Chapter 6 - Central Clearing (FRM - Part 1 - Book 3)
Chapter 6 - Central Clearing
Chapter 6 - Central Clearing
1. What does "clearing" refer to in the context of financial transactions?
A. The period when the trade is completed and payments are made
B. The process of initiating margining and netting in settlement
C. The processes from trade execution until settlement
D. The legal obligations after the trade is completed
Clearing refers to the processes from trade execution until settlement, which includes margining and netting.
2. What is a key function of a central counterparty (CCP) during the clearing process?
A. Margining
B. Payment settlement
C. Issuing legal contracts
D. Monitoring trade execution
One of the key functions of a CCP is margining, which helps to ensure that sufficient funds are available to cover potential losses.
3. What is the purpose of initial margin in the clearing process?
A. To cover credit risk of the clearing member
B. To cover the risk of the transaction itself
C. To guarantee the final settlement of the trade
D. To ensure that legal obligations are met
Initial margin is based on the risk of the transaction and not the credit risk of the member. It helps ensure there is enough coverage for potential losses.
4. What happens if the initial margin is insufficient to cover losses in a CCP clearing process?
A. The CCP immediately closes the trade
B. The clearing member faces liquidation
C. Default fund contributions are utilized
D. The trade is postponed until more margin is deposited
If the initial margin is insufficient to cover losses, default fund contributions are used to cover the shortfall.
5. Who typically qualifies as clearing members in the CCP process?
A. Small financial institutions
B. Government bodies
C. Individual investors
D. Large banks and global financial institutions
Clearing members usually include large players, such as large banks and global financial institutions, due to the size and complexity of the trades involved.
6. What is the role of novation in the clearing process?
A. To replace the original trade with two new trades between the CCP and the members
B. To adjust the margin requirements for clearing members
C. To ensure payment settlement happens in a timely manner
D. To liquidate failing trades
Novation involves replacing the original trade with two new trades between the CCP and the clearing members, ensuring that the CCP assumes the counterparty risk.
7. How do CCPs manage auction processes in clearing?
A. By involving the regulatory authorities in each auction
B. By allowing all members to place competitive bids
C. By using a random selection process
D. By managing the auction process to resolve defaults
CCPs manage the auction process to resolve defaults by finding buyers or sellers when a clearing member defaults, ensuring stability in the market.
8. What does a central counterparty (CCP) typically do when a member defaults?
A. Close out the trades at market value immediately
B. Auction off the trades to surviving members
C. Assign losses to the defaulting member’s trades
D. Immediately liquidate the defaulting member’s assets
When a member defaults, the CCP auctions off the trades to the surviving members to minimize losses, rather than closing out the trades at market value.
9. Why is participating in the auctioning process beneficial for the surviving members?
A. To minimize losses that would otherwise occur with lower market prices or the use of default fund contributions
B. To avoid any financial obligation for the defaulting member’s losses
C. To recover the full amount of their previous gains
D. To get a portion of the defaulting member’s remaining assets
Surviving members participate in the auctioning process to minimize their losses that would otherwise occur due to lower market prices or the use of default fund contributions.
10. What happens in case of failed auctions during a default situation?
A. The CCP immediately closes the defaulting member’s positions at a loss
B. The remaining members are required to pay additional margin
C. The CCP assigns losses to surviving members who had no positions with the defaulting member
D. The CCP may assign losses to members who had gains during the auction
Failed auctions may result in the CCP assigning losses to members who had previous gains, to help cover the defaulting member's losses.
11. What is "loss mutualization" in the context of clearing and settlement?
A. The process of liquidating all trades to recover losses
B. The redistribution of profits from successful trades to compensate for losses
C. The contributions made by members to a default fund to cover future losses from defaults
D. The process of creating insurance policies for members to avoid losses
Loss mutualization refers to members' contributions to a default fund, which helps cover future losses from member defaults, thereby containing the risk.
12. In the event of a member default, what happens if the defaulting member's own resources cannot cover the losses?
A. The CCP will cover the loss fully with its own resources
B. The losses are covered by the default fund contributed by all members
C. The defaulting member is liable for all remaining losses
D. The surviving members are required to pay the remaining losses
When a member defaults and their resources cannot cover the losses, the default fund contributions from all members are used to cover the remaining losses.
