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FRM Part I · FRM Exam Part I · Central Clearing

Which feature of the bilateral OTC derivatives market, as opposed to central clearing through a CCP, is most accurate?

In bilateral OTC markets, contract terms can be tailored and each party bears the credit risk of its own counterparty, mitigated through netting and collateral agreements. Default funds, novation and uniform margining are features of central clearing, not of bilateral trading.

  1. ACounterparty credit risk is mutualized across all clearing members through a default fund
  2. BTerms such as notional, maturity and collateral can be customized, and each party bears the credit risk of its direct counterpartyCorrect
  3. CStandardized contracts are novated so that the CCP becomes the buyer to every seller
  4. DDaily margining is mandatory and identical for all participants

Explanation

In bilateral markets, trades are customized and each party retains exposure to the other, managed through netting and CSAs. Mutualization via a default fund and novation to a CCP are features of central clearing. Margin terms in bilateral trades are negotiated rather than identical.

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