LO 76.3: Compare and assess methods a CCP can use to help recover capital when

LO 76.3: Compare and assess methods a CCP can use to help recover capital when a member defaults or when a liquidity crisis occurs.
There are two methods a CCP can use to help recover capital (in the event a member defaults or a liquidity crisis occurs): default fund assessments and variation margin haircuts (VMGH).
With default fund assessments, the CCP could ask all non-defaulted members for a supplementary contribution that is proportional to their prior contribution and capped at that prior contribution amount. However, assuming that the largest clearing members have defaulted, there is a reasonable risk that some of the non-defaulted members have been subjected to the same losses. As a result, the non-defaulted members may have insufficient liquid resources to cover the assessment. Or if they do have sufficient resources, they may simply choose to avoid the assessment by closing out their positions or moving them to another CCP. Therefore, the shortfall in the default fund demonstrates wrong-way risk, whereby the probability of non-payment is positively related to the default events that would lead to an assessment.
A clearing member may accumulate a large amount of losses over time and ultimately default. Prior to the default, that defaulting member would have already made a corresponding large amount of variation margin payments to other members. With variation margin haircuts (VMGH), the CCP collects the full variation margin payment from the member with the loss, and the CCP discounts the payment (on a pro-rata basis) to the corresponding member with the gain. The difference is held by the CCP to enhance the CCPs liquidity. The liquidity is financed by the members but if clearing members are already subject to liquidity constraints in weaker market conditions, a haircut on the variation margin payment could exacerbate the liquidity constraints.
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CCPs clearly benefit from having assessments and recovery options but they impose significant liquidity demands on non-defaulted members in weak market conditions. Such demands could ultimately cause those members to eventually default.
Topic 76 Cross Reference to GARP Assigned Reading – Cont
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Topic 76 Cross Reference to GARP Assigned Reading – Cont
Ke y Co n c e pt s
LO 76.1 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.
LO 76.2 With central clearing, OTC exposures net of collateral between key banks have fallen to a small percentage of bank equity. The initial conclusion is that there is reduced insolvency and contagion risk because CCPs have removed counterparty risk.
Central clearing has enhanced financial stability and reduced systemic risk, but it has not completely eliminated systemic risk.
LO 76.3 The central clearing requirements do not change the clearing members overall balance sheet value (assets or equity) so there is no solvency impact. However, there is a reclassification of assets between liquid and non-liquid so there is a liquidity impact. Therefore, the clearing member is giving up counterparty risk and accepting liquidity risk.
LO 76.4 A CCP has the following liquidity resources to cover potential losses should a clearing member default (in the following sequence): 1. 2. Default contribution of defaulting member. 3. Mutualization of large losses. 4. Recovery. 3. Failure resolution.
Initial margin.
LO 76.3 CCPs clearly benefit from having assessments and recovery options but they impose significant liquidity demands on non-defaulted members in weak market conditions. Such demands could ultimately cause those members to eventually default. There are two methods to consider in this situation: (1) default fund assessments and (2) variation margin haircuts (VMGH).
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Co n c e pt Ch e c k e r s
Topic 76 Cross Reference to GARP Assigned Reading – Cont
1.
2.
3.
4.
3.
Which of the following items is not a key advantage of central clearing? A. Lower liquidity risk. B. Lower operational risk. C. Greater price discovery. D. Greater clarity with regard to the need for collateral.
Which of the following statements with regard to central clearing, liquidity, and solvency is correct? A. Central clearing has enhanced financial stability and eliminated counterparty
B. An illiquid firm has total liquid asset values that are lower than total liability
risk.
values.
operating.
C. A firm that becomes insolvent will immediately impact its ability to continue
D. The use of short-term repurchase agreements and borrowing against the value of
assets is used to protect against insolvency.
Within a central counterpartys (CCP) role to absorb losses, which of the following risks is most relevant to the CCP? A. Insolvency risk. B. Liquidity risk. C. Market risk. D. Operational risk.
Which of the following items has the greatest impact on a clearing members balance sheet? A. Initial margin. B. Variation margin. C. Default fund contribution. D. Skin-in-the-game contribution.
Initial margins requirements for clearing members are based on market risk with computations most likely at a confidence level of: A. 90%. B. 93%. C. 99%. D. 100%.
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Topic 76 Cross Reference to GARP Assigned Reading – Cont
Co n c e pt Ch e c k e r An s w e r s
1. A Central clearing changes counterparty risk to liquidity risk, so the impact is greater liquidity risk which is a disadvantage of central clearing. The other items are all advantages of central clearing.
2. A Central clearing has eliminated counterparty risk; however, it has now introduced liquidity
risk.
An illiquid firm has total liquid asset values that are lower than total short-term liability values. Even if a firm is insolvent, if the firm has sufficient liquid assets to cover its short-term liabilities, then it will not immediately impact a firms ability to continue operating. The use of short-term repurchase agreements and borrowing against the value of assets is used to protect against illiquidity.
3. B Losses that arise due to the default of a clearing member will only impact a CCP to the
extent that the CCP must make payments to the defaulted counterparties. Therefore, such cash payments represent a potential liquidity risk for CCPs, which should be its primary concern.
A CCPs assets are subject to market risk and insolvency risk, but because most the CCPs assets are low risk and highly liquid, both risks are of little consequence. Operational risk is present in all entities but it does not have special prominence within a CCP.
4. C Default fund contributions are subject to a 2% capital charge so there is an impact on the
clearing members balance sheet.
Initial margin and variation margin have no impact on the value of the clearing members assets since the clearing member still owns the cash collateral that is posted as margin. A skin-in-the-game contribution is made by the CCP, not the clearing member.
5. C Market risk measures such as value at risk or expected shortfall are usually computed at a
confidence level between 99% and 99.75%.
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The following is a review of the Current Issues in Financial Markets principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Th e Ba n k /C a pi t a l M a r k e t s N e x u s G o e s G l o b a l
Topic 77
Ex a m Fo c u s
In this topic, we examine the interrelationship between banks and capital markets. As the dollar replaced the volatility index (VIX) as the gauge of deleveraging in the capital markets, the role of the dollar became increasingly more important. For the exam, understand the causes of deleveraging and the role of covered interest parity (CIP) prior to the financial crisis, and why the CIP relationship failed in the post-crisis period. In addition, it is important that you understand not only why the dollar is now considered a better estimator of leverage than the VIX, but also the impacts of a strengthening dollar on banks lending and hedging activities. A stronger dollar typically raises the cost of dollar borrowing and reduces banks lending and hedging activities.
Ba n k s a n d Ca pit a l M a r k e t s