What is a Novation?
A ‘novation’ is where an existing agreement is replaced with a new agreement to which all contracting parties agree.
Generally, novations occur by either:
- (i) an assignment or transfer of a transaction in which the terms to the original transaction are varied or added, resulting in a new contract and the original transaction terminates, or
- (ii) a transfer of the rights and obligations under an original arrangement, where one of the original parties exit the original contract and are effectively replaced by a new party in the substituted contract.
In the latter scenario, the new counterparty ends up assuming the rights and obligations of the exiting party. This is commonly the process for cleared trades (see below).
Why are Novations used?
Novations can be used in any business or sector but particularly so where contracts are common. They can be used when changing terms or parties under debt arrangements (such as changing lenders in a re-finance), real estate transactions and government contracting (where contractors cannot deliver on government projects).
Novations are a common lifecycle event in derivatives. In financial markets, they are used in options, credit default swaps or futures where there is a transfer of the transaction to a clearing house.
With respect to clearing, novation basically occurs where a vendor (or transferor) of a security, transfers the rights and obligations under the derivative contract to a clearing house, which then sells these onto a purchaser (or transferee). The transferor and transferee are to agree the contract terms, and the clearing house also is to agree the terms within a timeframe. If the clearing house does not agree, the two original parties to the transaction have to re-book a new trade and re-follow these steps.
So how do novations impact trade reports under EMIR Refit and MiFIR?
Do I need a new UTI?
MiFIR:
Under MiFIR, novations of derivatives contracts where a counterparty to the contract is replaced by a third party, is exempt and therefore not reportable (see page 29 Mifid ii reporting guidelines. This also includes trades that are terminated due to clearing. Given they are not reportable, no UTIs are needed for the ‘novated’ trade.
EMIR Refit (UK and EU):
Under EMIR Refit, novations are referred to as ‘Step-ins’ under Event Type (see Table 3 in ESMA’s Final Report). It is defined as an event, where a derivative (in part or in whole) is transferred from one to another and the current derivative transaction is either terminated or the notional is modified. The transferred transaction is reported as a new transaction. The ESMA Guidelines suggest that for the action type ‘New’ (i.e. new transaction), a new UTI is required. This is in line with the IOSCO approach to UTIs (see Consultative Report) and ISDA’s UTI Best Practice Paper. Note that the Final Report (Table 2 – row 3) provides that in the ‘Prior UTI’ field (field 2.3), the details to report are:
‘UTI assigned to the predecessor transaction that has given rise to the reported transaction due to a lifecycle event, in a one-to-one relation between transactions (e.g. in the case of a novation, when a transaction is terminated, and a new transaction is generated) . . .’
This essentially means prior UTIs are required to be reported for novated trades where the original trade was terminated and a new trade has resulted.
For UK EMIR Refit, there is additional detail around the population of the prior UTI field which is not dealt with under EU EMIR Refit. The FCA, in their Q&As, provide that the ‘the stepping-in counterparty is expected to make reasonable efforts to populate’ this field and if this cannot be done, the code ‘NOTAVAILABLE’ can be used and then as soon as practicable, once available, corrected to include the prior UTI. Here, the stepping-in party does not have to retrospectively resubmit the prior UTI.
Reporting differences for full novation vs partial novation
We have extracted the relevant rows from Table 12 of the ESMA Guidelines (below) to show the differences on reporting details:
- where there is a full novation vs a partial novation,
- which of the parties have to report the relevant details (including UTIs), and
- the action type to be reported by those parties.
| Business Event | Detail Reported By | Reportable? | Action type | Event type | Comment |
|---|---|---|---|---|---|
| Full novation | Remaining Party | Yes | Terminate & New | Step-in | Trade with original counterparty is terminated |
| Step-in | Yes | New | Step-in | ||
| Step-out | Yes | Terminate | Step-in | ||
| Partial novation | Remaining Party | Yes | Modify & New | Step-in | |
| Step-in | Yes | New | Step-in | ||
| Step-out | Yes | Modify | Step-in |
Should I still use the original trade date?
MiFIR:
Not relevant as the novated trade is not reportable.
EMIR Refit (UK and EU):
For a novation where a counterparty steps into a derivative and becomes a new counterparty to the derivative (excluding clearing events), the new trade should be reported by both parties with ‘New’ as the action type and ‘Step-in’ as the event type. Regarding the existing derivative’s report – this should be sent by both parties with ‘Terminate’ as the action type and ‘Step-in’ as the event type. Field 2.45 should be completed with the ’Early termination date’. Since the original contract has been terminated, one can expect that the new trade would not refer to the original trade date under the terminated trade.
How can TRAction assist?
If you are interested in learning more about how to report novations, UTI and UTI generation and not sure which of the jurisdictional regulations apply to you, please reach out to our team at TRAction.
