Learning Objectives: Explain regulatory initiatives for the OTC derivatives market and their impact on central clearing. Compare margin requirements in centrally cleared and bilateral markets and explain how margin can mitigate risk. Compare netting in bilateral markets vs centrally cleared.
Questions:
24.4.1. Joseph Donald, an officer in the compliance department at a financial institution, is reviewing the firm's adherence to recent regulatory changes in the OTC derivatives market. He is evaluating whether the firm's practices align with the G-20's regulatory initiatives that were established to enhance transparency, reduce systemic risk, and improve financial stability.
Based on the G-20's regulatory initiatives for the OTC derivatives market, identify the incorrect statement about the impact on central clearing.
a. The G-20 mandates that all standardized OTC derivatives must be cleared through Central Counterparties (CCPs) to reduce systemic risk through centralized risk management.
b. Standardized OTC derivatives are required to be traded on exchanges or electronic platforms to ensure full transparency of pricing and counterparty exposure.
c. Derivatives trades must be reported to a trade repository, allowing regulatory bodies to monitor risk exposure and market activity effectively.
d. Central clearing through CCPs is required for all OTC derivatives, including non-standardized and customized derivatives, to simplify the market structure.
24.4.2. Alex, a financial analyst at your company, is tasked with reviewing compliance with margin requirements in both centrally cleared and bilateral markets. With recent regulatory changes and the critical need to manage credit risk effectively, Alex needs to ensure that all trading activities align with the prevailing margin practices.
Select the incorrect statement regarding the comparison of margin requirements in centrally cleared versus bilateral markets and how margin can mitigate risk.
a. Central Counterparties (CCPs) enforce strict margining rules, including the collection of both initial and variation margins daily, along with contributions to a default fund to manage default risk.
b. In bilateral OTC markets, margin requirements can be negotiated based on the credit quality of the counterparties, allowing for bespoke arrangements that may differ significantly between transactions.
c. Margin requirements in centrally cleared markets are typically less strict than in bilateral markets because the presence of a CCP reduces the overall credit risk exposure.
d. Margin helps mitigate risk by ensuring that both parties in a transaction have financial collateral in place to cover potential losses, which is particularly crucial during periods of market volatility.
24.4.3. Morgan, a risk manager, is analyzing a recent shift in trading strategies at her financial institution. Her team is debating whether to continue using bilateral netting for certain non-standardized derivatives or to transition these into a CCP when possible. They are specifically considering the implications of netting on the firm’s overall exposure to counterparty risk.
Based on the scenarios provided, which netting approach results in the lowest exposure for Counterparty A when all trades are eligible for clearing?
a. No netting – Counterparty A maintains separate transactions with Counterparties B and C, resulting in a total exposure of 170.
b. Bilateral netting – Counterparty A nets transactions with B and C, reducing the total exposure to 50.
c. Partial Central Clearing – Counterparty A clears some trades through a CCP, leading to an exposure of 120.
d. Complete Central Clearing – All of Counterparty A's trades are cleared through a CCP, resulting in an exposure of 30.
Answers here:
Questions:
24.4.1. Joseph Donald, an officer in the compliance department at a financial institution, is reviewing the firm's adherence to recent regulatory changes in the OTC derivatives market. He is evaluating whether the firm's practices align with the G-20's regulatory initiatives that were established to enhance transparency, reduce systemic risk, and improve financial stability.
Based on the G-20's regulatory initiatives for the OTC derivatives market, identify the incorrect statement about the impact on central clearing.
a. The G-20 mandates that all standardized OTC derivatives must be cleared through Central Counterparties (CCPs) to reduce systemic risk through centralized risk management.
b. Standardized OTC derivatives are required to be traded on exchanges or electronic platforms to ensure full transparency of pricing and counterparty exposure.
c. Derivatives trades must be reported to a trade repository, allowing regulatory bodies to monitor risk exposure and market activity effectively.
d. Central clearing through CCPs is required for all OTC derivatives, including non-standardized and customized derivatives, to simplify the market structure.
24.4.2. Alex, a financial analyst at your company, is tasked with reviewing compliance with margin requirements in both centrally cleared and bilateral markets. With recent regulatory changes and the critical need to manage credit risk effectively, Alex needs to ensure that all trading activities align with the prevailing margin practices.
Select the incorrect statement regarding the comparison of margin requirements in centrally cleared versus bilateral markets and how margin can mitigate risk.
a. Central Counterparties (CCPs) enforce strict margining rules, including the collection of both initial and variation margins daily, along with contributions to a default fund to manage default risk.
b. In bilateral OTC markets, margin requirements can be negotiated based on the credit quality of the counterparties, allowing for bespoke arrangements that may differ significantly between transactions.
c. Margin requirements in centrally cleared markets are typically less strict than in bilateral markets because the presence of a CCP reduces the overall credit risk exposure.
d. Margin helps mitigate risk by ensuring that both parties in a transaction have financial collateral in place to cover potential losses, which is particularly crucial during periods of market volatility.
24.4.3. Morgan, a risk manager, is analyzing a recent shift in trading strategies at her financial institution. Her team is debating whether to continue using bilateral netting for certain non-standardized derivatives or to transition these into a CCP when possible. They are specifically considering the implications of netting on the firm’s overall exposure to counterparty risk.
Based on the scenarios provided, which netting approach results in the lowest exposure for Counterparty A when all trades are eligible for clearing?
a. No netting – Counterparty A maintains separate transactions with Counterparties B and C, resulting in a total exposure of 170.
b. Bilateral netting – Counterparty A nets transactions with B and C, reducing the total exposure to 50.
c. Partial Central Clearing – Counterparty A clears some trades through a CCP, leading to an exposure of 120.
d. Complete Central Clearing – All of Counterparty A's trades are cleared through a CCP, resulting in an exposure of 30.
Answers here:
