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FRM Part I · FRM Exam Part I · Central Clearing

In a centrally cleared derivatives market, Bank A and Bank B agree on a bilateral interest rate swap, and the trade is then accepted by a central counterparty (CCP) through novation. Which describes the resulting legal position?

Novation replaces the original bilateral trade with two new contracts, one between the CCP and each original party. The CCP becomes the buyer to every seller and the seller to every buyer, so the original counterparties no longer face each other directly.

  1. ABank A and Bank B remain counterparties to each other, and the CCP only guarantees the payments if either defaults
  2. BThe original contract is replaced by two contracts: one between Bank A and the CCP, and one between the CCP and Bank BCorrect
  3. CThe CCP becomes the sole counterparty to Bank A, and Bank B's obligations are transferred to Bank A
  4. DThe CCP takes an equity stake in both banks equal to the notional of the swap

Explanation

Novation extinguishes the original bilateral contract and replaces it with two contracts, with the CCP as buyer to every seller and seller to every buyer. The first option describes a guarantee, not novation, so the original contract would still exist.

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