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FRM Part I · FRM Exam Part I · Futures Markets

In an exchange-traded futures market with a clearinghouse, what is the main way the clearinghouse reduces counterparty risk between the long and short parties?

The clearinghouse acts as buyer to every seller and seller to every buyer through novation. Each trader therefore faces the clearinghouse instead of the original counterparty, and margining plus default resources limit the loss from any single member default.

  1. AIt becomes the buyer to every seller and the seller to every buyer, so each party faces the clearinghouse rather than each otherCorrect
  2. BIt guarantees the profit of every trader by pooling all gains into a single fund
  3. CIt sets futures prices so that no trader can ever lose more than the initial margin
  4. DIt requires all contracts to be settled by physical delivery

Explanation

Through novation, the clearinghouse steps between the original counterparties, becoming the counterparty to both. Each party then depends on the clearinghouse's integrity, which is supported by margining and a default fund. It does not guarantee profits, fix prices or force physical delivery.

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