RBI’s New Directions for Novation of OTC Derivative Contracts

Introduction to Novation in OTC Derivatives Contracts

The Reserve Bank of India has introduced a significant regulatory framework through the Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025, which was released on July 9, 2025, under Section 45W of the Reserve Bank of India Act, 1934.[1] This development marks a crucial evolution in India’s financial derivatives market, addressing the operational complexities that arise when parties seek to transfer their positions in over-the-counter derivative contracts. The new directions represent a modernization effort that aims to align India’s regulatory framework with international best practices while ensuring transparency, legal clarity, and operational efficiency in the derivatives market.

Novation, in the context of over-the-counter derivatives, refers to a sophisticated legal mechanism whereby one party to a derivative contract (the transferor) is replaced by a new party (the transferee), with the consent of the continuing party (the remaining party). This process effectively extinguishes the original contractual relationship and creates a new contract with identical economic terms but different counterparties. The RBI’s Draft Directions on Novation of OTC Derivative Contracts provide a clear regulatory framework for this process, highlighting its importance in providing liquidity and flexibility to market participants who may need to exit positions before maturity for commercial, strategic, or risk management reasons.

The regulatory intervention by the RBI comes at a time when India’s derivatives market has witnessed substantial growth and sophistication. The previous regulatory framework, established through a circular dated December 9, 2013, had served the market for over a decade.[1] However, changes in market practices, technological advancements, the evolution of the broader regulatory ecosystem governing OTC derivatives, and feedback from market participants necessitated a fresh look at the novation framework. The new directions aim to rationalize regulatory requirements, reduce operational friction, and provide greater clarity to market participants engaging in novation transactions.

Legal and Regulatory Framework Governing OTC Derivatives Contracts in India

The regulatory architecture for over-the-counter derivatives in India operates within a multi-layered legal framework. At the apex sits the Reserve Bank of India Act, 1934, which provides the RBI with comprehensive powers to regulate derivatives markets through specific provisions. Section 45U of the RBI Act, 1934 contains definitions relevant to derivatives, while Section 45V addresses transactions in derivatives generally. Most importantly, Section 45W of the RBI Act, 1934 confers upon the Reserve Bank the power to regulate transactions in derivatives, money market instruments, and related financial products.[2]

Section 45W empowers the Reserve Bank to issue directions to any person or class of persons dealing in derivatives, money market instruments, or securities. This section specifically enables the RBI to prescribe the manner in which such transactions shall be entered into or carried out, the parties who may enter into such transactions, the terms and conditions that shall govern such transactions, and the reporting requirements for such transactions. The Draft Novation Directions, 2025 have been issued in exercise of these statutory powers under Section 45W read with Section 45U of the RBI Act, 1934.

Beyond the RBI Act, the foreign exchange derivatives segment operates under the Foreign Exchange Management Act, 1999 (FEMA). The Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000, notified as FEMA.25/RB-2000 dated May 3, 2000, governs foreign exchange derivative contracts.[1] These regulations work in conjunction with the Master Direction on Risk Management and Inter-Bank Dealings issued by the Financial Markets Regulation Department. Together, these instruments create a regulatory framework that balances market development with prudential oversight.

For interest rate derivatives, the regulatory landscape is shaped by the Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019, which was notified on June 26, 2019.[1] This framework was further supplemented by the Reserve Bank of India (Forward Contracts in Government Securities) Directions, 2025, issued on February 21, 2025. These directions govern interest rate derivative products that reference rupee interest rates or government securities. The credit derivatives segment, though relatively smaller, operates under the Master Direction on Credit Derivatives issued on February 10, 2022.[1]

The Securities Contracts (Regulation) Act, 1956 also plays an important role in the overall derivatives ecosystem by defining exchanges and regulating exchange-traded derivatives. While the new novation directions specifically exclude exchange-traded derivatives from their scope, the interplay between exchange-traded and over-the-counter markets means that regulatory coordination remains important. The Companies Act, 2013 is also relevant, particularly because the novation directions explicitly exclude novations undertaken pursuant to court-approved schemes of merger, demerger, or amalgamation under this Act.[1]

Understanding the Draft RBI Novation Directions, 2025

The Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025 represents a codified and rationalized approach to regulating novation transactions in the Indian derivatives market. These directions apply specifically to over-the-counter derivatives transactions undertaken in terms of the provisions of what the directions term “Governing Directions” – essentially the various master directions and regulations that permit and govern specific types of OTC derivatives.[1]

The scope of application is carefully delineated. The directions apply to all OTC derivatives, which are defined as derivatives other than those traded on recognized stock exchanges, and this definition explicitly includes derivatives traded on Electronic Trading Platforms. This is a significant clarification because Electronic Trading Platforms have emerged as an important venue for derivatives trading, combining some characteristics of exchanges with the flexibility of OTC markets. The inclusion ensures that derivatives traded on these platforms remain subject to appropriate regulatory oversight regarding novation.

