Terminating or Novating Swap Positions
Terminating or Novating Swap Positions
Swap positions can be closed through termination (mutual agreement to end the trade) or novation (transfer to a third party). Understanding the mechanics, costs, and procedures for each approach is essential for position management and risk reduction.
Definition and Key Concepts
Termination vs. Novation
| Aspect | Termination | Novation |
|---|---|---|
| Parties | Original two parties | Original + transferee |
| Trade status | Extinguished | Continues with new party |
| Settlement | Cash payment | Assignment + possible payment |
| Documentation | Termination agreement | Novation agreement |
| Consent required | Mutual | All three parties |
Termination Types
| Type | Description | Use Case |
|---|---|---|
| Bilateral termination | Mutual agreement to end | Position no longer needed |
| Partial termination | Reduce notional | Resize hedge |
| Optional termination | Exercise embedded right | Callable/putable swaps |
| Event of Default | Non-defaulting party right | Counterparty failure |
| Termination Event | Automatic or at option | Tax event, illegality |
Novation Types
| Type | Description | Use Case |
|---|---|---|
| Full novation | Entire trade transfers | Counterparty change |
| Partial novation | Portion of trade transfers | Risk reduction |
| Step-out | Leave cleared position | Clearing member change |
| Step-in | Enter cleared position | Assume existing trade |
How It Works in Practice
Termination Process
Step-by-step:
| Step | Activity | Timing |
|---|---|---|
| 1 | Identify trade for termination | T-3 to T-1 |
| 2 | Request termination quote | T-1 |
| 3 | Negotiate termination value | T-1 |
| 4 | Execute termination agreement | T |
| 5 | Settle cash payment | T+2 |
| 6 | Update systems and reporting | T to T+1 |
| 7 | Release collateral | T+1 to T+2 |
Termination Value Calculation
Mark-to-market approach: Termination Value = Present Value of Remaining Cash Flows
Components:
- Fixed leg PV
- Floating leg PV (estimated using forward rates)
- Accrued interest to termination date
- Bid-offer adjustment
Novation Process
Step-by-step:
| Step | Activity | Timing |
|---|---|---|
| 1 | Identify transferee | T-5 to T-1 |
| 2 | Confirm transferee has ISDA with remaining party | T-3 |
| 3 | Agree transfer price | T-1 |
| 4 | Execute novation agreement (all 3 parties) | T |
| 5 | Settle any payment between parties | T+2 |
| 6 | Update systems and reporting | T to T+1 |
| 7 | Transfer collateral to new CSA | T+1 to T+2 |
Consent Requirements
| Transaction | Consent Needed |
|---|---|
| Bilateral termination | Original counterparty |
| Novation | Remaining party (and transferee) |
| Assignment | Per ISDA (typically requires consent) |
| CCP step-out | CCP and new clearing member |
Worked Example
Termination Example
Trade details:
- Product: 5-year USD interest rate swap
- Original trade date: 2023-01-15
- Maturity: 2028-01-15
- Notional: $50 million
- Fixed rate: 3.75% (we receive)
- Current date: 2025-01-15 (2 years remaining)
- Current 2Y swap rate: 4.25%
Termination value calculation:
Fixed leg remaining cash flows: 4 semi-annual payments of $50M × 3.75% / 2 = $937,500
Present value of fixed leg: PV = $937,500 × (1 + 1.04 + 1.08 + 1.12) / 1.0425² = $3,520,000
Floating leg PV (at par for theoretical SOFR swap): PV = $50,000,000 (approx.)
Net PV to fixed receiver: Termination Value = PV(Fixed) + Notional - PV(Floating) = ($3,520,000 + $50,000,000) - $50,000,000 = -$1,250,000 (we owe this amount)
Why negative: We receive 3.75% when market rates are 4.25%. Our below-market fixed rate has negative value.
Bid-offer impact: Dealer quotes termination at -$1,300,000 (50 bps adjustment)
Settlement: We pay $1,300,000 to counterparty to terminate.
Novation Example
Original trade:
- Party A (transferor) pays fixed to Party B
- Notional: $100 million
- Fixed rate: 4.00%
- Remaining tenor: 3 years
Novation:
- Party C (transferee) will assume Party A's position
- Party C will pay fixed to Party B going forward
Value calculation:
- Current 3Y swap rate: 3.75%
- Trade is in-the-money to Party A (paying below-market fixed)
MTM value to Party A: +$750,000
Transfer payment: Party C pays Party A $750,000 for the position
Post-novation:
- Trade continues between Party C and Party B
- Party A is fully released
- Party C now pays 4.00% (above current 3.75%)
Partial Termination
Scenario: Reduce hedge by $25 million (from $100M to $75M)
Process:
- Agree to terminate $25 million notional
- Calculate pro-rata termination value
- Cash settle for $25M portion
- Amend confirmation to reflect $75M remaining
Risks, Limitations, and Tradeoffs
Termination Costs
| Cost Component | Description |
|---|---|
| MTM payment | Value transfer based on rate moves |
| Bid-offer spread | Dealer margin on unwind |
| Accrued interest | True-up to termination date |
| Breakage costs | Funding impact if mid-period |
Novation Risks
| Risk | Description | Mitigation |
|---|---|---|
| Consent delay | Remaining party slow to approve | Start process early |
| Documentation gaps | Transferee lacks ISDA | Verify before agreeing |
| Value dispute | Parties disagree on transfer price | Use independent valuation |
| Credit concerns | Remaining party rejects transferee | Pre-screen credit |
Operational Challenges
| Challenge | Impact |
|---|---|
| System updates | Trade records must change |
| Collateral transfer | Margin moves between CSAs |
| Regulatory reporting | SDR updates required |
| Hedge accounting | May need re-designation |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Stale valuation | Using old rate for pricing | Get real-time quote |
| Missing accrued | Forgetting mid-period accrual | Include in calculation |
| Consent not obtained | Novation fails | Confirm consent in writing |
| Reporting failure | SDR not updated | Automate termination reporting |
Cleared Swap Considerations
CCP Termination
Step-out process:
- Notify current clearing member (FCM)
- Identify new FCM
- Execute porting documentation
- CCP transfers position to new FCM
- Margin moves to new FCM
Timing: Same-day for emergency; 2-3 days normal
CCP Compression
Rather than individual terminations, cleared positions can be compressed:
| Approach | Description |
|---|---|
| Coupon blending | Combine trades at average rate |
| Maturity matching | Net trades with same maturity |
| Multilateral | Across multiple counterparties |
Tax Considerations
US tax treatment:
- Termination may trigger gain/loss recognition
- Timing depends on whether hedge accounting applied
- Mark-to-market rules may apply to dealers
Consult tax advisor for:
- Timing of gain/loss recognition
- Character of gain/loss (ordinary vs. capital)
- Impact on hedge accounting qualification
Checklist and Next Steps
Termination checklist:
- Identify trade(s) for termination
- Verify authority to terminate
- Request termination quote
- Calculate expected value independently
- Negotiate final termination value
- Execute termination agreement
- Settle cash payment
- Update internal systems
- Report termination to SDR
- Release collateral
- Update hedge accounting records
Novation checklist:
- Identify transferee
- Confirm transferee has ISDA with remaining party
- Obtain credit approval for transferee
- Agree transfer price with all parties
- Prepare novation agreement
- Obtain consent from remaining party
- Execute novation (all three signatures)
- Settle any transfer payment
- Update systems (all three parties)
- Report novation to SDR
- Transfer collateral arrangements
- Update hedge documentation
Related articles:
- For hedge documentation, see Setting Up Hedge Documentation
- For counterparty monitoring, see Counterparty Risk Monitoring