13. Can a member suffer losses from a defaulting counterparty even if they never traded with the defaulting member?
A. Yes, because losses are shared among surviving members through the default fund
B. No, only the members who traded with the defaulting counterparty suffer losses
C. Yes, but only if the member had prior positions with the defaulting member
D. No, the losses are only attributed to the defaulting member
Due to loss mutualization, a member can suffer losses even if they never traded with the defaulting counterparty, as the losses are spread across all members.
14. What is the primary function of a Central Counterparty (CCP)?
A. To facilitate the trade execution between two parties
B. To offer insurance to parties involved in the trade
C. To reduce counterparty risk and simplify operational processes
D. To conduct financial transactions for the parties involved
The primary function of a CCP is to reduce counterparty risk and simplify operational processes by acting as the intermediary between two counterparties, effectively managing the credit risk.
15. How does a CCP reduce the interconnectedness of trades and participants in an OTC transaction?
A. By offering higher trade volumes for better liquidity
B. By acting as the central counterparty to both the buyer and seller
C. By allowing direct trades between the buyer and seller without intervention
D. By increasing the number of trades in the market
By acting as the central counterparty to both the buyer and seller, the CCP reduces the interconnectedness of trades and participants, mitigating the risk of defaults or nonpayments.
16. How does centralized clearing improve trade liquidity and transparency?
A. By providing a centralized platform for all trades and ensuring credit risk is managed
B. By requiring all participants to post collateral for each trade
C. By reducing the number of participants involved in each trade
D. By allowing trades to occur with reduced regulatory oversight
Centralized clearing improves trade liquidity and transparency by providing a single platform for trade execution, where credit risk is managed and visibility is enhanced for all participants.
17. What happens when a trade is submitted to a CCP after two parties (X and Y) negotiate an OTC agreement?
A. The trade is accepted and processed by the broker involved
B. The CCP will become the counterparty to one of the parties involved
C. The CCP becomes the counterparty to both parties and assumes their credit risk
D. The CCP rejects the trade if the parties are unable to meet margin requirements
Once a trade is submitted to a CCP, it becomes the counterparty to both parties (X and Y) and assumes their credit risk, ensuring that the transaction is processed securely.
18. How does a CCP manage the credit risk of parties involved in an OTC transaction?
A. By requiring parties to post collateral only after the trade is completed
B. By eliminating margin requirements for all parties
C. By requiring initial margin and daily variation margin to be posted by the parties
D. By offering insurance to both parties in the transaction
The CCP manages credit risk by requiring both parties involved in the transaction to post an initial margin and daily variation margin, ensuring that credit risk is appropriately covered.
19. Which of the following best describes **bilateral clearing**?
A. A process where each counterparty clears its own trades directly with the other party
B. A process where a third-party clearinghouse facilitates the trade clearing process
C. A method where the market maker facilitates clearing between buyers and sellers
D. A system where the trade is not cleared until both parties agree on the market price
Bilateral clearing involves each counterparty clearing its own trades directly with the other party, without the involvement of a central clearinghouse.
20. What is the key difference between bilateral and centralized clearing?
A. Bilateral clearing involves multiple clearinghouses, while centralized clearing involves one clearinghouse
B. Bilateral clearing does not involve a central counterparty, while centralized clearing does
C. Centralized clearing allows for fewer trades than bilateral clearing
D. Bilateral clearing requires more margin than centralized clearing
The key difference is that bilateral clearing does not involve a central counterparty, whereas centralized clearing involves a CCP acting as the intermediary to reduce counterparty risk.
21. What is one of the main advantages of central clearing through CCPs in terms of counterparty risk?
A. CCPs remove the need for standardized documentation in OTC transactions
B. CCPs eliminate the need for margining and netting processes
C. CCPs act as the counterparty to each trade, reducing counterparty risk
D. CCPs require all members to provide personal guarantees for trades
By acting as the counterparty to each trade, CCPs reduce counterparty risk, removing the need for direct negotiation between parties and preventing unfavorable closeouts.
22. How does loss mutualization work in central clearing through CCPs?
A. Losses are absorbed by the defaulting member's own resources
B. Losses are distributed among all surviving members, spreading the impact
C. Losses are absorbed by the central bank to prevent systemic risk
D. Losses are covered by the government through taxpayer funds
Loss mutualization works by distributing losses across all surviving members, which helps minimize the impact of a default, reduces costs, and lowers systemic risk.
