Licensed to at [email protected]. Downloaded February 19, 2022.

The information provided in this document is intended solely for you. Please do not freely distribute.

P1.T3. Financial Markets and Products

Bionic Turtle FRM Practice Questions

Chapter 6. Central Clearing

By David Harper, CFA FRM CIPM

www.bionicturtle.com
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Chapter 6. Central Clearing

P1.T3.21.11. OVER-THE-COUNTER (OTC) CENTRAL COUNTERPARTY (CCP) .............................. 3

P1.T3.603. BASIC PRINCIPLES OF CENTRAL CLEARING ............................................................... 6
P1.T3.604. IMPACT OF CENTRAL CLEARING ............................................................................... 8
P1.T3.605. RISKS FACED BY CENTRAL COUNTERPARTIES (CCPS) .............................................11

2
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Chapter 6. Central Clearing

P1.T3.21.11. Over-the-counter (OTC) central counterparty (CCP)
P1.T3.603. Basic principles of central clearing
P1.T3.604. Impact of central clearing
P1.T3.605. Risks faced by central counterparties (CCPs)

P1.T3.21.11. Over-the-counter (OTC) central counterparty (CCP)

Learning objectives: Provide examples of the mechanics of a central counterparty (CCP).
Describe the role of CCPs and distinguish between bilateral and centralized clearing ...
Identify and explain the types of risks faced by CCPs. Identify and distinguish between
the risks to clearing members and to non-members

21.11.1. In comparison to a bilateral transaction, which of the following statements is TRUE as

an advantage of a central counterparty (CCP)?

a) It is easier to exit a CCP position

b) There are no margin requirements for a CCP position
c) The CCP transactions legally mutate into uncleared transactions which reduces
systemic risk
d) The exposures on a CCP are more concentrated and therefore their credit risk is better
understood than bilateral transactions

21.11.2. Derivatives can be cleared through a central counterparty (CCP) or they can be cleared
bilaterally; i.e., uncleared transactions are cleared bilaterally. If the derivatives are cleared
through a CCP, they can be either exchange-traded or over-the-market (OTC). In this way, we
distinguish between the exchange and the clearinghouse (which may be owned by an
exchange). While exchanges operate CCPs, we can also refer to the emergent OTC CCPs. In
regard to central counterparties (CCPs), which of the following statements is TRUE?

a) Banks are easier to regulate than both OTC CCP and exchange CCP
b) An exchange CCP is more dependent on valuation models than an OTC CCP
c) CCP member defaults are negatively correlated such that CCPs are counter-cyclical
d) In the cleared market, CCPs want initial margin that covers a 5-day 99.0% price value at
risk (VaR)

3
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

21.11.3. Acme FinCorp (A), Bitarion Inc (B), and Congrezo LLC (C) have entered into many
derivative transactions. When transactions between A and B are netted, the net value to A is -
12; the net value to B is +12. When transactions between B and C are netted, the net value to B
is -9; the net value to C is +9. When transactions between A and C are netted, the net value to
A is +17; the net value to C is -17. Symbolically, in the direction of positive exposure:
 A -> B = +12
 B -> C = +9
 C -> A = +17
The total credit exposure of all three parties is equal to 12 + 9 + 17 = 38. Suppose that all
transactions are cleared through a central counterparty (CCP) rather than bilaterally. After
clearing through the CCP, what is the total credit exposure of all three (A + B + C) parties?

a) Zero
b) +2
c) +8
d) +27

4
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Answers:

21.11.1. A. True: It is easier to exit a CCP position

In regard to (B), (C) and (D) each is false. Instead,

 CCPs have initial and variation margin requirements
 Bilateral trades are more concentrated and "better understood," according to GARP.

21.11.2. D. TRUE: In the cleared market, CCPs want initial margin that covers a 5-day
99.0% price value at risk (VaR)

In regard to (A), (B), and (C), each is FALSE. Instead, the following are true statements:
 CCPs are easier to regulate than banks
 An OTC CCP is more dependent than and an exchange CCP on valuation models
 CCP member defaults are positively correlated and CCPs are pro-cyclical

21.11.3. C. True: +8

After CCP clearing:

 For A, +17 - 12 = +5 exposure to CCP
 For B, +12 - 9 = +3 exposure to CCP
 For C, +9 - 17 = -8 with max(0, -8) equals zero exposure to CCP

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-21-11-over-the-

counter-otc-central-counterparty-ccp.24083/

5
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

P1.T3.603. Basic principles of central clearing

Learning Objectives: Provide examples of the mechanics of a central counterparty (CCP).
Describe advantages and disadvantages of central clearing of OTC derivatives.

