As a gift in uncertain 2020, the last financial quarter witnessed a massive reform in the financial space when the Central Government notified the Bilateral Netting of Qualified Financial Contracts Act, 2020 (“Netting Act”). The Netting Act came into effect from October 01, 2020. Banks authorised as Authorised Dealer Category – I bank in India (“Indian Banks”) have been anxiously waiting for this legislation.
OTC derivative contracts play a significant role in permitting entities to hedge their foreign exchange and interest rate, risks and exposures. The Reserve Bank of India (“RBI”), as the regulator of OTC derivatives, inter alia permits AD Banks to offer various types of OTC derivative contracts to their clients.Under the terms of an industry prescribed ISDA Master Agreement (“ISDA Agreement”), the Indian Bank and the entity hedging its risk exposures enter into multiple OTC derivative contracts by way of confirmations from time to time. Each confirmation records the specific terms and conditions applicable to an OTC derivative contract.
If an event of default (which includes bankruptcy of a party) or a termination event is triggerred under the ISDA Agreement in relation to an OTC derivative contract, the non-defaulting party can terminate all transactions entered through the confirmations and determine the amount one party needs to pay the other party through a process called “close-out netting”. Given the inherent nature of an TC derivative contract, the payment obligations of the parties under each confirmation for an OTC derivative contract may vary. For instance, under some contracts, the defaulting party may be required to pay the non-defaulting party, whereas under some other contracts, the non-defaulting party may be required to pay the defaulting party. The non-defaulting party will net its payment obligations against the payment obligations of the defaulting party into one single obligation, which has to be paid either by the defaulting party or the non-defaulting party. This process of multiple netting of obligations as set out in the ISDA Agreement is referred to as close-out netting and is a common feature across global financial markets for all OTC derivative contracts. Interestingly, this is one of the three pillars for OTC derivative contracts.
Prior to the enactment of the Netting Act, the RBI did not permit bilateral netting as it was of the stated view that the legal position of bilateral netting is not unambiguously clear. Further, the Indian Banks were mandated to calculate the value of OTC derivative contracts on gross basis for the purpose of capital adequacy and exposure norms. This fact that the banking regulator deemed netting certainty, which is otherwise an established contractual principle, as not unambiguously clear coupled with the fact that Indian Banks were required to maintain capital on a gross basis, led to Indian Banks being at a significant disadvantage as compared to their counterparts across the globe. After the enactment of Netting Act, Indian Banks are no longer required to adhere to valuing OTC derivative contracts on gross basis and can calculate their exposure on a net basis. This single change has allowed Indian Banks to free up their capital and the provisions required to be maintained in their books for OTC derivatives contracts has also consequently reduced.
The Netting Act gives legal recognition to the process of close-out netting by allowing bilateral netting of those contracts which are notified by the Central Goverment or any financial sector regulators (including, the RBI) as qualified finanical contracts (“QFC”). A QFC must be entered between two qualified market participants (“QMPs”), and one of the QMP must be regulated by any financial sector regulator. Under the norms specified by RBI, OTC derivative contracts in India can only be entered into where one of the parties is an Indian Bank. Till date, no notification in relation to the Netting Act has been issued by the Central Government or any other financial sector regulator.
The Netting Act also aims to reduce the overall systemic risk contributing to the financial stability by reducing credit risk of parties. From a margin / collateral perspective, the Netting Act improves the collateral margining provisioning as margin can now be maintained only on net amounts. In this regard, further reforms in the nature of variation margin is expected from the RBI.
Bankruptcy remoteness is one of the critical aspects for any transaction involving receivables and payables from a single party. The Netting Act provides certainty to close-out of OTC derivative contracts (once notified as QFCs), thereby ensuring that the counterparty risk in assessing bankruptcy remoteness is negated. Additionally, if one of the party to a QFC is facing insolvency and a moratorium has been imposed by a court, tribunal or authority, the Netting Act would come to the rescue and it would only be the net amount that would be payable. Financial crisis saw situations where entities were required to pay up thier dues to an insolvency financial entity, but had to wait in queue for the recievables from such entity. The Netting Act provides certainty that there need not be any gross payments. Additionally, calculation based on close out netting for OTC derivartive contracts by an insolvent party will not be treated as a preferential transaction and can exist dehors moratorium.
While enactment of the Netting Act is the first step towards financial reforms, the need of the hour remains notification of QFCs. With the liberalization of the OTC derivative contracts that can be entered into by Indian Banks, Netting Act has indeed come at a right time!
Contributed by: Veena Sivramakrishnan, Partner; Sumant Prashant, Principal Associate
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