NISM-Series-VIII: Equity Derivatives · Introduction to Clearing and Settlement System

Novation and Counterparty Guarantee in Clearing and Settlement

Updated 11 October 2026 · Fact-checked

Novation is the process by which the clearing corporation steps in between the buyer and seller of a trade. The original contract is replaced by two new contracts: the clearing corporation becomes seller to every buyer and buyer to every seller. This makes it the central counterparty and guarantor of settlement.

Understand Novation and Counterparty Guarantee

When you buy a futures or options contract on an exchange, you do not know who sold it to you. You do not need to. The clearing corporation takes over the other side of your trade.

This is novation. After a trade is matched on the exchange, the original contract between the two parties is cancelled and replaced by two new contracts. In one, the clearing corporation is the seller to the buyer. In the other, it is the buyer from the seller. The clearing corporation is now the central counterparty (CCP) to both sides.

Why does this matter? In a bilateral deal, you carry the risk that the other party defaults. With novation, your counterparty is always the clearing corporation. It guarantees that the trade will be settled, even if the original opposite party fails to pay or deliver. This removes counterparty risk for the market participant.

A guarantee is only as good as the resources behind it. The clearing corporation therefore collects margins from members, sets exposure and position limits, marks positions to market, and maintains a settlement guarantee fund (also called a core settlement guarantee fund) built from contributions by members, the clearing corporation and the exchange. If a member defaults, these resources are used to complete settlement. Its own exposure is netted: for every buyer there is a seller, so its net position is zero.

For the exam, remember two points. The guarantee runs from the clearing corporation to the clearing member, and the clearing member is responsible to its own clients and trading members. And novation applies to trades on the exchange, not to OTC bilateral contracts.

Key formulas to remember

Effect of novation: Buyer ⇄ CCP ⇄ Seller (replaces Buyer ⇄ Seller); The CCP is seller to every buyer and buyer to every seller. One trade becomes two contracts.
CCP net position: Total long positions = Total short positions, so CCP net = 0; The clearing corporation takes no market view. It carries credit risk, not price risk, on matched positions.
Guarantee rule: Settlement guarantee = CCP obligation to perform, backed by margins + guarantee fund; The guarantee is to the clearing member. It is not a guarantee of profit or of price.
Order of default resources (concept): Defaulter's margin and deposits first, then the guarantee fund and other resources; The defaulter's own resources are used before the common fund. Check the workbook wording for the exact waterfall.

How to solve Novation and Counterparty Guarantee questions

Use this method for any question on novation, the CCP or the settlement guarantee.

1Identify what the question tests: definition of novation, role of the CCP, guarantee, or the guarantee fund.
2Draw the trade in your head: original buyer and seller, then replace them with the CCP on each side.
3Check who the counterparty is after novation. It is always the clearing corporation.
4Ask whether the trade is exchange-traded and cleared. If it is OTC bilateral, novation does not apply.
5For default questions, think of the order: defaulter's margins first, then guarantee fund resources.
6Eliminate options that say the CCP takes price risk, guarantees profits, or deals directly with end clients.
7Pick the option that matches the exact wording: replaces the original contract with two new contracts.

Quickest way: Three-word shortcut: Replace, Guarantee, Net-zero

When to use it: Use it for one-line definition or role questions when time is short.

Replace: novation replaces one contract with two, with the CCP in the middle.
Guarantee: the CCP guarantees settlement to clearing members.
Net-zero: the CCP's long and short positions match, so it has no market view.
Reject any option that contradicts one of these three words.

Common mistakes in Novation and Counterparty Guarantee

Saying novation means the two original parties still have a contract with each other.
Students think the CCP is just an added guarantor.
Fix: Remember the original contract is extinguished and replaced by two new ones with the CCP.
Believing the CCP guarantees that you make a profit or protects you from price loss.
The word guarantee is read too broadly.
Fix: The guarantee covers settlement performance, not market outcomes.
Thinking the clearing corporation takes a directional market position.
Students confuse being counterparty to all with trading for profit.
Fix: It is buyer to every seller and seller to every buyer, so its net position is zero.
Applying novation to OTC bilateral contracts.
Confusion between exchange-traded and OTC derivatives.
Fix: Novation by the CCP applies to trades cleared through the clearing corporation. Bilateral OTC contracts carry counterparty risk.
Assuming the guarantee fund is the first resource used in a default.
The fund is the most talked-about safety feature.
Fix: Remember the defaulter's own margins and deposits are used first, then the common fund.

Worked examples

Example 1

A buys 1 lot of Nifty futures and B sells it on the exchange. After novation, which statement is correct? (a) A and B remain direct counterparties (b) The clearing corporation is seller to A and buyer from B (c) The clearing corporation is buyer from A and seller to B (d) The exchange becomes the counterparty and A's contract is cancelled with no replacement

Show the solution

A is the buyer, so A needs a seller. After novation the CCP becomes A's seller.
B is the seller, so B needs a buyer. After novation the CCP becomes B's buyer.
Option (a) ignores novation. Option (c) reverses the roles. Option (d) says no replacement, which is wrong because two new contracts replace the original.

Answer: (b) The clearing corporation is seller to A and buyer from B.

Example 2

Clearing member X defaults on its obligations after a day's trades. Trade counterparties are other clearing members. Explain what happens to the counterparties' settlement and why.

Show the solution

Because of novation, the counterparties' contracts are with the clearing corporation, not with X.
The clearing corporation is bound to perform its obligations to them, so their settlement is guaranteed.
To meet the shortfall, it first uses X's margins and deposits.
If those are not enough, it uses the settlement guarantee fund and other resources it holds.

Answer: The counterparties are settled in full by the clearing corporation. It recovers from the defaulter's margins first, then uses the guarantee fund and other resources.

Exam tips

Expect direct definition questions. Learn the phrase: the CCP becomes seller to every buyer and buyer to every seller.
Watch for trap options claiming the CCP guarantees profits, takes market risk, or deals with clients directly.
Link novation to counterparty risk: it removes the risk of the original opposite party defaulting.
Remember the guarantee fund is a pooled safety resource and the defaulter's own margins come first.
Questions may contrast exchange-traded and OTC. Novation and CCP guarantee belong to the exchange-traded side.

Practice questions from Introduction to Clearing and Settlement System

Novation and Counterparty Guarantee in other exams

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

Novation and Counterparty Guarantee: frequently asked questions

What is novation in a clearing corporation?

Novation is the replacement of the original trade contract with two new contracts, with the clearing corporation as counterparty to each side. After it, the buyer and seller have no obligations to each other. Each deals only with the clearing corporation.

What does a central counterparty do?

A central counterparty stands between buyers and sellers and guarantees that trades are settled. It manages risk using margins, limits and a guarantee fund. Its long and short positions match, so it does not take a market view.

What is the settlement guarantee fund?

It is a pooled fund held by the clearing corporation to complete settlement if a clearing member defaults. It is built from contributions by members and the clearing corporation, among other sources. It is used after the defaulter's own margins and deposits.

Does the clearing corporation guarantee my profit?

No. It guarantees that the trade will be settled, not that it will be profitable. Price risk stays with you.