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Outline how exchanges help to reduce counterparty risk.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.a

The idea

An exchange reduces counterparty risk mainly through its clearing house, or central counterparty (CCP). After a trade is matched, the CCP steps in by novation and becomes the buyer to every seller and the seller to every buyer, so each trader's exposure is to the CCP and not to the original counterparty. The CCP controls its own risk by admitting only well-capitalised clearing members, collecting initial margin, settling gains and losses daily through variation margin, setting position limits, and holding a default fund contributed by members. A defaulter's losses are absorbed in order: its own margin, its default fund share, the CCP's own capital, then the surviving members' contributions. Counterparty risk is not abolished. It is concentrated in the CCP and shared among members. The exam point is that daily settlement keeps exposure to roughly one day of price movement.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature of exchange trading most directly limits the build-up of credit exposure over the life of a futures contract?

  1. Standardisation of contract sizes and maturity datesWhy not: Standardisation supports liquidity and fungibility but does not collect any losses as they occur.
  2. Daily marking to market through variation margin - correct
  3. Public dissemination of settlement pricesWhy not: Transparency helps valuation but no cash moves because of it, so no exposure is reduced.
  4. Annual fees paid by clearing membersWhy not: Fees fund operations; they are not a deposit against trading losses.

Marking to market each day and moving the gain or loss in cash means a defaulting party can owe at most about one day's price move beyond the margin already held. The other features help liquidity and transparency but do not settle exposure.

A harder one

A fund buys 20 futures contracts through its clearing member. The seller's clearing member defaults before expiry. What happens to the fund's position?

  1. It is cancelled and the fund recovers only its original margin.Why not: Cancelling would defeat the purpose of clearing; the CCP keeps the contract alive and honours it.
  2. The fund becomes an unsecured creditor of the defaulter's estate.Why not: That is the bilateral OTC outcome; novation to the CCP prevents it.
  3. It continues, since the CCP is its counterparty and covers the loss. - correct
  4. It continues, but the fund must top up the defaulter's margin shortfall.Why not: Shortfalls are met from the defaulter's resources, the CCP's capital and surviving members' fund contributions, not from non-defaulting clients.

After novation, the buyer's counterparty is the CCP, not the seller's member. The CCP uses its loss waterfall to cover the defaulter's shortfall, and non-defaulting parties see their positions continue unchanged.

The hardest tier

A CCP applies this loss waterfall: defaulter's initial margin, defaulter's default fund contribution, CCP's own capital tranche, and then the surviving members' default fund. A member defaults and closing out its positions costs USD 38 million. Its initial margin is USD 22 million, its default fund contribution USD 6 million, and the CCP's own capital tranche USD 5 million. How much of the loss falls on the surviving members' contributions?

  1. USD 5 million - correct
  2. USD 10 millionWhy not: Omits the CCP's own capital tranche, charging survivors before it is used.
  3. USD 11 millionWhy not: Omits the defaulter's own default fund contribution, which is used before survivors' money.
  4. USD 16 millionWhy not: Applies only the defaulter's initial margin and ignores the other layers ahead of the survivors.

Loss 38 minus initial margin 22 = 16; minus defaulter's fund share 6 = 10; minus CCP capital 5 = 5. Only that remainder reaches surviving members.

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