This article has been authored by Eeshan Sonak and Ayush Kulkarni second year law students at NALSAR University of Law.
The Central Government has recently notified the Bilateral Netting of Qualified Financial Contracts Act, 2020 (‘Act’), which provides a regulatory framework for offsetting claims between two parties to a financial contract in order to determine a single net payment obligation. The Act is effective from October 1, 2020. Before this Act, participants were required to keep aside a certain sum of money every time they performed a different transaction, i.e., on a ‘gross basis’. Now, participants can club all the transactions between them to assess a final amount to be paid or received on a ‘net basis’. This results in greater liquidity in the market and increased stability in the financial sector, thereby reducing systemic risk.
This article seeks to explain the nuances of bilateral netting in the simplest way possible. It does this with the aid of an example of an oversimplified Credit Default Swap (‘CDS’) between two banks. The article then analyzes the application of bilateral netting to insolvency, and demonstrates its advantages. All along, the authors have strived to break down certain terms and concepts, recognizing that financial derivatives can be difficult to comprehend for the average law student.
What is bilateral netting?
Transacting in the financial markets generally entails a lot of risks. Therefore, financial market participants employ a number of methods to mitigate these risks. Bilateral netting is one such method. It is a legally-binding agreement which enables two counterparties in a financial contract to consolidate/offset all the claims against each other into one single, master legal obligation of receivables or payables. Netting helps financial institutions measure credit exposure to a counterparty on net basis as opposed to gross basis. This adds security to the transactions, especially in the event of bankruptcy, by ensuring that all the swaps are executed instead of just the profitable ones for the company going bankrupt.
Bilateral netting can be of two types: Payment netting, which is an ongoing process, say for settlement of premiums in CDS arrangements; and close-out netting, which becomes effective upon termination of the contract due to default or insolvency.
The Bilateral Netting Act in India explained through a Credit Default Swap
In India, multilateral netting is exercised through a central counterparty, namely the Clearing Corporation of India. However, for other transactions such as Over-the-Counter (‘OTC’) derivative contracts, parties had to allocate a gross value and keep aside appropriate capital. This capital could not be used for lending purposes, and would therefore increase costs and reduce liquidity. While the concept of ‘set-off’ is routinely adjudicated upon by the Judiciary, the Reserve Bank of India (‘RBI’) has regarded the legal position of bilateral netting as “ambiguous” and therefore disallowed it. To explain the changes brought about by the bilateral netting Act, here’s a simple example of a CDS.
Suppose there are two banks – Bank 1 (‘B1’) and Bank 2 (‘B2’) – both looking to loan its deposits and charge interest so as to gain profits. A Company (‘C1’) is looking to expand its business and approaches B1 requesting a loan of Rs. 100 Crores. But C1’s financial records are unimpressive and its credit rating is A. B1 is certainly not looking to loan money to companies with a credit rating below AA. However, C1 is offering an attractive interest rate of 16% as opposed to the usual 12%, and B1 believes that its expansion plan may work out.
Now, let’s suppose B2 is run by a savvy manager who by her independent research thinks that C1’s expansion plan will be super successful. So, the manager of B2 approaches B1 and proposes that in the event C1 defaults on its loan, B2 shall pay the amount in its place; but until maturity (or default as the case may be), B1 will have to pay a premium of 5% of the loan every year to B2. It’s a win-win. B1 has effectively transferred its risk exposure in case of the default onto B2 and secured its capital. B2 on the other hand can make 5 crores a year without even lifting its finger. This, in banking parlance, is known as a ‘Credit Default Swap’.
B2 can do this as many times as it likes. Hence, the regulating authorities would want to ensure that it will be in a position to honour its obligations if all of the companies for which it has entered into a Credit Default Swap arrangement default. For instance, let’s say B1 has made 15 loans worth 100 Crores each to 15 companies. B2 has capital worth only 1000 Crores. So, the manager of B2 cannot buy more than 10 of those Credit Default Swaps from B1. The regulators will require B2 to earmark the 100 crores it owes to B1. This means that B2 cannot use those 100 Crores anywhere else, until the maturity period ends.
