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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank's bilateral OTC derivatives with a dealer are moved to a central counterparty (CCP) through novation. Which describes the legal and risk effect of novation for the bank?

Novation extinguishes the original bilateral contract and replaces it with two contracts, with the CCP acting as buyer to every seller and seller to every buyer. The bank then faces the CCP rather than the dealer, and still posts margin.

  1. AThe bank's original contract stays in force and the CCP only guarantees it against default of the dealer
  2. BThe original bilateral contract is replaced by two contracts, with the CCP becoming the buyer to every seller and seller to every buyerCorrect
  3. CThe bank's exposure to the dealer is eliminated and the bank takes no exposure to anyone else
  4. DThe CCP takes on the market risk of the bank's position and the bank no longer posts margin

Explanation

Novation replaces the bilateral trade with two trades facing the CCP, so the CCP stands between the original parties. The bank still faces counterparty risk, now to the CCP, and must post initial and variation margin. The guarantee-only view is wrong because the original contract is extinguished.

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