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FRM Part I · FRM Exam Part I · Central Clearing

Which statement best describes a key weakness of bilateral collateralization in the OTC derivatives market that contributed to the case for central clearing reform after 2008?

The weakness was opacity and interconnectedness. Bilateral exposures were spread across many counterparties without central visibility, so the default of a large dealer could produce uncertain, cascading losses. Bilateral netting and collateral existed, but they did not give the system transparency or a way to contain contagion.

  1. ACollateral agreements are always one-way, so dealers never post margin
  2. BBilateral netting only applies within a single product class, preventing any netting across trades with a counterparty
  3. CCollateral is exchanged only after the margin period of risk, so initial margin is never required
  4. DOpaque and uncoordinated bilateral exposures meant that a dealer's default could create uncertain, interconnected losses across many counterpartiesCorrect

Explanation

The bilateral web left counterparties unable to see each other's total exposures and created interconnectedness, so a major dealer failure could spread losses. The claim that agreements are always one-way is false, as many CSAs are two-way. Netting can span products under a master agreement. Initial margin was a feature of some bilateral arrangements, so it was not absent in every case.

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