{"id":530,"date":"2019-08-03T12:47:00","date_gmt":"2019-08-03T12:47:00","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=530"},"modified":"2025-11-26T20:53:13","modified_gmt":"2025-11-26T20:53:13","slug":"counterparty-risk-intermediation","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/frm\/part-2\/credit-risk-measurement-and-management\/counterparty-risk-intermediation\/","title":{"rendered":"Counterparty Risk Intermediation"},"content":{"rendered":"<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Which of the following are advantages of central counterparties (CCPs)?\",\n    \"text\": \"Which of the following are advantages of central counterparties (CCPs)? Options: A. Loss mutualization, adverse selection, and legal and operational efficiency. B. Offsetting, liquidity, and bifurcations. C. Legal and operational efficiency, moral hazard, and bifurcations. D. Default management, liquidity, and loss mutualization.\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is D. Default management, liquidity, and loss mutualization are key advantages of CCPs. CCPs also provide offsetting and legal and operational efficiency. Their disadvantages include moral hazard, adverse selection, bifurcations between cleared and non-cleared trades, and procyclicality.\"\n    }\n  }\n}\n<\/script><br \/>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@graph\": [\n    {\n      \"@type\": \"ImageObject\",\n      \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219.jpg\",\n      \"contentUrl\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219.jpg\",\n      \"caption\": \"Illustration of the role played by central counterparties\",\n      \"width\": 2269,\n      \"height\": 1280,\n      \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n      \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n      \"creditText\": \"AnalystPrep Design Team\",\n      \"creator\": {\n        \"@type\": \"Organization\",\n        \"name\": \"AnalystPrep\",\n        \"url\": \"https:\/\/analystprep.com\/\"\n      }\n    },\n    {\n      \"@type\": \"ImageObject\",\n      \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214.jpg\",\n      \"contentUrl\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214.jpg\",\n      \"caption\": \"Illustration of counterparty risk intermediation\",\n      \"width\": 1565,\n      \"height\": 697,\n      \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n      \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n      \"creditText\": \"AnalystPrep Design Team\",\n      \"creator\": {\n        \"@type\": \"Organization\",\n        \"name\": \"AnalystPrep\",\n        \"url\": \"https:\/\/analystprep.com\/\"\n      }\n    }\n  ]\n}\n<\/script><\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/bIHhJRyvt0k\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p><strong>After completing this reading<\/strong>,<strong> you should be able to<\/strong>:<\/p>\n<ul>\n<li>Identify counterparty risk intermediaries, including central counterparties (CCPs), derivative product companies (DPCs), special purpose vehicles (SPVs), and monoline insurance companies (monolines) and describe their roles.<\/li>\n<li>Describe the risk management process of a CCP and explain the loss waterfall structure of a CCP.<\/li>\n<li>Compare bilateral and centrally cleared over-the-counter (OTC) derivatives markets.<\/li>\n<li>Assess the capital requirements for a qualifying CCP and discuss the advantages and disadvantages of CCPs.<\/li>\n<li>Discuss the impact of central clearing on credit value adjustment (CVA), funding value adjustment (FVA), capital value adjustment (KVA), and margin value adjustment (MVA).<\/li>\n<\/ul>\n<h2>What is Counterparty Risk Intermediation?<\/h2>\n<p><strong>Counterparty risk<\/strong> is the likelihood that one of the parties involved in a transaction would default on its contractual obligation. Counterparty risk usually exists in derivative transactions and repurchase agreements.<\/p>\n<p>Over the years, counterparty risk mitigation has become a key goal for trading parties around the world. <strong>Counterparty risk intermediation<\/strong> is the practice of using a third party to intermediate and guarantee the performance of one or both counterparties.<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-6545\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214.jpg\" alt=\"An Illustration of Counterparty Risk Intermediation\" width=\"1565\" height=\"697\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214.jpg 1565w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214-300x134.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214-768x342.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214-1024x456.