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Account for novation as it applies in central clearing.

FRM® Part II · Credit Risk Measurement and Management · Central Clearing · FRM2.CR.18.b

The idea

Novation is the legal step by which the original contract between two parties is extinguished and replaced by two new contracts, one between the CCP and each party, on the same economic terms. It happens when the CCP accepts the trade for clearing, not merely when the two sides agree a price. After novation the seller delivers to the CCP and the buyer receives from the CCP, and the original parties no longer have any claim on each other. Because every cleared trade now has the same counterparty, offsetting positions can be netted across different original counterparties. Novation is not netting, and it is not a guarantee layered over the old contract: the old contract disappears. The exam point is that the CCP becomes the counterparty and the original bilateral link is released.

A practice question

From the question bank, with the reason each wrong option is wrong.

In central clearing, novation refers to:

  1. offsetting positive and negative contract values between two parties into one net payment.Why not: Describes bilateral netting, not novation.
  2. tearing up offsetting trades to reduce gross notional and the number of contracts while leaving every participant's net position exactly unchanged.Why not: Describes compression, not novation.
  3. replacing the original contract between two parties by two contracts, one between the CCP and each party, so the original link is extinguished. - correct
  4. adding a CCP guarantee on top of the original bilateral contract, which remains in force.Why not: Describes a guarantee layered on the old contract; under novation the old contract disappears.

Novation substitutes the CCP as counterparty to each side and discharges the original contract; both new contracts keep the same economic terms.

A harder one

Dealers A and B enter a swap on USD 100 million in which A pays 3% fixed and receives floating. After the swap is novated to a CCP, which description is correct?

  1. A pays 3% fixed to the CCP and receives floating from it; B receives 3% fixed from the CCP and pays floating to it, and the CCP's net cash flows are zero. - correct
  2. A and B still pay each other directly, and the CCP only guarantees B's payments if B fails to make them to A.Why not: Describes a guarantee layered on the original contract rather than novation.
  3. The CCP pays 3% fixed to A and receives it from B, so the CCP's position is the same as before.Why not: Reverses the direction of the fixed leg for A; A remains the fixed payer.
  4. Both contracts are cancelled and the CCP holds a single swap whose value belongs to the CCP.Why not: Treats novation as cancellation into one CCP-owned position; two matched contracts replace the original.

Novation replaces the contract with two mirror contracts on identical terms. The CCP receives what it pays on each leg, so its net cash flows are zero.

The hardest tier

Dealer A holds three bilateral trades with different counterparties, with values to A of +8 with B, -5 with C and +3 with D (USD million). Ignoring collateral, by how much does novating all of them to one CCP reduce A's total credit exposure?

  1. USD 11 millionWhy not: Reports A's exposure before novation (8 + 3) instead of the reduction.
  2. USD 6 millionWhy not: Reports A's exposure after novation (8 - 5 + 3) instead of the reduction.
  3. USD 3 millionWhy not: Reports only the USD 3 million exposure to D, not the netting benefit across all counterparties.
  4. USD 5 million - correct

Bilateral exposure is the sum of positive values, 8 + 3 = 11. At one CCP the net value is 8 - 5 + 3 = 6. The reduction is 11 - 6 = 5.

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