Why is Bilateral Netting Relevant?

[Lakshmi Babu is a corporate lawyer with an interest in financial regulation]

The Central Government has recently notified the Bilateral Netting of Qualified Financial Contracts Act, 2020 (“Netting Act”), which intends to implement the process of bilateral netting among eligible financial parties. The Netting Act is effective from October 1, 2020. Netting, in essence, means the off-setting of all claims among financial parties arising out of financial contracts and resultantly, such an off-setting process will determine the ‘net position’ or the ‘net exposure’ between the parties. This is particularly relevant in the case of banks and other financial institutions in the over-the-counter (“OTC”) derivatives market. Resultantly, these financial parties, who otherwise had to allocate a gross value to their positions, need to maintain only a net exposure. This reduces the volume of transactions on their balance sheet, and consequently may have a significant impact on the capital they need to allocate to cover the exposure arising from such transactions.

This post focuses on some of the main features of the Netting Act and changes put forth by it, which has an impact on financial parties and the OTC derivatives market in India. It further explains the mechanism available for financial parties in the event of insolvency and the benefits extended to qualified financial contracts, notwithstanding the Insolvency and Bankruptcy Code, 2016.

Background

The concept of set-off has been long part of the Indian jurisprudence. However, the Reserve Bank of India (“RBI”) has consistently maintained that the legal position regarding bilateral netting is not “unambiguously clear” and therefore bilateral netting on account of derivative contracts could not be permitted. Hence, the need for affirmative legislation was crucial. In India, multi-lateral netting is exercised through a central counterparty, namely the Clearing Corporation of India, where netting is generally implemented. However, for other transactions such as OTC derivative contracts, parties had to allocate a gross value and appropriate capital to the gross outstanding, thereby increasing costs. Further, these derivatives contracts always come with collateral allocation requirements through maintenance of a margin. Margining is the practice of constant adjusting of collateral status in OTC derivatives transactions, to reflect the net exposure accurately. The process of margining is practiced for OTC derivatives markets globally and, with that, it is necessary for India to implement exchange of margin system on a net basis, to be at par with changing financial practices.  A perusal of the Statements of Objects and Reasons of the statute indicates that the advent of the Netting Act will be a significant enabler for efficient margining, to pave the way for further regulatory changes by the RBI, in order to permit financial parties to count their mark-to-market value on a net basis.

Netting facilitates bankruptcy-remoteness

Close-out netting is another critical aspect of the Netting Act, which will have the most impact. Close-out netting is a process involving termination of a contract owing to an event of default and netting the values due by each party, to calculate the net exposure, upon such termination. Once close-out netting is enforceable, the parties will terminate all contracts in the event of a default or insolvency, as the case maybe, and the net value is subsequently assessed. Once the net value is calculated, one party (defaulting party) will have to pay the net value to the other party (non-defaulting party).

The concept of close-out netting assumes importance in the event of a financial party becoming insolvent. In the case of insolvency of a financial party with whom there is a netting agreement, primarily the non-defaulting party is owed the net value. Let us consider the scenario of insolvency in the absence of bilateral netting. The insolvency professional will not take into account the claim of the non-defaulting party for the net value, which is a right arising out of a netting agreement between the parties. Without netting, the non-defaulting party will become an ordinary creditor in case of insolvency for the entire value of the claim (gross value) and will go through the usual course of insolvency proceedings.

The impact of close-out netting in insolvency is that it becomes somewhat immune to it. Pursuant to section 5(3) of the Netting Act, Close-out netting in a financial contract can be enforceable against an insolvent party or a guarantor or any other person providing collateral even when insolvency proceedings or administration have been initiated. Likewise, section 5(4) of the Netting Act provides that when a qualified financial participant is subject to administration, even during the moratorium, adjudication, dissolution, scheme or insolvency, close-out netting shall be applicable and the amount or claim payable to the financial party shall be final and binding on the parties. This eliminates cherry-picking of claims by an administrator or an insolvency professional. This special treatment extended to financial parties at the time of insolvency is sometimes referred to as safe harbor provisions in various jurisdictions. The logic behind this special treatment is multifold. Firstly, closed-out netting reduces counterparty risk. These situations could imply a greater financial tension for the entire market on the insolvency of a major market player. It aids in reducing systemic risk occurring out of the failure of one entity triggering a domino effect. Therefore, such safe harbour provisions in the Insolvency legislations aid in stabilizing the economy from such shocks and promotes liquidity in the market.

Along with safe harbour provisions, the application of close-out netting results in the following events:

  1. Termination of all contracts between two eligible financial parties upon an event of default;

  2. The calculation of the close-out value or liquidation or replacement value for each entity;

  3. Determination of the net value calculated as above, by operation of set-off, giving rise to an obligation of one party to pay the other party.

  4. Acceleration of payment obligations of the net value or liquidation of collateral for the net value. (If parties have entered into a collateral agreement, realization of collateral for the net value would take effect.)
Conclusion

With the introduction of the Netting Act, India would be at par with most advanced jurisdictions when it comes to margin requirements and it would fulfill India’s G20 commitments in this respect. Further, financial participants are not required to set aside a higher capital for trading in the OTC derivatives market. It also reduces hedging costs and liquidity requirements for financial participants, encouraging greater participation in credit default swaps. The Government of India Economic Survey 2019-20 has claimed that bilateral netting arrangements could have helped 31 major banks in India who are participants of the OTC derivatives markets save around INR 22.58 billion in regulatory capital in Financial Year 2017-18.

It remains to be seen whether closed-out netting is indeed an effective tool in financial stability and regulation. In the aftermath of the financial crisis, where the imposition of Title 11 of the United States Bankruptcy Code was implemented for many financial entities, there were multiple critiques to netting and safe harbours in general. For one, the benefits of closed-out netting are only given to eligible financial parties, which means other entities will have to take the normal course of insolvency. This could be viewed as a measure, only to protect the big players in the market. This has been a concern globally, however, many policymakers view netting and insolvency safe harbours as the most tested method of risk mitigation, in order to reduce systemic risk in the market, as well as to maintain liquidity. Nevertheless, it is a huge leap for India’s financial markets, where greater market participation is expected as an immediate outcome. It has set into motion prospective changes in the sphere of OTC derivatives. The RBI has already released the draft variation margin direction for public consultation, which calls for maintaining a variation margin on a net basis and the draft regulation of exchange of initial margin requirements is underway. We can certainly expect more regulatory changes in the near future to implement bilateral netting to the Indian financial markets.

– Lakshmi Babu

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