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214-400x178.jpg 400w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-214-600x267.jpg 600w\" sizes=\"auto, (max-width: 1565px) 100vw, 1565px\" \/>The most ideal form of intermediation is central clearing. In exchange-traded instruments, this is achieved because the exchange itself serves as the intermediary. In OTC derivatives markets, there are several forms of counterparty risk intermediation. We look at each form below.<\/p>\n<h3>Special Purpose Vehicles (SPV)<\/h3>\n<p>A special purpose vehicle is a legal entity created to fulfill narrow, specific, or temporary objectives. The goal is to establish a bankruptcy-remote entity that gives a counterparty preferential treatment as a creditor in the event of a default. Although the setup process is anchored in law, an SPV still introduces legal risk because the envisaged preferential treatment may not materialize following a default event.<\/p>\n<p>SPVs typically manage assets that have been hived off the originator\u2019s balance sheet. They are also used to finance a large project without putting an entire firm or a counterparty at risk. Some jurisdictions are very specific with regard to the ownership structure, with some stipulating that the SPV should not be owned by the originating entity. The constant goal across jurisdictions is to change bankruptcy rules and put the non-defaulting or non-solvent counterparty at the forefront of the queue when claims are being settled.<\/p>\n<p>As noted above, SPVs transform counterparty risk into legal risk. Legal risk manifests in the sense that in some jurisdictions, the SPV is viewed more like a business segment of the originator such that the two are substantially the same. As such, the assets of the SPV can be consolidated with those of the business in case of a wind-up. Such a move effectively nullifies any preferential treatment of counterparties as initially envisaged during the formation of the SPV. US courts have a history of ruling in favor of consolidation, but those in the UK have been less keen to do so. Instead, they prefer to uphold the autonomy and remoteness of the SPV.<\/p>\n<p>A good example of the legal risk associated with SPVs is the case of Lehman Brothers, the U.S. investment bank that went down in 2008. Lehman had inserted a &#8220;flip clause&#8221; in their collateralized debt obligation contracts with investors. The clause was meant to shield investors by directing that in case of bankruptcy, the investors\u2019 claims would be settled in priority. At the end of bankruptcy proceedings in the U.S., the flip clause was nullified and declared &#8220;unenforceable.\u2019 In the UK, however, the court declared that the flip clauses were indeed enforceable, effectively paving the way for SPV investors to be compensated in priority. In the end, Lehman settled most of the investors\u2019 claims out of court.<\/p>\n<p>\n<strong>Bottom line<\/strong>: Mitigating counterparty risk with any mechanism that introduces legal risk is dangerous.<\/p>\n<h3>Guarantees<\/h3>\n<p>In this case, the performance of a derivative counterparty is guaranteed by a third party.<\/p>\n<h4>Examples<\/h4>\n<ul>\n<li>A letter of credit (credit letter) where a bank guarantees that a purchaser\u2019s payment to a seller will be made on time and in full. In case a buyer is unable to make the payment on the purchase, the bank will be obligated to cover the full or remaining amount of the purchase.<\/li>\n<li>Intragroup guarantee where the parent company guarantees all of a subsidiary\u2019s trades.<\/li>\n<\/ul>\n<p>Guarantees, however, do introduce the risk of double default where the original counterparty and the guarantor may default, leading to a loss.<\/p>\n<h3>Derivative Product Companies (DPCs)<\/h3>\n<p>A derivative product company is a bankruptcy-remote entity set up to specifically participate in derivative transactions. It differs from an ordinary SPV in that the originating bank injects capital eyeing a strong credit rating (usually triple-A) from credit rating agencies. To maintain its strong rating, the DPC must:<\/p>\n<ul>\n<li>Adhere to strict credit risk management and operational guidelines. For example, it may be barred from engaging in trades with a counterparty whose creditworthiness falls below a pre-established level.<\/li>\n<li>Remain bankruptcy-remote by maintaining some level of financial independence while still drawing some support from the parent. In case the parent defaults, the DPC can be passed on to another financially healthy institution or get dissolved in an orderly fashion.<\/li>\n<li>Minimize market risks by engaging in contracts that offset the exposure.<\/li>\n<\/ul>\n<p>The DPC then leverages its strong rating to sell insurance to derivative counterparties, promising to make the required payments if either of the counterparties defaults. A DPC may be established with a particular type of derivative market in mind, e.g., credit derivatives.