Prior to the financial crisis, it was common to trade CDSS bilaterally.
That is there was a contract between the buyer and the seller, and no one else was involved.
This was shown to have a major weakness as people realized that the ability of the seller to pay out, maybe linked to the bankruptcy of the reference entity, for example, CDSS on banks being sold by banks, is clearly problematic.
What we don't want to see is the seller default at the same time as the reference entity to get around this default correlation problem, the CDS market moved quickly to a centrally cleared model.
In clearing a central counterparty or clearing house steps in between the buyer and seller and becomes the counterparty to both.
This is the standard way in which exchange traded derivatives are traded.
Both sides pay an initial margin to the clearing house, which is then topped up via margin calls if the position is losing money.
Because margin calls happen daily, the system generally succeeds in removing the credit risk of the seller and restores the credit default swap to what It should be.
A contract offering insurance against the default of a reference entity.
It's important to note that the CDS market is still an OTC market, even though it uses central clearing, so the trade is agreed bilaterally, and then both sides give up the trade to a mutually agreed clearing house.
