Chapter 6: Principles of Clearing and Margin Flashcards
What is clearing?
Clearing is the process by which derivatives trades are confirmed and registered.
What is a default fund?
Cash that is paid in by members to a clearing house to be used in the event of a default
How does novation make contracts easy to trade?
You can take an equal and opposite position in the market, and as clearing house is the CCP on both the position is effectively closed
What is settlement risk?
The risk that expected payment or delivery won’t be made on time or at all
What is a mutual offset system?
An agreement between two exchanges that allow trades to be executed on one exchange to be booked and cleared through another.
What is a principal-to-principal system?
Clearing house guarantees the trades executed by its members on the exchanges that it serves
What is the impact of Brexit on derivatives clearing?
UK clearing houses need to decide whether EU customers need to move positions from London to EU.
What are the two types of clearing member?
General
Individual
What is “passporting”?
Offering EU rights to UK firms post Brexit, ended in 2020
Who is a clearing house typically owned by?
Members, or by the excange
What happens before the clearing process begins?
Trade reported to the universal clearing platform
What happens after a trade is matched on a clearing system?
Registration, where clearing members will give the details of the account which the trade is assigned to to the clearing platform.
What will the clearing platform call on clearing members to do after novation?
Make margin payments as necessary.
What is a default fund?
Contribution by members in case of member default
How are members contributions split up?
Will be done based on it’s clearing activities
e.g. swaps contributions will only be used for swap defaults
Known as mutual guarantee system
What are the four sources of default fund and what order are they drawn on?
- The default member’s margin held by the clearing house.
- The default fund contributions of that member.
- The default fund contributions of other clearing member firms.
- The insurance policy.
Called default “waterfall”
Who regulates prime brokers? UK, EU, US
UK - FCA
EU - MiFID II
US - SEC, FED, CFTC
How can OTC products be centrally cleared? (2)
Selective on counterparties: credit ratings etc
Standardised contracts: major indices, min size
What are the advantages of centralised clearing?
Eliminates CP risk, contract novated
Easier operationally
What is a price limit?
Circuit breakers that limit maximum bounds on absolute price movements on the contract on any day
Who imposes price limits?
The exchange
What is the purpose of price limits?
Gives time for participants to calm down and take a more reasoned view about trading conditions
How do exchanges limit price of orders?
Won’t allow orders outside a certain spread, limits mistakes and volatility.
What are position limits?
Limit the amount of positon one market participant can hold
What kind of actions are taken in the event of a position or price breach?
Cooling off period (time)
Changes to subsequent limit bands
Limiting trading for position breaches
What is contingent liability?
Liability that depends on the outcome of a certain event
E.g. futures or options