novation: one construct, many systems

In the law of obligations, novation is the substitution of a new contract or a new party for an existing one, with the agreement of all concerned, so that the original obligation is extinguished and replaced rather than merely transferred. Because the old debt is discharged, novation differs from assignment, which moves a benefit while leaving the original contract alive; Martha treats it as a defined mechanism within the law of financial obligations. The referent is the consensual replacement of one binding obligation by another, the very construct that clearing systems borrow when a central counterparty steps into the parties' places.[1]

Unit

A substituted obligation that discharges and replaces the original

Recovery means

Not applicable

Measured by

Established by the consent of all parties and the extinction of the prior obligation

In cleared financial markets, novation is the mechanism by which a central counterparty interposes itself between the original buyer and seller: the single bilateral contract is replaced by two new contracts, each facing the clearing house, so that it becomes buyer to every seller and seller to every buyer. Bliss and Papathanassiou describe how this novation concentrates and reallocates counterparty risk onto the clearing house. It is the identical legal construct as contractual novation (old obligation extinguished, new ones substituted by consent), operating as the structural core of central clearing rather than a one-off contract swap.[2]

Unit

The replacement of a bilateral trade by two contracts facing the clearing house

Recovery means

Not applicable

Measured by

Tracked by the clearing house's substituted exposures and the margin it holds against them