603.1. Which is TRUE of clearing?

a) By definition, clearing is central

b) Clearing occurs between execution and settlement
c) Clearing refers to the exchange of securities and/or cash and fulfillment of legal
obligations
d) On most exchanges, clearing is an intraday dynamic with an occasional maximum time
horizon of several days

603.2. Novation, which is critical to central clearing, is the legal process whereby the central
counterparty (CCP) positions itself between the buyer and seller by replacing a contract with
one or more other contracts. After novation, which risk(s) does the CCP bear?

a) Market risk
b) Conditional market risk
c) Novation implies that the CCP inherits only market risk
d) Novation ensures that the CCP is immunized from credit and market risk

603.3. According to Gregory,1 which of the following is a potential DISADVANTAGE of a central

counterparty (CCP)?

a) Bifurcations
b) Market liquidity
c) Loss mutualization
d) Default management

1
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives
(New York: John Wiley & Sons, 2014)

6
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Answers:

603.1. B. TRUE: Clearing occurs between execution and settlement

At a high-level, there are three steps in a transaction: execution, clearing, and settlement.
Clearing occurs between execution and settlement. Clearing can be bilateral or central.

603.2. B. Conditional market risk

Contract novation is an essential concept in central clearing. Novation is the legal process
wherein the CCP interposes between the buyer and seller: their single contract is replaced by
two contracts. Each of the new contracts has the CCP as a counterparty. See
https://en.wikipedia.org/wiki/Novation. By the legal act of novation, the CCP creates a so-called
matched book which bears no market risk. However, in the event of a default by one of the
original counterparties, the CCP will bear conditional market risk.

603.3. A. Bifurcations. In regard to (B), (C) and (D), each of these are advantages cited by
Gregory.

According to Gregory,2 the advantages of CCPs include:

 Transparency
 Offsetting
 Loss mutualization
 Legal and operational efficiency
 Liquidity
 Default management
The disadvantages include:
 Moral hazard
 Adverse selection
 Bifurcations: The CCPs will only clear standardized instruments (e.g., plain vanilla
interest rate swaps) but they cannot clear exotic instruments. Gregory's concern about
bifurcation has multiple aspects but the most relevant here is portfolio bifurcation: this is
when a member's portfolio contains some positions that can clear via the CCP (because
they are standard; e.g., vanilla swaps) and some positions that cannot (i.e., exotic). This
is common for a market: the client wants an exotic position and the market maker
hedges with vanilla instruments, so the hedge is in the same portfolio. Bifurcation here is
the problem that the exotic positions are clearing outside the CCP, with different
collateral mechanisms etc.
 Procyclicality

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-603-basic-principles-

of-central-clearing-gregory.9305/

2
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives
(New York: John Wiley & Sons, 2014)

7
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

P1.T3.604. Impact of central clearing

Learning Objectives: Compare margin requirements in centrally cleared and bilateral
markets, and explain how margin can mitigate risk. Compare and contrast bilateral
markets to the use of novation and netting. Assess the impact of central clearing on the
broader financial markets.

604.1. A central counterparty (CCP) is evaluating a new derivative instrument as a possible

candidate for trading on its central clearing platform. The following four features are associated
with the candidate derivative instrument. Which of the following is MOST LIKELY to render the
instrument incompatible with central clearing?

a) The candidate derivative instrument requires heterogeneous (ie, non-standard) legal

terms such that each contract is unique
b) The candidate derivative instrument is simple (ie, not complex) however valuation
models are quite sensitive to input assumptions
c) Several of the counterparties, who are interested to trade the candidate derivative
instrument, are not currently members of the CCP
d) The candidate derivative instrument has an historical price volatility that is significantly
above average, although volume has been deep

604.2. To the right, is Gregory's illustration of a centrally clearing market [Gregory Figure 3.6]:3

About this market, each of the following is

true EXCEPT which is false:

a) The dotted lines represent non-cleared bilateral

trades between members ("D" for dealers)
b) Non-clearing member (aka, "C" for clients) will
contribute to the CCP default fund but will not be
required to post margin
c) Non-clearing members (aka, "C" for clients) are
likely to have relationships with more than one
clearing member ("D" for dealers)
d) Non-clearing members (aka, "C" for clients) can
clear through a member ("D" for dealer) vis a
principal-to-principal or agency method

