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Bilateral Netting - A Step Towards A Vibrant Financial Sector

Published: Oct 27, 2020

By Prashanth S Shivadass & Pooja Rao

THE financial sector has undergone a significant liberalisation over the last 2 decades. This sector has come a long way with respect to being more integrated with the global financial system. With new innovations bringing in more challenges in the sector, there have been new institutions created and the already existing ones have been strengthened in order to build an efficient regulatory framework.

Bilateral Netting is one such framework that has been introduced in the year 2020 through the Bilateral Netting of Qualified Financial Contracts Act, 2020 ('Act').

As a concept, netting as commonly understood, is any amount that is payable or due after setting off or adjusting values between two or more parties. Essentially, the concept of netting reduces risks in the financial contracts. So far, in India, the Reserve Bank of India ('RBI') under the Payment and Settlement Systems Act, 2007 ('PS Act') had the power to regulate and oversee all payment and settlement systems.

The word "netting" as defined under the Section 2(e) of the PS Act means "the determination by the system provider of the amount of money or securities, due or payable or deliverable, as a result of setting off or adjusting, the payment obligations or delivery obligations among the system participants, including the claims and obligations arising out of the termination by the system provider, on the insolvency or dissolution or winding up of any system participant or such other circumstances as the system provider may specify in its rules or regulations or bye-laws (by whatever name called), of the transactions admitted for settlement at a future date so that only a net claim be demanded or a net obligation be owned."

Given the above, the Government placed the Bilateral Netting of Qualified Contracts Bill, 2020 ('Bill') in the Parliament on September 14, 2020. The Finance Minister had commented after placing the Bill that 'Bilateral Netting of Qualified Financial Contracts covers financial contracts entered into on bilateral basis outside clearing system. It will empower financial regulators RBI, SEBI, IRDAI etc. They'll notify contracts under their purview as qualified financial contractor. This Bill, if passed, will have a very big bearing on the financial stability of India and we'll have a buoyant market as a result of which business will have greater, affordable resources' ¹.

The PS Act, provides for the regulation and supervision of payment systems in India and designates the RBI as the authority for this. Under the PS Act, the RBI merely has a supervisory feature and must exercise its power of supervising and to discharge duties. The RBI also has the power to form a committee of its central board which is known as the Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) for the purpose of supervising the payments system and settlement. For this purpose, the payment systems include stock exchanges and clearing corporations set up under stock exchanges and all other systems carrying out either clearing or settlement or payment operations.

On the other hand, the Bill is critical for the stability of the financial sector as its main objective is to ensure financial stability and promote competitiveness in Indian financial markets also enforcing the bilateral netting mechanism in India. This Bill brings a firm legal basis for bilateral netting between two counter parties and has a big bearing on the financial stability of India. The band-width of the bill is inclusive of those aspects which are required for the overall growth of the sector, which in turn, would result in a healthy competition amongst businesses in the financial market.

The Bill has now received approval from both houses of the Parliament and assent from the President on September 28, 2020. This article, therefore, looks to analyse and ascertain the key provisions of the Act.

The big question - what is the definition of 'Netting'? Section 1(j) defines 'Netting' to mean "determination of net claim or obligations after setting off or adjusting all the claims or obligations based or arising from mutual dealings between the parties to qualified financial contracts and includes close-out netting".

The Act, under Section 3 applies to a 'qualified financial contract entered into on a bilateral basis between qualified financial market participants, either under a netting agreement or otherwise, where atleast one of such participants shall be an entity regulated by an authority specified in the First Schedule'. This is genesis of the Act and applicability of the Act to a certain transaction. The Section draws our attention to the term 'Authority specified in the First Schedule' which includes RBI, SEBI, IRDA etc.

Before plunging into more details of the Act, it is vital to understand this concept, by way of an example. Since financial contracts are the basis of Bilateral Netting, it will be prudent to take an example of financial contract:

CONTRACT-1

CONTRACT-2

CONTRACT-3

The Act thus provides that only a Qualified Financial Contract ('QFC'), approved by the relevant authority i.e., RBI, SEBI etc., will come under the ambit of this Act. Further, entities that are recognized by the aforementioned authorities alone, will fall under the ambit of this Act.

Section 5, therefore, provides that where netting is provided for in an agreement, it may be enforced. Prominently, Section 5(3) provides for close-out netting of a QFC which will be enforced even against an insolvent party, a guarantor or any other person providing collateral and security for a party. The above clause will not be limited by:

a) The appointment or even an application for appointment of an administration (administration means proceedings of the nature of placing under administration and incudes imposition of moratorium, reorganization, winding up, liquidation, insolvency, bankruptcy etc., as defined under Section 2(1)(a);

b) Applicability of any provision relating to administration;

c) Any other provision of law that may be applicable to an insolvent party.

Therefore, the Act's applicability towards netting is quite stringent even in cases where any proceedings under any other law renders the particular participant (entity) insolvent, in short.

Section 6 further illustrates when a close out netting clause maybe invoked. Two circumstances give rise to invocation of a close out netting clause (upon giving a notice to the other party of a QFC) - (1) in the event of default with respect to the other party or (2) termination event that may occur automatically as specified in the netting agreement.

Upon such notice, all obligations owed by one party to the other under the QFC must be reduced to or replaced with a single net amount, which will have the following effects:

(a) The termination, liquidation or acceleration of any present or future payment or delivery rights or obligations arising under or in connection with anyone or more QFCs to which a netting agreement applies;

(b) The calculation or estimation of a close-out value, market value, liquidation value or replacement value in respect of each right and obligation or group of rights and obligations terminated, liquidated or accelerated under the above clause and the conversion of each such value into a single currency;

(c) The determination of the net balance of the values calculated under the above clause whether by operation of set off or otherwise, giving rise to the obligation of one party to pay an amount equal to the net balance to the other party.

Bilateral Netting is a globally used and accepted mechanism. This system will help cut down a bank's risk exposure allowing the market to have more liquidity and allows banks to release more funds into the financial system. Currently, the existing gross settlement system draws some flak because the banks making settlement need to time and again check their credit capability whenever they have an over-the-counter transaction. Also, the current system of higher obligations requires banks to divert more capital toward collateral requirements than what would be required if bilateral netting is permitted. This mechanism would not only help the banks but would also help the companies with reduced liquidity.

The Finance Minister while introducing the Bill, claimed that bilateral netting would cover 40% of total financial contracts while the other 60% are multilateral contracts. This is definitely a step towards improving the financial sector in India.

¹ See, https://www.oneindia.com/india/explained-what-is-bilateral-netting-of-qualified-financial-contracts-bill-2020-3153204.html

[Prashanth S Shivadass is Founder & Pooja Rao is Associate, Shivadass & Shivadass (Law Chambers), Bangalore. The views expressed are strictly personal.]