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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

Which statement best describes how the 'clearing house' feature of exchanges reduces risk compared with an uncleared OTC market?

The clearing house becomes the buyer to every seller and the seller to every buyer, so each participant faces the clearing house instead of the original counterparty. Margin and default resources support this, but market risk remains and margin is still required.

  1. AThe clearing house becomes the counterparty to each side of a trade, so participants face the clearing house rather than each otherCorrect
  2. BIt eliminates all market risk by fixing prices at trade inception
  3. CIt requires all trades to be settled by physical delivery
  4. DIt removes the need for any margin because members are pre-approved

Explanation

Through novation, the clearing house interposes itself as buyer to every seller and seller to every buyer, with margin and default funds supporting this. It does not remove market risk, mandate physical delivery, or eliminate margin.

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