FRM Exam Part I · Central Clearing

Central Counterparties (CCPs) and Novation Explained

Updated 11 October 2026 · Fact-checked

A central counterparty (CCP) steps between the buyer and seller of a trade through novation. The original contract is cancelled and replaced by two contracts, one with each side. Each party now faces the CCP, not each other. To solve questions, identify the new contracts, who bears default risk, and the netting effect.

Understand Central Counterparties (CCPs) and Novation

In a bilateral trade, you face your counterparty directly. If it defaults, you bear the loss. Each pair of firms has its own contract, its own netting set and its own collateral terms. With many dealers, this creates a web of exposures.

A central counterparty (CCP) removes the web. Through novation, the original contract between A and B is extinguished and replaced by two new legal contracts: A against the CCP, and the CCP against B. The CCP becomes the buyer to every seller and the seller to every buyer. Its position is matched, so its net market risk is zero when all members perform.

The CCP does not remove credit risk. It concentrates it and manages it. It does this with membership standards, initial margin, variation margin (daily mark-to-market), and a default fund contributed by clearing members. If a member defaults, the CCP uses the defaulter's margin first, then its default fund contribution, then the CCP's own capital, then the non-defaulting members' fund contributions, as set by its rules.

The main benefit is multilateral netting. Bilateral netting nets positions between two parties. Multilateral netting nets each member's positions across all counterparties against the CCP. A member who owes ₹100 to one firm and is owed ₹100 by another ends with zero net exposure to the CCP. This cuts gross exposures, collateral needs and settlement flows.

Central clearing needs standardization. Contracts must have uniform terms so they can be fungible, valued and, in a default, closed out or auctioned to other members. Highly customized trades are hard to clear. Other CCP functions include daily valuation, collateral management, settlement and default management. Risks remain: CCPs are concentrated, so their failure would be systemic, and margin can be procyclical.

Key formulas to remember

Novation result: A–B trade → A–CCP trade + CCP–B trade; The original contract is extinguished. The CCP is the counterparty to both sides.
CCP net position: Σ long positions − Σ short positions = 0 (when all members perform); The CCP is matched, so it has no net market exposure.
Number of bilateral links: n(n − 1) ÷ 2 bilateral relationships vs n links to a CCP; Shows how a CCP simplifies the web. For 10 firms: 45 vs 10.
Multilateral net exposure: Net exposure to CCP = Σ (positions across all trades with all counterparties); Gains and losses offset across counterparties, which bilateral netting cannot do.
Default waterfall order: Defaulter's margin → defaulter's default fund contribution → CCP capital → surviving members' default fund contributions; Exact order and any CCP capital layers vary by CCP rules. Learn the logic: defaulter pays first.

How to solve Central Counterparties (CCPs) and Novation questions

Use this method for any question on CCPs, novation or netting.

1Identify the structure: bilateral trade, or trade cleared through a CCP.
2If cleared, restate the trade after novation: two contracts, each party against the CCP.
3Decide who bears counterparty risk now. It is the CCP for members, and members collectively through the default fund.
4For netting questions, list each party's positions with all counterparties and add them. Gains offset losses only within the netting set.
5Compare gross and net exposure. Report the reduction.
6For default questions, apply the waterfall: defaulter's resources first, then mutualized resources.
7Check the option wording: standardization, margin, loss mutualization and transparency are CCP features; customization and no collateral are bilateral features.

Quickest way: Three-check shortcut

When to use it: Use for conceptual MCQs on what a CCP does or what clearing changes.

Ask: does the answer say the CCP becomes counterparty to both sides? That is novation.
Ask: does it claim risk is eliminated? Reject it. Risk is transferred, netted and mutualized.
For numbers, net each member across all counterparties and compare with the gross sum.

Common mistakes in Central Counterparties (CCPs) and Novation

Saying a CCP eliminates counterparty risk.
Students read 'guarantees performance' as 'no risk'.
Fix: Say it replaces many exposures with one exposure to the CCP, managed with margin and a default fund. Risk is concentrated.
Thinking novation keeps the original contract alive.
Novation sounds like an assignment or a guarantee.
Fix: The original contract is extinguished and replaced by two new contracts with the CCP.
Confusing bilateral netting with multilateral netting.
Both use the word netting.
Fix: Bilateral nets between two parties. Multilateral nets across all counterparties through the CCP.
Assuming the CCP bears market risk.
It is a party to every trade.
Fix: Its long and short positions match, so net market risk is zero while members perform. Its risk is default of members.
Putting the default fund before the defaulter's own margin in the waterfall.
Students focus on mutualization.
Fix: The defaulter pays first. Survivors' contributions are used only after the defaulter's resources and any CCP capital layer are exhausted.
Assuming any OTC derivative can be cleared.
Students overlook the standardization requirement.
Fix: Clearing needs standardized terms and enough liquidity to value and close out positions. Bespoke trades stay bilateral.

Worked examples

Example 1

Bank A has three OTC trades with different dealers, all cleared through a CCP after novation. The values to A are +USD 40 million with Dealer B, −USD 25 million with Dealer C and +USD 10 million with Dealer D. What is A's net exposure to the CCP, and what would its exposure be if the trades were bilateral with no netting across dealers?

Show the solution

After novation, all three trades are with the CCP, so they form one netting set.
Net exposure to the CCP = 40 − 25 + 10 = USD 25 million.
Bilaterally with no cross-dealer netting, A's exposure is the sum of the positive values only: 40 + 10 = USD 50 million, as the −25 is owed by A and does not offset the other dealers' claims.
Reduction = 50 − 25 = USD 25 million.

Answer: Net exposure to the CCP is USD 25 million, versus USD 50 million bilaterally, a reduction of USD 25 million.

Example 2

A market has 12 dealers, each trading with every other dealer. How many bilateral relationships exist, and how many links exist if all trade through a CCP? What is the difference?

Show the solution

Bilateral links = n(n − 1) ÷ 2 = 12 × 11 ÷ 2 = 66.
With a CCP, each dealer has one link to the CCP, so 12 links.
Difference = 66 − 12 = 54.

Answer: There are 66 bilateral relationships versus 12 links to the CCP, which is 54 fewer.

Exam tips

Expect conceptual MCQs: pick the option that says the CCP becomes buyer to every seller and seller to every buyer.
Reject any option claiming a CCP eliminates credit risk or removes the need for margin.
In netting questions, compute net and gross exposure, then compare. Watch the sign of each position.
Link standardization to benefits: it allows fungibility, valuation and close-out. Customized trades usually stay bilateral.
Remember the defaulter-pays-first logic for waterfall questions.

Practice questions from Central Clearing

Central Counterparties (CCPs) and Novation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Central Counterparties (CCPs) and Novation: frequently asked questions

What is novation in central clearing?

Novation replaces the original contract between buyer and seller with two new contracts, each against the CCP. The original contract ends. Each party then faces the CCP, not each other.

What is the difference between bilateral and centrally cleared derivatives?

Bilateral derivatives are private contracts between two parties, often customized, with terms and collateral agreed between them. Centrally cleared derivatives are standardized and novated to a CCP, with margin and default fund rules set by the CCP. Netting is multilateral in the cleared case.

What are the benefits of multilateral netting?

It offsets a member's gains and losses across all counterparties. This lowers net exposure, collateral needs and settlement flows. It also makes positions easier to monitor and close out.

Does a CCP remove counterparty risk?

No. It concentrates risk in the CCP and manages it with margin, a default fund and membership rules. If the CCP itself failed, the effects could be systemic.