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Name the kinds of risk that CCPs face and explain each.

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

The idea

A CCP faces several distinct risks. Credit risk is the chance that a member fails and its margin and default resources do not cover the loss. Market risk arises while the defaulter's portfolio is hedged or auctioned and prices move. Liquidity risk is the need to pay variation margin to surviving members in cash immediately, even though the defaulter's collateral may be held in securities. Investment risk is loss on the cash margin the CCP reinvests. Operational risk covers system failure, error and cyber attack. Legal risk covers uncertainty over netting, collateral and default rules. Model risk is margin set too low by a poor model. Wrong-way risk occurs when a member's default is linked to losses on its own portfolio. Exam point: match the scenario to the risk by asking what actually fails.

A practice question

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

What is the credit risk faced by a CCP?

  1. That the CCP's trading platform fails during a busy sessionWhy not: This is operational risk, not credit risk.
  2. A member defaults and margin and other resources fall short - correct
  3. That a court refuses to recognise the CCP's netting arrangementsWhy not: This is legal risk, not credit risk, as it concerns enforceability.
  4. That the market value of the CCP's reinvested cash fallsWhy not: This is investment (market) risk, not credit risk.

Credit risk at a CCP is the risk that a member fails to perform and its margin and the CCP's other resources fall short.

A harder one

A clearing member defaults. The CCP holds the defaulter's collateral in government bonds, but must pay variation margin to surviving members in cash by the end of the day. Which CCP risk does this illustrate?

  1. Credit risk, because the defaulter's margin proves insufficient to cover the lossWhy not: The scenario states nothing about insufficient margin; the problem is the timing of cash, not the size of the collateral.
  2. Legal risk, because the bonds cannot be enforced as collateralWhy not: No enforceability problem is described.
  3. Market risk, because the defaulter's portfolio has moved in priceWhy not: The issue is the cash payment obligation, not a market move.
  4. Liquidity risk, as cash is needed while collateral is in securities - correct

The CCP must meet its payment obligations to survivors immediately, even if its resources are not in cash. This timing mismatch is liquidity risk, usually handled with committed credit lines and access to central bank facilities.

The hardest tier

A CCP's initial margin is calibrated to a 99 percent confidence level. Over 250 business days of backtesting, member portfolios' losses exceeded the posted margin on 7 days, against an expected 2.5. What does this most clearly indicate?

  1. Operational risk: the CCP's systems failed to collect margin on seven daysWhy not: Margin breaches in backtests are a model calibration issue, not evidence of collection failure.
  2. Liquidity risk: the CCP cannot convert margin into cash quickly enoughWhy not: Liquidity is about turning collateral into cash, not the sufficiency of margin.
  3. Model risk: margin is too low, so the default fund bears more - correct
  4. No issue: at 99 percent confidence about 7 breaches in 250 days is normalWhy not: At 99 percent the expected number is 250 x 0.01 = 2.5; 7 is nearly three times larger.

Expected exceptions at 99 percent confidence are 250 x 1% = 2.5. Seven breaches suggest that the margin model is too low, which is model risk, leaving losses beyond margin to be absorbed by the default fund.

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