Describe how OTC derivatives are centrally cleared, and discuss the CCP (central counterparty) in terms of its roles, mandate, benefits and drawbacks.
The idea
A central counterparty, or CCP, steps between the two sides of a trade by novation, becoming buyer to every seller and seller to every buyer, so members face the CCP instead of each other. After the 2008 crisis the G20 mandated that standardised OTC derivatives be cleared centrally, reported to trade repositories and, where suitable, traded on exchanges or electronic platforms. A CCP protects itself with initial and variation margin and a default fund. A defaulter's losses are met in order: its margin, its default fund contribution, the CCP's own capital, then surviving members' contributions. Benefits are multilateral netting, transparency, and standardised default handling. Drawbacks are concentration of risk in a few CCPs, procyclical margin, moral hazard from mutualisation, and fragmented netting across CCPs. Exam point: the CCP concentrates risk rather than removing it.
A practice question
After the 2008 crisis, which commitment did G20 leaders make about OTC derivatives?
- All OTC derivatives should be moved onto exchanges and bilateral trading should be prohibitedWhy not: Overstates the commitment; bespoke contracts remained bilateral and exchange trading was only for suitable products.
- Credit derivatives should be banned because they spread risk through the financial systemWhy not: No ban was agreed; the response was clearing, reporting and capital and margin rules.
- Standardised OTC derivatives should be centrally cleared and reported to trade repositories - correct
- Central counterparties should be prohibited from collecting margin to reduce procyclical effectsWhy not: The reverse: CCPs rely on margin, and margining of non-cleared trades was also strengthened.
The G20 mandate had four parts: central clearing of standardised OTC derivatives, trade reporting, exchange or platform trading where appropriate, and higher capital for non-cleared trades.
A harder one
Three dealers have bilateral OTC trades. A is owed USD 10 million by B, B is owed USD 8 million by C, and C is owed USD 6 million by A. If all are moved to one CCP with multilateral netting, the total amount owed to the CCP by net payers falls from USD 24 million of gross positive exposures to:
- USD 4 million - correct
- USD 24 millionWhy not: Assumes no benefit: bilateral trades in a cycle cannot be netted bilaterally, but multilateral netting reduces them.
- USD 2 millionWhy not: Counts one net payer only; two members owe 2 million each.
- USD 8 millionWhy not: Adds the net receiver's amount to the payers' amounts, which counts the receiver's 4 million as exposure.
Net positions: A = +10 - 6 = +4; B = +8 - 10 = -2; C = +6 - 8 = -2. The CCP's exposure to the net payers is 2 + 2 = 4 million, down from gross 24 million.
The hardest tier
After a spike in market volatility, a CCP sharply raises initial margin, and clearing members struggle to find liquid assets at short notice. This best illustrates which drawback of central clearing?
- Wrong-way risk between the CCP and its membersWhy not: Wrong-way risk concerns exposure rising as credit quality falls, not a margin increase after volatility.
- Fragmentation of netting sets across several CCPsWhy not: Fragmentation raises margin because trades are not netted together; it is not triggered by a volatility spike.
- Procyclicality of margin calls in a stressed market - correct
- Moral hazard from mutualised default fund contributionsWhy not: Moral hazard is the incentive to take risk because losses are shared; it does not describe margin increases.
Risk-sensitive margin rises in stress, forcing members to raise liquidity just when it is scarce. This procyclicality is a recognised drawback of central clearing.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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