Skip to content

FRM Exam Part II · Central Clearing

Central Counterparties (CCPs) and Novation Explained

Updated 11 October 2026 · Fact-checked

A central counterparty (CCP) is a clearing house that steps between the buyer and seller of a trade. Through novation, the original contract is replaced by two contracts: one between the CCP and each side. The CCP becomes buyer to every seller and seller to every buyer. Clearing members face the CCP directly; clients access it through a member.

Understand Central Counterparties (CCPs) and Novation

In a bilateral trade, each side carries the credit risk of the other. If your counterparty defaults, you may lose the value of the contract. In a large OTC market, this creates a web of exposures. One failure can spread to many firms.

A central counterparty (CCP) reduces this web. After a trade is agreed, the CCP takes over through novation. Novation means the original contract between buyer and seller is legally extinguished and replaced by two new contracts. The CCP is the seller to the original buyer and the buyer to the original seller. Terms such as notional, maturity and price stay the same. Only the counterparty changes.

The result is that each participant faces the CCP, not the original trading partner. The CCP is therefore left with a matched book: its long and short positions offset, so it has no net market exposure if all members perform. Its risk is the default of a clearing member, not market direction. It manages that risk with margin, a default fund and its own capital.

The CCP also provides multilateral netting. Positions with many counterparties collapse into one net position per member per product. This lowers exposures and settlement flows compared with bilateral netting, where netting works only within each pair. Other CCP functions include daily marking to market, collecting variation and initial margin, managing defaults, and standardising contracts and settlement.

Access is tiered. Clearing members are the firms admitted to the CCP. They meet membership, capital and operational requirements, post margin and contribute to the default fund. Clients (often buy-side firms) are not members. They clear through a clearing member, which guarantees the client's performance to the CCP. The CCP faces the member; the member faces the client. Clients are exposed to the member's default and to porting and segregation risks.

Key formulas to remember

Novation result
Original trade A ↔ B becomes A ↔ CCP and CCP ↔ B
Terms stay identical. The CCP is buyer to every seller and seller to every buyer.
CCP net market position
Σ long positions − Σ short positions = 0 (when all trades are cleared)
The CCP's book is matched, so its exposure is to member default, not market direction.
Bilateral vs multilateral netting
Multilateral net exposure ≤ Sum of bilateral net exposures
Holds when netting is legally enforceable. Bilateral netting works only within each pair of counterparties.
Clearing chain
Client ↔ Clearing member ↔ CCP
The client has no direct contract with the CCP. The member guarantees the client's obligations.

How to solve Central Counterparties (CCPs) and Novation questions

Use this method for any question on CCP structure, novation or the roles of members and clients.

  1. 1Identify the original trade: who is buyer, who is seller, and what are the terms.
  2. 2Check whether the trade is cleared. If so, apply novation: replace the one contract with two contracts against the CCP.
  3. 3Decide who faces whom. Members face the CCP directly. Clients face their clearing member.
  4. 4Find where credit risk now sits: the CCP bears member default risk; each participant bears CCP risk.
  5. 5If the question involves netting, net each member's positions across all counterparties in the same product at the CCP.
  6. 6Link the risk to the CCP tool that covers it: margin, default fund contributions, CCP capital.
  7. 7Check each answer option against the exact definition and eliminate those that blur member and client roles.

Quickest way: Three-line CCP check

When to use it: Use for conceptual multiple-choice items where you must pick the correct statement about CCPs.

  1. Ask: after novation, who is the counterparty? The answer is always the CCP, with terms unchanged.
  2. Ask: does the CCP take market risk? No, its book is matched. Its risk is member default.
  3. Ask: is the person a member or a client? Clients go through a member and do not contribute to the default fund.

Common mistakes in Central Counterparties (CCPs) and Novation

  • Saying the CCP eliminates counterparty risk.

    The phrase 'removes bilateral risk' gets shortened to 'removes risk'.

