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The Bilateral Netting of Qualified Financial Contracts Act, 2020

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Financial institutions and other financial intermediaries employ a number of risk mitigating mechanisms to reduce their risk exposure in their business transactions. The two most commonly used mechanisms are collateral arrangements and close-out netting [1]. These risk-mitigating mechanisms ensure that that risk arising from one party’s exposure to the solvency of the counterparty and to fluctuations in the value of the relevant assets are tightly controlled. Both mechanisms help the financial institutions to manage the counterparty risk as well as market risk.

There are two types of netting [2]. Payment netting refers to a process coalescing offsetting cash flow obligations between two parties into a single net payable or receivable in the usual course of business when both parties are solvent. Close-out netting is applicable to transactions between a defaulting firm and a non-defaulting firm. Close-out netting refers to a process involving termination of obligations with a defaulting party under a bilateral contract and subsequent merging of positive (receivable) and negative replacement values (payables) into a single net payable or receivable. The policymakers and international standard setting bodies have strongly recommended that legal framework for close-out netting must be established in the interest of financial stability. The Financial Stability Board recommended as part its recommendations of the Key Attributes of Effective Resolution Regimes for Financial Institutions [3] that the legal framework governing set-off rights, contractual netting and collateralisation agreements should be clear, transparent and enforceable during a crisis or resolution of firms, and should not impede the effective implementation of resolution measures. Several global standards on insolvency law prescribe specific recommendations for the enactment of safeguards for financial contracts, particularly netting [4] and collateral arrangements to provide certainty to financial transactions and to maintain financial stability. The recommendations number 101-107 of the UNCITRAL Guide on Insolvency emphasise [5] that netting and set-off may reduce the potential for systemic risk that could negatively affect the stability of financial markets by providing certainty with respect to the rights of parties to a financial contract when one of those parties defaults.

Therefore, while there is a resounding support by the policymakers to close-out netting, the empirical evidence clearly indicates that there are solid reasons for this support. That is why most of the major countries for OTC derivatives market (50 countries) have established a legal framework for bilateral netting of financial agreements. The statistics published each year by the Bank for International Settlements (BIS) consistently show that close-out netting reduces the gross mark-to-market value of outstanding derivative transactions across all asset classes. For example, netting benefit, measured as the difference between gross mark-to-market value and credit exposure after netting, was over 79 per cent (USD 9.2 trillion) as of December 31, 2019 [6]. The mark-to-market exposure of all OTC derivatives globally is reduced from USD 11.4 trillion to USD 2.4 trillion as a result of close-out netting. So, the netting benefit is not inconsequential.

The present legal framework in India does not allow netting of bilateral financial contracts {over-the-counter derivatives (OTC)}, while it is allowed for multilateral transactions. Therefore, the financial contracts intermediated through the central counter-parties, like clearing corporations, get the benefit of netting under the Payment and Settlement Systems Act, 2007 and under the securities laws. However, in the absence of any legally unambiguous basis for finality of bilateral netting for certain entities, the Reserve Bank of India (RBI) currently does not allow bilateral netting of mark-to-market values arising on account of OTC derivatives, forcing the banks to provide capital on gross basis for such derivatives, trapping large amount of capital unproductively with banks. However, calculating the regulatory capital on gross-exposure basis is inefficient over calculating that on net-exposure basis.

Further, due to the emerging global consensus of imposition of margins for non-centrally cleared OTC derivatives, it has become necessary for India to implement exchange of margin system for OTC derivatives to improve stability and resilience of our financial system. However, imposition of margin on gross basis would make the OTC derivative market very costly and may cause serious disruption in its functioning, as such derivatives account for a significant part of the total derivatives market. Recognising that a law on bilateral netting would be a significant enabler for efficient margining, RBI has announced, in its Statement on Developmental and Regulatory Policies dated February 6, 2020, introduction of margin system for OTC derivatives in line with the emerging international norms to mitigate the systemic risk and strengthen the resilience of the financial sector. Allowing for the close-out netting could result in substantial savings for the banks and other financial institutions in two ways, i.e., (i) by decreasing the regulatory capital requirements for OTC derivatives; and (ii) by decreasing margin requirements for non-centrally cleared derivatives (NCCDs).

