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Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition by Jon Gregory

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6.5 Central Counterparties

6.5.1 Introduction

The lesson so far – after considering SPVs, DPCs, monolines and CDPCs – appears to be that relying on a default-remote entity as one's counterparty is a poor way to mitigate counterparty risk. No matter what their underlying credit quality, never assume your counterparty cannot possibly fail. Assuming they are too big to fail may be more reasonable but this creates moral hazard, which, at least from a regulator's and policymaker's perspective, is highly unpleasant. It might seem strange then that the solution to counterparty risk is another default-remote entity, called a CCP.

The global financial crisis from 2007 onwards triggered grave concerns regarding counterparty risk, catalysed by events such as Lehman Brothers, the failure of monoline insurers (with Triple-A ratings), the bankruptcy of Icelandic banks (more Triple-A ratings) and losses arising from some (yes, you've guessed it, Triple-A) structured products. Counterparty risk in OTC derivatives, especially credit derivatives, was identified as a major risk to the financial system. Whilst there are many ways to control and quantify counterparty risk better, in times of crisis maybe it is natural to look for a panacea. A central counterparty (CCP) offers such a solution since counterparties would simply trade with one another through the CCP, which would effectively act as guarantor to all trades. All OTC derivatives traded through a CCP would then be free of counterparty risk. ...

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