23. What is one of the benefits of the legal and operational efficiency provided by CCPs?
A. It increases the complexity of margining and netting
B. It eliminates the need for standardized documentation
C. It improves operational efficiency and reduces costs in the clearing process
D. It requires additional regulatory oversight for all trades
The legal and operational efficiency of CCPs improves clearing processes such as margining and netting, reducing costs and streamlining operations.
24. How does central clearing through CCPs facilitate liquidity in the market?
A. By reducing the number of trades in the market
B. By centralizing all trades in a single exchange
C. By facilitating netting and the closing of trades
D. By making it difficult for traders to exit positions
By facilitating the netting of trades and making it easier to close positions, CCPs enhance liquidity, allowing for quicker and more efficient transactions.
25. How do CCPs promote standardized documentation in OTC derivatives?
A. By encouraging parties to create their own terms for each trade
B. By removing the need for contracts altogether
C. By allowing informal agreements between counterparties
D. By promoting the use of standardized documentation for all trades
CCPs promote the use of standardized documentation in OTC derivatives, which improves consistency and clarity, helping to mitigate potential legal and operational issues.
26. How does increased transparency through CCPs benefit the OTC markets?
A. It hides the trading positions of parties from regulators
B. It allows for better monitoring and reaction to extreme events
C. It makes it easier for parties to evade regulatory oversight
D. It reduces the number of participants in the market
Increased transparency allows CCPs to have a consolidated view of trading positions, enabling them to monitor and respond to extreme events more effectively, enhancing market stability.
27. What is the main risk associated with moral hazard in central clearing?
A. Members take on higher risk because they have direct access to the CCP's default fund
B. Members are incentivized to monitor risk more aggressively
C. Members may take on higher risk, knowing that the CCP bears the costs of this risk
D. The CCP itself increases its own risk exposure to provide more incentives for members
Moral hazard occurs when parties take on higher risks because they know the CCP will absorb the losses, reducing their incentive to monitor and control risk properly.
28. What is the potential issue with adverse selection in central clearing?
A. Participants may avoid trading products whose risks are overpriced by the CCP
B. Participants with better understanding of risks may trade more products with underpriced risks and fewer products with overpriced risks
C. The CCP overprices the risk of all products uniformly
D. There is no impact of adverse selection on the market participants in central clearing
Adverse selection happens when participants, understanding the risks better than the CCP, exploit situations where the CCP underprices the risks of certain products, leading to a distorted trading environment.
29. What is procyclicality in the context of central clearing?
A. The CCP decreases margin requirements during volatile market periods
B. The CCP increases margin requirements during periods of market stability
C. The CCP increases margin requirements in volatile markets or crises, potentially worsening systemic risk
D. The CCP has no impact on margin requirements during economic crises
Procyclicality refers to the CCP's tendency to raise margin requirements during market volatility or crises, which could exacerbate systemic risks by forcing more participants to liquidate positions.
30. What is the challenge related to credit risk in central clearing?
A. The CCP takes on more credit risk than participants
B. Credit risk is easier to assess due to the transparency of all participants' trades
C. Members can fully assess the credit risk of other members due to centralized visibility
D. The lack of transparency in members’ trades makes it difficult for participants to determine credit risk
Credit risk in central clearing is complicated by the lack of transparency into other members' trades, making it difficult for participants to assess the default risk associated with each member and their contributions to the default fund.
31. What was one of the key regulatory changes for OTC derivatives after the 2007–2009 credit crisis?
A. OTC derivatives could only be traded between non-financial entities
B. Standardized OTC derivatives must be cleared through CCPs
C. Non-standardized OTC derivatives were completely banned
D. CCPs were not required for any derivatives transactions
After the 2007–2009 credit crisis, the G-20 leaders mandated that standardized OTC derivatives must be cleared through CCPs to reduce systemic risk in the financial system.
32. Which of the following is a result of trading standardized OTC derivatives on electronic platforms?
A. Increased price transparency for all market participants
B. Reduced transparency, limiting information to dealers only
C. Market participants no longer need to monitor trading prices
D. Only financial institutions can access price data
Trading standardized OTC derivatives on electronic platforms improves price transparency, allowing all market participants to have greater visibility into trading prices.
