Counterparty Risk

Central Counterparties: New Uses for Century-Old Market Mechanisms

By: Allan D. Grody

Tammy Brown

FIN 610-9042

Dr. Dilshad Khawaja

July 31, 2011

Executive Summary

Central counterparties (CCP) have been existence since the last decades before the nineteenth century. There forms and structures have evolved over the last century but there purpose has remained the same. CCP have created an institution that essentially takes away systematic risk from a network of customers that are trying to provide products or services in an investment market. In the article I reviewed, Grody suggest that even though there is risk associated with central counterparties they rarely fail. There have been only three near failures in the century long life (2011, p.114). Grody (2011) also explains, “The daily settlements of these trades allows for the earliest warnings of failure to pay with enough capital in reserve, built up by multiple margin calls throughout the life of the contract” (2011, p.115). It has become a concern that, like investment banks, with the amount of risk associated with taking on counterparty risk will CCPs become the next institutions that will become too large to fail? What is the benefit to the economy as a whole for these financial institutions to stay in existence? We will see through innovated ideas and new processes and policies that have been put into place by risk managers how central counterparties will alleviate the risk and financial strain that “too big to fail” financial institutions have put on the backs of taxpayers.

Central Counterparties (CCP)

CCP take away the risk associated with the funding of financial instruments such as repo markets, credit default swaps, over the counter derivatives, and other securities lending. This is done by bringing interested parties together to conduct transactions that the CCP feels in free from substantial risk. The CCP evaluates the financial position of each party by collecting the necessary...