Definition
Novation
Novation is the legal process by which the clearing corporation replaces a single trade between two members with two new trades, becoming the counterparty to each side and assuming the settlement obligation.
When two members trade on an Indian exchange, the clearing corporation novates the contract: the original bilateral obligation is extinguished and replaced by two contracts, each between a member and the clearing corporation. This is what makes the clearing corporation a central counterparty.
Novation is the legal mechanism that lets the clearing corporation guarantee settlement and net obligations across all of a member's trades. It removes the need for members to assess each other's creditworthiness, since after novation every party's counterparty is the well-margined, well-capitalised clearing corporation.
Related terms
- Clearing CorporationA clearing corporation is the entity that clears and settles trades on an exchange, becoming the buyer to every seller and the seller to every buyer through novation, and guaranteeing settlement.
- Central Counterparty (CCP)A central counterparty is an institution that interposes itself between the two sides of a trade, becoming buyer to the seller and seller to the buyer, thereby guaranteeing performance and concentrating risk management.
- NettingNetting is the offsetting of a member's buy and sell obligations in the same security and settlement so that only the net quantity of shares and net amount of money change hands.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.