Account for what central clearing means for wrong-way risk.
The idea
Central clearing changes the shape of wrong-way risk without removing it. A cleared trade is novated to the CCP, so a specific link between a trade and a correlated seller is replaced by exposure to a margined CCP. Daily variation margin, initial margin and multilateral netting greatly reduce the exposure that can build up. What remains is exposure to the CCP and its default fund. That depends on other members defaulting in stressed markets, on procyclical margin that drains liquidity in a crisis, on concentration in large members, and on wrong-way risk in the collateral posted, such as a member posting its home sovereign's bonds. CCPs manage this with haircuts, concentration limits and restrictions on trades with obvious dependence. Exam point: clearing mitigates wrong-way risk, it does not eliminate it.
A practice question
Which features of central clearing help reduce the wrong-way risk of bilateral derivatives?
- Daily variation margin, initial margin and multilateral netting. - correct
- Longer margin periods of risk and higher thresholds for large clients.Why not: Both would increase exposure rather than reduce it.
- Pricing with a larger CVA charge on each trade, paid by the client to the CCP.Why not: A CVA charge prices the risk but is not a feature of clearing that reduces it.
- Replacement of collateral with unsecured credit lines for creditworthy members.Why not: Removes collateral, the main risk mitigant.
Daily margining limits exposure build-up, initial margin covers moves during close-out, and multilateral netting reduces the gross exposures, all of which cut the exposure that can build while a counterparty weakens.
A harder one
After a bank clears a CDS portfolio through a CCP, which wrong-way risk remains?
- Risk that the CCP will refuse to accept margin in cash.Why not: Not a wrong-way risk; it is an eligibility issue.
- None, because the CCP's own default is excluded by regulation.Why not: Regulation reduces but does not exclude CCP failure.
- Exposure to the CCP and its default fund, which depends on other members' defaults in the same stressed markets. - correct
- The wrong-way risk on the original seller of protection, unchanged, because the trade is still with that seller.Why not: Novation replaces the original seller with the CCP.
Novation removes the original counterparty but leaves risk from margin shortfall, default-fund contributions and the CCP's own resilience, all of which correlate with market stress.
The hardest tier
A risk manager argues that clearing all derivatives would remove wrong-way risk because the CCP is default-free. Which evaluation is most accurate?
- It is fully right: a CCP is backed by the central bank in every jurisdiction and cannot fail, so no dependence remains.Why not: Central bank backing is not a general feature, and CCPs can in principle fail.
- Partly right: bilateral wrong-way risk falls, but the CCP and default fund stay exposed to procyclical margin. - correct
- It is wrong: clearing moves all of the wrong-way risk to the client, which increases it because margin is unfunded.Why not: Margining generally reduces the dependence for the client.
- It is wrong: clearing only reduces right-way risk and has no effect on exposures that have wrong-way features.Why not: Clearing mitigates exposure in both cases; it is not selective in this way.
Central clearing reduces but does not eliminate wrong-way risk; it changes its form. Concentration, margin procyclicality, collateral quality and member contagion remain.
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.
- Weigh up how wrong-way risk bears on CCPs (central counterparties).
- Outline the methods for modelling wrong-way risk: hazard rate, structural, parametric and jump approaches.