How Futures Clearing Houses Work: Novation, Margin and the Default Waterfall

A futures clearing house stands between the buyer and seller of every contract: once a trade is matched, the clearing house becomes the seller to every buyer and the buyer to every seller. It protects itself by collecting margin from its members, settling gains and losses at least daily, and keeping a pool of pre-funded resources, called a default waterfall, to cover a member that fails.

In short: Clearing replaces thousands of bilateral credit relationships with one central counterparty (CCP). Through novation, each trade becomes two contracts, one with the buyer and one with the seller, both facing the clearing house. Losses are collected in cash every day, so no one can build up a large unpaid debt. If a clearing member defaults, the clearing house uses, in order, the defaulter’s margin, the defaulter’s guarantee fund contribution, the clearing house’s own capital, the other members’ guarantee fund contributions, and then its power to assess members for more. This makes counterparty risk on exchange futures very low, but not zero, and it protects clearing members, not necessarily the customers of a failed broker.

The problem a clearing house solves

Imagine a market without one. Every trader would have to judge the creditworthiness of every counterparty and track who owed what to whom. If one large trader failed, its counterparties would suffer losses, possibly causing them to fail in turn.

Clearing solves this by putting a single, well-capitalised, closely regulated entity in the middle. You do not need to know who is on the other side of your trade. The comparison with private, uncleared forward contracts is in futures vs forwards.

Major clearing houses include CME Clearing (for CME, CBOT, NYMEX, and COMEX), ICE Clear US and ICE Clear Europe, and, in Canada, the Canadian Derivatives Clearing Corporation (CDCC), which clears Montreal Exchange contracts. In the US, clearing houses are registered with the CFTC as derivatives clearing organizations and are subject to its regulations. The exchanges they serve are described in how futures exchanges work.

Who faces the clearing house

Only clearing members deal directly with the clearing house. These are large firms, typically futures commission merchants (FCMs) and banks, that meet capital and operational requirements. Everyone else, from hedge funds to retail traders, clears through a clearing member.

So there are two layers:

The clearing house guarantees performance to its clearing members.
Each clearing member is responsible to the clearing house for its customers’ positions, and holds its customers’ money.

This distinction matters. When a clearing member’s customer loses money and cannot pay, the clearing member must still pay the clearing house. And when a clearing member itself fails, as MF Global did in 2011, the clearing house’s guarantee protects the system, but the customers’ recovery depends on segregation rules and the bankruptcy process.

Step 1: novation

When a buyer and seller trade, the clearing house steps in:

Original trade: A buys 1 contract from B.
After novation: A has bought 1 contract from the clearing house; B has sold 1 contract to the clearing house.

The clearing house is now flat: it is long one contract to B and short one to A. It has no market risk as long as both sides keep paying. Its only risk is that one of them fails.

Step 2: margin and daily settlement

The clearing house collects two kinds of money:

Initial margin (also called a performance bond): collateral posted when a position is opened, sized to cover a severe price move over the time it would take to close out a defaulting member’s positions.
Variation margin: cash paid by those whose positions lost value to those whose positions gained, at least once a day, based on the official settlement price.

Because losses are paid every day, nobody is allowed to accumulate a large unpaid loss. The details for individual traders are in how futures margin works.

Worked example: one day of clearing

Using the real CBOT corn contract: 5,000 bushels, tick of 1/4 cent per bushel = $12.50. Prices are illustrative.

On Monday, A buys one December corn contract from B at $4.50. After novation, A is long and B is short, each facing the clearing house.

Monday’s settlement price is $4.55.

	Calculation	Cash flow
A (long)	($4.55 - $4.50) x 5,000	Receives $250
B (short)	($4.50 - $4.55) x 5,000	Pays $250
Clearing house		Net zero

In ticks: 5 cents is 20 ticks x $12.50 = $250.

On Tuesday, both positions are re-marked from $4.55, not from $4.50. If B cannot pay the $250, B’s clearing member must pay it anyway, and can use B’s initial margin to do so.

Clearing houses also net positions: a member that is long 1,000 contracts for one customer and short 900 for another may only need to post margin on part of that, depending on the account structure and the rules for customer margin.