33. What is the purpose of reporting all OTC trades to a central trade repository?
A. To allow financial institutions to track profits from their trades
B. To reduce the cost of trading for non-financial entities
C. To help regulators assess the risks associated with OTC derivatives
D. To limit the number of trades that can be reported
Reporting all OTC trades to a central trade repository allows regulators to have better oversight of the market, helping them assess the risks and make informed regulatory decisions.
34. Which of the following statements applies to the CCP clearing mandate for OTC derivatives under the new regulations?
A. The CCP clearing requirement applies only to trades between financial institutions
B. The CCP clearing requirement applies to trades between both financial and non-financial institutions
C. The CCP clearing requirement applies only to non-financial institutions
D. The CCP clearing requirement has been revoked for all derivatives
The requirement for CCP clearing applies primarily to trades between financial institutions for standardized OTC derivatives, helping to mitigate systemic risk and ensure smoother market functioning.
35. How did the G-20 regulatory initiatives impact the central clearing of OTC derivatives?
A. It decreased the use of central clearing for OTC derivatives
B. It allowed dealers to bypass CCPs if they are non-financial entities
C. It restricted the use of CCPs to only non-financial institutions
D. It significantly increased the amount of central clearing for standardized OTC derivatives
The G-20 initiatives increased the amount of central clearing for standardized OTC derivatives by mandating CCP clearing for interdealer transactions involving standardized products, reducing systemic risk.
36. Which of the following is a key feature of centrally cleared transactions?
A. Transactions with nonstandard terms and high valuation complexity
B. Standard legal and economic terms with active trading and valuation models
C. Transactions exclusively between two non-financial institutions
D. Transactions that do not require margin posting
Centrally cleared transactions are typically standardized, with clear legal and economic terms, and active trading to ensure liquidity and ease of unwinding positions.
37. What is the main difference between margining requirements for centrally cleared and bilateral (uncleared) transactions?
A. Only centrally cleared transactions require initial margin
B. Bilateral transactions require initial margin and variation margin, unlike centrally cleared transactions
C. Both types of transactions require initial margin and variation margin, but uncleared transactions require margin to be forwarded to a third party in trust
D. Bilateral transactions do not require margin at all
Both centrally cleared and bilateral transactions require initial and variation margin. However, for uncleared transactions, initial margin is typically forwarded to a third party in trust, unlike centrally cleared transactions.
38. How does initial margin help mitigate risk in centrally cleared markets?
A. It covers the potential loss from fluctuations in the market price of the underlying asset
B. It helps to cover a worst-case loss in the event of a member's default
C. It is used to compensate for transaction costs incurred by the central clearing party
D. It acts as a bonus for clearing members
Initial margin in centrally cleared markets acts as a cushion to cover potential losses in case a member defaults. It helps to ensure that there are sufficient funds to cover a worst-case scenario.
39. What is the purpose of variation margin in both centrally cleared and bilateral markets?
A. To cover the cost of settling a trade
B. To maintain the initial margin amount for the entire life of the transaction
C. To cover the daily net change in the member's position
D. To calculate the profits of each trading member
Variation margin is used to cover the daily net change in the value of a member's position. It helps ensure that the margin levels stay appropriate to the evolving risk profile.
40. How does the use of margin in both centrally cleared and bilateral transactions mitigate risk?
A. By limiting market access to only well-capitalized institutions
B. By ensuring that there are sufficient funds to cover potential losses in the event of a default
C. By reducing the collateral requirements for institutions with low credit risk
D. By covering profits from margin calls
Margin mitigates risk by ensuring that there are sufficient funds (initial and variation margin) available to cover potential losses in the event of a default, protecting both counterparties and the broader financial system.
41. What is the process called when the CCP interposes itself between the buyer and seller, replacing the original bilateral contract?
A. Novation
B. Netting
C. Marginalization
D. Settlement
The process of interposing the CCP between the buyer and the seller is called novation. It replaces the bilateral contract with a contract between each participant and the CCP.
