Question

What are 1) Stock Exchange with a multiple cap functionality, Central counterparty, and Novation

Answer 1

In stock exchange, the word ‘cap’ refers to ‘market capitalisation’. Under multiple cap functionality, three main classifications are:

• Large cap
• Mid cap
• Small cap

A central counterparty (CCP) interposes/inserts itself between counter-parties to contracts which are traded in financial markets (usually derivatives). Essential role of any CCP is to become a buyer to every seller and to become a seller to every buyer in a contract, thereby ensuring the performance of open contratcs. CCP becomes a principal to all trades with its clearing members involved in a contract. To support the interposition of the CCP as common counterparty to all trades, modern central counterparty clearing arrangements involve counterparty substitution by means of novation or other equivalent legal mechanisms such as open offer.

Through novation mechanism, which essentially means 'discharging a debt', the original existing financial contract between the buyer and seller is extinguished or terminated, and is substituted by two new contracts, one between the CCP and the buyer, and the other between the CCP and the seller. The consideration of the new contract usually is the discharge of the old contract. Thus, with novation, a new legal basis is created for contractual rights and obligations, which requires a binding contract and intention to enter into a novation.