However, the directions carve out two important exceptions where novation does not require compliance with these directions. First, novations undertaken by central counterparties for the purpose of effecting settlement of novation of OTC derivative contracts are excluded. Central counterparties play a unique role in the financial system by interposing themselves between buyers and sellers, thereby reducing counterparty risk. Their novation activities are typically governed by separate regulatory frameworks given their systemic importance. Second, novations pursuant to court-approved schemes of merger, demerger, or amalgamation under the Companies Act, 2013 or any other law are also excluded. This exception recognizes that corporate restructurings involve comprehensive legal processes with their own safeguards and should not be hindered by additional novation requirements.

The directions come into force with immediate effect upon their finalization, though the draft was released for public consultation with comments invited until August 1, 2025. This consultation process reflects the RBI’s commitment to inclusive regulatory development that takes into account the views and concerns of market participants, industry associations, and other stakeholders.

Key Definitions and Conceptual Framework

The novation directions establish a precise definitional framework that is essential for legal certainty and operational clarity. The term “novation” itself is defined as the replacement of a market maker with another market maker in an OTC derivative contract between two counterparties to an OTC derivative transaction with a new contract between the remaining party and a third party.[1] This definition emphasizes that novation is specifically about market makers transferring their positions, which makes sense given that market makers are the primary liquidity providers in OTC derivatives markets and are most likely to need flexibility in managing their derivative portfolios.

The definition of “market-maker” adopts the meaning assigned in the Master Direction on Market-makers in OTC Derivatives issued on September 16, 2021. Market-makers are typically banks and financial institutions that have been specifically authorized by the RBI to quote two-way prices (both buy and sell prices) in derivatives and provide liquidity to users. They play a central role in the functioning of OTC derivatives markets by standing ready to take the opposite side of user transactions, thereby ensuring that end users can execute their hedging or trading strategies.

The directions introduce and define three key parties to a novation transaction. The “transferor” is the party to a transaction that proposes to transfer, or has transferred, by novation to a transferee all its rights, liabilities, duties and obligations with respect to a remaining party.[1] The “transferee” is the party that proposes to accept, or has accepted, the transferor’s transfer by novation of all these rights, liabilities, duties and obligations. The “remaining party” is the user that continues to be a counterparty in the new contract post novation – essentially, this is the party that did not initiate the novation and whose counterparty is being changed.

The definition of “user” is also adopted from the Master Direction on Market-makers in OTC Derivatives. Users are typically entities that enter into derivative contracts for hedging or risk management purposes, as opposed to market-making purposes. They represent the demand side of the derivatives market and include corporations, institutional investors, and other entities with genuine economic exposures that they wish to hedge through derivatives.

An important definitional element is the concept of “Governing Directions,” which refers to the various master directions, regulations, and notifications that govern specific types of OTC derivatives. For foreign exchange derivatives, this includes FEMA regulations and the Master Direction on Risk Management and Inter-Bank Dealings. For interest rate derivatives, this includes the Rupee Interest Rate Derivatives Directions and the Forward Contracts in Government Securities Directions. For credit derivatives, this includes the Master Direction on Credit Derivatives. This framework ensures that novated contracts remain subject to all the eligibility criteria, documentation requirements, and other regulatory standards that applied to the original contract.

Guidelines and Procedural Mechanisms for Novation of OTC Derivative Contracts

The novation of OTC Derivative Contracts establish a clear procedural framework that market participants must follow when undertaking novation. The foundational requirement is that the novation of an OTC derivative contract must be done with the prior consent of the remaining party.[1] This requirement protects the non-transferring party by ensuring they have a say in who their counterparty will be. Since derivatives involve counterparty credit risk – the risk that the other party will default on their obligations – the remaining party has a legitimate interest in approving any change in their counterparty. This consent requirement cannot be waived or bypassed, and any attempted novation without proper consent would be invalid.

The second critical requirement relates to pricing. The transaction must be undertaken at prevailing market rates, with the amount corresponding to the mark-to-market value of the OTC derivative contract at the prevailing market rate on the novation date being exchanged between the transferor and the transferee.[1] This requirement serves multiple purposes. It ensures that the transfer occurs at fair market value, preventing any value transfer between the transferor and transferee that might otherwise occur if the contract were transferred at off-market rates. It also provides clarity on the economic settlement between the transferring parties, which is separate from the continuation of the derivative contract itself.

