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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

In a centrally cleared derivatives market, a clearing house (CCP) becomes the legal counterparty to each side of a trade after novation. What is the main effect of this arrangement on a clearing member's counterparty credit exposure?

Through novation the CCP steps between the buyer and seller, so each clearing member faces the CCP rather than its original counterparty. Credit risk is not eliminated but concentrated in the CCP, which manages it through margins and default funds.

  1. AEach member's exposure is to the CCP rather than to the original trading counterpartyCorrect
  2. BThe member's exposure to the original counterparty is doubled because two contracts now exist
  3. CAll credit risk is eliminated because the CCP cannot default
  4. DThe member must now monitor the creditworthiness of every other member individually

Explanation

Novation replaces the original bilateral contract with two contracts, one between each party and the CCP. The member is therefore exposed to the CCP, not to its original counterparty. Credit risk is concentrated in the CCP, not eliminated, so the claim that it disappears is wrong.

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