<\/p>\n<p>In the run-up to the 2007\/2008 financial crisis, DCPs were considered relatively safe financial vehicles that served as a testament to the continued growth of financial markets. In the aftermath of the crisis, however, DCPs were thrown into the limelight because of the ease with which they went down despite enjoying top-notch ratings. For example, Lehman Brothers had a strong A rating at the time it went down, while banks in Iceland had triple-A ratings just weeks before they were declared bankrupt. The crisis showed how dangerous it could be to rely on credit ratings as a dynamic measure of credit quality.<\/p>\n<p><strong>Bottom line<\/strong>: The use of DPC to convert counterparty risk into other forms of financial risk such as legal risk, market risk, and operational risk may be ineffective.<\/p>\n<h3>Central Counterparty (CCP)<\/h3>\n<p>Central counterparties, also known as CCPs, protect market participants from counterparty \/credit\/default risk and settlement risk by guaranteeing the trade between a buyer and a seller. The use of a central counterparty (CCP) to mitigate risks associated with the default of a trading counterparty is called clearing.<\/p>\n<p>CCP clearing means that a CCP becomes the legal counterparty to each trading party, providing a guarantee that it will honor the terms and conditions of the original trade even in the event that one of the parties defaults before the discharge of its obligations under the trade.<\/p>\n<h3>Monoline Insurance Companies<\/h3>\n<p>A monoline insurance company, also called \u201cmonoline,\u201d is an insurance company that specializes in providing financial guarantees (wraps). Initially, monolines used to provide wraps to US municipal bonds. In recent years, monolines have been actively involved in the securitization market, providing cover for products such as mortgage-backed securities and collateralized debt obligations.<\/p>\n<p>There exists a similarity between monoline and DPC structures in that in both, the capital requirement is dynamically related to the portfolio of assets they insure. However, monolines enjoy slightly more favorable capital requirements and their expected losses are likely to be lower because they generally wrap good quality products. This means that the amount of capital a monoline holds in comparison with the total notional insured amount is small.<\/p>\n<p>Unlike DPCs, monolines are not required to post collateral against their transactions during normal business conditions. This is justified by the fact that:<\/p>\n<ul>\n<li>They take a long-term credit view and therefore avoid short-term exposure, which is driven by short-term market volatility.<\/li>\n<li>Since they carry triple-A ratings, they are generally considered low-risk entities that are extremely unlikely to fail.<\/li>\n<\/ul>\n<p>The fact that monolines do not post collateral means that they can \u201cride the wave\u201d in the short-term and ignore short-term volatility and illiquidity.<\/p>\n<h2>Central Counterparties<\/h2>\n<h3>OTC Clearing<\/h3>\n<p>As mentioned earlier, clearing refers to the use of a central counterparty (CCP) to mitigate risks associated with the default of a trading counterparty. Clearing implies that a CCP comes in between counterparties to guarantee performance.<\/p>\n<p>OTC CCPs interpose themselves directly or indirectly between counterparties and act as a buyer to every seller and seller to every buyer. CCPs reallocate default losses using methods such as netting, collateralization, and loss mutualization. The overall goal is to reduce systemic and counterparty risks.<\/p>\n<p>One advantage of CCPs is that they allow the netting of all trades executed through them. The second advantage is that CCPs also manage collateral requirements from their members to reduce the risk of movement in the value of the underlying portfolios. While these are things that are easily achievable in the bilateral market, CCPs introduce new aspects that are not present in bilateral markets. One of these is loss mutualization, where one counterparty&#8217;s losses are spread across all clearing members as opposed to being shared among a small number of counterparties, a scenario that could be financially devastating for the members involved. CCPs also facilitate orderly close-outs by auctioning the defaulter&#8217;s contractual obligations. It also enables the orderly transfer of clients&#8217; positions from financially distressed members to other members.<\/p>\n<h3>Roles of OTC CCPs<\/h3>\n<p>The main roles of CCPs are as follows:<\/p>\n<ol type=\"i\">\n<li>Setting up rules and standards for its clearing members.<\/li>\n<li>Closing out all the positions of a defaulting clearing member.<\/li>\n<li>Maintaining financial resources to cover losses in the event of default of a clearing member. These include:\n<ul>\n<li>A variation margin to track market movements.<\/li>\n<li>The initial margin to cover close-out costs over and above the variation margin.<\/li>\n<li>A default fund to help with the mutualization of losses.