The mark-to-market value represents the current economic value of the derivative contract based on current market conditions. If a derivative contract has positive value to one party, that party would need to be compensated for transferring that value to someone else. Conversely, if the contract has negative value (is “out of the money”), the party accepting that obligation would need to be compensated. By requiring the exchange of mark-to-market value at prevailing market rates, the directions ensure economic rationality and transparency in novation transactions.

The third key requirement is that parties to the novation must adhere to the provisions of the Governing Directions, and the new contract post novation must be in compliance with those provisions.[1] This ensures regulatory continuity – a novated contract cannot be used to circumvent regulatory requirements that applied to the original contract. For instance, if the original contract was subject to specific hedging requirements, underlying exposure documentation, or concentration limits, those same requirements continue to apply post-novation.

The Tripartite Agreement Mechanism

At the heart of the novation process lies the tripartite agreement between the transferor, transferee, and remaining party. This agreement is the legal instrument that effects the novation by simultaneously extinguishing the old contractual relationship and creating a new one. The directions specify that through this tripartite agreement, the transferee steps into the contract to face the remaining party while the transferor steps out.[1]

The legal effect of the tripartite agreement is carefully articulated in the directions. The original contract stands extinguished and is replaced by a new contract with terms and parameters identical to the original contract, except for the change in counterparty for the remaining party.[1] This ensures economic continuity – the remaining party’s economic position and contractual rights are preserved, even though their counterparty has changed. The hedging effectiveness of the derivative from the remaining party’s perspective is maintained, which is crucial for entities using derivatives for risk management purposes.

The tripartite agreement must satisfy two critical criteria. First, the counterparty credit risk and market risk arising from the OTC derivative contract must be transferred from the transferor to the transferee.[1] This means the transferee assumes all the risk that the transferor previously bore regarding this contract. The transferee becomes responsible for making payments if the derivative moves in favor of the remaining party, and conversely, becomes entitled to receive payments if the derivative moves in their favor.

Second, the transferor and the remaining party must each be released from their obligations under the original transaction to each other, and their respective rights against each other must be cancelled.[1] This clean break is essential to the concept of novation – the transferor cannot retain any lingering obligations or rights under the original contract. Simultaneously, rights and obligations identical in their terms to the original transaction are reinstated in the new transaction between the remaining party and the transferee. This creates the legal structure where the remaining party has effectively the same contract, just with a different counterparty.

The directions also clarify that the transferor and transferee may agree on charges or fees between them for the transfer of the trade, but these fees and their settlement terms need not form part of the novation agreement.[1] This sensibly separates the commercial arrangements between the transferring parties from the legal mechanics of the novation itself. The fee paid by a transferee to a transferor (or vice versa, depending on the contract’s value) represents compensation for the transfer and may reflect factors like the administrative costs of novation, the credit quality of the parties, and the market value of the position being transferred.

Documentation Standards and Industry Practice

Recognizing that standardized documentation reduces legal uncertainty and operational risk, the novation directions task two key industry associations with developing standard agreements for novation. The Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the Foreign Exchange Dealers’ Association of India (FEDAI) are directed to devise standard agreements for novation in consultation with market participants and based on international best practices.[1]

FIMMDA is the industry association representing participants in India’s fixed income, money market, and derivatives markets. FEDAI performs a similar role for the foreign exchange market. These associations have historically played an important role in developing market conventions, standard documentation, and best practices that complement formal regulation. By tasking these associations with developing novation documentation, the RBI is leveraging industry expertise and ensuring that the resulting standards reflect practical market needs.

The reference to international best practices is significant because derivatives markets are global in nature, and many Indian market participants are also active in international derivatives markets. Aligning Indian novation documentation with international standards facilitates cross-border transactions and allows Indian institutions to benefit from the extensive legal and operational experience accumulated in more developed derivatives markets. Organizations like the International Swaps and Derivatives Association (ISDA) have developed widely-used standard documentation for derivatives transactions globally, and these can serve as useful reference points for Indian standards.

The directions also provide flexibility by noting that market participants may alternatively use a standard master agreement for novation.[1] This recognizes that different institutions may have different documentation needs and that a one-size-fits-all approach may not be appropriate for all situations. Larger institutions with significant derivatives activity may prefer customized master agreements that are tailored to their specific operational and legal requirements, while smaller participants may benefit from using industry-standard forms.