Now, let’s complicate things a little bit. Suppose B2 comes across another Company (‘C2’), looking to raise capital by availing a loan of 200 Crores. Like C1, its financials are poor, and it has a credit rating of BB. The manager of B2 is unsure about lending 200 crores. And like the earlier case, C2 is offering an attractive interest rate of 16%. The manager of B2 goes to the B1. This time, B1 thinks that C2 has a great plan and will not default. Both parties enter into a CDS with the same terms as earlier; B2 will pay 5% of the loan (10 Crores) to B1 every year.
Now, we have two streams of cashflow. 5 crores from B1 to B2, and 10 crores vice versa. Also, 100 Crores are earmarked by B2 and 200 Crores by B1. Basically, in aggregate, 300 Crores are earmarked and will stay out of the economy. This translates into less businesses availing loans and investments, which means less business activities, less employment opportunities, less creation of economic value, and less growth. And this is just about two parties making two transactions. RBI data suggests that Rs. 42,194 crores were locked-up in FY17, Rs. 45,956 in FY18 and Rs. 58,308 crores in FY19 because of the earmarking requirements.
How does Bilateral Netting Simplify things?
Previously, India’s legal framework prohibited netting of bilateral financial contracts, forcing the banks to provide capital on a gross basis, thereby trapping large amounts of capital unproductively with banks. Instead, if B1 and B2 ‘net’ their transactions, only B2 will have to pay 5 crores to B1 every year. This would also mean that instead of the 300 crores that were previously earmarked by both banks, only B1 will have to earmark 100 Crores, thus freeing up 200 Crores worth of capital. This can lead to a spur in lending and investment, thereby strengthening the financial sector and our economy.
Connection with Insolvency
One of the major advantages of this Act is its power to override or circumvent other statutes, especially the Insolvency and Bankruptcy Code (‘IBC’). Thus, while the IBC provides close-out netting only for limited kinds of counterparties – Section 2 read with Section 36(4)(b) – the Netting Act creates a level playing field for all the market participants who enter into Qualified Financial Contracts (‘QFCs’).
Continuing with our earlier example, suppose B2 (the counterparty) turns insolvent and so do the Companies C1 and C2 who have availed loans from the Banks. Under the agreements, B1 (non-defaulting party) has to pay B2 (defaulting party) 200 crores and B2 has to pay the bank 100 Crores. In the absence of close-out netting, B1 would have to pay 200 crores to B2 and then wait, possibly for years, for whatever fraction of 100 crores B2 recovers in bankruptcy. However, if close out netting is enforceable, the non-defaulting party will pay the defaulting party only the net difference, which in this case is 100 Crores.
Thus, by reducing credit exposure from gross to net exposure, the contract becomes somewhat immune to insolvency. Since a company or bank stands to lose a lot, it would tend to do good business and honour its obligations instead of simply declaring insolvency. Bilateral netting also eliminates cherry-picking by administrators or insolvency professionals and is therefore also referred to as a ‘safe harbour provision’. Cherry-picking is the act of an insolvent organization to selectively decide which claims to satisfy. Insolvent organizations usually enforce those transactions that benefit them the most, while essentially leaving the counterparty as an unsecured creditor for any benefits it is owed from its other transactions with the insolvent organization.
The Act provides an unambiguous legal framework for enforcing bilateral netting which reduces credit exposure of banks from gross to net exposure. It is based on the Model Netting Act by the International Swaps and Derivatives Association (‘ISDA’), and adopts a more flexible and principle-based approach instead of enumerating all the different types of agreements or contracts covered under its ambit. Parties are also given a significant leeway to determine the scope of concepts like ‘event of default’ and ‘termination event’ instead of prescribing rigid statutory thresholds. The Act encourages price efficiency of derivative products by facilitating optimal use of capital thereby enabling banks to increase credit limits for counterparties and clients. It also facilitates the development of the corporate bond market by boosting the CDS market and simplifying the recovery mechanism in the event of default by a counterparty.