Weigh up how wrong-way risk bears on CCPs (central counterparties).
The idea
Wrong-way risk matters for a central counterparty because a clearing member is more likely to default in the same stressed markets in which its positions lose value, so the CCP's loss and the default arrive together. The defences are daily variation margin, initial margin sized for stressed moves over the close-out period, and a default fund mutualised among members. Wrong-way risk shows up in several ways. A member may clear trades that pay out when it fails, such as CDS on itself or its affiliates, which CCPs restrict or margin heavily. Margin increases in a crisis drain members' liquidity. Liquidating a large, concentrated portfolio is costly in a stressed market. The surviving members that fund the default fund are weakened by the same event.
A practice question
Where does wrong-way risk mainly arise for a central counterparty (CCP)?
- In members defaulting in the same stressed markets where their positions lose value. - correct
- In the CCP's own recovery rate, which is fixed by regulation at 40% for every cleared product and member.Why not: No fixed regulatory recovery rate applies to a CCP; the risk concerns the dependence of member default and market moves.
- In the CCP's bilateral netting agreements with each client, which are uncollateralised.Why not: A CCP's exposures are collateralised and novated; this is not where the dependence arises.
- In clearing members' trading profits, which tend to rise with volatility and leave the CCP exposed to them.Why not: Profits do not create a CCP exposure; losses on defaulted members' positions do.
A CCP is exposed if a clearing member defaults while its portfolio has lost value and has to be closed out. Member default tends to occur in the same stressed markets that produce those losses: wrong-way risk.
A harder one
A CCP clears credit default swaps. A clearing member sells protection on a reference entity that is the member itself or an affiliate. Which CCP policy best addresses this specific wrong-way risk?
- Valuing the trade at zero exposure because a defaulted reference entity cannot be a buyer of protection.Why not: Misstates exposure; on default of the reference entity the CCP must pay the buyer protection.
- Accepting the trade with a lower margin because the member knows the reference entity best.Why not: Rewards the position with lower margin even though the loss will occur in the member's default.
- Restricting or prohibiting such trades, or requiring significantly higher initial margin for them. - correct
- Requiring the trade to be cleared through another CCP to reduce concentration.Why not: Moving the position elsewhere does not remove the dependence between the member and the reference entity.
A member selling protection on itself will fail exactly when the contract pays out, so the CCP's loss is both certain and large. CCPs limit or heavily margin such trades.
The hardest tier
A clearing member holds a very large, concentrated position in one asset class and defaults. Which statement best illustrates how wrong-way risk affects the CCP's close-out?
- The CCP can always close out at the last mid price, because novation guarantees prices.Why not: Novation transfers the contract to the CCP but does not guarantee an exit price.
- Wrong-way risk applies only to initial margin and not to the cost of closing out positions.Why not: The liquidation cost in stress is a main channel through which wrong-way risk hits a CCP.
- The defaulter's portfolio is easier to liquidate when it is large, since big positions attract more bidders.Why not: A large concentrated position is harder, not easier, to liquidate in stress.
- The CCP must auction a large portfolio in the stressed market behind the default, so costs may exceed the margin model. - correct
Initial margin is sized from normal-period price moves and liquidity. The default of a large member and the market stress that triggered it occur together, so the close-out can be worse than modelled.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in CVA
- Account for why pricing counterparty risk is wanted and what makes it hard.
- Explain the concept of CVA, the adjustment made to a derivative's value for credit risk.
- Work out CVA, plus its expression as a spread, in the simple setting where wrong-way risk, netting and collateralization are all absent.
- Judge how shifts in credit spread and recovery rate assumptions affect CVA.
- Describe bilateral CVA (BCVA) together with debt value adjustment (DVA).
- Account for how unilateral CVA (UCVA) differs from BCVA, and how unilateral DVA (UDVA) differs from BCVA.
- Work out the DVA and the BCVA, then restate BCVA as a spread.
- Explain the way netting enters the computation of CVA.
- State what incremental CVA and marginal CVA are, compute them and show how CVA is turned into a running spread.
- Show how the CVA figure changes once collateralization is built in, paying attention to initial margins, thresholds and the margin period of risk.
- Spell out wrong-way risk and set right-way risk against it.
- Identify illustrations of right-way risk as well as wrong-way risk.
- Review how collateral bears on wrong-way risk.
- Identify cases that illustrate collateral exposed to wrong-way risk.
- Outline the methods for modelling wrong-way risk: hazard rate, structural, parametric and jump approaches.
- Account for what central clearing means for wrong-way risk.