What changed
This circular provides operational guidance on novation of OTC derivative contracts, building on earlier guidelines from 2007 and 2011. It details the mechanism, including tripartite agreements, MTM exchange, and documentation requirements. It also introduces minimum holding periods: six months for contracts up to one year, nine months for longer ones, with exceptions for winding-up or liquidation.
What it means for you
Banks can now manage counterparty credit risk and exposure more flexibly through novation, especially during mergers or business closures. The upfront MTM exchange ensures no cash flow impact on the remaining party, reducing operational complexity. However, the holding period restrictions may limit short-term portfolio adjustments, and transferees must ensure the remaining party is a borrower, tying novation to existing lending relationships.
What you must do
- Ensure all novation deals use a tripartite agreement with identical terms to the original contract.
- Exchange the MTM value upfront between transferor and transferee, with no cash flows to the remaining party.
- Adhere to minimum holding periods: 6 months for contracts ≤1 year, 9 months for >1 year, unless winding-up or liquidation applies.
- Verify that the transferee bank has the remaining party as a constituent borrower before novation.
- Conduct independent due diligence as per RBI circular DBOD.No.BP.BC.44/21.04.157/2011-12 and the Master Circular on Risk Management and Inter-Bank Dealings.
Who it affects
All Scheduled Commercial Banks (excluding RRBs and LABs), All India Term-Lending and Refinancing Institutions, Banks dealing in OTC derivative contracts
What is the minimum period a derivative contract must be held before novation?
For contracts with original maturity up to one year, the minimum holding period is six months. For contracts with maturity over one year, it is nine months. This does not apply if the transferor bank is winding up or under liquidation.
Who bears the cost of the MTM exchange in a novation?
The transferor and transferee exchange the MTM value upfront between themselves. The remaining party is not involved in any cash flows related to the novation.
Can a bank novate a derivative contract to any counterparty?
No, the transferee bank must have the remaining party as a constituent borrower. Additionally, the transferee must conduct independent due diligence as per RBI guidelines.