3
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives
(New York: John Wiley & Sons, 2014)

8
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

604.3. Each of the following arguments about the future of central counterparties (CCPs) is true,
according to Gregory,4 except which is FALSE?

a) CCP disadvantages include vulnerability to moral hazard and adverse selection, and the
possibility of pro-cyclical effects
b) It seems likely that there will be a relatively large number of CCPs due to bifurcation on
two levels: regional and product
c) CCPs are unlikely to fail, due to margins, but if a CCP fails, a redeeming quality is that
its bailout should be relatively simple
d) In accordance with a sort of "conservation of risk" principal, CCP will not so much reduce
counterparty risk as transform it into different forms

4
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives
(New York: John Wiley & Sons, 2014)

9
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Answers:

604.1. A. The candidate derivative instrument requires heterogeneous (ie, non-standard)

legal terms such that each contract is unique. In order to centrally clear a transaction, there
are three important conditions: standardization, simplicity (i.e., lack of complexity), and liquidity.
Unique legal terms render central clearing difficult.

In regard to (B), (C), and (D), none are inherently problematic.

604.2. B. Should be instead: Non-clearing member (aka, "C" for clients) will post margin
but will not be required to contribute to the CCP default fund

In regard to (A), (C) and (D), each is TRUE.

604.3. C. is false. Gregory says that CCPs can fail and the bailout of a CCP could be a
more complex and sizable task than even the bailouts of banks and financial institutions
such as Bear Stearns and AIG.

In regard to (A), (B) and (D), each is TRUE.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-604-impact-of-

central-clearing-gregory.9313/

10
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

P1.T3.605. Risks faced by central counterparties (CCPs)

Learning Objectives: Identify and explain the types of risks faced by CCPs. Identify and
distinguish between the risks to clearing members as well as non-members.

605.1. To which risk are central counterparties (CCPs) MOST exposed when they require
margin--especially initial margin because initial margin generally imposes linearity--such that
problems can arise "with respect to volatility, tail risk, complex dependencies and wrong-way
risk"?

a) Legal risk
b) Model risk
c) Default risk
d) Liquidity risk

605.2. Each of the following is a risk faced by central counterparties (CCPs) EXCEPT which is
not?

a) Reputational risk associated with remedying a clearing member default

b) Hindsight bias risk implied by increased transparency of network interconnectedness
c) Liquidity risk due to variation margin, investment of financial resources, and liquidity
support
d) Knock-on effects ensuing from the default of a clearing member including failed auctions
and resignations

605.3. Each of the following is a lesson learned from prior central counterparty (CCP) failures
EXCEPT which is not?

a) Operational risk must be controlled as much as possible

b) Variation margins should be recalculated frequently and collected promptly
c) Excessive reliance on external liquidity tends to promote adverse selection by bad
agents
d) Initial margin and default funds should be resilient to large negative asset shocks or
gaps

11
Licensed to at [email protected]. Downloaded February 19, 2022.
The information provided in this document is intended solely for you. Please do not freely distribute.

Answers:

605.1. B. Model risk

The prices of exchange-traded products can be directly observed (and further their volatility can
be accurately measured), but OTC derivative prices are not directly observed. Consequently,
valuation models are needed to mark products for the purpose of variation margin. CCPs are
exposed to model risk, especially in regard to their setting of initial margin.

605.2. B. False, nonsensical. Hindsight bias is the natural tendency to see past events as
more predictable that they in fact were.

According to Gregory,5 CCPs face risks that include default risk (e.g., clearing member
distress), non-default loss events (e.g., fraud), model risk, liquidity risk, operational risk, legal
risk, and several other risks.

In regard to (A), (C) and (D), each is TRUE.

605.3. C. False. External liquidity is desirable to a CCP; e.g., “A CCP should have
availability to external liquidity sources since it could otherwise default due to being
illiquid but not insolvent."5

In regard to (A), (B) and (D), each is TRUE as a lesson learned from prior CCP failures.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p1-t3-605-risks-faced-by-

central-counterparties-ccps-gregory.9324/

5
John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives
(New York: John Wiley & Sons, 2014)

12