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Outline what CCPs do and set bilateral clearing against centralized clearing.

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

The idea

A CCP does four jobs: it novates trades so that it faces each member, it guarantees performance by collecting margin and holding a default fund, it nets positions across members, and it runs a single default management process, usually an auction of the defaulter's book. In bilateral clearing each pair of counterparties faces the other directly, negotiates its own collateral terms in a credit support annex under a master agreement, monitors the other's credit quality and closes out its own trades alone after a default. Central clearing replaces that web of pairwise exposures with one exposure to the CCP under uniform rules, but it works only for standardised, reasonably liquid contracts. Bespoke trades stay bilateral. Exam point: clearing moves counterparty risk to the CCP, it does not remove it.

A practice question

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

Which of the following is a core function of a central counterparty?

  1. Matching buyers and sellers by quoting prices to the marketWhy not: Quoting and matching are trading-venue functions; a CCP clears trades after they are executed.
  2. Insuring members against market losses on their positionsWhy not: A CCP covers counterparty default, not the ordinary market gains and losses of members who perform.
  3. Setting the price at which every member must transactWhy not: Confuses clearing with price setting; prices are agreed by the trading parties or discovered on the venue.
  4. Guaranteeing the performance of cleared trades - correct

A CCP novates trades, guarantees their performance through margin and its default fund, nets exposures and manages defaults. It does not run the order book or insure members' market risk.

A harder one

A dealer wants to clear two trades. The first is a plain-vanilla 5-year USD interest rate swap on a standard fixing. The second is a bespoke 17-year amortising swap with an embedded option and a customised schedule. Which statement is most accurate?

  1. Both are equally eligible, because a CCP will accept any contract it can valueWhy not: Ignores that CCPs clear only standardised, liquid contracts for which prices and a default auction can be run.
  2. The vanilla swap is clearable; the bespoke swap would normally stay bilateral - correct
  3. The bespoke swap is the better candidate, because customised terms reduce counterparty riskWhy not: Reverses the logic; customisation makes a contract harder to price, hedge and auction, so it is less suitable for clearing.
  4. Neither is eligible, because OTC swaps may never be cleared under any regulationWhy not: Wrong; liquid vanilla interest rate swaps are the main example of OTC contracts that are centrally cleared.

Central clearing needs standardisation and enough liquidity for reliable margining and default auctions. Vanilla swaps meet this; bespoke, illiquid contracts typically remain bilateral.

The hardest tier

Fifteen dealers currently trade OTC derivatives with each other bilaterally, with every pair directly linked. If the trades move to three separate CCPs, one for each of three asset classes, and each dealer is linked to all three CCPs, by how many does the number of links fall?

  1. 90Why not: Assumes a single CCP (15 links) instead of three, so 105 - 15 is taken as the reduction.
  2. 165Why not: Counts the bilateral links as 15 x 14 = 210 (each pair twice) before subtracting the 45 CCP links.
  3. 45Why not: Reports the number of links remaining with three CCPs instead of the reduction from the bilateral network.
  4. 60 - correct

Bilateral links: 15 x 14 / 2 = 105. With three CCPs each dealer has 3 links: 15 x 3 = 45. The fall is 105 - 45 = 60. A single CCP would cut links to 15, but splitting across CCPs keeps more links.

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