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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank's risk committee is reviewing why regulators pushed standardized OTC derivatives toward central clearing after the 2008 crisis. Which of the following best describes the principal way a central counterparty (CCP) reduces systemic counterparty risk for its clearing members?

A CCP steps between the original counterparties through novation, becoming buyer to every seller and seller to every buyer. This allows multilateral netting and uses margin and a default fund to absorb losses, reducing bilateral counterparty risk without removing market risk.

  1. AIt guarantees that every derivative will rise in value, eliminating market risk
  2. BIt becomes the buyer to every seller and seller to every buyer (novation), enabling multilateral netting and mutualized loss absorptionCorrect
  3. CIt removes the need for any margin because the CCP is backed by the central bank
  4. DIt converts all bilateral exposures into unsecured claims on the largest dealer bank

Explanation

Through novation the CCP interposes itself between original parties, so exposures are netted across all members and managed via margin and a default fund. Margin is still required, and the CCP does not eliminate market risk. Option 3 is wrong because CCPs collect initial and variation margin regardless.

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