3:06 pm - Monday September 26, 0298

Role of central counterparties and processing of OTC derivatives

This post makes an attempt to cover the role of central counter-parties and processing of OTC derivatives in four parts as under:

Part I – All about Central Counterparties

Part II – Best practices framework for CCPs

Part III – Some loud thinking on their future roles

Part IV – Can they add comfort to clearing OTC derivatives

Part I – All about Central Counterparties

What is counterparty risk?

Counterparty risk is the risk that a counterparty in a transaction will default prior to the expiration of the contract and will be unable to make agreed contractual payments. In this event, the risk can be quantified as the replacement cost – the cost in replacing the defaulted transaction at current market rates to meet the obligations. Sometimes, the counterparty can default on the expiry day, after the other party has met the obligation under the transaction in which case, the loss would be the entire value of the transaction. Sometimes, counterparty risk is mistaken as the lending risk. The feature that differentiates and distinguishes counterparty risk is the inability to ascertain the exact exposure at any given future date.

In the case of a derivative transaction with a named counterparty, the market value is known only if the market rate is available. For any date in future, since the market rate is not known, the market value is unknown. At best one can work out its value with assumed rates. Therefore, if a counterparty to a derivative transaction defaults prior to the expiration of the contract, the said transaction will need to be replaced. And therefore, the maximum loss will be the replacement cost of the transaction

What is a central counterparty?

A CCP – central counterparty – is “an entity that interposes itself between counterparties to contracts in one or more financial markets, becoming the seller to the buyer and the buyer to the seller” (CPSS / IOSCO, Recommendations for Central Counterparties, November 2004). CCP is defined by legal / contractual obligations for transactions it clears, not by function. Central Novation or Open Offer are main legal mechanisms. A CCP ultimately takes Counterparty Risk on itself, as opposed to mutualising the risk exposure amongst its members. CCP concentrates risks and manages them. It does not eliminate counterparty risk exposures. Some of the leading central counterparties are: ICE, CME, NYSE-Liffe-LCH.Clearnet, Eurex, ICE Trust Europe, LCH.Clearnet SA

What does a central counterparty do?

CCPs help facilitate the clearing and settlement process in financial markets. CCPs enter the stage after a trade is concluded and act as intermediary between the trading partners. A CCP interposes itself between counterparties to financial transactions, becoming the buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial stability. Although a CCP has the potential to reduce risks to market participants significantly, it also concentrates risks and responsibilities for risk management. Intraday margin is a generally accepted risk management tool of central counterparties to cover increased risk exposure during the day. Central counterparties may call for intraday margin on a routine basis, but also in case of extreme price volatility or large changes in positions of clearing members.

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