LO 76.3: Describe the transformation of counterparty risk into liquidity risk.

LO 76.3: Describe the transformation of counterparty risk into liquidity risk.
In the absence of margin requirements for a bilateral OTC trade, the two counterparties would simply mark to market (MTM) their position each day. Such MTM gains/losses are unrealized in nature so they do not have any cash flow impact (i.e., no liquidity impact). However, they do impact asset values and reported income so there is an impact on solvency.
In contrast, the same trade with a CCP has three distinct cash flow impacts: An initial margin from each counterparty must be paid up front. MTM gains/losses between the CCP and clearing members must be settled on a cash
basis each day or even more often (i.e., variation margin).
Clearing members could be required to contribute to a default/guaranty fund to cover
member defaults.
>From an overall balance sheet and solvency perspective: The initial margin deposit by the clearing members to the CCP is simply that and is not a transfer of (cash) assets. The clearing member maintains the asset on its balance sheet so there is virtually no impact on solvency.
The variation margin deposits (if applicable) would have been previously accounted for
as a MTM loss. The actual cash payment to the CCP is treated similarly to the initial margin deposit in that there is no transfer of assets to the CCP. There is simply a transfer from the clearing members liquid to non-liquid assets (i.e., classification change).
The default fund contributions are treated similarly to the initial and variation margin defaults. However, the clearing member is subject to a 2% capital charge for the default fund contributions.
>From a liquidity perspective:
Initial and variation margins must be deposited as liquid assets (i.e., cash) so there is a noted reduction in liquidity.
In summary, 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.
CCP Liq u id it y Re s o u r c e s