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FRM Part II · FRM Exam Part II · Solvency, Liquidity and Other Regulation After the Global Financial Crisis

A bank enters a standardized interest rate swap that is subject to mandatory clearing. Compared with leaving it uncleared, which outcome is the most likely consequence for the bank's counterparty risk and funding?

Clearing replaces bilateral exposure with exposure to the central counterparty, secured by initial and variation margin and default fund contributions. Counterparty risk is reduced and mutualized rather than eliminated, and the bank's need for high-quality liquid collateral rises, creating additional liquidity and funding demands.

  1. ABilateral credit exposure is replaced by exposure to the CCP, with initial and variation margin required, which increases demand for high-quality liquid collateralCorrect
  2. BCounterparty risk is eliminated entirely, so no margin is required
  3. CThe bank pays no margin because the CCP guarantees performance for free
  4. DExposure is netted only against the original counterparty, with no benefit across other cleared trades

Explanation

Novation to a CCP swaps bilateral exposure for CCP exposure, backed by initial margin, variation margin and default fund contributions. This raises collateral and liquidity demands. Risk is not eliminated, margin is mandatory, and the CCP nets across a member's cleared trades, so the other options are wrong.

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