Introduction

In the financial markets, counterparty risk refers to the risk that one party in a transaction may default on its obligations, leading to potential losses for the other party. This risk is particularly relevant in over-the-counter (OTC) transactions, where parties trade directly with each other without the intermediation of an exchange or clearinghouse. To mitigate counterparty risk, exchanges play a crucial role by providing a centralized and regulated marketplace for trading financial instruments. This chapter explores how exchanges can effectively alleviate counterparty risk and ensure the integrity of financial transactions.

Role of Exchanges in Alleviating Counterparty Risk

Central Counterparty Clearing (CCP)

Exchanges that offer central counterparty clearing services act as intermediaries between buyers and sellers. When a trade is executed, the CCP becomes the counterparty to both parties involved in the transaction. By becoming the buyer to every seller and the seller to every buyer, the CCP effectively guarantees the performance of the trade. If one party defaults, the CCP steps in to fulfill the trade, ensuring that the other party does not suffer losses due to the default.

Margin Requirements

Exchanges set margin requirements for trading participants. Margin is a form of collateral that traders must deposit to cover potential losses from adverse price movements. By requiring traders to post initial and variation margin, exchanges ensure that participants have sufficient funds to absorb potential losses, reducing the likelihood of defaults.

Mark-to-Market and Daily Settlement

Exchanges typically employ mark-to-market practices, wherein the value of positions is recalculated at the end of each trading day based on the prevailing market prices. Participants must settle any gains or losses daily. This process ensures that traders are continuously held accountable for their positions and reduces the buildup of large unsettled obligations.

Examples

Example 1: Stock Exchange (Equity Markets)

Consider a stock exchange where two parties, Alice and Bob, enter into a stock trade. Alice buys 100 shares of XYZ Corp. from Bob. Without a CCP, Alice bears the risk that Bob might default on delivering the shares. However, with a CCP in place, the CCP becomes the buyer to Bob and the seller to Alice. If Bob defaults, the CCP steps in, ensuring that Alice receives the shares she bought, and Bob receives the proceeds from the sale.

Example 2: Futures Exchange (Derivatives Markets)

In a futures exchange, Sam and Emma enter into a futures contract. Sam agrees to sell 1,000 barrels of oil to Emma at a specified price on a future date. The exchange imposes initial margin requirements on both Sam and Emma, which they must deposit to open the futures position. Additionally, daily mark-to-market is performed, and variation margin is exchanged to account for changes in the contract’s value. These margin practices ensure that both parties fulfill their obligations and minimize counterparty risk.