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Contrast clearing done bilaterally with clearing done through a central counterparty.

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

The idea

In bilateral clearing each party faces its counterparty directly. Credit risk is spread across many relationships and mitigated only by netting within each pair under a master agreement, plus bilateral collateral. Terms can be customised, and on default each survivor closes out and replaces its own trades separately, which can cause fire sales. With a CCP, trades are standardised, novated and netted across all counterparties. Margin is mandatory and risk-based, and one coordinated default process runs. The trade-offs run both ways. Central clearing cuts total exposures through multilateral netting but concentrates risk in the CCP, can raise collateral demand, and nets only within one CCP. Do not say that clearing always reduces collateral. If many bilateral trades were uncollateralised, moving them to a CCP increases margin. The exam point is netting scope, concentration and standardisation.

A practice question

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

Under bilateral clearing of OTC derivatives, who bears the credit risk of a trade?

  1. A CCP, which is the counterparty to every trade.Why not: Describes central clearing, not bilateral clearing.
  2. The clearing members only, through a shared default fund.Why not: Describes a CCP structure; bilateral trades have no default fund.
  3. Each party bears the credit risk of its counterparty, mitigated by netting and bilateral collateral agreements. - correct
  4. The trade repository, which guarantees performance on reported trades.Why not: Confuses a repository with a guarantor; a repository records data and guarantees nothing.

In bilateral trading each party faces the other directly, with exposure reduced by netting within the pair and by collateral under an agreement such as a CSA.

A harder one

Dealer A's net values with four counterparties are +30 with B, -20 with C, +10 with D and -5 with E (USD million). Ignoring collateral, A's credit exposure under bilateral clearing with netting agreements, and its net exposure if all trades were novated to one CCP, are respectively:

  1. USD 40 million and USD 15 million - correct
  2. USD 35 million and USD 15 millionWhy not: Offsets the USD 5 million with E against B and D bilaterally, which is not possible.
  3. USD 15 million and USD 40 millionWhy not: Reverses the two cases: bilateral exposure is the larger, gross-of-offset figure.
  4. USD 40 million and USD 65 millionWhy not: Adds absolute values for the CCP case instead of netting them.

Bilaterally, only positive netting-set values are at risk: 30 + 10 = 40. At a CCP, all values net: 30 - 20 + 10 - 5 = 15.

The hardest tier

A dealer's net notional positions by counterparty are +100 with B, -70 with C and +40 with D (USD million). Bilaterally, initial margin is 3% of each counterparty's net notional, with no offset between counterparties. At one CCP, initial margin is 3% of the dealer's total net notional. Moving to the CCP saves initial margin of:

  1. USD 2.1 millionWhy not: Reports the CCP initial margin instead of the saving.
  2. USD 6.3 millionWhy not: Reports the bilateral initial margin instead of the saving.
  3. USD 3.0 millionWhy not: Uses only the largest position (100) for the CCP margin.
  4. USD 4.2 million - correct

Bilateral IM = 3% x (100 + 70 + 40) = 6.3. CCP IM = 3% x (100 - 70 + 40) = 2.1. Saving = 6.3 - 2.1 = USD 4.2 million.

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