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P2.T6.600. Functions of central counterparties (CCPs) (Gregory)

Nicole Seaman

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Learning objectives: Explain the objectives and functions of central counterparties (CCPs). Discuss the strengths and weaknesses of CCPs.

Questions:

600.1. Which of the following is TRUE about a central counterparty (CCP)?

a. The central counterparty (CCP) mitigates market risk by a process called novation
b. The central counterparty (CCP) reduces concentration risk because it conducts margin calls
c. The central counterparty (CCP) enables price transparency by providing a trade execution venue
d. The central counterparty (CCP) reduces counterparty risk by interposing itself between buyers and sellers as a legal counterparty


600.2. You recently attended a meeting of your firm's senior executives where the group discussed the G20's (see https://en.wikipedia.org/wiki/G-20_major_economies) intention to mandate the clearing of all standardized over-the-counter (OTC) derivative contracts over a central counterparty (CCP). In general, the group was enthusiastic about this policy direction. However, several executives were cautious and warned about the limits of a CCP; these critics made the following four statements. According to Gregory, each of these critical statements is true EXCEPT which is false?

a. Peter says, "CCPs can reduce systemic risk (which is well documented) but can also increase it."
b. Mary says, "CCPs can exacerbate market risk because multilateral netting complicates the pricing of a derivatives contract, compared to pricing a bilateral derivative"
c. Shawn asserts, "A CCP cannot make counterparty risk disappear. It can only centralise it in a single place and convert it into different forms of risk such as operational and liquidity."
d. Paul warns, "As with most risk mitigation, for every advantage of a CCP, there are related disadvantages. The benefit of a CCP is not to be a panacea but rather to lead to more advantages than disadvantages."


600.3. Gregory explains that "Central counterparties (CCPs) must have a fine-tuned structure with respect to collateralisation, settlement and risk management and obviously must be extremely unlikely to fail. Furthermore, the very nature of what a CCP does creates potentially dangerous problems such as moral hazard and adverse selection. Finally, the failure of a CCP will clearly be an extremely problematic event, potentially far worse than the failure of any other financial institution." In regard to the mitigation of counterparty risk, each of the following statements is true about a risk mitigation in a CCP EXCEPT which is false?

a. CCPs require "initial margin" to overcollateralize their counterparty risk
b. CCPs requre "variation margin" (ie, collateral) to mitigate their counterparty
c. Members of a CCP need to commit funds to a "default fund" or "reserve fund."
d. Each CCP must pay premiums toward a multi-CCP re-insurance fund which reimburse the total cost, including systemic and knock-on effects, of any CCP failure

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