Recognising that a legal framework for bilateral netting would provide substantial benefits to the financial sector, the Government announced in Budget 2020-21 that a legislation for bilateral Netting would be introduced in Parliament. Accordingly, the Bilateral Netting of Qualified Financial Contracts Bill, 2020 (“the Bill”) was introduced in the Lok Sabha in the Monsoon Session of 2020 and was passed by both the Houses of Parliament. The Bill is based on the similar legal frameworks of other countries and global standard setting bodies. The Bill, inter alia, provides for,-

1. designation of any bilateral agreement or contract or transaction, or type of contract, as qualified financial contract by the Central Government or any of the regulatory authorities as specified in the First Schedule;

2. enforceability of netting of a qualified financial contract;

3. invocation of close-out netting which may be commenced by a notice given by one party to the other party of a qualified financial contract upon the occurrence of an event of default with respect to the other party or a termination event that may, in certain circumstances, occur automatically as specified in the netting agreement;

4. determination of the net amount payable under the close-out netting in accordance with the terms of the netting agreement entered into by the parties and in the absence of the netting agreement, where the parties to a qualified financial contract fail to agree on the sum with regard to the net amount payable under the close-out netting, determination of such sum through arbitration; and

5. imposing of certain limitations on powers of administration practitioner such that the close-out netting would be final and irreversible and any insolvency proceedings would not affect the netting.

 

The law would permit bilateral netting of qualified financial contracts and would result in substantial benefits for the financial sector. These are as follows.

1. It is estimated that the capital savings and fund-saving by banks - post the enactment of the Bill and the imposition of margin system would be around Rs. 58000 crore for 2020. The reduction in counterparty credit risk exposure through netting will strengthen resilience of the financial sector. Considering that banks may face capital erosion due to stress in the real sector at times, any capital optimisation would enable them to discharge their financing function effectively for the productive sectors of the economy.

2. The law would help in rationalising prices of the derivative products on account of optimisation of capital use and would enable banks to increase credit limits for counterparties and clients.

3. The law would further develop the corporate bond market by energising the credit-default swap market.

4. The law would facilitate business exits by improving recovery mechanism for the qualified financial contract when counterparty to such a contract defaults.

 

In view of the above, it may be stated that this important legislative reform of the Government would not only provide substantial saving to the financial sector and strengthen the financial stability, it would also help in further developing the financial market.

 

Status

The Bilateral Netting of Qualified Financial Contracts Act, 2020 [7] has received the assent of the President on the September 28, 2020 and was published in the Gazette of India Extraordinary on the September 28, 2020. The Act has been brought into force on October 1, 2020 [8].


1. UNIDROIT. 2013. Principles on Close-Out Netting.

2. Mengle, D. 2010. ISDA Research Notes: The Importance of Close-Out Netting. International Swaps and Derivatives Association.

3. Financial Stability Board. 2014. Key Attributes of Effective Resolution Regimes for Financial Institutions.

4. Op.cit. 1.

5. United Nations Commission on International Trade Law. 2005. UNCITRAL Legislative Guide on Insolvency Law.

6. International Swaps and Derivatives Association. 2020. Key Trends in the Size and Composition of OTC Derivatives Markets in the Second Half of 2019.

7. The Bilateral Netting of Qualified Financial Contracts Act, 2020. Accessed on September 29, 2020 at egazette.nic.in/WriteReadData/2020/222064.pdf.

8. The commencement notification dated October 1, 2020.Accessed on October 8, 2020 at http://egazette.nic.in/WriteReadData/2020/222198.pdf.


Contributed by

Dr. Shashank Saksena (IES 1987)

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