Quiz: Market Infrastructure

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6 questions to check your understanding of the chapter “Market Infrastructure”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   The Principles for Financial Market Infrastructures (PFMI) cover five types of financial market infrastructure. What does a central securities depository (CSD) do?

   1. A.It transfers and settles securities by book entry, and provides settlement services
   2. B.It maintains a centralized electronic record (database) of trade data, and provides recordkeeping services
   3. C.It provides securities accounts, and provides central safekeeping and asset services such as redemptions
   4. D.It steps between the parties to a trade, becoming the buyer to every seller and the seller to every buyer, and ensures that the trade is performed
   Answer and explanation

   Answer: C

   Divided by function, financial market infrastructure falls into five types: payment systems, CSDs, securities settlement systems, central counterparties, and trade repositories. The role of a CSD is to provide securities accounts, and to provide central safekeeping and asset services such as redemptions. The entity that transfers and settles securities by book entry is a securities settlement system. The entity that maintains a centralized electronic record of trade data is a trade repository, and the one that steps between the parties to ensure a trade is performed is a central counterparty. One entity can perform the functions of several types. For example, many CSDs also operate a securities settlement system.

   Learn more: Overview of Market Infrastructure

2. Question 2

   A customer that is not a clearing member asks a clearing member to clear. Who is responsible to the central counterparty for performing the customer's obligations?

   1. A.The clearing member, as a direct participant, is responsible to the central counterparty
   2. B.The customer that asked for clearing is directly responsible to the central counterparty
   3. C.All direct participants, including the clearing member, are equally responsible
   Answer and explanation

   Answer: A

   The party responsible to the central counterparty for performing the customer's obligations is the clearing member, as a direct participant. A party that participates directly in a central counterparty is called a direct participant, and a party that uses it through a direct participant is called an indirect participant. The customer is an indirect participant and is not directly responsible to the central counterparty. Nor do the other direct participants equally bear the performance of the obligations of a customer that did not ask them to clear.

   Learn more: Central Counterparties: JSCC, LCH, CME and Others

3. Question 3

   Under Japan's Financial Instruments and Exchange Act, who is required to send trade information to a trade repository?

   1. A.Financial instruments business operators, etc. send, as a rule, information on all trades, including trades for which a central counterparty has assumed the obligations, and the central counterparty sends none
   2. B.A central counterparty sends, as a rule, information on all trades that financial instruments business operators, etc. enter into, and the operators send none
   3. C.Financial instruments business operators, etc. send, as a rule, information on trades for which a central counterparty has assumed the obligations, and the central counterparty sends information on the other trades
   4. D.A central counterparty sends information on the trades for which it has assumed the obligations, and financial instruments business operators, etc. send, as a rule, information on the trades other than those
   Answer and explanation

   Answer: D

   The Financial Instruments and Exchange Act requires a central counterparty (called a financial instruments clearing organization, etc. in the Act) to send information on the trades for which it has assumed the obligations. It requires financial instruments business operators, etc. to send, as a rule, information on the trades other than those for which a central counterparty has assumed the obligations. Of the trades for which a central counterparty has assumed the obligations, only those that a Cabinet Office order specifies are covered. Who sends the information depends on whether a central counterparty has assumed the obligations.

   Learn more: Trade Repositories

4. Question 4

   As a hypothetical example, a participant holds two interest rate swaps cleared at the same central counterparty, with the same maturity and floating-rate index. The fixed rate is 2% per year and the floating rate is 3%. Trade A, which pays fixed, has a notional amount of 10 billion yen, and trade B, which receives fixed, has 6 billion yen. In portfolio compression, trade B is terminated in full, and trade A is terminated in part, for 6 billion yen. How does the participant's total of one year of interest receipts and payments change before and after the termination?

   1. A.From a receipt of 40 million yen before, it falls to a receipt of 10 million yen
   2. B.From a receipt of 40 million yen before, it is unchanged
   3. C.From a receipt of 40 million yen before, it rises to a receipt of 100 million yen
   4. D.From a receipt of 40 million yen before, it changes to a payment of 20 million yen
   Answer and explanation

   Answer: B

   Before termination, trade A is a receipt of 10 billion yen × (3% − 2%) = 100 million yen. Trade B is 6 billion yen × (2% − 3%) = −60 million yen, which is a payment of 60 million yen. The total is a receipt of 100 million yen − 60 million yen = 40 million yen. After termination, trade A's notional amount is 4 billion yen, so it is a receipt of 4 billion yen × (3% − 2%) = 40 million yen, the same as the total before termination. The total notional amount falls from 16 billion yen to 4 billion yen, but the total of receipts and payments does not fall. Compression makes the balance measured by total notional amount smaller while leaving the amount of risk roughly unchanged. The 10 million yen is 40 million yen reduced by the ratio of the total notional amounts (4 ÷ 16). The 100 million yen is the value you get by removing only trade B's payment, and the payment of 20 million yen is the value you get by removing only the 60 million yen receipt on the terminated part of trade A (40 − 60). Both overlook that the offsetting receipt or payment on the other side disappears at the same time.

   Learn more: Portfolio Compression

5. Question 5

   As a hypothetical example, clearing member H defaults, and the loss of the central counterparty (CCP) is covered with Member H's resources first, then the CCP's own resources, then the non-defaulting members' default fund. Member H's margin and default fund contribution total 8 billion yen, the CCP's own resources are 1 billion yen, and the other members' default fund totals 20 billion yen. When the loss is fixed at 15 billion yen, how much comes from the non-defaulting members' default fund?

   1. A.1 billion yen
   2. B.7 billion yen
   3. C.6 billion yen
   4. D.14 billion yen
   Answer and explanation

   Answer: C

   Resources are used in order under the default waterfall. First, Member H's 8 billion yen is used, which leaves 15 − 8 = 7 billion yen. Next, the CCP's own 1 billion yen is used, which leaves 7 − 1 = 6 billion yen. This 6 billion yen comes from the non-defaulting members' default fund. It is within 20 billion yen, so the fund is enough. The figure of 7 billion yen is the value you get by skipping the step that uses the CCP's own resources. The figure of 14 billion yen is the value you get by skipping the step that uses Member H's resources (15 − 1). The figure of 1 billion yen is the amount of the CCP's own resources, not the non-defaulting members' share.

   Learn more: CCP Default Management

6. Question 6

   As a hypothetical example, two swap dealers compare their valuations swap by swap. Under the US CFTC rules, a difference of less than 10% of the higher valuation need not be treated as a discrepancy. When both parties' valuations are positive, which of the following swaps is treated as a discrepancy subject to dispute resolution?

   1. A.A swap with a higher valuation of 400 million yen and a lower valuation of 362 million yen
   2. B.A swap with a higher valuation of 300 million yen and a lower valuation of 275 million yen
   3. C.A swap with a higher valuation of 150 million yen and a lower valuation of 140 million yen
   4. D.A swap with a higher valuation of 200 million yen and a lower valuation of 180 million yen
   Answer and explanation

   Answer: D

   The 10% line depends on whether the difference is less than 10% of the higher valuation. For 400 million yen and 362 million yen, the difference is 38 million yen, or 9.5%. For 300 million yen and 275 million yen, the difference is 25 million yen, or about 8.3%. For 150 million yen and 140 million yen, the difference is 10 million yen, or about 6.7%. All three are below 10%, so they are differences that need not be treated as discrepancies. For 200 million yen and 180 million yen, the difference is 20 million yen, exactly 10% of the higher valuation. It is not "less than 10%", so it is treated as a discrepancy.

   Learn more: Portfolio Reconciliation