FRM Part I · FRM Exam Part I · Central Clearing
A bank and a hedge fund agree to an interest rate swap that is eligible for clearing at a central counterparty (CCP). After the trade is accepted for clearing, the original bilateral contract is 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 legally replaced by two contracts, each facing the CCP, so the CCP becomes the counterparty to both sides. Netting, rehypothecation and margin transformation describe different activities and do not describe the replacement of the original contract.
- ANetting by close-out
- BNovationCorrect
- CRehypothecation
- DMargin transformation
Explanation
Novation is the legal replacement of the original bilateral contract with two new contracts, with the CCP becoming buyer to every seller and seller to every buyer. Close-out netting concerns combining obligations on default, rehypothecation concerns reuse of collateral, and margin transformation is not the term for this replacement.
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