Explanation:
Contract novation is an essential concept in central clearing. Novation is the legal process wherein the CCP interposes between the buyer and seller: their single contract is replaced by two contracts. Each of the new contracts has the CCP as a counterparty. See https://en.wikipedia.org/wiki/Novation. By the legal act of novation, the CCP creates a so-called matched book which bears no market risk. However, in the event of a default by one of the original counterparties, the CCP will bear conditional market risk.
Q-603.2. Novation, which is critical to central clearing, is the legal process whereby the central counterparty (CCP) positions itself between the buyer and seller by replacing a contract with one or more other contracts. After novation, which risk(s) does the CCP bear?
A
Market risk
B
Conditional market risk
C
Novation implies that the CCP inherits only market risk
D
Novation ensures that the CCP is immunized from credit and market risk
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