<\/li>\n<\/ul>\n<\/li>\n<\/ol>\n<p>Some banks and most end-users of OTC derivatives access CCPs through a clearing member and will not become members themselves. That\u2019s because to become a clearing member, a party must abide by a strict set of membership, operational, and liquidity requirements. CCPs make the failure of a counterparty less dramatic, regardless of its size, by acting as shock absorbers. Once a member defaults, the CCP moves in swiftly to terminate all financial transactions with that particular member without suffering losses. The positions of the defaulter are then auctioned to other clearing members to allow for continuity among the surviving members.<\/p>\n<h3>The CCP Landscape<\/h3>\n<p>A CCP works within a set of rules and operational arrangements that are designed to allocate, manage, and decrease counterparty risks in bilateral markets. It, therefore, transforms the topology of financial markets by placing itself between buyers and sellers.<\/p>\n<p>The following view, although a bit simplistic, helps to show the role CCPs play in trading. Each of the six entities denoted B represents a dealer bank. In contrast, the left side of the image shows the labyrinth of contracts in bilateral markets.<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-6546\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219.jpg\" alt=\"Illustration of the Role played by Central Counterparties\" width=\"2269\" height=\"1290\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219.jpg 2269w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219-300x171.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219-768x437.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219-1024x582.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219-400x227.jpg 400w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2019\/08\/Page-219-600x341.jpg 600w\" sizes=\"auto, (max-width: 2269px) 100vw, 2269px\" \/>Clearly, CCPs reduce the interconnectedness within financial markets, reducing the effect of the insolvency of a party. Moreover, CCPs uphold transparency on the positions of the dealers. On the downside, CCPs, really, are not immune to financial distress, and the collapse of a single CCP can be disastrous.<\/p>\n<p>Going by the illustrations above, it would appear that the CCP landscape is simple. However, the true CCP landscape is much more complicated. But why?<\/p>\n<ul>\n<li><strong>Client clearing<\/strong>: Parties that cannot be members of a CCP have to clear through a clearing member. This makes collateral transfer and default quite complicated.<\/li>\n<li><strong>Bilateral trades<\/strong>: Some OTC derivatives are not suitable for clearing, and a reasonable portion of derivatives contracts will always remain as bilateral transactions.<\/li>\n<li><strong>Multiple CCPs<\/strong>: There exist numerous CCPs globally that may be implicitly interconnected through sharing members.<\/li>\n<\/ul>\n<h2>CCP Risk Management<\/h2>\n<p>Given the central role central counterparties play in financial markets, it would be dangerous to operate without risk mitigation strategies. One risk management strategy CCPs employ is that they require counterparties to post collateral. This enables them to cover the market risk of the trades they clear. CCPs also require parties to provide a variation margin as well as an initial margin. The variation margin addresses the net change in the market value of the members&#8217; positions while the initial margin is an additional amount to cover the worst-case close-outs when clearing a member defaults.<\/p>\n<p>In case a CCP member defaults, the CCP quickly halts all financial relations with that particular counterparty without suffering any losses. The positions of the member that has defaulted are taken up by other clearing members. This is usually actualized by auctioning the positions of the defaulting counterparty to other members by sub-portfolio, such as interest swaps. In most cases, members are more than willing to participate in the auction, given that they can realize a favorable workout of default with no negative consequences.<\/p>\n<h3>Loss Waterfall<\/h3>\n<p>In cases where the initial margin and the contribution from the default fund prove insufficient and\/or the auction fails, the CCP has other financial resources to address the losses. A &#8220;loss waterfall&#8221; describes diverse ways in which the resources will be utilized. It describes the methods that can be employed in the neutralization of the default of one or more CCP members:<\/p>\n<ol>\n<li>Defaulting member\u2019s initial margin and default fund contribution.<\/li>\n<li>Part of CCP\u2019s equity.<\/li>\n<li>Surviving members\u2019 default fund contributions.<\/li>\n<li>Rights of assessment.<\/li>\n<li>CCP\u2019s remaining equity.<\/li>\n<li>\u201cLast-ditch\u201d attempts to remain afloat or CCP fails.