Step 3: the default waterfall

If a clearing member cannot meet its obligations, the clearing house declares it in default, takes control of its positions, hedges them, and then auctions or liquidates them. If the losses are bigger than the defaulter’s collateral, it works through a fixed sequence of resources:

Order	Resource	Whose money
1	Defaulting member’s initial margin	The defaulter
2	Defaulting member’s guarantee fund contribution	The defaulter
3	Clearing house’s own contribution (“skin in the game”)	The clearing house
4	Non-defaulting members’ guarantee fund contributions	Surviving members
5	Assessments on non-defaulting members, up to a cap	Surviving members

Real figures

CME Clearing publishes its financial safeguards and updates them regularly. As shown on its website in late 2026, its Base package (which covers most futures and options) had a guaranty fund requirement of about $7.6 billion, a designated CME Clearing contribution of $100 million, and assessment powers of about $20.8 billion, sized under CME’s rules at 2.75 times the guaranty fund. These numbers change over time; check CME’s financial safeguards page for current figures.

Worked example: a hypothetical default

Illustrative numbers only. A clearing member defaults with a portfolio that, after hedging and auction, produces a $500 million loss.

Layer	Available	Used	Remaining loss
Defaulter’s initial margin	$350 million	$350 million	$150 million
Defaulter’s guarantee fund contribution	$60 million	$60 million	$90 million
Clearing house contribution	$100 million	$90 million	$0

The surviving members lose nothing in this example. If the loss had been $700 million, the clearing house’s $100 million would be used up, and the remaining $190 million would come from the other members’ guarantee fund contributions, shared among them according to the rules.

How it has worked in practice

Lehman Brothers, 2008

Lehman held derivatives portfolios at several clearing houses when it failed in September 2008. According to the Bank for International Settlements, all but one were auctioned, liquidated or transferred within weeks without using up Lehman’s own collateral. The largest example was the interest rate swap portfolio cleared in London, about 66,390 trades with roughly $9 trillion of notional value, which was unwound using about a third of the margin held, with no losses to the clearing house or its members.

Nasdaq Clearing, 2018

The other side of the story came in Scandinavia. On September 10, 2018, Einar Aas, an individual trader who was himself a direct clearing member, failed to meet a margin call at Nasdaq Clearing. He had bet on the spread between Nordic and German electricity futures, which moved sharply against him. After his portfolio was auctioned, the loss exceeded his collateral by €114 million.

According to the BIS, Nasdaq’s waterfall had a €7 million layer of its own capital and then a €166 million default fund from members. Nasdaq used its €7 million and about €107 million of the members’ default fund, roughly two-thirds of it. Other members, who had nothing to do with the trade, lost money and had to replenish the fund.

The BIS drew lessons: margin models need realistic liquidity assumptions, offsets between correlated positions should be prudent (Aas had received a 50% offset between his two legs), and a position large relative to a small market needs extra margin.

Why counterparty risk is low but not zero

Low, because:

Losses are paid in cash at least daily.
Initial margin covers severe price moves.
Several layers of loss-absorbing capital sit behind each member.
Clearing houses are heavily regulated, and large ones are treated as systemically important.

Not zero, because:

A large enough or fast enough loss can exceed margin, as in 2018.
Several members could fail at once in a crisis.
Margin models are based on history, and history can be exceeded.
Clearing protects members. If your own broker fails or misuses funds, your recovery depends on customer protection rules, not the clearing guarantee. That is covered in how futures customer funds are protected.

What can go wrong for traders

Margin calls are fast. Because clearing houses settle daily or more often, your broker must collect losses from you just as fast.
Margin can rise in stress. Clearing houses raise requirements when volatility jumps, and brokers pass that on.
Concentration costs more. Large positions in small markets can attract extra margin, and should.
Broker risk remains. The clearing house guarantees your broker’s obligations to it, not your broker’s obligations to you.

The short version

A clearing house becomes the counterparty to both sides of every futures trade through novation, collects initial margin to cover severe moves, and settles gains and losses in cash every day. If a member defaults, it absorbs the loss through a waterfall: the defaulter’s margin and guarantee fund contribution, the clearing house’s own capital, the other members’ guarantee fund, and finally assessments. The system handled Lehman’s huge portfolios in 2008 without losses, but the 2018 Nasdaq Clearing default showed that a single concentrated position can still eat into other members’ money. Counterparty risk on exchange futures is low, but it is not zero, and it is separate from the risk that your own broker fails.