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I am currently studying for the FRM exam, and I come from a mathematics background rather than a finance background. I am learning about CCPs and find them to be an interesting topic, but I find myself confused about how the auction process works if there is a default by a member. An excerpt from my study materials says

When a member defaults, rather than closing out the trades at market value, the CCP typically auctions off the trades to surviving members through an auctioning process. Participating in the auctioning process is in the best interest of the members in order to minimize their losses that would otherwise occur with lower market prices or with the use of default fund contributions.

I am also confused about the last sentence. I don't understand why members would pay more for an asset than the market value. I really think think a concrete example would clear this concept up, but I cannot find an example of this online.

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There's different vantage points. If you're not party to the trade that is defaulting, you gain by not having to cough up as much or at all from through default fund contributions.

If you are party to the trade then you gain by having your trade not devalued by as much.

This is my understanding of this but my knowledge of CCPs is waning.

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Remember that markets are mostly about price discovery and the price discovered, depending on your viewpoint, is either the economic value of the contract or the fair value. On default if the positions contracted by the defaulter (these could be long or short, I'll try to cover both) are dumped on the market they will only be able to trade with liquidity available in the market at that time and that is sure to move the price. The best way not to move the price is to bring participants together at a set time to trade or bid on the lost being divested. That's pretty much what an auction is. Because there are more participants involved the price impact will be lower and thus they will be bought at a less advantageous price. Reduced price volatility helps all market participants. The auction will also discover the economic price given the increased number of participants inputting their view of what's economic.

Price stability assurance is one thing but another key reason is to allow the participants to close positions against the defaulting counterparties at the best price. The participants in the auction are likely to have multiple complex positions against the defaulter and they want to unwind these in the most orderly fashion. They particularly don't want to have extra risk at that time and price stabilisation from an auction allows them exit at a stable price.

The fair value of a contract is related to the economic value but is the value that the participants settle on in a liquid market. Dumping contracts in the market doesn't discover fair value, it distorts the market since it will pull liquidity in a particular direction temporarily. Distorting a market also makes market abuse easier as you can depress or increase the price more easily in a one sided marker.

In sum the auctioning of a defaulting participant's positions brings liquidity together to reduce the price impact and volatility whilst allowing the participants to unwind their positions against the counterparty with reduced risk. Lower risk and better price discovery is worth the price of potentially getting a worse price.

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