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Discuss the exposures a CCP bears and how it controls them.

FRM® Part II · Credit Risk Measurement and Management · Central Clearing · FRM2.CR.18.e

The idea

A CCP's main exposure is credit risk on its members. Its book is matched, so when a member defaults the CCP is left with the defaulter's unmatched positions. It bears the price move between the last variation margin received and the completion of hedging or auction. It also faces liquidity risk, since it must keep paying variation margin to members with gains even when the defaulter does not pay. Other exposures are investment risk and concentration on the collateral it holds, wrong-way risk where a member's default is correlated with its positions, and operational and legal risk. Controls are membership standards, daily variation margin, initial margin, position limits, and add-ons for concentrated or wrong-way positions. They also include stress-tested default funds, committed liquidity lines, conservative collateral investment and backtesting of margin models. The exam point is that margin and fund resources are finite.

A practice question

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

Which set of controls does a CCP use to limit its exposure to clearing members?

  1. Offsetting directional bets in the market to hedge the members' positions.Why not: A CCP does not take directional positions; it controls exposure through margin and member standards.
  2. Membership standards, daily variation margin, initial margin, position limits and a stress-tested default fund. - correct
  3. Relying on members' credit ratings so that margin is not needed.Why not: Ratings do not substitute for margin; margin is the primary defence against default.
  4. Moving variation margin to weekly settlement to reduce operational burden.Why not: Less frequent settlement increases exposure, as losses accumulate between calls.

CCPs control credit exposure with eligibility rules, collateral (VM and IM), limits on large or concentrated positions and mutualised stress-tested resources.

A harder one

A CCP invests cash collateral in overnight deposits with a single bank that is also its largest clearing member. Which exposure does this most directly create?

  1. Directional market risk on the matched book, because overnight deposits move with interest rates and the CCP holds them on its balance sheet.Why not: Confuses investment of collateral with market risk of the cleared book.
  2. Liquidity risk eliminated by diversification across all members.Why not: Describes the opposite; the deposits are concentrated in one name and offer no diversification.
  3. Concentration and wrong-way risk: if that member fails, the CCP faces a defaulter and a loss on part of its own collateral at the same time. - correct
  4. Pure operational risk, because the deposits are held in cash.Why not: Cash held with a bank carries credit exposure to that bank, not just operational risk.

The CCP's collateral is exposed to the same institution whose default it must manage, so the two events are correlated, which is wrong-way risk and concentration.

The hardest tier

A clearing member sells large amounts of credit default protection on a reference entity whose default would very likely coincide with the member's own distress. The CCP margins these positions at the same 99% model as other credit positions. Which control best addresses the exposure?

  1. A specific wrong-way risk margin add-on or position limit, because ordinary margin underestimates the loss if the member and the reference entity fail together. - correct
  2. No change is needed, because the standard 99% margin model already covers all correlated defaults, including those of a member and the reference entity together.Why not: Assumes the standard model captures default correlation; it does not capture wrong-way risk.
  3. Reduce the default fund, because high margin already covers all losses.Why not: Misreads the exposure; the default fund must protect against the larger loss, not shrink.
  4. Accept the positions but reduce variation margin frequency to avoid procyclicality.Why not: Reducing VM frequency increases the exposure instead of controlling wrong-way risk.

Wrong-way risk means the exposure is largest when the member is most likely to default. CCPs add margin or limit such positions because ordinary models assume no such link.

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