As part of the novation agreement, any relevant document related to the original OTC derivative contract and the underlying exposure must be transferred from the transferor to the transferee.[1] This documentation transfer is essential because many OTC derivatives, particularly those used for hedging, are subject to requirements regarding underlying exposures. For instance, a foreign exchange derivative hedging an import obligation must be backed by documentation evidencing that import transaction. When the derivative is novated, the transferee needs to receive this underlying documentation to demonstrate compliance with regulatory requirements.

Reporting Requirements and Trade Repository Obligations

Transparency and regulatory oversight in the derivatives market depend critically on accurate and timely reporting of transactions. The novation directions establish clear reporting obligations requiring market-makers involved in the novation of an OTC derivative contract to ensure that details pertaining to the novation are reported to the Trade Repository of Clearing Corporation of India Limited (CCIL).[1]

CCIL operates the designated trade repository for OTC derivatives in India and plays a central role in collecting, maintaining, and disseminating information about OTC derivative transactions. Trade repositories were mandated globally following the 2008 financial crisis as a mechanism to improve transparency in previously opaque OTC derivatives markets. By aggregating data on derivatives transactions, trade repositories enable regulators to monitor market activity, identify emerging risks, and assess systemic exposures.

The reporting must be done in terms of the provisions specified in the Governing Directions, which means that novation reporting must comply with the same standards, timelines, and formats that apply to reporting of other derivative transactions. This ensures consistency in the trade repository’s data and facilitates meaningful analysis of market activity. The specific reporting requirements vary depending on the type of derivative – foreign exchange derivatives, interest rate derivatives, and credit derivatives each have their own reporting standards as specified in their respective governing directions.

By placing reporting obligations on market-makers rather than on all parties to the novation, the directions recognize the reality that market-makers typically have more sophisticated operational infrastructure and reporting capabilities than users. Market-makers already have systems in place for reporting their derivative transactions, so extending this to novation reporting is operationally straightforward. However, this does not absolve other parties of responsibility – they must cooperate with the market-maker to ensure accurate reporting, including providing any necessary information.

Supersession of Previous Regulatory Framework

The new novation of OTC derivative contracts explicitly supersede previous regulatory provisions, creating a clean slate for the regulatory treatment of novation. The directions list in an annex the notifications and clarifications that are superseded, specifically including Notification No. DBOD.No.BP.BC.76/21.04.157/2013-14 dated December 9, 2013, and a mailbox clarification regarding the applicability of novation guidelines when transfers between entities happen by operation of law, dated December 12, 2014.[1]

The 2013 circular had provided the framework for novation for over a decade, during which time the derivatives market evolved significantly. The market saw the introduction of new products, changes in trading venues with the emergence of Electronic Trading Platforms, enhancements to the trade repository infrastructure, and revisions to various master directions governing different types of derivatives. These developments created some ambiguities and areas where the 2013 framework did not align perfectly with newer regulatory provisions.

The 2014 mailbox clarification addressed a specific question about whether novation guidelines apply when transfers occur by operation of law, such as in statutory mergers. The new directions address this more comprehensively by explicitly excluding court-approved schemes of merger, demerger, or amalgamation from the scope of the novation directions. This approach provides greater clarity and recognizes that such transfers have their own legal framework and safeguards.

The supersession of these older provisions means that once the new directions come into force, market participants must comply with the new framework. Any internal policies, procedures, or documentation based on the old framework should be updated. Industry associations like FIMMDA and FEDAI would need to review and potentially revise their standard documentation to ensure alignment with the new requirements.

Regulatory Objectives and Policy Considerations for RBI Novation of OTC Derivative Contracts

The RBI’s issuance of updated novation of OTC derivative contracts reflects several underlying policy objectives. First, the central bank seeks to enhance transparency in the OTC derivatives market. By establishing clear rules for how novation must be conducted and requiring reporting to the trade repository, the RBI ensures that regulators maintain visibility into changing counterparty relationships in the derivatives market. This is important for assessing systemic risk, monitoring market practices, and identifying potential issues before they become problems.

Second, the directions aim to protect market participants, particularly users who are having their counterparty changed through novation. The requirement for prior consent of the remaining party ensures that no party is forced to accept a counterparty they do not approve. The requirement that transactions occur at prevailing market rates protects parties from value extraction through off-market pricing. The requirement that all regulatory standards continue to apply post-novation prevents regulatory arbitrage.

