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Analysis of Bilateral Netting of Qualified Financial Contracts Act, 2020

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Introduction

Bilateral Netting of Qualified Financial Contracts Act, 2020 also known as ‘Netting Act’ was recently enacted by the Parliament on 1st October, 2020 which can be termed as the first step towards simplifying the financial product and derivative market of India. This move is also with respect to India’s commitment in the G20 and FSB submit to adhere to the global standards. India will be the 10th country to enact legal provisions with respect to netting agreement after U.S.A, U.K, Australia, Canada, Japan, France, Germany, Singapore and Malaysia.

The essence of the Act majorly is to consolidate and provide a legal framework for bilateral netting of qualified financial contracts which are the major instruments of the OTC (Over the Counter) Derivatives market. Post this enactment, the long privately negotiated OTC derivatives will come under the legal net. It also provides for offsetting claims between two parties involved in a financial contract by determining a single payment obligation due between the parties which till now was termed illegal by RBI.

Background

This Act was much awaited as the Parliament in 2018 tried to pass a similar bill. In the erstwhile regime, multilateral close-out netting was legally enforced through Clearing Corporation of India Limited under Payment and Settlement Systems (Amendment) Act, 2015. However bilateral netting was not allowed which created hardships among the financial institutions specifically the banks. This law is a breather for the already lagging banking industry of India. This statute will bolster confidence among the financial institutions and increase the liquidity in the economy.

Why This Law Is Such Important

In the absence of any legally unambiguous basis for finality of bilateral netting for entities, financial institutions mainly the banks were forced to provide capital on gross basis for these derivatives rather than the net exposure basis. This resulted in trapping or locking of huge amount of capital with the banks which can be easily invested or utilized for some other purposes.

The current statute will be a significant enabler for efficient margining, regulatory changes by RBI and allowing the financial institutions to count their mark to market value (realistic estimate of a financial situation) on net basis.

Explanation of Key Concepts

Gross Basis and Net Basis

While dealing with OTC derivative contracts, each participants have to take out and lock certain amount to protect and honor their end of the bargain if some unforeseen circumstance happens. Before this statute, the participant have to take out a certain amount every time they perform a different transaction which is also termed as gross basis. This law simplifies this process by allowing the participants to club all the transaction between them to assess the net amount that have to be paid or received from all the transactions between the two participants.

Bilateral Netting

It is a process through which all the transaction between two financial participants are clubbed in order to assess the actual amount to be paid or received in a single transaction rather than performing multiple transactions.

As defined under section 2 clause (j) of the Act, it’s basically determining of net claim or obligations arising from mutual dealings between the parties who have entered into a qualified financial contract.

Consider a situation where two financial participants have multiple derivative contracts between them. In the erstwhile regime each of these transactions was considered in isolation resulting in performance of multiple cash flows between each other. Under bilateral netting, all these agreements are consolidated into a single transaction resulting in single payment between the two.

Qualified Financial Contracts (Derivative Contracts)

It is a type of bilateral contract between two financial participants. Though generally it includes credit default swap agreements, interest rate swap agreements, etc. However as per the law the relevant authority will notify some agreements as QFC.

Close-Out Netting

The most important part of the Act which provides powers to the party to terminate its obligations under the contract and combining of positive and negative replacement values to assess the net payable or receivable amount.

The process of enforcing such provision is provided under section 6 of the Act which is mainly commenced by a notice given by one party to the other.

Interplay with Insolvency and How It Protects the Participants

One of the biggest advantage of this statute that it has been provided with powers to override the other laws specifically the IBC providing a better safety net for the participants. Be it moratorium, order of liquidation or winding up, it has been specifically stated under Section 5 clause 3 of the Act that the statute has the ability to circumvent the law and make the defaulting party or to be more specific the insolvent party meets its obligations under the netting agreement. Thus instead of going through the process laid down under IBC to claim the debt, the QFC participant can enforce the netting agreement obligating the insolvent party to pay.

In a nutshell appointment of administration practitioner for the insolvent party under the statute restricts the practitioner from rendering ineffective cash or collateral transfer despite imposition of moratorium by the Court of law.

The law is clearly aimed for the expeditious disposal of netting obligations. However with no amendments in the IBC law and this netting law being in nascent stage with not much clarity in the process, it is yet to be seen the practicality and efficiency of this law with respect to insolvency.

Close-out netting forming the most important part of the law will not only let the party terminate the contract between them but will lead to acceleration of payment obligations due by one party to another on the basis of net value calculated.

Significance

  1. Simplifies the regulatory process as multiple transaction had to be recorded for each and every transaction in isolation with respect to multiple OTC derivative contracts between the same parties in the erstwhile regime.
  2. The statute led to freeing of capital as regulatory practice of locking in money with each transaction will be done away when the calculation will be on the net basis. This will have a domino effect on number of fronts:
    1. More funds will be available to the banks as erstwhile locked funds will now be available with them to loan.
    2. The credit swap market will strengthen providing protection by hedging of risk among two financial participant.
    3. It will bolster confidence among the financial institutions to provide more capital to companies by purchasing of bonds as they will get a sense of protection through credit swap agreement.
  3. The statute in a great way reduce the great credit risk. Without this law, India’s central bank regulations require banks to measure credit exposure to a counterparty for OTC derivative contracts on gross marked to market basis which does not provide or assess the real picture instead of net market to market basis. Thus increasing credit risk in the event of insolvency of counterparty.
  4. The act allows offsetting of claims arising from dealings between the two parties and releasing of locked in capital in the banking system for onward lending.
  5. Instead of involving number of parties like in multilateral netting where transactions have to be cleared and settled through Clearing Corporation of India which is a lengthy process leading to time consumption to free the locked away funds, bilateral netting will be much more efficient and speedy with the same added advantage of protection and risk mitigation.

Also Read: Supreme Court defers plea of 94-year-old woman seeking to declare 1975 Emergency as unconstitutional

Conclusion

This law is a great financial initiative of government especially in this drastic time where we only can hear news of how our banking industry is failing. A globally acclaimed and tested method over the world, this law will infuse the much needed strength in the corporate bond market and will provide more opportunity to our financial industry to participate more enthusiastically in the OTC derivative market.

As per Economy Survey 2019-20, bilateral netting arrangements could have saved INR 22.58 billion of the banks locked in as regulatory capital. Due to this law, this locked in fund could be better utilized creating liquidity and greater investment in the economy.

By Simranjeet Singh, partner at Athena Legal

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