The key protection which CCPs have against counterparty credit risk is their default waterfall. They take margin from clearing members and imagestheir clients, and default fund contributions from clearing members, and use these amounts as a bulwark against losses should a clearing member default.

The different levels in the default waterfall – margin, CCP equity, default fund, default fund assessment rights, and so on – are accessed in sequence, much like the tranches of a CDO. Typically the defaulter’s margin and default fund are used first, then an amount of CCP equity is at risk, then the mutual default is used, and typically more default fund can then be called from surviving members. That is, the default waterfall starts off individual, with the defaulter (or rather their estate) paying, and then becomes mutual.  Continue reading