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Answer: The candidate derivative instrument requires heterogeneous (ie, non-standard) legal terms such that each contract is unique
### Correct answer: A Central clearing works best for instruments that are **standardized**, easy to value, liquid enough to support margining, and suitable for multilateral netting. If each contract requires **heterogeneous, non-standard legal terms**, then the instrument is not homogeneous enough for a CCP to clear efficiently. #### Why A is correct - A CCP needs contracts that can be **interposed, netted, margined, and default-managed** in a standardized way. - Unique legal terms mean each trade may require bespoke documentation and individualized risk treatment. - That makes the instrument **less compatible with central clearing**. #### Why the others are not the best answer - **B:** Sensitivity to model assumptions is a valuation risk, but a simple product can still sometimes be cleared if models are robust and market data are available. - **C:** The fact that some counterparties are not current CCP members does not by itself make clearing impossible; they may clear through members. - **D:** High volatility increases margin requirements, but does not automatically make the product incompatible with clearing if the market is sufficiently liquid and standardized. ### Key principle The strongest barrier to central clearing is usually **lack of standardization**, especially in legal terms and contract structure.
Author: Manit Arora
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Q-604.1. A central counterparty (CCP) is evaluating a new derivative instrument as a possible candidate for trading on its central clearing platform. The following four features are associated with the candidate derivative instrument. Which of the following is MOST LIKELY to render the instrument incompatible with central clearing?
A
The candidate derivative instrument requires heterogeneous (ie, non-standard) legal terms such that each contract is unique
B
The candidate derivative instrument is simple (ie, not complex) however valuation models are quite sensitive to input assumptions
C
Several of the counterparties, who are interested to trade the candidate derivative instrument, are not currently members of the CCP
D
The candidate derivative instrument has an historical price volatility that is significantly above average, although volume has been deep
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