42. What is the key advantage of novation in centralized clearing?
A. The original bilateral contract remains in place, ensuring mutual obligations
B. It transforms bilateral trades into centralized contracts, making the CCP responsible for counterparty risk
C. It eliminates the need for margin requirements
D. It eliminates the role of the CCP in managing trades
Novation transforms bilateral contracts into centralized contracts where the CCP becomes the counterparty for each participant, thus assuming counterparty risk and ensuring the safety of the trading system.
43. What is the effect of novation on the original bilateral contracts between market participants?
A. The original contracts remain in force, and both parties must continue fulfilling their obligations
B. The original contracts are cancelled, and the CCP takes on the counterparty risk
C. The contracts are renegotiated between the parties
D. The original contracts are replaced by a bilateral contract with the CCP
Under novation, the original bilateral contracts are replaced by contracts between the participants and the CCP. The original contracts cease to exist, and the CCP assumes the counterparty risk.
44. How does netting benefit participants in a centralized clearing process?
A. It eliminates the need for margin posting
B. It increases the number of redundant trades
C. It consolidates redundant trades into a single net obligation, reducing total risk
D. It makes each participant responsible for monitoring the risks of all trades
Netting helps to reduce total risk by consolidating redundant trades into a single net obligation between each participant and the CCP, minimizing the potential systemic risk from defaults.
45. What is the main benefit of netting in terms of reducing systemic risk in centralized clearing?
A. It eliminates the counterparty risk entirely
B. It increases the number of trades between participants
C. It allows market participants to avoid margin requirements
D. It minimizes the potential domino effect resulting from a participant’s default
Netting helps to reduce systemic risk by consolidating redundant trades, thus minimizing the potential domino effect that could occur if a participant defaults.
46. What is the primary advantage of central clearing through a CCP in reducing systemic risk?
A. It increases counterparty risk
B. It reduces counterparty risk by offsetting positions through novation and netting
C. It eliminates the need for initial margin
D. It concentrates trading in a single market
Central clearing through a CCP reduces counterparty risk by offsetting positions (through novation and netting), ensuring that the CCP assumes the risk of default rather than individual market participants.
47. What is one potential disadvantage of requiring members to post higher initial margin during times of increased market volatility?
A. It reduces the liquidity in the market
B. It increases the risk of counterparty default
C. It could increase systemic risk by putting more pressure on market participants
D. It causes the CCP to fail
Requiring members to post higher initial margin during periods of increased market volatility can increase systemic risk by placing more financial pressure on market participants, potentially leading to defaults and increased instability.
48. What is a risk associated with concentrating all trades in a single CCP?
A. It eliminates market transparency
B. It reduces the liquidity in the market
C. It causes market fragmentation
D. It exposes the market to the risk of CCP failure, increasing systemic risk
Concentrating all trades in a single CCP exposes the entire market to the risk of CCP failure, which could lead to a systemic collapse if the CCP is unable to handle the defaults or liquidity pressures.
49. What challenge does the long-term maturity of OTC derivatives pose for CCPs in the central clearing process?
A. CCPs are unable to handle short-term transactions
B. CCPs may not be effective in clearing long-dated, complex, and illiquid trades
C. It results in the failure of CCPs
D. CCPs are unable to deal with high-frequency trades
The long-term maturity of OTC derivatives can be a challenge for CCPs, as they may struggle to manage complex, illiquid trades that have long durations, especially those that span years or decades.
50. How does central clearing through a CCP improve liquidity in the financial market?
A. By reducing the transparency of trades
B. By concentrating all trades in one market, increasing participant interaction
C. By eliminating the need for margin posting
D. By preventing the occurrence of defaults
Central clearing can improve liquidity by consolidating all trades in one place, facilitating smoother market operations and increasing interaction among market participants.
51. What is the most significant risk associated with the default of a clearing member in a CCP?
A. Reduced transparency in the market
B. Increased liquidity in the market
C. The potential default or distress of other clearing members due to high default correlation
D. Higher margin requirements for other clearing members
The most significant risk is the potential for the default or distress of other clearing members because of high default correlation among OTC derivatives market participants.
52. How does the CCP handle the default of a clearing member in terms of loss allocation?
A. The CCP absorbs all losses incurred due to the default
B. Losses are passed on to the defaulting clearing member only
C. Losses are passed on to the other market participants based on their trading volume
D. Losses are passed on to other clearing members through rights of assessment, loss allocation methods, or both
In the event of a default, the CCP may pass on the losses to other clearing members using rights of assessment, loss allocation methods, or both. This may lead to further defaults if other members are unable to bear the additional losses.
