Centralized clearing refers to the process involving the settlement of derivatives traded over an exchange and can also be used for settlement of OTC derivatives as well. The example on the screen uses a futures contract. This futures contract is agreed between two market council parties and here the price of the future's contract is at 100. Once it has been entered into over the exchange, it then gets canceled and replaced with two new contracts. Both have a body referred to as the central counterparty or also can be referred to as the Clearing House as the counterparty to each of those traits. The long side of the initial derivative agreed over the exchange still has a long position, but their counterparty, the short side of that trade now, is the central counterparty. Equally, the initial short position still has a short position in this new transaction, but this new contract has the central counterparty as the long side to this trade. The central counterparty has an offsetting long and short position, and therefore takes no market risk. The purpose of this is to remove the counterparty risk that each of those two market counterparties face to each other. Both of those market counterparties now has the central counterparty as the source of the credit risk that they face. If one of the market counterparties defaults on their obligations, this is not a loss that is suffered by the other side of that initial transaction. If the short futures position were to go bankrupt for example, the long future would not suffer any loss as a result of this, the central counterparty would still fulfill any obligations to the long side of the contract.

The central counterparty now faces counterparty risk to both sides of the transaction. And to mitigate that counterparty risk, they both require that money is paid for both the long futures and the short futures position to the Clearing House as effectively a good faith deposit to prove that both counterparties will be able to pay up any losses that they suffer. This is referred to as initial margin. Having entered into this trade and with both sides having paid initial margin over to the Clearing House, or central counterparty, the Clearing House then ensures that exchange trade derivatives gains or losses are settled on a daily basis. If using the same example as before, we assume that the futures price then increases to 102 the next day. The long side of the contract has made a gain and the short site has made a loss. The centralized clearing process will require that the short futures position pays money into the central counterparty, and the central counterparty will take that out of their margin account and pay it into the margin account of the long futures position to represent the $2 gain that they have made and they can take that $2 out of their margin account. The $2 paid in by the short futures position and the $2 taken out by the long futures position are referred to as variation margin. By this process, gains and losses on centrally cleared derivatives are settled on a daily basis.