A dealer can hedge a market risk and still lose if the hedge counterparty fails. A central counterparty (CCP) accepts eligible trades and becomes the buyer to each seller and the seller to each buyer. Members face a common institution with membership requirements, collateral rules and a default-management process.
Under novation, the original bilateral contract is extinguished and replaced by two contracts with the CCP. The contractual market cash flows remain matched while both members perform. The CCP nevertheless has contingent credit exposure: a member's default leaves it owing the surviving side while replacing or closing the defaulter's position. Clients accessing clearing through a member also need to consider that member's failure and the arrangements for transferring client positions.
Bilateral close-out netting combines positive and negative transaction values within one legally enforceable agreement. If you are owed $9 million on one trade and owe $7 million on another with the same counterparty, the net replacement claim is $2 million. A $7 million payable to a different counterparty cannot ordinarily offset that claim.
Common mistakes
- Treating novation as the end of credit risk. The member now depends on the CCP, and may also bear mutualized default losses. The answer "central clearing eliminates counterparty risk" ignores both channels.
- Equating netting with compression. Netting can leave the original contracts and notional outstanding. Compression removes redundant contracts subject to preserving agreed risks. In Example 1, $24 million of original obligations, $4 million of net member funding and $6 million of compressed obligations are different measures.
- Using a universal margin horizon or waterfall. A five-day horizon, a fixed CCP capital percentage or an assessment limit supplied in one case is not a rule for every CCP. Apply the stated model and rulebook, and distinguish prefunded assets from contingent calls.
Bottom line
- Novation replaces bilateral trades with CCP contracts; netting offsets claims, while compression removes redundant contracts.
- IM protects against close-out changes; default funds mutualize residual losses and create incentives that require controls.
- Apply the stated waterfall and distinguish prefunded resources, assessments, recovery tools and liquidity.
- EE averages positive exposures at one date; PFE is a percentile; EPE averages EE across time.
Exam shortcut
For any exposure question, label the viewpoint, legal netting set, future date and collateral rights before calculating. If the stem asks for EE, floor each scenario and then average. If it asks for EPE, add time weights; if it asks for effective EPE, take running maxima first. In a waterfall question, keep a residual-loss column and consume each stated layer once.
The full lesson (about 5,809 words, 39 min read) adds 6 worked examples, all 6 common mistakes, a self-check, free in the app.
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