Bilateral Netting UPSC

Bilateral Netting

• A bilateral netting agreement enables two counterparties in a financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to the other. 

• Netting refers to offsetting of all claims arising from dealings between two parties, to determine a net amount payable or receivable from one party to other. (see infographic)

• Similarly, a multilateral netting agreement allows counterpartiesto offset claims against each other through a Central Counterparty (CCP) in a clearing house under the Payment and Settlement Systems (Amendment) Act (2015).

• Earlier, Indian financial contract laws did not permit bilateral netting, however, they did allow multi-lateral netting.

• In India, Bilateral contracts constitute 40% of total financial contracts, while multilateral contracts constitute 60%.

• Netting is very common in advanced economies where the settlement is based on net positions in bilateral or multilateral financial arrangements rather than by gross positions. 

• At present, major jurisdictions such as the U.S., U.K., Australia, Canada, Japan, France, Germany, Singapore and Malaysia have legal provisions in place for netting agreements.
• Global regulatory bodies such as the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision have supported the use of such netting. 

About Bilateral Netting of Qualified Financial Contracts Act, 2020

• It seeks to provide a legal framework for bilateral netting of qualified financial contracts (QFC) which are over the counter derivatives (OTC) contracts.

• Act seeks to provide

• 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 namely: 

- Reserve Bank of India (RBI), 

- Securities and Exchange Board of India (SEBI), 

- Insurance Regulatory and Development Authority of India (IRDAI), 

- Pension Fund Regulatory and Development Authority (PFRDA) 

- International Financial Services Centres Authority (IFSCA). 

• determination of the net amount payable under the close-out netting in accordance with the terms of the netting agreement.
• imposing of certain limitations on powers of administration practitioner.

Significance of this move

• Reduce credit risk and regulatory capital burden for banks, freeing up capital for other productive uses and also reduce systemic risk during defaults.

• Without bilateral netting, Indian banks have had to set aside higher capital against their trades in the over-the-counter (OTC) market, which impacts their ability to participate in the market.
• The capital saving would enable banks to provide price efficiency in offering hedging instruments to businesses in India, and catalyse the corporate bond market through developing the credit default swap (CDS) market.

• Reduce hedging costs and liquidity needs for banks, primary dealers and other market-makers, thereby encouraging participation in the OTC derivatives market to hedge against risk. 

• Increased market participation in the CDS market would also provide an impetus for corporate bond market development.

• Establish an efficient recovery mechanism for financial contracts under instances of default by a counterparty.

• Adhere to India’s G20 and FSB commitment to implement global regulatory reforms in the OTC derivatives market.

• A strong netting system generally gives rise to a thriving derivatives market, as it provides the most accurate picture of a company’s financial position, solvency and liquidity risk.