<\/li>\n<\/ol>\n<p>Once a member has defaulted, the first to take effect is the \u201cdefaulter pays\u2019 approach. In this instance, the defaulting member\u2019s initial margin and default fund contribution are seized immediately and used to settle the loss. The two forms of collateral are posted in cash and specifically in the currency in which the contracts are dominated. The goal is to avoid liquidity risk and ensure that the process takes the shortest time possible.<\/p>\n<p>In an ideal world, the \u201cdefaulter pays\u201d approach would be designed to work to perfection, with every clearing member required to contribute all the necessary funds to pay for their own potential default. In practice, this requirement is not enforced because the financial implications would be too high for members. As such, the initial margin and default fund contribution are set at a level that ensures that there\u2019s enough to cover losses to a high level of confidence, say, 99% of all simulated default scenarios.<\/p>\n<p>The worst-case scenario occurs when the members&#8217; default fund and the initial margin have been depleted. If this happens, the CCP turns to its own equity and contributes an amount that ensures there\u2019s enough left to run the CCP\u2019s day-to-day operations, or rather continue functioning normally.<\/p>\n<p>If the loss still persists after the CCP has given away a portion of its equity, the concept of loss mutualization sets in. First to be seized are members\u2019 contributions to the default fund. If the loss manages to blast through the default fund, the next phase, a right of assessment, kicks in. In this phase, the CCP requests members to part with more money, usually up to a limit specified in advance. In most cases, the \u201crights of assessment\u201d kicks in if a significant fraction of the default fund (e.g. 25%) is used.<\/p>\n<p>In practice, the rights of assessment are capped at say, 100% of the last default fund contribution subject to a maximum of 3 defaults within a six-month period. But why are the rights capped? If these rights were unlimited, the CCP would have the \u201cprivilege\u201d to ask for as much additional funds as needed from members, but this would create moral hazard and unlimited exposure for members who would be required to dip into their pockets at the worst possible time.<\/p>\n<p>If the loss is still not exhausted after rights of assessment, the CCP is left with no choice but to dip into its remaining equity to cover the shortfall. If there\u2019s a residual loss even after the CCP\u2019s equity has been depleted, the CCP has two options:<\/p>\n<ol type=\"i\">\n<li>Attempt to secure some liquidity support from a well-capitalized entity such as a central bank.<\/li>\n<li>Explore additional, more aggressive methodologies that can be used to allocate losses among members. It could even commandeer any member assets it happens to be sitting on.<\/li>\n<\/ol>\n<p>If none of these options bears fruit, the CCP fails (is declared insolvent).<\/p>\n<p>In practice, it is extremely difficult for a default event to result in losses that blast through all of the above buffers and actually culminate in the failure of a CCP.<\/p>\n<h2>Comparison between Bilateral and Central Clearing<\/h2>\n<ul>\n<li>\n<h4>Counterparty<\/h4>\n<p>In bilateral markets, the original counterparties transact directly with each other. In central clearing, the CCP acts as the counterparty to each of the original parties.<\/p>\n<\/li>\n<li>\n<h4>Collateral<\/h4>\n<p>There\u2019s considerable wiggle room in bilateral markets on matters collateral. Although applicable rules are continually being changed to standardize collateral provision, a great deal of flexibility still reigns in CCP markets, collateral requirements are standardized, almost always non-negotiable, with eligible securities clearly specified. There are strict margin rules that must be followed, e.g., daily or intra-day posting.<\/p>\n<\/li>\n<li>\n<h4>Products<\/h4>\n<p>In bilateral markets, just about any product can be traded, as long as counterparties can come to an agreement with regard to all the relevant parameters.<\/p>\n<p>In CCP markets, on the other hand, there\u2019s a limited range of tradable products that are standardized, plain-vanilla, and liquid. This ensures that the risk profile of all contracts can be analyzed with an almost zero chance of unexpected variability. Also, it ensures that the market is sufficiently interconnected such that it is easy to replace a contract.<\/p>\n<\/li>\n<li>\n<h4>Eligible Participants<\/h4>\n<p>Anyone can participate in bilateral trades as long as they can find a counterparty who deems their creditworthiness acceptable.<\/p>\n<p>CCP markets, on the other hand, are only open to clearing members, typically large and financially stable financial institutions. A clearing member can sponsor an entity and effectively clear that entity\u2019s transactions. Only a few entities are able to use a clearing member as a conduit because the entity must be ready to provide collateral.