LO 76.1: Examine how the clearing of over-the-counter transactions through

LO 76.1: Examine how the clearing of over-the-counter transactions through central counterparties has affected risks in the financial system.
Using central counterparties (CCPs) to clear over-the-counter (OTC) transactions has boosted the importance of CCPs in the financial system. CCPs essentially eliminate the counterparty risk inherent in bilateral transactions by making the CCP the counterparty to each side of the trade so that virtually no default risk remains.
Key advantages of central clearing include: Halting a potential domino effect of defaults in a market downturn. More clarity regarding the need for collateral. Lower operational risk. Better price discovery. More regulatory transparency in OTC markets. Better risk management. With mandatory payments of initial and variation margins, the negative impact to a defaulted counterparty is reduced or eliminated. Normally, a default by one counterparty (clearing member) means a loss for other counterparties. With the introduction of CCPs, clearing members are now exposed to the CCP and any defaults by one clearing member no longer result in a loss for the other clearing members. In case of default, assuming the CCP has the available funds, the CCP will pay the variation margins that are owed to the non- defaulting members.
Figure 1 demonstrates numerically how multilateral netting reduces counterparty exposures.
2018 Kaplan, Inc.
Page 191
Topic 76 Cross Reference to GARP Assigned Reading – Cont
Figure 1: Reduction of Risk Exposure Through Multilateral Netting
Bilateral Netting
Multilateral Netting
Im pa c t o f C e n t r a l C l e a r in g

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