53. Which loss allocation method used by CCPs may impose losses on winning positions?
A. Tear-ups
B. Variation margin gains haircutting (VMGH)
C. Default fund contributions
D. Initial margin assessments
Variation margin gains haircutting (VMGH) is a loss allocation method that can impose losses on winning positions, where members whose positions have increased in value (and thus are owed variation margin) may not receive the full amount of their gains.
54. What happens during a "tear-up" in the CCP clearing process?
A. The CCP terminates the unmatched position and balances resources by drawing from both the defaulter's initial margin and the default fund
B. The CCP passes on the loss to the defaulting clearing member only
C. The CCP absorbs the entire loss of the defaulting clearing member
D. The CCP increases margin requirements for the remaining clearing members
In a tear-up, the CCP terminates unmatched positions and may draw resources from both the defaulter's initial margin and the default fund to balance the resources.
55. How might the default of a clearing member impact the reputation of the CCP?
A. The reputation of the CCP improves due to its ability to handle defaults
B. The CCP's reputation remains unaffected by member defaults
C. The CCP may experience a negative reputational impact, leading to further resignations of clearing members
D. The CCP compensates all members for the losses, improving its reputation
The default of a clearing member can negatively impact the CCP's reputation, especially if it leads to resignations of other clearing members, further harming its stability and credibility.
56. What type of risk arises for CCPs due to the use of valuation models to price OTC derivatives?
A. Credit risk
B. Model risk
C. Operational risk
D. Systemic risk
Model risk arises when CCPs use valuation models for pricing OTC derivatives. Errors in these models, particularly related to volatility assumptions, can lead to mispricing and inadequate margin calculations.
57. What is particularly sensitive to model risk in the context of CCP operations?
A. Counterparty risk management
B. Investment returns from margin funds
C. Legal enforceability of contracts
D. The determination of initial margins
The determination of initial margins is particularly sensitive to model risk, as incorrect assumptions about volatility can result in under- or over-estimation of the necessary margins.
58. What is a key factor that could cause liquidity risk for CCPs?
A. The need to maintain a matched book of trades
B. The large cash inflows and outflows due to margin calls and initial margins
C. The reliance on long-term OTC derivative contracts
D. The dependence on a single clearing member
Liquidity risk arises from large cash inflows and outflows resulting from margin calls and initial margin requirements. CCPs must manage the liquidity of these flows carefully to avoid risk.
59. How do CCPs manage the trade-off between liquidity and credit risk when handling margin funds?
A. By investing solely in liquid securities such as treasury bonds
B. By maximizing return on investments, disregarding liquidity concerns
C. By avoiding any investment in less liquid securities like corporate bonds
D. By balancing investments between more liquid securities and less liquid securities
CCPs aim to balance investments between more liquid securities (like treasuries) and less liquid securities (like corporate bonds) to maximize return while minimizing liquidity and credit risk.
60. In a stressed market condition, what is a critical consideration for CCPs when managing liquidity risk?
A. The ability to raise margin levels without any market constraints
B. The ability to absorb all liquidity risk by drawing on the default fund
C. The ability to quickly convert investments into cash under stressed market conditions
D. The reliance on a diversified portfolio of illiquid assets
In stressed market conditions, CCPs need to be able to quickly and easily convert investments into cash, especially when defaults are more likely to occur in environments with lower liquidity.
61. What additional risk arises due to the centralization of functions within a CCP?
A. Operational risk due to concentration at the CCP
B. Liquidity risk from inadequate margin management
C. Credit risk from mispriced derivatives
D. Legal risk from jurisdictional conflicts
Centralizing functions within a CCP increases operational risk due to the concentration of critical operations at a single point. This risk is exacerbated if the CCP experiences failures that impact multiple counterparties.
62. Which of the following is an example of operational risk in a CCP?
A. Variation margin gains haircutting (VMGH)
B. Business interruption due to systems failures
C. Default by a clearing member
D. Legal disputes over margin segregation
Operational risk includes disruptions such as business interruptions caused by systems failures, which can have disastrous impacts on counterparties, particularly those with large positions.
