Outline the strengths and weaknesses of central clearing.
The idea
Central clearing has four main strengths. Multilateral netting and compression reduce exposures and gross notional. Daily variation margin stops losses from accumulating. Standardised rules, transparency and a coordinated default management process limit contagion. Mutualised resources can absorb a large member's failure. It also has weaknesses. Risk concentrates in a few CCPs that become too big to fail, so recovery and resolution planning is needed. Margin models can be procyclical, calling more collateral in stress when liquidity is scarcest. Mutualisation creates moral hazard. Netting is lost when trades are split across CCPs. Only standardised products can be cleared, and competition between CCPs can pressure margin standards. Do not claim clearing eliminates risk. The exam point is to match the weakness named in a scenario to its source: concentration, procyclicality, moral hazard or fragmentation.
A practice question
Which is a recognised strength of central clearing?
- Removal of any need for collateral from members.Why not: Clearing requires margin; it does not remove collateral needs.
- Lower collateral demands in every case.Why not: Collateral demands can rise where trades were previously uncollateralised.
- Multilateral netting and a standardised, coordinated default management process. - correct
- Elimination of liquidity risk for members.Why not: Clearing creates liquidity demands through margin calls.
Netting across counterparties and a single, rules-based default process are the main benefits. Clearing does not eliminate collateral needs or liquidity risk.
A harder one
A member's initial margin at a CCP is USD 8 million at 0.6% daily volatility. The CCP's model scales margin in proportion to volatility. Volatility jumps to 1.5%. The additional margin call is closest to:
- USD 12.0 million - correct
- USD 20.0 millionWhy not: Reports the new margin level instead of the additional call.
- USD 7.2 millionWhy not: Multiplies the old margin by the 0.9 percentage point change in volatility.
- USD 4.8 millionWhy not: Multiplies the old margin by the old volatility, 0.6.
New IM = 8 x (1.5/0.6) = 20. Additional call = 20 - 8 = USD 12.0 million, an example of procyclicality: more collateral is demanded when stress is highest.
The hardest tier
A dealer's net swap positions are +40 at CCP X (owed to the dealer) and -30 at CCP Y (owed by the dealer). Had both been cleared at a single CCP, the positions would have netted. Ignoring collateral, by how much does fragmentation across two CCPs increase the dealer's credit exposure to CCPs?
- USD 10 millionWhy not: Reports the single-CCP net exposure instead of the increase.
- USD 40 millionWhy not: Reports the exposure to CCP X instead of the increase over the netted position.
- USD 30 million - correct
- USD 70 millionWhy not: Adds the absolute values of the two positions.
At two CCPs, exposure is 40 (CCP Y gives no offset). At one CCP, it is 40 - 30 = 10. The increase is USD 30 million.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Central Clearing
- State what a central counterparty (CCP) is and outline how central clearing works.
- Account for novation as it applies in central clearing.
- Explain multilateral offset, compression and netting, illustrating each with a case.
- Outline how margin and default funds are applied and estimated under central clearing.
- Discuss the exposures a CCP bears and how it controls them.
- Show a loss waterfall at work through illustrations.
- Account for the ways losses are absorbed and the default of one or more CCP members is handled.
- Contrast clearing done bilaterally with clearing done through a central counterparty.
- Contrast the initial margin and default fund contributions asked of clearing members, with respect to how losses are covered, what clearing costs and the moral hazard created.