefore model potential margin calls under stressed prices, not only expected ones.
Two points of nuance help. Clearing reduces counterparty credit risk but does not remove market risk: a hedge that moves against you still costs money.
And access is usually indirect for non-financial companies, which clear through a clearing member rather than becoming members themselves, so the member's own requirements and fees matter as much as the clearing house rules.
In practice
Real-world examples.
Example
A pension fund manager hedges equity exposure with index futures cleared through CDCC. Because the clearing house becomes the counterparty, the fund's credit team does not need to set a limit for the bank on the other side of the trade. Its monitoring focuses on the clearing member instead.
Example
A bank treasury uses cleared repurchase agreements to fund a bond portfolio overnight. Netting across its positions reduces the gross amount of cash and collateral that has to settle each morning. Settlement staff handle fewer movements with less operational risk.
Example
An energy company's finance team models a 15% adverse price move on its hedge book and finds it would face a $4.5 million margin call within two days. It arranges a standby credit line specifically to cover margin. The hedge stays in place during the next price spike instead of being closed at a loss.
Formula
Calculation
Initial margin = Number of contracts x Margin per contract. Variation margin = Number of contracts x Contract multiplier x Price change.
A corporate treasurer sells 20 interest rate futures contracts through a clearing member to hedge a borrowing cost. Initial margin is set at $2,000 per contract, so initial margin = 20 x $2,000 = $40,000 posted to the clearing house.
The contract multiplier is 100 and the price moves against the position from $85.00 to $86.50, a change of $1.50.
Variation margin owed = 20 x 100 x $1.50 = $3,000, which must be settled that day.
If the price later moves from $86.50 to $84.00, a favourable change of $2.50, the position receives 20 x 100 x $2.50 = $5,000, leaving a net gain of $5,000 - $3,000 = $2,000 across the two days while the $40,000 of initial margin remains on deposit.Case study
Seen in the real world.
Lakeshore Grain Partners is an illustrative agricultural trading business invented for this example rather than a real company. It hedged forward sales with cleared futures and considered the hedge free because gains on the physical crop would offset losses on the contracts at harvest.
In this fictional scenario prices rose sharply for three consecutive weeks. The hedge performed exactly as designed, protecting the sale price, but the mark-to-market losses on the futures had to be paid in cash through daily variation margin while the offsetting gain on the unsold crop existed only on paper. Lakeshore faced margin calls of about $2.8 million against available cash of $1.1 million.
It closed part of the hedge at the worst possible moment to raise cash, and the unhedged portion was then exposed when prices fell back. The illustrative lesson is that central clearing turns a timing mismatch into a funding requirement, so a hedging policy needs a liquidity plan attached to it.
Watch out
Common mistakes.
- Treating margin posted to a clearing house as a cost, when it is restricted cash recorded as an asset and returned when the position closes.
- Assuming clearing removes all risk, when it addresses counterparty credit risk and leaves market risk with the position holder.
- Forgetting that a correct hedge can still cause a cash crisis, because variation margin settles daily while the offsetting physical gain may settle months later.
Questions
People also ask.
What does novation mean in clearing?
The original trade between two parties is replaced by two trades facing the clearing house, so each party's counterparty becomes the clearing house.
Who can clear directly through CDCC?
Approved clearing members that meet its capital, operational and membership requirements; other businesses clear indirectly through a member.
What is the difference between initial and variation margin?
Initial margin is a buffer against a future adverse move, while variation margin settles the actual daily profit or loss on the position.
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