P2.T9.

Current Issues

Cont, Rama, “Central clearing and risk

transformation”

Bionic Turtle FRM Practice Questions

By David Harper, CFA FRM CIPM
www.bionicturtle.com
Cont, Rama, “Central clearing and risk transformation”
P2.T9.804. CENTRAL CLEARING AND RISK TRANSFORMATION ..................................................... 3

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Cont, Rama, “Central clearing and risk transformation”
P2.T9.804. Central clearing and risk transformation

P2.T9.804. Central clearing and risk transformation

Learning objectives: Examine how the clearing of over-the-counter transactions through
central counterparties has affected risks in the financial system. Assess whether central
clearing has enhanced financial stability and reduced systemic risk. Describe the
transformation of counterparty risk into liquidity risk. Explain how liquidity of clearing
members and liquidity resources of CCPs affect risk management and financial stability.
Compare and assess methods a CCP can use to help recover capital when a member
defaults or when a liquidity crisis occurs.

804.1. In the typical central counterparty (CCP) loss waterfall, if a clearing member defaults then
the first layer of protection is the defaulting member's own initial margin. However, if this initial
margin contribution is insufficient, which of the following is the next source of funds in the loss
waterfall?

a) The general default fund

b) The CCP's "skin in the game"
c) The initial margin of other, non-defaulting members
d) The default fund contribution of the defaulting member

804.2. Apex Evergreen is a clearing member with the following summary balance sheet:

Which of the following statements is TRUE?

a) Apex is insolvent
b) Apex is in default
c) Apex is not liquid (aka, illiquid)
d) Apex has a leverage ratio of 20.0

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804.3. Rama Cont writes that "the introduction of central clearing in OTC markets has been
effective in reducing counterparty exposures across clearing members. But, rather than
removing counterparty risk, central clearing transforms it [...]". According to Cont, each of the
following statements is true EXCEPT which is false?

a) The transfer of initial margin and variation margin from the clearing member to the CCP
reduces the firm's solvency but is neutral with respect to the member's liquidity
b) Although market risk depends on the net position for a long-short portfolio, the liquidation
cost is proportional to the gross notional size
c) Margin requirements should include a liquidity charge that is higher for portfolios with (i)
positions whose sizes are large relative to market depth and/or (ii) positions in less liquid
instruments
d) If the liquidation horizon increases linearly with the notional size (N), and the notional
size of a position increases by a factor of four (4), then value at risk (VaR) or expected
shortfall (ES) increase by a factor of four, but the liquidation costs is likely to increase by
a factor of eight (8)

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Answers:

804.1. D. True: The default fund contribution of the defaulting member

Rama Cont on Provisioning for default losses: the CCP loss waterfall (abbreviated): "The
liquidity resources available to a CCP are used to absorb potential losses arising from the
default of clearing members according to the loss waterfall, in the following order:
1. Initial margin: The first layer of protection against losses is provided by the margin
requirements. Each clearing member posts an initial margin requirement with the CCP,
which corresponds to a measure of the risk of the member’s portfolio over a standard
risk horizon which depends on the asset class being cleared. The initial margin paid in
by each member may only be used to absorb the losses arising from the member’s
portfolio, but cannot be used to offset losses of other members or other CCP losses.
2. Default fund contribution of defaulting member: If the loss exceeds the initial margin
contribution, the failing member’s Default Fund contribution is used to offset the
additional losses.
3. Mutualization of large losses: If the loss exceeds the sum of the defaulting member’s
margin and Default Fund contribution: a. first the CCP makes a limited (capped)
contribution to offset the remaining loss: this contribution is sometimes referred to as
“skin-inthe-game”; b. if the CCP’s contribution is insufficient, the Default Fund
contributions of other members are used to absorb remaining losses.
4. Recovery: If losses exceed the size of the Default Fund, the CCPs may have recourse
to: a. an additional contribution to the Default Fund by non-defaulting clearing members:
this assessment is often capped by the initial contribution of the members; b. other
measures to replenish the CCP’s liquidity resources.
5. Failure Resolution: If recovery measures fail to replenish the resources of the CCP or if
the CCP or its members choose not to proceed with recovery measures, the CCP may
enter failure resolution."

