Novation
Novation is the legal process by which an original bilateral contract between two parties is extinguished and replaced by two new contracts, each with the central counterparty as one side. After novation, the buyer faces only the CCP and the seller faces only the CCP. Bilateral counterparty risk is replaced by exposure to a single, highly regulated entity. Novation is automatic on exchange-cleared trades and increasingly common in the OTC market after the G20 Pittsburgh 2009 reforms. The ISDA 2002 Novation Agreement provides the standard template for bilateral OTC novations.
Why it matters
Two friends shake hands on a bet. Later, they ask a bonded bookmaker to take over the bet from both sides. The original handshake is torn up. Now Friend A's bet is with the bookmaker, and the bookmaker's bet is with Friend B. Neither friend has any contract with the other any more. The bookmaker has equal and opposite obligations to each side, so its net market exposure is zero, but it stands between them as guarantor. That legal substitution, not just a guarantee, is novation.
Formulas
Worked examples
Party A sells 5 ASX wheat futures contracts to Party B at A$330 per tonne, matched on ASX 24 at 11:02 am.
ASX Clear (Futures) novates the trade. The original A-to-B contract is discharged. Two new contracts are created. Party A is now short 5 contracts to ASX Clear (Futures), and ASX Clear (Futures) is short 5 contracts to Party B. From this point, A and B have no contractual relationship with each other. Each pays initial and variation margin to the CCP. If A defaults, B's position is unaffected, because B's contract is with the CCP, not with A.
OTC novation under ISDA 2002 Novation Agreement. Hedge Fund X is a party to an interest rate swap with Bank Y. X wishes to exit the swap by transferring it to Hedge Fund Z.
All three parties sign the ISDA 2002 Novation Agreement. X is the transferor, Z is the transferee, Y is the remaining party. The original X-Y swap is extinguished. A new identical swap is created between Z and Y. Y's economic position is unchanged, but Y now faces Z's credit. Consent from all three parties is required because Y is being asked to accept a new counterparty. This is fundamentally different from an assignment, which transfers rights only and may not require remaining-party consent.
Common mistakes
- ✗Novation is the same as assignment. Assignment transfers rights under a contract, novation creates a new contract that extinguishes the old one. Novation requires the remaining party's consent, assignment usually does not.
- ✗The CCP changes the economic terms of the trade. The CCP only changes the counterparty. Price, size, maturity, and underlying remain identical. The CCP is paid in margin and fees, not by changing the trade economics.
- ✗Novation is optional on exchange trades. It is automatic for all exchange-cleared trades once the trade is matched and accepted by the CCP. Bilateral OTC novations require explicit tripartite consent under ISDA documentation.
Revision bullets
- •Extinguishes the original contract, creates two new ones
- •Replaces bilateral risk with CCP exposure
- •Automatic on exchange-cleared trades
- •Tripartite consent needed for bilateral OTC novations
- •ISDA 2002 Novation Agreement is the OTC standard
- •Different from assignment, which transfers rights only
Quick check
After novation of an exchange-traded futures contract through ASX Clear (Futures), the buyer's legal counterparty becomes:
Which party's consent is required for an OTC novation under the ISDA 2002 Novation Agreement?
Connected topics
In learning paths
Sources
- Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.Describes how clearing houses use novation to interpose themselves between buyer and seller.
- International Swaps and Derivatives Association. 2002 ISDA Novation Agreement and User's Guide. ISDA, 2002.Industry-standard template that governs tripartite novation of OTC derivative trades.
- Australian Securities Exchange. Central counterparty clearing through ASX Clear (Futures). ASX, accessed 2026.Describes the automatic novation of all matched trades on the ASX 24 market.
- Reserve Bank of Australia. Appendix A1.2 ASX Clear (Futures). RBA CS Facility Assessment 2014-15.Regulatory assessment of how ASX Clear (Futures) uses novation to assume credit risk on cleared trades.