Third, the RBI seeks to facilitate market liquidity and efficiency. By providing a clear framework for novation, the directions make it easier for market-makers to manage their derivative portfolios. A market-maker who has accumulated a large position with a particular counterparty may face concentration risk or balance sheet constraints. The ability to novate some of those positions to other market-makers provides operational flexibility and helps maintain market functioning. Similarly, a market-maker may wish to exit the derivatives business or a particular market segment, and novation provides a mechanism to do so in an orderly manner.

Fourth, the directions seek to align Indian practices with international standards. By directing industry associations to base their standard documentation on international best practices, the RBI is ensuring that Indian market participants can operate effectively in global derivatives markets. This is particularly important for Indian banks and financial institutions that have significant international operations and for foreign institutions operating in India.

Fifth, the RBI aims to rationalize regulatory requirements by consolidating various provisions into a single, coherent framework. The previous approach of having a main circular supplemented by various mailbox clarifications created some confusion about exactly what rules applied. The new directions provide a single authoritative source for novation requirements, reducing regulatory uncertainty.

Implications for Market Participants

The RBI Novation of OTC Derivative Contracts directions will affect different categories of market participants in different ways. For market-makers, who are the primary users of novation, the new framework provides greater clarity and a more streamlined process. They will need to ensure their novation procedures comply with requirements such as the tripartite agreement structure, mark-to-market exchange, and reporting obligations. Banks and financial institutions serving as market-makers should review their internal policies, procedures, and documentation to align with the updated framework.

For users of derivatives, particularly corporations and institutional investors using derivatives for hedging, the most important aspect is the protection afforded by the consent requirement. Users should establish clear internal processes for evaluating novation requests, which should include credit assessment of the proposed transferee, review of any changes to documentation or operational processes, and confirmation that the novated contract will continue to meet their hedging needs. Users should not feel pressured to consent to novation and should exercise their right to refuse consent if they have concerns about the proposed transferee’s credit quality or other factors.

For legal and compliance teams at financial institutions, the new directions require attention to several areas. Documentation templates must be reviewed and updated to reflect the tripartite agreement structure and other requirements. Training should be provided to front-office and middle-office staff on the novation process and requirements. Reporting systems must be configured to capture and report novation transactions to CCIL’s trade repository in the required format and timeframe.

For industry associations like FIMMDA and FEDAI, the directions create a clear mandate to develop standard novation documentation. This work should be undertaken through broad consultation with market participants to ensure the resulting standards are practical and meet market needs. The associations should also consider developing guidance notes or frequently asked questions documents to help market participants understand and implement the novation framework.

For auditors and risk managers, the novation framework has implications for how derivative portfolios are assessed and monitored. Auditors should verify that institutions have proper processes for novation, including appropriate approvals, documentation, pricing verification, and reporting. Risk managers should incorporate novation into their operational risk frameworks and should monitor novation activity for any patterns that might indicate issues.

Conclusion

The Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025 represents a significant modernization of the regulatory framework governing an important aspect of India’s derivatives market. By providing clear rules for how parties can transfer derivative positions, the directions balance the need for market flexibility and liquidity with important protections for market participants and regulatory oversight. The requirement for consent of the remaining party ensures that counterparty changes do not occur against anyone’s wishes. The requirement for mark-to-market pricing ensures economic transparency. The tripartite agreement structure provides legal clarity about the extinguishment of old obligations and creation of new ones. The reporting requirements ensure regulatory visibility into changing market relationships.

As India’s derivatives market continues to grow and evolve, having a robust and clear framework for novation will become increasingly important. The novation mechanism provides essential flexibility for market-makers to manage their portfolios, enables orderly exits from positions or market segments, and facilitates risk management. At the same time, the regulatory framework ensures that this flexibility does not come at the cost of transparency, participant protection, or regulatory oversight. The supersession of the decade-old 2013 circular and its replacement with the new directions reflects the RBI’s commitment to keeping the regulatory framework current and aligned with market developments and international practices.

Market participants should use the implementation period to familiarize themselves with the new requirements, update their internal processes and documentation, and ensure their operational systems can support the novation framework. Industry associations should expeditiously develop standard documentation to facilitate smooth market functioning under the new regime. As the derivatives market continues to mature, frameworks like the novation directions will play an important role in ensuring that Indian markets operate efficiently, transparently, and in line with global standards.

References

[1] TaxGuru. (2025). RBI Draft Rules on Novation of OTC Derivatives 2025. Available at: https://taxguru.in/rbi/rbi-draft-rules-novation-otc-derivatives-2025.html 

[2] Ministry of Law and Justice. (1934). The Reserve Bank of India Act, 1934 – Section 45W. Available at: https://www.indiacode.nic.in/bitstream/123456789/2398/1/a1934-2.pdf