63. Legal risks in a CCP arise due to:
A. Inconsistent laws across different jurisdictions
B. Mispricing of OTC derivatives
C. Inadequate investment policies
D. Operational failures within a CCP
Legal risks stem from conflicts between laws in different jurisdictions or from regulations that may be inconsistent with the CCP's operational framework, such as those related to margin and position segregation.
64. What type of risk occurs when a CCP loses margin funds due to investment actions outside its policy?
A. Operational risk
B. Legal risk
C. Investment risk
D. Liquidity risk
Investment risk occurs when a CCP suffers losses on its investments of margin funds, either due to actions outside its stated investment policy or unfavorable market conditions.
65. How does a default scenario typically affect the CCP in terms of risk correlation?
A. It reduces the correlation of risks within the CCP
B. It isolates operational and legal risks from other types of risk
C. It decreases the probability of fraud and legal claims
D. It increases the correlation of various risks such as operational, investment, and legal risks
In a default scenario, various risks such as operational, investment, and legal risks are likely to be correlated, exacerbating the overall impact on the CCP.
66. Which of the following best describes the exposure of non-members in a CCP?
A. Non-members face higher exposure to CCP defaults than clearing members
B. Non-members are exposed to losses only if their counterparty, a clearing member, defaults
C. Non-members contribute to default funds, which makes them more exposed than clearing members
D. Non-members face no exposure to CCPs or clearing members
Non-members are only exposed to CCP defaults if their counterparty, a clearing member, defaults. They do not contribute to default funds, so their exposure is lower compared to clearing members.
67. What is the risk faced by non-members when a clearing member defaults in a CCP?
A. Non-members may face losses if they are unable to port their trades
B. Non-members' initial margin is always fully protected
C. Non-members' trades will be automatically transferred to another clearing member without loss
D. Non-members will never face losses as they are not involved in the clearing process
Non-members may face losses if they are unable to port their trades to another clearing member after the default of their original clearing member. This situation may require closing out their trades at a loss.
68. How can clearing members pass on losses to non-members in the event of a default?
A. By utilizing the default fund contributions of other members
B. By increasing the margin requirements for non-members
C. By passing on losses through the rights of assessment
D. By using VMGH or tear-up procedures
Clearing members can pass on losses to non-members through variation margin gains haircutting (VMGH) or tear-up procedures. These methods may reduce the gains of non-members, but they are not involved in the default fund utilization.
69. Which of the following liabilities cannot be passed on to non-members in the case of a CCP default?
A. Losses from the CCP's utilization of its default fund
B. Losses due to VMGH or tear-up
C. Forced allocation of losses to non-members
D. Losses from a defaulting clearing member’s actions
Clearing members cannot pass on losses resulting from the CCP's utilization of its default fund or forced allocation to non-members. Non-members are primarily exposed to losses through VMGH or tear-up procedures.
70. How does the exposure of non-members to CCP risks differ from that of clearing members?
A. Non-members are required to contribute to the CCP’s default fund
B. Non-members' risks are higher than those of clearing members due to non-segregated margins
C. Non-members are not required to contribute to default funds, limiting their exposure
D. Non-members have no exposure to CCPs or clearing members
Non-members do not contribute to the CCP’s default fund, which limits their exposure compared to clearing members. Their risk exposure depends on the security and segregation of their initial margins.
71. Which of the following best describes the auction process used by CCPs when clearing members default?
A. CCPs close out trades at market value in the auction process
B. CCPs auction trades to existing members instead of closing them out at market value
C. CCPs pass on the losses directly to the defaulting member's counterparties
D. CCPs liquidate all positions held by the defaulting member in the auction process
In the auction process, a CCP does not close out trades at market value. Instead, it auctions the trades to existing members, allowing the CCP to manage risk while ensuring liquidity.
72. What does the concept of moral hazard refer to in central clearing?
A. The risk of financial instability caused by excessive collateral
B. The risk that participants will trade more risky products knowing that the CCP will bear the loss
C. The risk that members have less incentive to monitor risk because the CCP assumes most of the risks of the transactions
D. The risk of market manipulation due to unregulated trading activities
Moral hazard in central clearing refers to the risk that members will have less incentive to monitor risk because the CCP assumes most of the risks involved in transactions.
