Learning objectives: Explain the loss waterfall in a CCP structure. Define initial margin and variation margin and describe the different approaches and factors in calculating initial margin. Discuss the impact of initial margin on prices, volume, volatility, and credit quality. Explain factors that can lead to failure of a CCP and discuss measures to protect CCPs from default.
Questions:
602.1. In his summary evaluation of the pros and cons of the central counterparty (CCPs) Gregory writes, "Bilateral OTC markets have been extremely successful and their growth has been greater than that of exchange-traded products over the last 15 years. Whilst it seems obvious that a bilaterally cleared market is more vulnerable to systemic risk, this is not an argument for the naïve introduction of CCPs. CCPs reallocate counterparty risk, but they do not make it disappear. This can be beneficial – for example, a corporate hedging their balance sheet may be wiped out if a major dealer defaults. In a CCP world, this risk is potentially reallocated to market participants who can bear it more reasonably (at a cost, of course). CCPs reduce systemic risk (e.g., mitigating the impact of clearing member failure) and increase it (e.g., by increasing margins during a period of stress where firms may have to liquidate assets to meet large margin calls which in turn may exacerbate price volatility). Hence, CCPs transform systemic risk but do not definitely reduce it overall. The question as to whether CCPs really reduce counterparty and/ or systemic risk overall should be carefully considered. In bilateral markets, dealers compete for business partially based on their ability to manage counterparty risk. " (Source: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012))
Each of the following is true as an advantage of trading through a central counterparty (CCP) EXCEPT which is inaccurate?
a. Regulatory relief: If the bank's counterparty is a CCP, then Basel III assigns no capital charge (ie, zero weighting) for counterparty risk due to virtually no risk of failure
b. Multilateral netting: Contracts traded through a CCP can be netted and this increases the flexibility to enter new transactions and terminate existing ones and reduces margin costs
c. Loss multualization: Even when a default creates losses that exceed the financial commitments from the defaulting member, these losses are distributed throughout the CCP members, reducing their impact on any one member
d. Liquidity: A CCP will improve market liquidity through the ability of market participants to trade easily and benefit from multilateral netting. Market entry is enhanced through the ability to trade anonymously and the mitigation of counterparty risk
602.2. Which of the following is TRUE about initial margin requirements at a central counterparty (CCP)?
a. Variation margin is much more complex and subjective than initial margin
b. The members' reserve fund is legally excluded from the loss waterfall in a CCP structure
c. The initial margin requirements of a CCP should increase in volatile market regimes but this creates a procyclicality problem
d. Initial margin depends primarily on the credit quality of the clearing member and only a small component, if any, is linked to the market risk of centrally cleared trades
602.3. The general functions of a central counterparty include: Pricing and settlement; Netting/trade compression; Collateral management; Reporting; Loss mutualization; and the Auction process. To which of these functions does Gregory refer to as "the main advantage of a CCP and the one function that is, without doubt, performed significantly better than in bilateral markets (as illustrated during the Lehman bankruptcy, for example). " (Source: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012))
a. Netting/trade compression
b. Collateral management
c. Reporting
d. Auction process
Answers here:
Questions:
602.1. In his summary evaluation of the pros and cons of the central counterparty (CCPs) Gregory writes, "Bilateral OTC markets have been extremely successful and their growth has been greater than that of exchange-traded products over the last 15 years. Whilst it seems obvious that a bilaterally cleared market is more vulnerable to systemic risk, this is not an argument for the naïve introduction of CCPs. CCPs reallocate counterparty risk, but they do not make it disappear. This can be beneficial – for example, a corporate hedging their balance sheet may be wiped out if a major dealer defaults. In a CCP world, this risk is potentially reallocated to market participants who can bear it more reasonably (at a cost, of course). CCPs reduce systemic risk (e.g., mitigating the impact of clearing member failure) and increase it (e.g., by increasing margins during a period of stress where firms may have to liquidate assets to meet large margin calls which in turn may exacerbate price volatility). Hence, CCPs transform systemic risk but do not definitely reduce it overall. The question as to whether CCPs really reduce counterparty and/ or systemic risk overall should be carefully considered. In bilateral markets, dealers compete for business partially based on their ability to manage counterparty risk. " (Source: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012))
Each of the following is true as an advantage of trading through a central counterparty (CCP) EXCEPT which is inaccurate?
a. Regulatory relief: If the bank's counterparty is a CCP, then Basel III assigns no capital charge (ie, zero weighting) for counterparty risk due to virtually no risk of failure
b. Multilateral netting: Contracts traded through a CCP can be netted and this increases the flexibility to enter new transactions and terminate existing ones and reduces margin costs
c. Loss multualization: Even when a default creates losses that exceed the financial commitments from the defaulting member, these losses are distributed throughout the CCP members, reducing their impact on any one member
d. Liquidity: A CCP will improve market liquidity through the ability of market participants to trade easily and benefit from multilateral netting. Market entry is enhanced through the ability to trade anonymously and the mitigation of counterparty risk
602.2. Which of the following is TRUE about initial margin requirements at a central counterparty (CCP)?
a. Variation margin is much more complex and subjective than initial margin
b. The members' reserve fund is legally excluded from the loss waterfall in a CCP structure
c. The initial margin requirements of a CCP should increase in volatile market regimes but this creates a procyclicality problem
d. Initial margin depends primarily on the credit quality of the clearing member and only a small component, if any, is linked to the market risk of centrally cleared trades
602.3. The general functions of a central counterparty include: Pricing and settlement; Netting/trade compression; Collateral management; Reporting; Loss mutualization; and the Auction process. To which of these functions does Gregory refer to as "the main advantage of a CCP and the one function that is, without doubt, performed significantly better than in bilateral markets (as illustrated during the Lehman bankruptcy, for example). " (Source: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012))
a. Netting/trade compression
b. Collateral management
c. Reporting
d. Auction process
Answers here:
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