Clearinghouse overconfidence

[singhr15]

Hi David.....Can you please explain why option d is is not correct answer ?

Which is of true of a central counterparty (CCP)?

a. By requiring collateral, the CCP effectively eliminates the need for netting and margin
b. End users of derivatives that trade on the central clearinghouse must become members of the CCP
c. Via novation, The CCP "steps in" between buyer and seller and becomes the counterparty to each, replacing one contract with two
d. The essential, required feature of a CCP is exchange-trading which provides price transparency

 

[Dr. Jayanthi Sankaran]

Hi @singhr15,

Traditionally, OTC derivative transactions have been bilaterally settled between two counterparties. However, this involves credit risk. The importance of CCP's came into existence after the 2008 Lehman Brother's bankruptcy crisis. Lehman had large positions in instruments created from sub-prime mortgages. However, the sub-prime market tanked causing its lenders to force it into bankruptcy. Since Lehman was very active in the OTC derivatives markets, it had over a million transactions outstanding with over 8,000 different counterparties. The collateral posted by these counterparties were used by the investment bank for various purposes. Figuring out what was owed to whom became a nightmare, overnight!

In these OTC derivatives markets, historically, transactions have been conducted bilaterally without an exchange. In order to reduce credit risk, the OTC markets have borrowed some ideas from the exchange-traded markets. CCP's are clearing houses for standardized OTC transactions. They take on the credit risk of the counterparties. The members of the CCP's have to post initial margin and variation margin.

The CCP acts as a clearing house to several members at a time. However, they still deal with OTC derivative transactions, and are not therefore like traditional exchanges such as the NYSE, NASDAQ etc. which deal with highly liquid security transactions with price transparency. There have been questions in the financial literature as to the risk of default of the CCP itself, and provisions/legislation for their protection. Just some thoughts.....

Thanks
Jayanthi

 

[Nicole Seaman]

Hello @singhr15

Please make sure to ask any questions about the practice questions in their original forum thread. The links to the forum threads are posted on the answers page in the practice question sets. This ensures that duplicate questions are not being asked, it helps others who may have the same questions and it keeps the forum organized. For reference, the link to this forum thread is here: https://forum.bionicturtle.com/threads/p2-t9-500-clearinghouse-advantages.8792/#post-36770.

Thank you,

Nicole

 

[David Harper CFA FRM]

Hi @singhr15

Choice (D) is tempting, but as @Jayanthi Sankaran explains Choice (C) is much better because it speaks to the essential role of a CCP in the mitigation of counterparty credit risk. Choice (D) deliberately includes "essential, required" to further make it a bad answer.

Don't get me wrong. Price transparency is an advantage. But it's not the crux. Here is a great blog--old but good--which helps if only in how he clarifies the distinction between counterparty risk mitigation (the essential function of a CCP) and price transparency, see http://economicsofcontempt.blogspot.com/2010/04/exchanges-vs-clearinghouses-this-is.html
e.g.,

A clearing requirement is a requirement that all eligible derivatives be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current OTC derivatives markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in OTC derivatives; an exchange-trading requirement is not.

In sum, virtually all of the systemic risk mitigation in derivatives reform — reduced counterparty risk, the huge increase in transparency, the reduced complexity, regulatory access to the necessary data, etc. — comes from the clearing requirement.

An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as "boards of trade"). It is important to remember that an exchange-trading requirement has nothing to do with clearing — they are completely separate issues. People tend to think of exchanges as synonymous with clearinghouses because, at least in the US, the big exchanges own their own "captive clearinghouses," so most exchange-traded derivatives are also cleared through the exchange's clearinghouse. But they are two separate functions entirely.

And, just to emphasize that you have a great point (i.e., that price transparency is an advantage of the CCP), here is Gregory:

12.2.1 Advantages
A CCP performs many functions and therefore offers a number of distinct advantages compared to bilateral OTC markets. Some of the potential advantages of central clearing are:
...

• Price transparency and fungibility: CCPs create price transparency since cleared products are subject to variation margin requirements based on mark-to-market prices determined by the CCP. Such price transparency reduces disputes about margin requirements. Fungibility makes trading out of positions through a CCP easy and due to netting benefits, unlike bilateral markets, can be done with any other counterparty."

And, finally, from the source assigned reading (Clearinghouse Overconfidence) on What a Clearinghouse Can Do:

"A. Standardizing and Price Transparency: Many financial markets are opaque. An occasional trader is likely unaware of the average price for similar transactions and, uninformed, can overpay. A repeat trader knows more and can better assess if an offered price is too low or too high. This experienced trader turns its knowledge of the market into a stream of value. In such informationally opaque markets, spreads widen between the occasional trader’s buying price and another occasional trader’s selling price, with experienced, knowledgeable traders profiting from the wide spreads.
In contrast, a clearinghouse can make pricing public. It uses standardized financial products and can report trades regularly. Standardization facilitates price comparison for occasional traders, inducing regulars to sharpen their pricing, narrowing the spread between what they pay and what they charge for the same deal. Because a clearinghouse with public pricing gives outsiders the same information as the regular traders, spreads narrow. Trading becomes less
expensive."

I hope that at least defends why I think (C) is, at a minimum, better than (D), although I had intended the use of "necessary, required" to render (D) as strictly false. Thanks!