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  • QA 229
    Question:
    What is 'novation' and how does it feature in futures trading?
    Background:
    In futures trading what is meant by Novation? The word does not show up in the Guide but I am told that novation is one of the advantages of trading in futures? Can you explain?
    Asked by:
    Finance Sector - India
    Answer:

    Novation is the assumption by a third party of the rights and benefits as well as the obligations of one of the parties to a contract. To note however that the term novation is not actually used in the context of futures trading and instead, in respect of this question, we would rather speak of the assumption of counterpart risk or performance risk. *

    To explain…

    Commodity exchanges that trade futures are structured around Clearing Houses that guarantee the correct execution of all transactions. The Clearing House does this by interposing itself between every buyer and seller = it acts as the seller to all buyers and as the buyer to all sellers. Following the matching of a buy and sell order, buyer and seller each contract with the Clearing House, not directly with each other. Therefore, by becoming the counterpart the Clearing House assumes the risk that one of the parties to a contract will not honour its obligations, i.e. it has assumed the counterpart or performance risk. The financial strength of the Clearing House, coupled with the daily control measures imposed on individual buyers and sellers, guarantees no contract should ever fail.

    Assumption of counterpart risk by the Exchanges enables futures markets to function. Futures markets handle millions of individual contracts and, certainly for coffee, execution can be extended almost two years into the future. It is for example possible to buy or sell New York arabica futures already in September 2009 for delivery as late as July 2011. Without the central Clearing House guaranteeing execution there would always be the risk of non-performance = one of the parties defaults.

    In other words, the Exchange's assumption of the counterpart risk obviates the need for individual operators to ascertain the standing and credit-worthiness of those who trade on the futures markets.

    The day-to-day trade in green coffee on the other hand is quite different!  Sellers at origin and buyers in consuming countries potentially always face the risk of contract failure = a buyer does not pay for the goods, or a seller fails to deliver. Each individual buyer and seller therefore has to evaluate the performance or counterpart risk that is potentially inherent in each contract they conclude. But, correctly ascertaining standing and credit-worthiness is not always easy to do…

    This is why the international trade in green coffee is based on mutual trust and reputation, especially where long-term contracts are concerned…

    Futures markets and how the coffee trade uses them are fully reviewed in Chapters 8 and 9 of the Guide. Chapter 10 deals with risk issues related to credit.

    Posted 21 August 2009

    * Assignment on the other hand is the assumption by a third party of the rights and benefits only, with the obligations remaining with the original party.

    Related chapter(s):
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    Q&A 018, 035, 221