Book 2. Credit Risk
FRM Part 2
CR 18. Central Clearing

Presented by: Sudhanshu
Module 1. Central Counterparties
Module 2. CCP Risk Management
Module 3. Central Clearing Market Impact
Module 1. Central Counterparties
Topic 1. Central Counterparty (CCP)
Topic 2. Mechanics of Central Clearing
Topic 3. Netting, Multilateral Offset and Compression
Topic 1. Central Counterparty (CCP)
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Definition: A Central Counterparty (CCP) is a financial institution that acts as a solution for systemic risk mitigation. It provides clearing services for many different types of financial transactions between member firms. The CCP sits between the two original counterparties to a trade, ensuring the deal is completed even if one party defaults.
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Role in Clearing: The CCP essentially stands in the middle of a transaction, becoming the buyer to every seller and the seller to every buyer. This process is known as complete clearing.
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Novation: The key mechanism by which a CCP steps into a transaction. Novation means the CCP legally replaces the original counterparties, taking on all counterparty risk. The original parties are no longer exposed to each other's default risk. This process reduces interconnectedness and increases transparency.
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Result: Reduces market interconnectedness and increases transparency. The CCP reduces the number of counterparty relationships needed. For example, if there are 10 firms trading with each other, in a bilateral system they would need 45 relationships. With a single CCP, they only need 10 relationships, one with the CCP.



Topic 1. Central Counterparty (CCP)
Topic 2. Mechanics of Central Clearing
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CCP Business Model: CCPs earn revenue by charging fees on trades and from interest on the assets they hold. A key aspect of their business is managing the risk they absorb, which allows them to offer a competitive service.
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CCP Ownership Models:
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Vertical: An exchange owns the CCP, which clears only products associated with that exchange. This model is often tied to specific trading venues.
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Horizontal: The clearing members collectively own the CCP, which can transact in a wider range of markets and products. This model fosters greater competition and can lead to lower fees due to economies of scale.
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Challenges for Clearing OTC Derivatives: OTC derivatives, such as credit default swaps and interest rate swaps, pose unique challenges that are not present in more standardized markets.
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Standardization: For a CCP to effectively manage risk, the products it clears must be standardized. This allows for easier valuation and netting.
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Complexity: Exotic or complex derivatives are difficult to value, which is essential for accurate margin calculations. The lack of standard models for pricing makes it hard for a CCP to assess its risk.
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Liquidity: Illiquid products lack the data needed for pricing and margin calculations. If a member defaults, the CCP might struggle to liquidate an illiquid position, leading to losses.
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Wrong-Way Risk (WWR): This is a specific type of risk where the credit exposure to a counterparty is positively correlated with that counterparty's probability of default. In other words, as a counterparty's financial health deteriorates, the CCP's exposure to them increases.
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Market Volume: A sufficient volume is needed to justify the CCP's costs and ensure the effectiveness of multilateral netting.
Topic 2. Mechanics of Central Clearing
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Netting: A general process used to reduce the number of transactions and lower total liabilities. In a bilateral setting, two parties can net their obligations to reduce their overall exposure. The CCP, however, takes this concept much further.
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Multilateral Offset: This is a key benefit of central clearing that extends the concept of netting from two parties to many. The CCP steps in and nets out transactions between multiple parties, significantly reducing overall exposure and risk. For example, consider three firms: Firm A owes Firm B $100, Firm B owes Firm C $100, and Firm C owes Firm A $100. In a bilateral system, three separate payments are required, totaling $300. With a CCP, the obligations are centrally managed and canceled out, resulting in zero net payment. This drastically reduces the number of cash flows and capital requirements.
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Compression: A more advanced form of netting where the outright cancellation of multiple offsetting contracts is used to substitute them with fewer, larger contracts. This reduces the gross notional exposure while maintaining the same net exposure. This is particularly useful in markets with a high volume of offsetting trades, such as interest rate swaps. For example, a firm with two contracts—a long position of $100 million and a short position of $90 million—can use compression to replace these with a single, net long position of $10 million.
Topic 3. Netting, Multilateral Offset and Compression
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Relationship: Multilateral offset and compression are powerful tools that work together to increase efficiency, reduce operational complexity, and lower the initial margin requirements for clearing members. By reducing the overall size of the market's gross exposure, they make the financial system more stable.

Topic 3. Netting, Multilateral Offset and Compression
Practice Questions: Q1
Q1. There are numerous challenges when clearing over-the-counter (OTC) derivative products through a central counterparty (CCP). Which of the following lists best summarizes the key challenges for central clearing of OTC derivative products?
