Context: The Lok Sabha passed the Bilateral Netting of Qualified Financial Contracts Bill 2020 that seeks to further develop the financial market in India and provide an unambiguous legal framework for enforceability of netting of a qualified financial contract.
- This Bill is significant as India currently does not have a legal framework for bilateral netting.
- Netting enables two counterparties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to others in the event of default.
- It is not only in India that such a legal framework is being introduced, as many as 50 countries in the world already have a similar legal framework.
- India has factored in the International Swap and Derivative Association (ISDA) model Act on netting while framing the Bill.
- This Bill would help Banks and financial institutions save capital.
- The proposed law on bilateral netting will be a significant enabler for efficient margining, and the capital saving would enable banks to provide efficiency in offering hedging instruments to businesses in India. It would also help catalyse the corporate bond market by developing the credit default swap market.
More on Bilateral Netting from the Economic Survey 2019-20
- The Economic Survey 2019-20 had also argued in favour of ‘bilateral netting’ as a way to release bank capital. “…Let’s assume you and I are banks — I have? 100 exposure to you and you have? 90 exposure to me. In the current environment, both of us have to keep? 190 capital aside to cover this. But the risk in the system is only ? 10 — which is my net position vis-a-vis you. So actually, we should only be keeping? 10 capital aside…”
- Bilateral netting allows two parties involved in a swap agreement to net off their swap positions.
- According to the survey, Indian financial contract laws do not permit bilateral netting, however, they do allow multi-lateral netting where parties can offset claims against each other through a central counterparty.
- Global regulatory bodies such as the Financial Stability Board and the Basel Committee on Banking Supervision have supported the use of such netting.
- Without bilateral netting, Indian banks have had to set aside higher capital against their trades in the over-the-counter market, which impacts their ability to participate in the market. Moreover, it also increases the systemic risk during defaults.
- According to RBI estimates, bilateral netting arrangements could have helped 31 major banks participating in India’s OTC derivatives market save about Rs 2,258 crore in regulatory capital during FY2017-18.
- Bilateral netting would also help reduce hedging costs and liquidity needs for banks, primary dealers and other market-makers, thereby encouraging participation in the over-the-counter derivatives market.
- It would also help develop the corporate default swaps market, which, in turn, would provide support to the development of the corporate bond market.
- The Credit Default Swaps (CDS) market doesn’t exist in India because we don’t have bilateral netting. If you don’t have a CDS market, you cannot have a corporate bond market.
- Bilateral netting has been an idea suggested by the regulator for many years since it helps banks in capital conservation.
- The idea was part of the Financial Resolution and Deposit Insurance (FRDI) Bill, which was eventually pulled back in 2018, owing to concerns over a bail-in clause for distressed banks.