Question

QUESTION 3: You have been provided with a slide contrasting bilateral vs. multilateral netting. Consider the following:

Redmond enters into a 3 month forward foreign exchange contract with Smith. It is agreed that both parties will post cash (margin) collateral based on contract mark to market values. Redmond decides it wishes to “unwind” its credit risk and does an offsetting forward contract with Unger with the same terms. Answer the following.

1. Assuming bilateral netting, describe Redmond’s credit exposure.

2. Assume multilateral netting with both forward contracts and cash collateral are done through a CCP. Describe Redmond’s credit exposure.

Answer 1

a.A bilateral netting agreement enables two counterparties in a financial contract to offset claims against each other to determine a single net payment obligation that is due from one counterparty to the other, meaning that the payables and receivables are netted off.Such a provision would allow companies, especially banks, to set aside far lesser capital based on their net positions rather than gross settlements, where the entire amount due must be covered.

a.CCPs can reduce counterparty credit risk by netting exposures across their members: that is, offsetting an amount due from a member on one transaction against an amount owed to that member on another, to reach a single, smaller net exposure. When trades are centrally cleared, the original counterparties’ contracts with one another are replaced or ‘novated’ — with a pair of equal and opposite contracts with a CCP. Hence the CCP becomes the buyer to the original seller, and the seller to the original buyer.

For some financial products, members’ net payment obligations to or from the CCP are settled on a daily basis (or more frequently if there are large movements during the course of the day) to prevent the build-up of large exposures. Payments that become due because of changes in financial market prices are known as ‘variation margin’ payments.

The first line of defence is collateral provided by the defaulting member. CCPs require a pre-set amount of collateral — referred to as ‘initial margin’ — to be posted to the CCP by each party in a transaction. In the event of default, the defaulting member’s initial margin can then be used (or liquidated) to cover any losses or obligations that are incurred.

The reduction (through netting and collateralisation), the mutualisation and the orderly distribution of losses are the key differences between trades that are centrally cleared compared to non-cleared transactions. The netting benefits reduce the size of exposures at default, and also the liquidity demands on traders during what could be stressed market conditions. Losses in excess of collateral provided by the defaulters are mutualised and allocated in a transparent and orderly fashion, reducing some of the uncertainty that would otherwise arise in the event of a firm’s failure.

Central counterparties — one type of financial market infrastructure — sit between the buyer and seller of a trade, taking on the obligations of each counterparty. In the event that one counterparty fails, CCPs can reduce counterparty credit risk, through the default management procedures and resources of the CCP as well as the ‘netting’ of exposures that would arise from a world of non-cleared trades.