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FRM Part II · FRM Exam Part II · Central Clearing

A risk manager reviews a bilateral OTC portfolio and notes that two dealers are each large, highly interconnected counterparties to many other firms. Which concern about the traditional bilateral OTC market structure does this most directly illustrate?

The scenario shows that concentrated, opaque networks of bilateral exposures can transmit a major dealer's failure to its many counterparties. Interconnectedness without transparency or multilateral netting creates contagion risk, a key motivation for pushing standardised OTC derivatives toward central clearing.

  1. AConcentrated, opaque networks of bilateral exposures can propagate a dealer's failure through counterpartiesCorrect
  2. BStandardised contracts make exposures easier for regulators to observe
  3. CDaily variation margin eliminates all counterparty credit risk
  4. DMultilateral netting reduces gross exposures across all dealers

Explanation

In bilateral markets, exposures form a web with limited transparency, so failure of a major dealer can spread losses (a too-connected-to-fail concern). Standardisation, multilateral netting and full margin describe features of central clearing or mitigation, not the weakness described.

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