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FRM Part II · FRM Exam Part II · Central Clearing

A regional bank clears a large portfolio of interest rate swaps through a CCP. A risk manager lists the main ways a CCP reduces counterparty risk relative to uncollateralised bilateral trading. Which of the following is a core mechanism by which a CCP does this?

A CCP reduces counterparty risk by stepping in as the legal counterparty to both sides of each trade through novation and by collecting initial and variation margin. It does not absorb market risk, waive collateral, or become immune to failure.

  1. AIt guarantees every trade's market risk by absorbing all price movements for members
  2. BIt becomes the legal counterparty to both sides of each trade and collects initial and variation marginCorrect
  3. CIt eliminates the need for members to post any collateral after the first trading day
  4. DIt removes all default risk by being exempt from insolvency

Explanation

Through novation the CCP becomes buyer to every seller and seller to every buyer, and it manages exposure with variation margin (daily mark-to-market) and initial margin. It does not absorb market risk, does not waive collateral, and can itself fail.

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