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Explain the clearing developments that have lowered risk.

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

The idea

Since the 2007 to 2009 crisis, several developments have lowered risk in clearing and settlement. Regulators, following the G20 agreement of 2009, expect standardised OTC derivatives such as interest rate swaps and index credit default swaps to be cleared through central counterparties, and require trades to be reported to trade repositories so supervisors can see exposures. Non-cleared trades face mandatory exchange of variation margin and, for large dealers, initial margin, plus higher capital charges. Portfolio compression tears up offsetting trades among dealers, cutting gross notional and operational load without changing net market exposure. In foreign exchange, CLS Bank settles both currency legs together through payment versus payment, removing the settlement risk exposed by the Herstatt failure in 1974. Remember that compression and repositories reduce complexity and opacity, while CCPs and margin reduce credit exposure.

A practice question

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

Which development addresses the settlement risk exposed when Bankhaus Herstatt failed after receiving currency payments but before making its own payments?

  1. Portfolio compression of swap booksWhy not: Compression reduces gross notional and trade counts; it does not tie the two currency legs together.
  2. CLS payment-versus-payment FX settlement - correct
  3. Reporting of positions to trade repositoriesWhy not: Reporting gives regulators visibility but leaves principal at risk during settlement.
  4. Central clearing of credit default swapsWhy not: CDS clearing concerns credit-derivative exposure, not the timing of currency payment legs.

Herstatt risk arises when one leg of an FX trade is paid and the other is not. CLS settles both legs simultaneously, so either both happen or neither does.

A harder one

A dealer takes part in a compression exercise that terminates offsetting interest-rate swaps with other dealers. What does this achieve?

  1. Lower net market risk, since offsetting positions are removed.Why not: The terminated trades offset each other by construction, so net market risk is unchanged.
  2. Elimination of counterparty risk because remaining trades are novated to a CCP.Why not: Compression does not require clearing; it is a trade-termination service.
  3. Replacement of the swaps with exchange-traded futures.Why not: The venue and instrument of the remaining trades does not change.
  4. Lower gross notional and fewer trades, with net market exposure unchanged. - correct

Compression finds loops or offsetting positions and tears them up, shrinking gross notional, margin and operational burden. Net positions, and so net market risk, stay the same.

The hardest tier

Which statement about post-crisis margin rules for non-cleared derivatives between large dealers is most accurate?

  1. Only variation margin is exchanged, since initial margin is reserved for CCPs.Why not: The rules added initial margin for in-scope dealers on non-cleared trades.
  2. Initial margin is netted between the parties so that only one side posts.Why not: Initial margin is calculated and collected by each side gross, without offsetting the other's.
  3. Variation and initial margin are both exchanged, initial margin gross. - correct
  4. Margin is waived whenever the parties have a netting agreement in place.Why not: A netting agreement does not exempt a trade; netting only affects how exposure is measured.

To make bilateral trading safer and nudge standard trades to CCPs, regulators require large dealers to exchange variation margin and gross, segregated initial margin on uncleared trades.

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