The Bilateral Netting of Qualified Financial Contracts Bill, 2020 (Netting Bill) was passed this week in both the houses of the Parliament. The Bill covers over the counter derivatives contracts which are entered into on bilateral basis outside clearing system.
The Finance Minister Mrs.Nirmala Sitharaman while addressing the Rajya Sabha said that under existing laws, banks have to make higher provisions for such bilateral contracts which are outside the Clearing Corporation of India’s framework since calculations are done on a gross basis rather than a net basis. “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,” the minister added. Bilateral contracts constitute 40 per cent of total financial contracts while multilateral contracts constitute 60 per cent, she added. She further said that based on the data collected by 31 private, public and foreign banks, the amount of bank capital that went unutilised due the absence of this bill, from FY17-FY20 stood at Rs 2.14 lakh crore.
Bilateral netting is a concept in the financial sector that enables two parties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one party to another party in the event of default. The legal frameworks in many countries allow bilateral netting of the financial contract; it was prohibited in India in the absence of an unambiguous legal framework of bilateral netting. The Bilateral Netting of Qualified Financial Contracts Act, 2020 now removes this deficiency in the legal framework by providing legal enforceability of close-out netting for bilateral financial contracts in India. Netting refers to offsetting all claims arising from dealings between two parties, to determine a net amount payable or receivable from one party to the other. In the other words, two parties could determine the net amount payable amount in a bilateral financial contract. Individuals also eligible for netting benefits provided the counterparty to such a transaction must be an entity regulated by the authorities like RBI, SEBI, IDRAI, FRADAI, and IFSCA. These regulators notify the contract under their purview as a qualified financial contractor.
Till now, the capital requirement for banks was reckoned on the basis of the gross value of the OTC derivative, now after the President of India’s endorsement, the bill becomes an act and it will be calculated on the net basis, resulting in capital saving. Further, this will enable the introduction of an efficient margining system for such OTC derivatives and facilitate the productive use of bank funds. The savings in margins for OTC derivatives would be important in ensuring price efficiency for banks while offering hedging instruments to businesses. It will also act as a catalyst for the development of the corporate bond market by energising the credit default swap market.