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Outline what characterises a central counterparty (CCP) and how it operates.

FRM® Part I · Financial Markets and Products · Central Clearing · FRM1.FM.6.a

The idea

A central counterparty (CCP) is a legal entity that steps between the two sides of a trade through novation: the original contract is cancelled and replaced by two new ones, so the CCP becomes the buyer to every seller and the seller to every buyer. Because the two legs offset, its book is matched and it carries no net market position while all members perform. Only clearing members, who meet capital and operational standards, face the CCP directly. Risk is controlled by daily variation margin, initial margin sized to potential losses, a mutualised default fund and the CCP's own capital. After a member defaults, losses are met in order: the defaulter's margin, the defaulter's default fund contribution, the CCP's own capital, then surviving members' contributions. Exam point: the defaulter pays first, and the CCP's own capital sits before the survivors' money.

A practice question

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

When a central counterparty accepts a trade for clearing, the original contract between the two parties is cancelled and replaced by two contracts, each with the CCP. What is this legal mechanism called?

  1. Novation - correct
  2. Close-out nettingWhy not: Close-out netting is the termination and netting of a defaulter's trades; it does not replace the counterparty to a live trade.
  3. RehypothecationWhy not: Rehypothecation is the re-use of posted collateral by its holder and has nothing to do with substituting the counterparty.
  4. Collateral transformationWhy not: Collateral transformation is swapping assets into forms eligible as margin and does not alter who the counterparty is.

Novation extinguishes the bilateral contract and substitutes two new contracts with the CCP, which becomes the buyer to every seller and the seller to every buyer. The other terms describe default netting, collateral re-use and collateral swaps.

A harder one

Which statement correctly distinguishes initial margin from the default fund at a CCP?

  1. Initial margin is pooled across members and the default fund is held separately for each memberWhy not: Reverses the two: margin is member-specific, while the default fund is the mutualised pool.
  2. Both are pooled, and the CCP may draw on either before touching the defaulter's variation marginWhy not: Treats initial margin as mutualised; it is the defaulter's own collateral and is used first and only against its own default.
  3. The default fund covers normal daily price moves and initial margin covers extreme losses onlyWhy not: Swaps the roles; daily price moves are covered by variation margin, and the default fund covers extreme losses beyond margin.
  4. Initial margin is member-specific and used first; the default fund is pooled and used later - correct

Initial margin is calibrated to the risk of the member's own portfolio, and is the first line of defence against that member alone. The default fund is a shared pool for extreme losses that exceed the defaulter's margin and its own contribution.

The hardest tier

A clearing member defaults and the CCP incurs a close-out loss of USD 640 million. The defaulter's initial margin is USD 310 million, its default fund contribution is USD 45 million, and the CCP's own capital tranche is USD 35 million. The surviving members' contributions total USD 900 million, of which Member B contributed USD 90 million. Assuming losses are shared pro rata to contributions, B's loss, in USD million, is closest to:

  1. 25 - correct
  2. 28.5Why not: Ignores the CCP's own capital tranche, so the survivors are asked to absorb USD 285 million instead of 250 million.
  3. 33.0Why not: Applies only the defaulter's initial margin and skips both the defaulter's default fund contribution and the CCP's capital, leaving 330 million.
  4. 90.0Why not: Assumes B loses its whole contribution; the loss left after the defaulter's resources and the CCP's capital is far below the pool.

Loss after defaulter's margin: 640 - 310 = 330. After its contribution: 330 - 45 = 285. After CCP capital: 285 - 35 = 250. B's pro rata share of the survivors' pool is 90/900 = 10 percent, so its loss is 250 x 0.10 = 25.0.

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