<\/p>\n<\/li>\n<li>\n<h4>Contract Netting<\/h4>\n<p>In bilateral markets, netting may not be allowed in the contractual agreement. When present, it is often a result of a mutual agreement between counterparties. What\u2019s more, trades are not offset as market participants often get into trades intending to bet on specific events and do not wish to be market-neutral.<\/p>\n<p>In CCP markets, the CCP naturally tries to maintain market neutrality by netting transactions.<\/p>\n<\/li>\n<li>\n<h4>The Concentration of Counterparty Risk<\/h4>\n<p>In bilateral markets, risk mitigation is not strictly enforced. A risk-averse counterparty will tend to spread out its positions among different counterparties in order to limit exposure to a single party.<\/p>\n<p>In CCP markets, there\u2019s more focus on risk mitigation, with the CCP requiring clearing members to adhere to strict margin or default fund requirements. This creates a sense of protection for counterparties and it is not unusual to find a counterparty channeling a large percentage of its positions through a given CCP.<\/p>\n<\/li>\n<li>\n<h4>Close-out<\/h4>\n<p>In bilateral markets, the close-out process can be messy, lacks clear guidelines, and disputes are fairly common. The process is entirely between two bilateral parties and can quickly spiral into a default scenario for all of a party\u2019s positions, not just for a single transaction.<\/p>\n<p>In CCP markets, close-out is a well-coordinated process marked by clear guidelines. The loss waterfall, for example, ensures that there\u2019s a structured process of handling the default of a counterparty such that significant losses can be absorbed without subjecting any particular member to severe financial strain. Contracts can be replaced almost immediately.<\/p>\n<\/li>\n<li>\n<h4>Costs<\/h4>\n<p>In bilateral markets, counterparties incur costs in the form of counterparty risk, funding, and capital costs.<\/p>\n<p>In CCP markets, the main cost comes in the form of initial margin, and capital costs are relatively lower.<\/p>\n<\/li>\n<\/ul>\n<h2>CCP Capital Charges<\/h2>\n<p>Although the presence of a central counterparty goes a long way toward mitigating various risks, they do not eliminate all the risks. In addition, default fund contributions do well to avoid CCP failure, but losses still occur. For these reasons, CCPs attract some capital charges.<\/p>\n<p>CCP capital requirements for qualifying CCPs (QCCPs) come in two forms:<\/p>\n<ul>\n<li><strong>Default Fund Exposure<\/strong>: This covers the exposure that comes from the contributions made to the CCP default fund. The fund is always at risk even if the CCP doesn&#8217;t default. The quantification of default fund exposure is quite complex because of three main reasons:\n<ul>\n<li>It is possible for a CCP member to lose some or all of their contribution, due to the default of one or more CCP members or some other events, even if the CCP itself does not fail.<\/li>\n<li>Each CCP is at liberty to set its preferred default fund contribution, a situation that results in each CCP having a specific risk.<\/li>\n<li>Alternative loss allocation methods may be mobilized if an extreme loss is incurred. Such a loss may be experienced by clients of clearing members.<\/li>\n<\/ul>\n<\/li>\n<li><strong>Trade Exposure<\/strong>: This risk arises from the current market-to-market exposures, variation margin, potential future exposure (PFE), and the initial margin posted to the CCP. It is only at risk in the event of failure or collapse of the CCP and not its members. The key driver of trade exposure comes from the significant quantity of initial margin required by a CCP.<\/li>\n<\/ul>\n<h2>Advantages and Disadvantages of CCPs<\/h2>\n<h3>Advantages<\/h3>\n<ol type=\"i\">\n<li><strong>Transparency<\/strong>: Bilateral markets lack knowledge of exposure faced by institutions while CCPs have diverse information, and, therefore, CCP can act on adverse exposure faced by a member.<\/li>\n<li><strong>Loss mutualization<\/strong>: In the event of default by a counterparty, the loss is distributed among counterparties, making the effects less consequential.<\/li>\n<li><strong>Offsetting<\/strong>: Transactions between counterparties in a CCP can be offset while, in bilateral markets, it is impossible to offset transactions. Therefore, CCP offers flexibility to members to enter or terminate transactions while reducing costs.<\/li>\n<li><strong>Legal and operational efficiency<\/strong>: Through collateral calls, netting, and settlement functions instituted by CCP, operational efficiency is achieved and costs reduced. Moreover, legal risk is reduced through the centralization of rules and methodologies.<\/li>\n<li><strong>Default management<\/strong>: In CCP markets, the auction process is effectively managed so that price distortions are minimal as compared to unorganized substitutions of positions in case of defaulting clearing members.