India Establishes Netting Certainty for Bilateral OTC Derivatives

Parliament passed a bill providing legal basis for bilateral netting of OTC derivatives contracts which are not centrally cleared.

India’s Parliament has passed a bill providing a legal framework to ensure enforceability of close-out netting in bilateral OTC derivatives contracts in the event of default.

The ‘Bilateral Netting of Qualified Financial Contracts Bill’ is based on ISDA’s Model Netting Act, a model law which sets out the basic principles necessary to ensure the enforceability of bilateral close-out netting, provided as guidance to policymakers and regulators worldwide.

Close-out netting is “the single most effective tool for reducing credit risk between counterparties, and is critical to establish certainty and encourage participation in local markets,” ISDA chief Scott O’Malia said last year.

Under existing laws in India, banks have to make higher provisions for bilateral OTC derivatives contracts which are not centrally cleared as calculations are done on a gross basis rather than a net basis, Finance Minister Nirmala Sitharaman said on Wednesday (23 September).

Sitharaman had pledged in the 2020-2021 Union Budget earlier this year to formulate legislation for netting of financial contracts.

On Wednesday, she urged lawmakers to pass the bill, saying it will have a huge bearing on the stability of the financial sector and release large amounts of locked up capital in the banking system for onward lending.

“This particular legislation is so necessary for stability of financial market. Money locked up in banks is not available while economy is starved for funds. This will enhance liquidity and economy will get lubrication.”

Data collected by 31 private, public and foreign banks indicates that over INR 2.14 trillion (USD 260 billion) in bank capital went unutilised from fiscal 2017-2020 due to the absence of the new bill, Sitharaman said.

“This bilateral netting legislation will help us in evaluating risks far more in real-time basis and actual risk assessment will happen rather than a notional risk assessment based on the gross figures.”

Bilateral netting allows claims arising from dealings between two parties to be offset in order to determine the net amount payable or receivable from one party to the other. The bill provides for netting enforcement if the bilateral contract has a netting agreement.

“[The bill] will reduce the price of derivative products on account of optimal utilisation of all the capital… corporate bond markets will be greatly energised because the credit default swap markets will be better functioning now,” Sitharaman said.

Under the bill, individuals are also eligible for netting benefits, provided the counterparty is an entity regulated by one of India’s financial authorities (RBI, SEBI, IRDAI, PFRDA, IFSCA).

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