Novation
Also written Central counterparty substitution · Counterparty undertaking
The clearing corporation stepping into the middle of every trade — becoming the buyer to every seller and the seller to every buyer — so that neither side carries the other's default risk.
In plain language
When you buy shares on an exchange, you never find out who sold them to you. That is not an accident of plumbing; it is the point.
The moment a trade matches, the original contract between the two brokers is replaced by two new contracts, each one with the clearing corporation in the middle. The seller now has a contract to deliver to the clearing corporation. The buyer now has a contract to receive from the clearing corporation. That substitution is novation.
Its effect is that you stop worrying about the person on the other side. You are facing an institution that has collected margin from both of you and stands behind the settlement with its own resources.
How it works
The SEBI SECC Regulations, 2018 define it precisely: novation means the act of a clearing corporation interposing itself between both parties of every trade, being the legal counterparty to both.
The reason it is necessary is multilateral netting. On a single settlement day one clearing member's thousands of trades are compressed into one net obligation per security and one net funds figure. Once that compression has happened, a default cannot be unwound by going back to "the original counterparty" — that counterparty no longer exists as a distinct exposure. The workbook makes exactly this point: in a multilateral netting scenario, when a default occurs, it is difficult to unwind the trade to find the original counterparty who will have to bear the loss.
Novation is what makes the guarantee legally possible, and the margining system — initial margin, extreme loss margin, the settlement guarantee fund — is what makes it financially possible. In the cash segment India has two clearing corporations, NSE Clearing Limited (NCL) and Indian Clearing Corporation Limited (ICCL).
A worked example
Broker A sells 50,000 shares at Rs 420 on the exchange. The order matches against Broker B.
| Before novation | After novation | |
|---|---|---|
| Seller's counterparty | Broker B | Clearing corporation |
| Buyer's counterparty | Broker A | Clearing corporation |
| Value at risk | Rs 2.10 crore, on B's credit | Rs 2.10 crore, on the CC's guarantee |
Now suppose Broker B fails to bring in funds on the pay-in date.
Without novation, Broker A would have to pursue Broker B — a private commercial dispute over Rs 2.10 crore, with A's own client waiting for money that may never arrive. With novation, Broker A is paid out on schedule by the clearing corporation, which then recovers from B's margins, deposits and collateral, and if those fall short, from the default waterfall.
Broker A's client never learns that anything went wrong. That is the entire commercial value of the mechanism.
Why NISM asks about it
Chapter 2 (Market Participants) introduces novation as the function that makes a clearing corporation a central counterparty, and Chapter 5 (Clearing Process, section 5.2) develops it. Both chapters carry sample questions on it — one phrased as "providing financial guarantee for all transactions executed on the Exchange is known as ___" and one as "the process of the original trade being cancelled and the clearing agency taking over as counterparty to all trades". The answer to both is novation, and it is one of the most reliably repeated single-word questions in the paper.
Common exam traps
- Novation is not netting. Netting computes what is owed; novation decides to whom. The sample question asking which procedure determines the net settlement obligations of clearing members has the answer multilateral netting, not novation. Read which of the two the question is asking for.
- Novation is not insurance, indemnity or a guarantee product. The distractor list in the workbook question is literally "Insurance / Indemnification / Coverage". None of them is right.
- The clearing corporation becomes the counterparty to the clearing member, not to the underlying investor. A retail client's legal relationship is still with the broker.
- Novation does not abolish default risk; it concentrates and collateralises it. That is why the margining framework in Chapter 4 exists at all.
- Do not say the clearing corporation "cancels" the trade in the sense of annulling it. The economic trade survives; only the counterparty is substituted.
Where this is taught
- Series X-A · Chapter 6: Securities Market Segmentsintroduced here
- Series XXI-A · Chapter 2: Introduction to Securities Marketsintroduced here
- Series VII · Chapter 2: Market Participants in the Securities Marketintroduced here
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series XVI · Chapter 7: Clearing, Settlement and Risk Managementintroduced here
- Series I · Chapter 2: Foreign Exchange Derivativesintroduced here
- Series XXI-B · Chapter 2: Introduction to Securities Marketsintroduced here
- Series VIII · Chapter 7: Clearing, Settlement and Risk Managementintroduced here
- Series XV · Chapter 2: Introduction to Securities Marketintroduced here
- Series V-D · Chapter 19: Interest Rate Derivativesintroduced here
- Series IV · Chapter 7: Clearing, Settlement and Risk Management of IRD
- Series I · Chapter 7: Clearing, Settlement and Risk Management in ETCD
- Series VII · Chapter 5: Clearing Process
Related terms
- InteroperabilityA clearing member choosing one clearing corporation to clear and settle everything it trades, across all exchanges, instead of being tied to a separate clearing corporation per exchange.
- Multilateral nettingThe clearing corporation's method of collapsing every trade a clearing member did in a settlement into one net figure per security and one net funds figure, so each member either pays in or receives a pay-out.
- Pay-inThe leg of settlement in which clearing members hand over what they owe: funds into the clearing corporation through the clearing bank, and securities into its pool account through the depository.
- Pay-outThe leg of settlement in which the clearing corporation releases what members are owed: funds credited to their clearing bank accounts, and securities now credited directly to the client's demat account.
- Settlement Guarantee FundA fund held by the clearing corporation, built from contributions by the exchange, the clearing corporation and clearing members plus a share of settlement penalties, used to complete settlement if a member defaults.
- Central counterpartyThe clearing corporation that interposes itself in every exchange trade, becoming buyer to every seller and seller to every buyer, so neither side carries the other's credit risk.
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
- Systemic riskThe risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
- ClearingThe daily accounting step that reconciles what every party owes and is owed on its open and closed positions, and turns a day of trades into one net obligation per member.
- Net obligation reportThe end-of-day report giving a trading member's net obligation, margin deposit, margin utilised, available deposit, the pay-in or pay-out required and the transaction fee payable or receivable.
- Principal riskThe risk of having paid or delivered without receiving the other side — the settlement half of counterparty risk, eliminated by a central counterparty acting through novation.
- Market Infrastructure InstitutionsThe institutions that form the plumbing of the securities market — stock exchanges, depositories and clearing corporations, and under SEBI's cyber framework also KRAs and QRTAs.
- Credit Default SwapA contract in which a protection buyer pays a regular premium to a protection seller, who agrees to pay any loss in value on a specified reference obligation if a credit event such as default occurs.
- Counterparty credit riskThe risk that the other party to an OTC derivative fails before the settlement date. It does not arise in exchange-traded derivatives, where the clearing corporation becomes central counterparty.
- Securities marketThe market in which securities are issued, purchased by investors and subsequently transferred among investors — the regulated channel that moves household savings to businesses.
- Default waterfallThe fixed order in which a clearing corporation uses its resources to cover a member default: defaulter's money first, then insurance, its own capital, the Core SGF, and last a haircut to pay-outs.
- Clearing corporationThe entity that steps between every buyer and seller in the derivatives segment by novation, becoming the counterparty to both sides and guaranteeing that the trade settles.
- Counterparty riskThe risk of an economic loss because the other party to a contract fails to fulfil its obligation — acute in forwards, and removed for exchange-traded derivatives by the clearing corporation's guarantee.