73. How does procyclicality affect a CCP during volatile markets or crises?
A. By reducing margin requirements to ease liquidity pressure
B. By increasing liquidity buffers to protect against defaults
C. By reducing exposure to risky assets in the portfolio
D. By increasing margin requirements, which may exacerbate systemic risk
Procyclicality in CCPs refers to the increase in margin requirements during volatile markets or crises, which can amplify systemic risks by forcing participants to reduce their positions in an already stressed environment.
74. What is the purpose of netting in a CCP system?
A. To eliminate duplicate bilateral contracts and improve flexibility
B. To increase the margin requirements for all participants
C. To increase transaction costs by adding an extra layer of intermediaries
D. To reduce the number of clearing members involved in transactions
Netting in a CCP system eliminates duplicate bilateral contracts by consolidating them, which improves flexibility and reduces overall transaction costs.
75. Which of the following best describes adverse selection in the context of a CCP?
A. The risk that participants will trade less risky products and avoid high-risk products
B. The risk that participants with a better understanding of product risks will trade more products with underpriced risks
C. The risk that the CCP will underprice the margin requirements for high-risk products
D. The risk that participants will misrepresent the risks of products to the CCP
Adverse selection in the CCP context refers to the risk that participants with a better understanding of product risks will trade more products whose risks are underpriced by the CCP, while avoiding products whose risks are overestimated.
76. How are initial margin requirements set by CCPs?
A. Based on the risk of the members
B. Based on the risk of the transactions, not on the risk of the members
C. Based on the market value of the positions held by the members
D. Based on the liquidity of the underlying assets
CCPs set initial margin requirements based on the risk of the transactions, not the risk of the members. This helps ensure that collateral is adequate to cover potential defaults related to market movements.
77. What does novation refer to in the context of central clearing?
A. The process of increasing margin requirements during a market crisis
B. The elimination of net obligations between OTC participants
C. The replacement of a bilateral contract with another contract or contracts with the CCP
D. The reduction of counterparty risk through the netting process
Novation refers to the process where one contract (a bilateral contract) between OTC participants is replaced by another contract with the CCP, thus terminating the bilateral obligations between the two participants.
78. What is the purpose of netting in a CCP system?
A. To create a single net obligation between each participant and the CCP from multiple bilateral trades
B. To eliminate the need for collateral posting
C. To increase the number of contracts between OTC participants
D. To calculate variation margin based on market price fluctuations
Netting in a CCP system creates a single net obligation between each participant and the CCP, consolidating multiple bilateral contracts into a single liability or receivable.
79. What is the primary purpose of margining in a CCP system?
A. To reduce transaction costs
B. To guarantee a profit for the clearing members
C. To eliminate the need for novation
D. To cover member defaults or security mark-to-market movements through the posting of collateral
Margining is the process of posting collateral (such as cash or marketable securities) to cover member defaults (initial margin) or security price changes (variation margin) to ensure the stability of the CCP.
80. Legal risks in CCPs may arise from which of the following?
A. Differing laws in different jurisdictions or inconsistent laws with CCP’s regulations
B. Defaulting by clearing members in the absence of margin calls
C. High correlation of default risks among OTC derivatives market participants
D. Losses due to incorrect pricing models
Legal risks arise due to differing laws in different jurisdictions or from laws that are inconsistent with the CCP’s regulations. This can impact processes such as the segregation and movement of margin and positions.
81. Which of the following is NOT true regarding investment risk in CCPs?
A. Investment risk refers to the risk of losses resulting from margin fund investments
B. It involves losses from actions performed both within and outside the stated investment policy
C. It pertains to OTC derivative pricing errors made by the CCP
D. It can increase if there is a major market impact or a default scenario
Investment risk refers to the risk of losses from investments made with margin funds, either within or outside the specified investment policy. It does not relate to pricing errors or OTC derivative valuation.
82. What risk is described when a CCP requires higher margin during volatile market conditions, potentially increasing systemic risk?
A. Default risk
B. Procyclicality
C. Counterparty risk
D. Operational risk
Procyclicality refers to the scenario where CCPs raise margin requirements during volatile or crisis periods, which can exacerbate systemic risk in financial markets.