A. Illiquid products, jurisdictional fragmentation, presence of wrong-way risk, and legal concerns.
B. Lack of standardization, increased counterparty risk, increased dependency risk, and less transparency.
C. Jurisdictional fragmentation, increased counterparty risk, less transparency, and standardization.
D. Product complexity, illiquid products, presence of wrong-way risk, and lack of standardization.
Practice Questions: Q1 Answer
Explanation: D is correct.
Lack of standardized products, complexity, illiquid products, and the presence of wrong-way risk are characteristics of OTC derivative products that make CCP clearing challenging. OTC derivative products need to be standardized before they can be cleared through a CCP. More complex and illiquid derivative products are problematic for CCPs because their unique features make them difficult to value. Products with wrong-way risk are also more complex and create additional concerns for CCPs in the event of default.
Module 2. CCP Risk Management
Topic 1. Margin and Default Funds
Topic 2. Managing a Member Default
Topic 3. Margin Period of Risk (MPoR)
Topic 4. The CCP Loss Waterfall
Topic 1. Margin and Default Funds
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Initial Margin: A deposit required from all members to cover potential default losses in a worst-case scenario with a high degree of confidence (e.g., 99%). The amount of initial margin is typically calculated using a Value-at-Risk (VaR) methodology, which estimates the maximum potential loss over a specific time horizon, such as one or two days. It is a key tool for mitigating procyclicality—the tendency of margin requirements to increase during market downturns. The CCP holds this collateral to cover potential losses and ensure that it can continue to operate and manage the defaulted position.
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Consists of cash and highly liquid securities.
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Variation Margin: Additional collateral collected daily (or even intra-day) to account for mark-to-market price changes. When the value of a position changes, the CCP collects or pays variation margin to the clearing member to keep the exposure at zero. This process ensures that the CCP's exposure to each member is constantly reset to reflect current market prices.
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Typically accepted only in cash.
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Default Fund: A pooled resource to which all members contribute. Its purpose is to provide a final layer of protection to the CCP against potential losses from a member's default through a process called loss mutualization. If the defaulting member's initial and variation margin are not enough to cover the losses, the CCP will then draw from the default fund to cover the deficit. This ensures that the burden of the default is shared across the entire clearing community.
Topic 1. Margin and Default Funds
Topic 2. Managing a Member Default
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Primary Risk: The most significant risk faced by a CCP is the default of one of its members. The CCP must have a clear and efficient plan to manage this event to maintain market stability and protect its remaining members.
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Default Management Process:
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Macro-hedging: The CCP’s first step is to quickly reduce the defaulted portfolio’s exposure to major market risks using liquid hedges. This action helps to contain the immediate risk and prevent further losses.
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Auction: The defaulted portfolio is then put up for auction to surviving members. The goal is to offload the risk to other firms in the market. The CCP seeks a fair price, ideally transacting at midmarket values. However, it may be forced to accept a premium, which can impact its ability to cover losses.
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Porting: The most efficient method for handling a default is to transfer, or "port," the defaulted member’s trades to a solvent, surviving member. This allows the CCP to quickly restore a matched book without having to liquidate the positions.
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Alternative Solutions (Used when primary methods fail):
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Variation Margin Gains Haircutting (VMGH): This involves the CCP "haircutting" or discounting the gains it would normally pay to members who were on the winning side of a trade with the defaulting member. This is a form of loss mutualization.
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Tear-Up: If the auction does not work, the CCP may cancel, or “tear up,” unmatched contracts with clearing members. The goal of a tear-up is to restore the CCP to a matched book by canceling trades that were opposite to those of the defaulting member.
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Forced Allocation: This requires surviving members to take on specific positions from the defaulted portfolio. This is similar to a tear-up in its effect but does not cancel existing trades. Instead, members may be forced to enter into reverse trades to offset the defaulted positions.
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Topic 2. Managing a Member Default
Topic 3. Margin Period of Risk (MPoR)
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Definition: The Margin Period of Risk (MPoR) is the time it takes for a CCP to liquidate or hedge a defaulted member's positions. It is a critical factor in determining the appropriate level of initial margin. A longer MPoR requires a higher initial margin to account for greater potential price movements.
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Three Sub-periods:
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Pre-default: The time from the last margin posting until the CCP declares a member to be in default. During this period, the CCP is exposed to potential losses from market moves that are not covered by the last margin call.
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Macro-hedging: The time needed for the CCP to put on liquid hedges to neutralize the defaulted portfolio's exposure to major market risks (e.g., interest rate risk, credit spread risk).
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Auctions: The period taken to sell off the portfolio to surviving members or to find a new member to take on the positions. The risk is considered to be zero at the conclusion of this process.
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Importance: A shorter MPoR is highly desirable for a CCP as it reduces its exposure to risk. CCPs can shorten their MPoR by having efficient default management procedures, frequent margin calls (e.g., intra-day), and robust technology to quickly identify and manage a default.
