Where a firm has a live and current OTC derivative trade (or position) with a particular counterparty, at any point during its lifetime that trade or position may be subject to novation.
Novation is a generic term meaning the legal act of replacing one participating member of a contract with another. The term is used in various situations involving the change of parties to a legal contract, and not just for OTC derivative trades.
Novation arises where one of the parties to a trade chooses to exit that trade, by introduction of a third party in its place. This situation is represented in Figures 38.1 and 38.2, the first of which represents the original parties to the trade, prior to novation: