Nicole Seaman

Director of CFA & FRM Operations
Staff member
Learning Objectives: Compare bilateral and central clearing. Compare initial margin and default fund requirements for clearing members in relation to loss coverage, cost of clearing, and moral hazard. Describe the advantages and disadvantages of central clearing.

24.31.1. In the context of OTC derivative markets, which of the following statements BEST describes the key difference between bilaterally and centrally-cleared transactions?

a. Bilaterally-cleared transactions are subject to stricter regulatory oversight compared to centrally-cleared transactions.
b. Centrally-cleared transactions typically involve higher counterparty risk compared to bilaterally-cleared transactions.
c. Centrally-cleared transactions offer greater transparency and operational efficiency compared to bilaterally-cleared transactions.
d. Bilaterally-cleared transactions have standardized margin requirements, while centrally-cleared transactions have negotiated margin requirements.

24.31.2. ClearCo, a central counterparty (CCP), is reviewing its risk management framework to ensure adequate protection against potential losses while minimizing the cost of clearing for its members.

The CCP is considering two proposals:
  1. Proposal A: Increase initial margin requirements by 20% and maintain the current default fund contributions.
  2. Proposal B: Keep initial margin requirements unchanged and increase default fund contributions by 30%.
Given the following information:
  • Current initial margin posted by all members: $500 million
  • Current default fund contributions by all members: $200 million
  • Historical data suggests that a 20% increase in initial margin would reduce the probability of losses exceeding the margin by 30%.
  • The CCP's own capital (skin-in-the-game) is $100 million.
Which proposal would be most effective in reducing the CCP's exposure to losses beyond the margin while minimizing the cost of clearing for members?

a. Proposal A because it reduces the probability of losses exceeding the margin without increasing the total cost of clearing for members.
b. Proposal A because it increases the total financial resources available to cover losses by $100 million.
c. Proposal B because it increases the total financial resources available to cover losses by $60 million without increasing the margin requirements.
d. Proposal B, because it reduces the moral hazard for members by requiring them to contribute more to the default fund.

24.31.3. Total Clear, a central counterparty (CCP), is considering expanding its clearing services to include a new class of derivatives. The CCP's risk management team has analyzed the potential impact of this expansion and presented the following findings:
  • The new derivatives class has an estimated notional value of $500 billion.
  • Clearing the new derivatives is expected to reduce counterparty risk exposures by 70% compared to the current bilateral market.
  • The CCP will need to invest $50 million in infrastructure upgrades and $20 million in additional staffing to support the new clearing service.
  • Clearing members will be required to post an additional $10 billion in initial margin and contribute $5 billion to the default fund.
  • The increased transparency and liquidity in the cleared market could potentially reduce trading costs by 5%.
Which of the following BEST describes the main advantage and disadvantage of expanding the CCP's clearing services to include the new derivatives class?

a. Advantage: Reduced counterparty risk exposures. Disadvantage: Increased costs for clearing members.
b. Advantage: Reduced trading costs for market participants. Disadvantage: High investment costs for the CCP.
c. Advantage: Increased market transparency and liquidity. Disadvantage: Higher systemic risk due to concentration of risk in the CCP.
d. Advantage: Increased default fund contributions from members. Disadvantage: Reduced counterparty risk exposures.

Answers here: