New RBI guidelines for novation of OTC derivative contracts
New RBI guidelines for novation of OTC derivative contracts
A novation involves replacing a market maker with another party in an OTC derivative contract, ensuring continuity between the remaining party and a new counterparty.
The Reserve Bank of India (RBI) has proposed new directions for the novation of over-the-counter (OTC) derivative contracts. These guidelines govern how a market participant can exit a contract and a new party can take their place.
A novation involves the replacement of a market maker with another party in an OTC derivative contract between two counterparties (the transferor stepping out of the existing deal and the remaining party), creating a new contract between the remaining party and a third party (the transferee). The transferee becomes the new counterparty to the remaining party.
Key guidelines for undertaking a novation include:
1. Prior consent of the remaining party in the contract is mandatory before novation can occur.
2. Prevailing market rates on the date of transfer shall apply between the transferor and the transferee.
3. A tripartite agreement replaces the old contract with a new contract carrying identical terms, except for the change in counterparty for the remaining party.
4. This agreement ensures the transfer of counterparty credit and market risk arising from the OTC derivative contract from the transferor to the transferee.
5. The tripartite agreement also ensures that the remaining party and the transferor are released from their obligations under the old contract.
6. The transferor and transferee can mutually agree on any charges or fees for the transfer, which will not form part of the novation.
7. Relevant documents shall be transferred from the transferor to the transferee.
8. Standard agreements for novation will be devised by the Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the Foreign Exchange Dealers’ Association of India (FEDAI), in consultation with market participants and aligned with international best practices.
9. The novation must be reported to the Trade Repository of the Clearing Corporation of India.
Currently, OTC derivative contracts are governed by the RBI’s 2013 circular, which provides comprehensive operational guidelines on novation.
