Jurisdictions are increasingly seeking guidance on implementing legislation to ensure the enforceability of close-out netting, the “single most important risk mitigation tool in derivatives markets”.
ISDA (the International Swaps and Derivatives Association) has published an update to its Model Netting Act, providing a template for jurisdictions considering legislation to ensure the enforceability of close-out netting.
Close-out netting enables firms to terminate outstanding obligations to a defaulting counterparty and calculate the mark-to-market net amount due to one party by the other. Without close-out netting, firms would need to manage credit risk on a gross basis, dramatically reducing liquidity and credit capacity. Market and credit risk in relation to derivatives transactions would also be more difficult to estimate and manage on a gross basis.
Provided there is a high degree of legal certainty over the enforceability of close-out netting under the local law, regulators allow it to be recognised as risk-reducing for the purposes of calculating regulatory capital requirements, enhancing the efficiency of regulatory capital and reducing the associated cost.
“Close-out netting is the single most important risk mitigation tool in derivatives markets, and results in drastically lower credit exposures between counterparties,” said ISDA general counsel Katherine Tew Darras. “We believe the development of close-out netting legislation creates more certainty for financial institutions, and encourages more participation. Once these elements are introduced, the conditions are in place for local derivatives markets to thrive.”
According to ISDA, an increasing number of jurisdictions are seeking guidance on implementing a comprehensive legislative regime for close-out netting and related collateral arrangements to increase the safety, efficiency and international competitiveness of their domestic financial markets and to improve access to the international financial markets for their leading financial institutions and large end users.
ISDA has prepared the 2018 Model Netting Act and accompanying guide to meet that need, drawing on its experience working with policymakers and regulators to draft legislation on the enforceability of close-out netting and financial collateral arrangements. The act and guide provide guidance and model provisions for legislators looking to increase legal certainty for netting under local law.
The 2018 act and guide have been updated to reflect the widespread adoption of bank resolution regimes, the introduction of mandatory margin requirements and the growth of Islamic finance. They also reflect various international legal and regulatory standards on netting, and include a list of jurisdictions that have enacted netting legislation or are in the process of doing so.
In Asia Pacific, close-out netting is already enforceable through various mechanisms in Australia, Hong Kong, India, Indonesia, Japan, Malaysia, New Zealand, the Philippines, Singapore, South Korea, Taiwan and Thailand. There is however still some legal uncertainty in Indonesia and the Philippines, according to ISDA’s counsel in both countries.
Meanwhile in China (though not mentioned in the act and guide), close-out netting is not a legal concept expressly recognised under domestic laws and it has not been tested in court upon the bankruptcy of a Chinese counterparty. Nevertheless, Chinese courts have upheld close-out netting provisions as a matter of contract, according to a recent whitepaper by ISDA and King & Wood Mallesons.
The 2018 Model Netting Act and Guide is available here.