Explanation:
Given the role CCPs play in mandatory central clearing, CCPs are expected to be designated as "systemically important" entities. As a result, the likelihood of government support or bailout in a severe stress scenario is likely. This creates a moral hazard problem because CCPs designated as systemically important could potentially accept higher risk and may have less stringent risk management governance knowing that a government bailout in a default scenario is likely.
(Book 3, Module 32.1, LO 32.c)
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Question 4
Firm X is looking to mitigate counterparty risk by centrally clearing trades through a central counterparty (CCP). The firm is aware of some of the potential benefits of central clearing, but is concerned that the drawbacks have not been properly considered by its risk management department. Which of the following definitions is associated with the moral hazard problem of using a central counterparty?
A
CCPs are expected to be designated as systemically important entities.
B
Counterparties are likely to over-trade products for which the CCP underestimates risk.
C
Losses arising from a counterparty’s default are spread across all central clearing members.
D
When margin calls are made, members have to liquidate sufficient assets to meet the margin calls.
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