Topic 4. The CCP Loss Waterfall
- The loss waterfall is a predetermined, sequential framework that outlines how a CCP will absorb losses in the event of a member default. It is designed to protect the CCP and its non-defaulting members by ensuring that the defaulting member's own resources are exhausted first. The transparency of this process is crucial for market confidence.
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This is the order in which losses from a member default are absorbed:
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Defaulting Member's Margin: The first line of defense is the defaulting member's initial margin and variation margin. These are specifically held by the CCP to cover any losses from that member's positions.
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Defaulting Member's Default Fund Contribution: If the defaulting member's margin is not sufficient, the CCP will use the member's contribution to the default fund to cover the remaining losses.
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Equity of the CCP: Before tapping into the resources of surviving members, the CCP itself must contribute its own capital, often referred to as its "skin in the game." This ensures that the CCP has a financial incentive to manage risk and defaults effectively.
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Non-defaulting Members' Default Funds: The loss mutualization aspect of the CCP is realized at this stage. The contributions of surviving, non-defaulting members to the default fund are used to absorb the losses. These are pre-funded contributions that are proportional to each member's risk.
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Rights of Assessment: In extreme situations, if the default fund is exhausted, surviving members may be required to make additional, limited contributions to cover the remaining losses. This is a crucial safety net for catastrophic events.
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Further Liquidity Support / CCP Failure: If all previous layers are exhausted, the CCP may seek external support from central banks or other authorities. If this fails, the CCP itself may fail, which would have severe systemic consequences for the financial markets.

Topic 4. The CCP Loss Waterfall
Practice Questions: Q1
Q1. Which of the following statements regarding risk management by central counterparties (CCPs) is most accurate?
A. Netting in different currencies is possible.
B. Only cash is accepted as variation margin.
C. An important source of returns for CCPs is the interest earned on held assets.
D. During the margin period of risk (MPoR), most of the risk is reduced with auctions where the defaulting member’s portfolio is sold off.
Practice Questions: Q1 Answer
Explanation: B is correct.
Usually, only cash is accepted as variation margin. Netting in a single currency is possible but not in different currencies. CCPs operate primarily by charging fees on all trades and to a lesser extent by earning income on the assets in their possession. The most important risks are reduced substantially and quickly using liquid hedges via macro-hedging.
Practice Questions: Q2
Q2. Given the following three events, what is the proper order of the CCP loss waterfall?
I. Non defaulting member’s default fund contributions are exhausted.
II. Defaulting member’s collateral and default fund contributions are exhausted.
III. CCP taps an amount of its equity that enables them to function normally.
A. I, II, III.
B. II, I, III.
C. II, III, I.
D. III, II, I.
Practice Questions: Q2 Answer
Explanation: C is correct.
The first layer in the loss waterfall is for the defaulting member’s collateral and default fund contributions to be exhausted. The next layer is for the CCP to tap into its own equity to the point where it could still function normally. Non defaulting members will then have their default funds exhausted before moving to the rights of assessment.
Module 3. Central Clearing Market Impact
Topic 1. Bilateral vs. Central Clearing
Topic 2. Advantages of Central Clearing
Topic 3. Disadvantages of Central Clearing
Topic 1. Bilateral vs. Central Clearing
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Key Differences
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Counterparty Risk: In a bilateral system, each firm is directly exposed to the default of its trading partner. This creates a web of interconnected risks that can trigger a domino effect across the market. In central clearing, the CCP absorbs all counterparty risk by becoming the legal counterparty to every transaction through novation. This single point of contact significantly simplifies the risk profile and makes the system more resilient.
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Systemic Risk: Bilateral clearing has high systemic risk due to direct interconnectedness. A default by a major firm can spread quickly, leading to a system-wide crisis. In central clearing, systemic risk is lower, as risk is consolidated and managed by a single, well-capitalized entity. The CCP’s default management process is designed to contain a failure and prevent it from spreading.
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Netting: Bilateral clearing is limited to two parties. Firms can only net obligations with a single counterparty. Central clearing facilitates multilateral netting and compression across all members. This significantly reduces the total number of trades and the overall notional exposure in the system.
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Transparency: Bilateral clearing has low transparency. The market lacks a central hub to monitor overall exposure, making it difficult to assess systemic risk. In central clearing, transparency is high. The CCP has a complete, real-time view of all trades and positions, allowing regulators and the CCP itself to monitor market risk and exposure effectively.
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Default Management: Bilateral clearing uses an ad hoc and potentially chaotic process for default management. Without a predefined process, a default could lead to legal disputes and a lack of market confidence. In central clearing, there is a standardized process governed by the loss waterfall. This transparent and predefined framework ensures that losses are absorbed in a predictable order, starting with the defaulting member.