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804.2. C. True: Apex is not liquid (aka, illiquid) because its short term assets (i.e., $10.0
cash + $25.0 marketable securities = $35.0) are less than its short-term liabilities ($50.0
deposits + $20.0 payables = $70.0).

In regard to (A), (B) and (D), each is false. Please note that we cannot conclude from this
information that Apex is necessarily in default, although it is possible.

Rama Cont (emphasis ours): "Realized losses vs accounting losses: In the balance sheet of a
firm, one traditionally distinguishes liquid assets--cash or securities readily convertible into cash-
-from other assets; similarly, one distinguishes short-term liabilities from other liabilities. A firm
is said to be solvent if the total value of assets exceeds total liabilities: the difference is the
firm’s equity, or capital. A firm is said to be liquid if the liquid assets exceed the short term
liabilities: this means that there are enough liquid assets to pay off liabilities due in the short
term.

If asset values fall below liabilities, the firm becomes ‘insolvent’. This may occur for
instance following the failure of a large counterparty, if the resulting loss in asset value exceeds
the capital of the firm. As long as the firm is liquid and can meet its short term payments this
may or may not entail any immediate consequence. In the case of a regulated financial
institution, solvency and capital ratios are monitored by regulators; if such a regulated firm
becomes insolvent, the regulator may choose to intervene, take over the management or
restructure the firm. Structural models of credit risk and counterparty risk are in fact models of
insolvency risk. Capital requirements, conceived as buffers against potential losses in asset
value, address the issue of solvency.

Illiquidity, however, is a different story: if a firm, regulated or not, fails to meet a short-term
payment obligation, such as a coupon or margin call, it is in default. In the case of margin calls,
short-term’ refers to one working day in most jurisdictions.

In theory, a firm may be (in)solvent without being (il)liquid or vice versa. In practice, many
financial institutions manage their liquidity through short term repurchase agreements (repos) or
by borrowing against their assets ..."

804.3. A. is false because the inverse is true: The transfer of initial margin and variation
margin from the clearing member to the CCP has no effect on the firm's solvency but
does impact the firm's liquidity.

Cont here summarizes what is arguably the key idea (that gives rise to his recommendations
emphasis ours): "What is the impact of these operations [i.e., margin requirements] on the
balance sheet? First, we note that the transfer of initial margin and variation margin are
‘solvency-neutral’: they do not alter the value of assets, the capital or the solvency of the firm.
The clearing member retains ownership of the collateral posted as initial margin (and continues
to receive interest on this collateral). So, posting initial margin has little or no impact on its
solvency since the collateral continues to remain on the clearing member’s balance sheet.
Similarly, Default Fund contributions are technically owned by the clearing member; here there
is a small impact on the balance sheet since Default Fund contributions lead to a 2% capital
charge (in the case of ‘qualified’ CCPs) for the clearing member. As for variation margin, any
cash outflow in the form of variation margin corresponds to a mark-to-market loss which is
already accounted for in the valuation of the clearing member assets.

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So, the payment of the variation margin corresponds to a transfer from the firm’s liquid assets to
its non-liquid assets, to compensate for a loss in the latter, the total asset value remaining the
same.

However, the impact of these collateral requirements on liquidity resources can be

substantial. Both initial margin and variation margin are deposited in the form of liquid assets.
Most CCPs adopt a narrow definition of ‘liquid assets’ and require initial and variation margin
payment to be made in cash and in some cases G8 sovereign debt instruments, with a haircut
for all noncash or foreign currency collateral. Thus, unlike accounting losses and ‘writedowns’,
initial margin and variation margin directly impact the liquidity reserves of the clearing member.

Thus the overall effect of central clearing on the clearing member’s balance sheet is the
net transfer of value from liquid to non-liquid assets, the total asset value remaining
unchanged. This operation does not affect the equity of the firm, nor does it impact its
solvency risk. We therefore observe that the net impact of the systematic application of
initial margin and variation margin requirements is to replace counterparty risk resulting
from exposures to clearing members -and the associated solvency risk- by liquidity risk."

In regard to (B), (C) and (D), each is TRUE according to Cont.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p2-t9-804-central-clearing-

and-risk-transformation-cont.13524/