FMP6 - Central Clearing

Question 1

Provide examples of the mechanics of a central counterparty (CCP)

Answer 1

• Initial margins set in CCP so that if it takes 5 days to close out a members position, it is 99% sure the initial margin will cover the losses
• When member defaults, CCP auctions off transaction to offset defaulting members transactions

Question 2

Describe the role of CCPs and distinguish between bilateral and centralised clearing

Answer 2

CCPs act as a counterparty to all market participants to reduce credit risk, bilaterally cleared markets is where market participants clear with the other member of the trade

Question 3

Describe advantages and disadvantages of central clearing of OTC derivatives

Answer 3

+ Much easier for market participants to exit a CCP transaction
+ Improve liquidity in OTC markets
+ Encourages standard documentation
+ Manages netting, margins, settling, and default resolution
- Operational failure has huge impact due to amount of trades it handles
- Moral hazard and adverse selection
- Difficult for members to evaluate credit risk they’re taking

Question 4

Explain regulatory initiatives for the OTC market and their impact on central clearing

Answer 4

G-20 Pittsburgh resulted in three major regulation changes:
1. Standardised derivatives must be cleared through a CCP, results in less credit exposure between traders and less systematic risk and interconnectivity
2. OTC derivatives to be traded on electronic platforms to increase transparency
3. All trades in OTC market to be reported to central trade repository

Question 5

Compare margin requirements in centrally cleared and bilateral markets and explain how margin can mitigate risk

Answer 5

Margin mitigates the risk of default as there is a fund to recoup losses, centrally cleared markets and bilateral markets require initial and variation margin.

Question 6

Compare netting in bilateral markets versus in centrally cleared markets

Answer 6

Bilateral market participants must net between each other in specific trades (can be inefficient), central clearing will net all payments between participants so much more efficient

Question 7

Identify and explain the types of risks faced by CCPs

Answer 7

• Systematic risk in that if one member defaults, others tend to as well
• Model risk as very reliant on valuation models
• Liquidity risk, investments need to be easily converted to cash if a member defaults
• All members treated the same, so margins are unaffected by bad or good credit risks