Explanation:
The statement refers to the concept of loss mutualization, which is actually an advantage of CCP cleared markets, not a disadvantage. Loss mutualization is a process where the losses of a defaulting counterparty, which exceed the financial commitments from the defaulter, are distributed among the CCP members. This mechanism is designed to protect the financial system from the domino effect that could occur if one party defaults on its obligations. By spreading the losses among all members, the CCP ensures that no single member bears the full brunt of the default, thereby reducing the overall risk in the market. This is a key feature of CCPs and is one of the main reasons why they are used in financial markets.
Choice A is incorrect. Moral hazard indeed poses a significant risk in CCP cleared markets. Market participants may become complacent about their counterparty risk management practices, believing that the presence of the CCP eliminates the need for them to consider risk. This can lead to reckless behavior and increased systemic risk.
Q.862 Which of the following is NOT a disadvantage of central counterparty (CCP) cleared markets?
A
Moral hazard has a serious effect on the counterparty risk management practices of the market participant as they believe that, in the presence of the CCP, they do not have to take risk into consideration.
B
The function of frequently requiring greater margin requirements under a CCP may increase the procyclicality in the economy.
C
When the losses of the defaulting counterparties exceed the financial commitments from the defaulter, then these losses are distributed throughout the CCP members.
D
The central counterparty is vulnerable to adverse selection, which means that since the members trading OTC derivatives know more about the risks than the CCP itself, the members may intentionally pass the toxic contracts or assets to the CCP.
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