<\/li>\n<li><strong>Liquidity<\/strong>: In CCP markets, there is an increased ability to trade combined with the multilateral netting benefits and limited barriers to entering the market, and, hence, appropriate liquidity can be achieved.<\/li>\n<\/ol>\n<h3>Disadvantages<\/h3>\n<ol type=\"i\">\n<li><strong>Moral hazard<\/strong>: Counterparties have a limited ability to monitor each other&#8217;s credit quality and act appropriately because a third party (in this case, CPP) bears all the responsibilities.<\/li>\n<li><strong>Procyclicality<\/strong>: This refers to the optimistic dependence on the state of the economy. CCPs may adjust collateral requirements depending on the state of the economy. On the negative side, the CCP may raise the collateral requirements during an unfavorable economic time.<\/li>\n<li><strong>Bifurcations<\/strong>: Bifurcation is the division of a larger whole or primary entity into two smaller and separate parts. In the case of CCP, the obligation to clear standard products may be from cleared and uncleared trades, which may result in risky transactions for customers and confusion in positions that initially seemed to be hedged.<\/li>\n<li><strong>Adverse selection<\/strong>: Counterparties with more information on the associated risks of a transaction than the CCP may transfer more risky products to the CCP, leaving the CCP at the risk of adverse selection.<\/li>\n<\/ol>\n<h2>Central Clearing and xVA<\/h2>\n<p>Central clearing of OTC derivatives aims squarely at reducing counterparty risk through the risk management practices of the CCP. Particularly, this applies with respect to their collateral requirement. This implies that credit value adjustment (CVA) and associated capital charges would no longer be an issue when clearing via a CCP. However, two issues arise from the above view:<\/p>\n<ol type=\"i\">\n<li>First, counterparty risks, funding, and capital issues (which include CVA, FVA, and KVA) primarily come up from uncollateralized OTC derivatives with non-financial end-users. As a result, such end-users will be excluded from the clearing directive, making them not move to central clearing except voluntarily. Since most of such end-users find it hard to post collateral, voluntary clearing is impossible. This makes uncollateralized bilateral transactions that are most important from the xVA approach persist.<\/li>\n<li>Central clearing and other variations, such as the new bilateral collateral rules, may reduce components such as CVA, while increasing other components such as FVA and MVA. Therefore, it is essential to understand xVA to comprehend the equilibrium of diverse effects clearly.<\/li>\n<\/ol>\n<blockquote>\n<h2>Practice Question<\/h2>\n<p>Which of the following are advantages of central counterparties?<\/p>\n<p>A. Loss mutualization, adverse selection, and legal and operational efficiency.<\/p>\n<p>B. Offsetting, liquidity, and bifurcations.<\/p>\n<p>C. Legal and operational efficiency, moral hazard, and bifurcations.<\/p>\n<p>D. Default management, liquidity, and loss mutualization.<\/p>\n<p>The correct answer is <strong>D<\/strong>.<\/p>\n<p>Default management, liquidity, loss mutualization, offsetting, and legal and operational efficiency are all advantages of CCPs.<\/p>\n<p>Disadvantages of CCPs include moral hazard (counterparties have a limited ability to monitor each other&#8217;s credit quality), adverse selection (counterparties pass the riskier products to the CCP), bifurcations (mismatch between cleared and non-cleared trades), and procyclicality (the positive dependence with the state of the economy).<\/p>\n<\/blockquote>\n\n            <div \n                class=\"elfsight-widget-pricing-table elfsight-widget\" \n                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Describe the risk management process of&#8230;<\/p>\n","protected":false},"author":3,"featured_media":1528,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[11],"tags":[],"class_list":["post-530","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-credit-risk-measurement-and-management","blog-post","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Counterparty Risk Intermediation | FRM Part 2 Study Notes - AnalystPrep<\/title>\n<meta name=\"description\" content=\"In this chapter, the roles played by Derivative Product Companies (DPCs) and Monoline Insurers is covered by understanding counterparty risk mitigation through entities playing the role of inter-mediators and guarantees or insurance offered based on default events.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/frm\/part-2\/credit-risk-measurement-and-management\/counterparty-risk-intermediation\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Counterparty Risk Intermediation | FRM Part 2 Study Notes - 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