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Capital Requirements: In a bilateral system, each firm must hold capital against its bilateral exposures. The capital held is often redundant, as it is calculated independently for each counterparty. In central clearing, members hold capital primarily through initial margin and default fund contributions to the CCP. This mutualized approach can be more capital-efficient for the market as a whole.
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Operational Efficiency: Bilateral clearing has low operational efficiency due to the need to manage a large number of bilateral agreements, payments, and settlements. Central clearing has high operational efficiency due to the centralization of clearing, netting, and settlement. This reduces the number of payments and simplifies operational workflows.
Topic 1. Bilateral vs. Central Clearing
Topic 2. Advantages of Central Clearing
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Reduced Counterparty Risk: The CCP, a highly capitalized entity, becomes the central counterparty for all transactions, thereby eliminating direct bilateral credit risk between trading parties. This allows firms to trade with a broader range of counterparties without extensive individual due diligence.
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Reduced Systemic Risk: By centralizing risk, the CCP acts as a buffer against cascading failures. A single member's default is contained by the CCP's default management process and loss waterfall, preventing the failure from spreading throughout the market via a chain reaction.
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Increased Operational Efficiency: The CCP's role in multilateral netting and compression significantly reduces the number of payments and settlements required. Instead of managing numerous bilateral obligations, firms only need to manage a single net position with the CCP, leading to streamlined operations and lower costs.
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Greater Transparency: A CCP provides regulators and market participants with a centralized view of exposures, positions, and market activity. This transparency is crucial for effective risk monitoring, supervision, and crisis management, particularly in the opaque OTC derivatives markets.
Loss Mutualization: The default fund mechanism ensures that the financial impact of a member's failure is shared proportionally among all surviving members. This collective approach to risk-sharing is a key advantage, as it protects the stability of the CCP and the wider market by preventing any single firm from bearing the entire cost of a default.
Capital Efficiency: By reducing the overall number of outstanding positions and centralizing risk, central clearing often allows for lower aggregate capital requirements compared to a bilateral system. This frees up capital for other investments and trading activities.
Topic 2. Advantages of Central Clearing
Topic 3. Disadvantages of Central Clearing
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Concentration Risk: A major failure at a CCP could have disastrous consequences for all members. This is the single biggest risk associated with central clearing. If a CCP were to fail, the entire system could be at risk due to its central role.
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Challenges for OTC Derivatives: Not all OTC products are suitable for clearing due to a lack of standardization, liquidity, or the presence of complexity and WWR. This limits the scope of central clearing to only the most common and liquid products.
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Jurisdictional Fragmentation: Different regulatory bodies may require clearing to occur in specific local or regional CCPs. This can create silos and prevent the full benefits of multilateral netting across different jurisdictions.
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Complexity for Non-members: Non-member firms must clear through a member firm, adding a layer of complexity and cost. This can create a two-tiered system where smaller firms may not be able to participate directly in the benefits of central clearing.
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Potential for High Margin Requirements: Initial margins can be prohibitively high for some participants, especially during times of market stress. This can create procyclicality, where margins increase during a downturn, forcing firms to sell assets to meet margin calls, which in turn exacerbates the market downturn.
Practice Questions: Q1
Q1. Which of the following statements is not an improvement that centrally cleared markets offer relative to bilateral markets? Centrally cleared markets:
A. remain market neutral by netting trades.
B. formalize the default workout process by using a loss waterfall structure.
C. offer more flexibility in contract selection because of their collateral collecting process.
D. improve the counterparty risk picture by replacing the original counterparty with a series of counterparties.
Practice Questions: Q1 Answer
Explanation: C is correct.
Bilateral markets permit any type of customized financial contract and customized collateral that is freely negotiated between the two bilateral parties. In a centrally clearedmarket, flexibility is reduced because contracts must be standardized, and collateral rules are fixed and nonnegotiable.
Practice Questions: Q2
Q2. Following the financial crisis of 2007–2009, the roles of central counterparties (CCPs) were increased to reduce systemic risk through a centralized clearing process. Which of the following actions is not an advantage of the CCP in the centralized clearing process?
A. Increase transparency.
B. Manage loss mutualization.
C. Eliminate counterparty risk.
D. Improve operational efficiency.
Practice Questions: Q2 Answer
Explanation: C is correct.
CCPs reduce counterparty risk, but they do not eliminate this risk. Improved legal and operational efficiencies, increased transparency, and loss mutualization are major advantages of the CCP central clearing process.
CR 18. Central Clearing
By Prateek Yadav
CR 18. Central Clearing
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