FRM Part II · FRM Exam Part II · Central Clearing
A bank and a hedge fund agree a bilateral interest rate swap that is then submitted for clearing at a central counterparty (CCP). After the trade is accepted, the original contract between the bank and the hedge fund is extinguished and replaced by two contracts, one between the bank and the CCP and one between the hedge fund and the CCP. What is this process called?
The process is novation. The original bilateral trade is extinguished and replaced by two trades, each facing the CCP, so the CCP becomes the counterparty to both original parties and takes on their counterparty credit risk.
- ANovationCorrect
- BCompression
- CRehypothecation
- DNetting by close-out
Explanation
Novation replaces the original bilateral contract with two contracts facing the CCP, so the CCP becomes buyer to every seller and seller to every buyer. Compression only reduces the number or notional of trades, rehypothecation is reuse of collateral, and close-out netting applies on default.
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