1. The Legal Structure

Novation vs Netting: Under novation, original contract A-B is extinguished and replaced by A-CCP and CCP-B. This is different from simple multilateral netting.

The Default Waterfall - EMIR / PFMI standard adopted by RBI and SEBI:

1. Defaulter's Initial Margin and Variation Margin
2. Defaulter's Default Fund contribution
3. CCP's own capital - Skin-in-the-Game [typically 25% of capital under EMIR]
4. Surviving members' Default Fund contributions
5. Further assessment rights / Cash calls on members

If this fails, CCP itself goes into insolvency / resolution.

2. Insolvency Protection Framework

India:

• Payment and Settlement Systems Act, 2007 Sec 23: Netting and settlement finality is protected. Settlement done through CCIL/NCL is final and cannot be reversed even if member is declared insolvent after.
• CCIL Bye-Laws: If CCIL itself is declared insolvent or liquidator appointed, all outstanding trades shall stand terminated forthwith by way of close-out at Mark to Market price of previous day.
• Insolvency and Bankruptcy Code 2016: Sec 231 gives overriding effect but PSS Act is treated as special law for financial contracts.
• SEBI Circular for NCL, ICCL: Mandates segregation of client collateral.

Global: EU Settlement Finality Directive, US Bankruptcy Code Sec 362 safe harbour for financial contracts, UK Financial Collateral Arrangement Regulations.

3. Detailed Case Laws

Case 1: British Eagle International Air Lines Ltd v Compagnie Nationale Air France 1 WLR 758 (HL) - Why CCPs need novation[1975]

Airlines had IATA clearing house for multilateral netting. British Eagle went insolvent, was net debtor to scheme but Air France owed money to British Eagle individually. House of Lords held multilateral netting arrangement without novation is invalid on insolvency as it violates pari passu rule - it would give preference over insolvency distribution. Air France must pay liquidator full amount owed to British Eagle.

This led to modern CCP design where contracts are entered into with the CCP. LSE research notes: "The robustness of this arrangement on insolvency has been confirmed by the later case of Ansett" where novation was upheld.

Indian Supreme Court in Bharti Airtel Ltd v Vijaykumar V Iyer 2024 INSC 15 cited British Eagle to hold contractual netting giving preference over IBC distribution is invalid unless protected by statute.

Case 2: Lehman Brothers Default - LCH.Clearnet 2008 - The Successful CCP Default Management

On 15 Sept 2008, Lehman Brothers was declared defaulter by LCH.Clearnet, JSCC, HKSCC. LCH had $9 trillion notional interest rate swaps portfolio of Lehman.

Process:

• Default Management Committee convened - senior traders from surviving members
• Portfolio netted down, hedged
• Losses covered entirely by Lehman's collateral prior to default.

No loss to surviving members. Courts later dealt with distribution of surplus in Lehman Waterfall I, II litigation - UK Supreme Court 2017: Held insolvency rules on currency conversion are a complete code, no second non-provable claim.

It proved CCPs worked during crisis and led to G20 mandate for mandatory CCP clearing.

Case 3: Einar Aas - Nasdaq Clearing AB, 10-11 Sept 2018 - When CCP Almost Failed

This is the leading CCP default case now.

Facts: Einar Aas, Norwegian private power trader, had huge spread position: Long Nordic power, Short German power, betting convergence. Prices diverged sharply. Nasdaq Clearing issued margin call. Aas failed to pay.

Nasdaq declared him defaulter on morning of 11 Sept 2018. Pledged collateral did not cover loss. CCP drew on mutualised default fund. Hole was EUR 114 million - EUR 7 mn of CCP capital wiped, EUR 107 mn from non-defaulting members' funds.

Consequences:

• Swedish FI fined Nasdaq Clearing 300 mn SEK ($36 mn) in 2021 for deficient margin model, breach of EMIR margin rules.
• Revealed model risk - LSE study: "Nasdaq Clearing almost failed in September 2018 due to undersizing IM... losses wiped out CCP's skin in the game"
• Reform: EMIR review increased skin-in-the-game, concentration add-ons.

This is taught as CCP can fail not only due to bank default but due to single large non-bank trader.

Case 4: Indian Cases - NSE Clearing / CCIL

a) National Stock Exchange v Rusoday Securities Ltd (SC 2021) - 90-page judgment on defaulter's withheld securities
Trading facilities of Rusoday withheld on 13.10.1997. Question: Can NSE realise withheld securities prior to declaration of defaulter/expulsion? SC held NCL/CCIL bye-laws give lien, can withhold and realize to meet settlement obligations to protect market integrity.

b) Edelweiss Custodial Services Ltd v NSE Clearing Ltd (SC 2023)
Issue of F&O collateral - client securities pledged for margin. NSE Clearing liquidated after broker default. SC examined whether collateral rules adequately protect investor while being operationally conducive. Upheld CCP's right to liquidate but emphasized segregation and disclosure obligations.

c) Caisse de Liquidation Paris (1974), Kuala Lumpur Commodity Clearing House (1983), Hong Kong Futures Guarantee Corporation (1987)
Three CCPs closed due to envisaged insolvency, all caused by improper risk management and default of participants. Cited in IMF Working Paper on Central Counterparties.

4. Banking Angle

For banks that are clearing members:

• Default fund contribution treated as capital exposure under Basel III - 1250% risk weight if CCP not Qualifying.
• Under BR Act, RBI can inspect CCIL as Systemically Important FMIs.
• If bank defaults to CCP, CCP can close out and set off under PSS Act Sec 23, which overrides moratorium under IBC.

Summary Principle:

A CCP default does not eliminate risk, it concentrates and mutualises it. Law protects novation and netting on member insolvency, but if default exhausts waterfall, loss falls on surviving banks. Therefore skin-in-the-game and margin adequacy are the key litigation points - as Einar Aas shows.