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Outline the benefits and costs of centrally clearing OTC derivatives.

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

The idea

The benefits of central clearing are lower and more transparent counterparty risk, multilateral netting of exposures, daily collateralisation of mark-to-market moves, orderly and coordinated default management, and a lower chance that one failure spreads through a web of bilateral links. The costs are that risk becomes concentrated in a few CCPs whose failure would be systemic. Loss mutualisation weakens members' incentive to police one another, which is moral hazard. Margin and default fund contributions must be funded with liquid collateral. Netting can be fragmented across CCPs or between cleared and uncleared trades. Margin also rises when volatility rises, which is procyclical. Each cost has a mirror-image benefit, so compare them rather than list them. Exam point: the main trade-off is lower contagion against greater concentration and liquidity demand.

A practice question

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

Which of the following is a recognised cost or drawback of central clearing?

  1. Greater opacity about who holds which positionsWhy not: Clearing generally increases transparency, because positions are recorded with the CCP.
  2. Slower close-out after a member defaultWhy not: A CCP's pre-agreed default process is usually faster and more coordinated than separate bilateral close-outs.
  3. A larger web of pairwise credit exposures between dealersWhy not: Clearing replaces pairwise exposures with exposures to the CCP; it shrinks the web.
  4. Risk concentrated in a few large CCPs - correct

Moving risk to a few CCPs makes each one systemically important: if one failed, the damage would be widespread. This concentration is the principal cost, along with margin funding and moral hazard.

A harder one

Clearing members share losses from a member's default through a pooled default fund. Which problem does this loss mutualisation create?

  1. Moral hazard, as members monitor each other less - correct
  2. Adverse selection in the choice of margin model by the CCPWhy not: Mutualisation affects members' monitoring incentives, not how the CCP chooses its margin model.
  3. Basis risk between cleared and uncleared contractsWhy not: Basis risk concerns pricing differences between instruments, unrelated to sharing default losses.
  4. Wrong-way risk in the pricing of variation marginWhy not: Wrong-way risk concerns correlation between exposure and a counterparty's default, not the incentive effect of pooled loss-sharing.

When a defaulter's losses beyond its own resources fall on all survivors, each member bears only part of the cost of another's risk-taking, so it has less reason to police that risk. This is a standard moral hazard argument against mutualisation.

The hardest tier

A dealer has an interest rate swap with a financial counterparty X worth +USD 20 million to the dealer and a credit default swap that cannot be cleared worth -USD 15 million, both under one bilateral netting set that exchanges variation margin daily. The dealer clears the swap but keeps the credit default swap with X, which continues to exchange variation margin. By how much does the cash variation margin the dealer must pay out change, in USD million?

  1. Increases by 5Why not: Takes the old net amount as the change; the old netting set required no payment out, so 5 is not the increase in payments.
  2. Increases by 20Why not: Counts the variation margin received from the CCP as if it were an outflow.
  3. Increases by 15 - correct
  4. Increases by 35Why not: Adds the 20 received and the 15 paid out; they are not both outflows.

Before: one netting set, net +5, so X pays the dealer and the dealer pays nothing. After: the dealer receives 20 from the CCP and pays 15 to X. Its payment out rises from 0 to 15. Splitting a netting set raises gross collateral flows even though the economic position is unchanged.

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