    Fix: Say the CCP transforms and concentrates counterparty risk. Risk moves to the CCP and its default resources.

  • Thinking novation changes the price or maturity of the trade.

    Students confuse novation with renegotiation.

    Fix: Novation changes only the counterparty. All economic terms stay the same.

  • Believing the CCP has market risk from a net long or short position.

    Students forget the CCP is on both sides of every trade.

    Fix: The CCP's book is matched. Loss arises only when a member defaults and the CCP must close out or replace its positions.

  • Treating clients as clearing members that pay into the default fund.

    Both groups post margin, so roles blur.

    Fix: Only clearing members contribute to the default fund. Clients deal through a member, which guarantees their trades to the CCP.

  • Assuming multilateral netting always cuts exposure more than bilateral netting in every case for every firm.

    A general benefit is stated as an absolute rule.

    Fix: Multilateral netting generally reduces total exposure when legally enforceable. Benefits depend on the portfolio and on how many products are cleared at the CCP. Netting across separate CCPs is not possible.

Worked examples

Example 1

Bank A buys a 5-year USD interest rate swap from Bank B, notional USD 100 million, and the trade is cleared at a CCP. Describe the contracts after novation and the party that bears Bank A's credit risk.

Show the solution
  1. Original trade: Bank A (payer or receiver per the swap terms) against Bank B, notional USD 100 million, 5 years.
  2. Novation extinguishes the A–B contract and creates two contracts: A ↔ CCP and CCP ↔ B.
  3. Terms on each leg mirror the original: same notional, fixed rate, floating index and maturity.
  4. Bank A now faces the CCP only. If Bank B defaults, Bank A's contract is unaffected because the CCP absorbs the default via its resources.
  5. Bank A's remaining credit risk is against the CCP, which is mitigated by margin and the default fund.

Answer: Two contracts replace one: A with the CCP and the CCP with B, on identical terms. Bank A's counterparty is the CCP, not Bank B.

Example 2

A CCP has three clearing members, X, Y and Z, in one swap product. X owes Y a net USD 30 million in value terms, Y owes Z USD 20 million, and Z owes X USD 10 million. After novation to the CCP, what is each member's net position with the CCP?

Show the solution
  1. Net each member's positions. A positive figure means the member is owed money.
  2. X: owes Y 30, is owed by Z 10. Net = +10 − 30 = −20 (X owes the CCP 20).
  3. Y: is owed 30 by X, owes Z 20. Net = +30 − 20 = +10 (CCP owes Y 10).
  4. Z: is owed 20 by Y, owes X 10. Net = +20 − 10 = +10 (CCP owes Z 10).
  5. Check: −20 + 10 + 10 = 0, so the CCP's book is matched.

Answer: X owes the CCP USD 20 million; Y and Z are each owed USD 10 million by the CCP. The CCP's net position is zero. Gross obligations of USD 60 million reduce to USD 20 million of net payments.

Exam tips

  • Questions often ask who bears the risk after novation. Answer with the CCP's counterparty and its default resources, not 'no risk'.
  • Read carefully whether the question is about a member or a client. The default fund and direct CCP contract belong to members only.
  • In netting questions, compute net per member, then check that the CCP's total nets to zero. This catches arithmetic slips.
  • Watch for options that say novation alters pricing or terms. These are wrong.

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 bilateral contract with two new contracts, each with the CCP as counterparty. The economic terms stay the same. Only the counterparty changes.

What is the difference between a clearing member and a client?

A clearing member is admitted to the CCP, contracts directly with it and contributes to the default fund. A client accesses the CCP through a member, which guarantees the client's obligations to the CCP.

Does a CCP take market risk?

Not in normal conditions, because it is buyer to every seller and seller to every buyer, so its book is matched. Its main risk is that a clearing member defaults and it must close out that member's positions.

Why does a CCP reduce systemic risk?

It limits contagion from one firm's default by standardising risk management, using margin and netting exposures across members. It also concentrates risk, so CCP resilience is critical.