Mission Level Playing Field!

Netting vis-à-vis over the counter (“OTC”) derivatives market in India, has been a burning issue since over last 2 decades. While there have been discussions and speeches, at the government, regulator and industry level, about the concerns attached with “the legal position regarding bilateral netting being not unambiguously clear”[1], the ambiguity has emanated primarily from lack of a level playing field for banks established under special statutes[2]. There has also been a mention at various instances, about talks with the Government in terms of the netting issue and proposals to amend existing legislations (to provide legislative backing to netting), such as the Reserve Bank of India Act[3] itself, the parent act granting legal certainty to OTC derivatives also.

Given the regulatory views and market sentiments, the level playing field concerns moved beyond specific sectors to being applicable at pan India level, where some market participants switched netting off for particular kind of Indian counterparties, while many other global participants chose a safer option and didn’t switch on netting for India per se.

Understanding the critical nature of netting, standalone provisions for netting recognition were included in the Financial Resolution and Deposit Insurance Bill, 2017 (“FRDI Bill”), which was tabled in the lower house of the Parliament in 2017. However the FRDI Bill was subsequently withdrawn in the parliament session in August 2018. Though shortly afterwards, the government commenced work on a standalone legislation for netting.

The Bilateral Netting of Qualified Financial Contracts Act, 2020 (“Netting Act”) has received the Presidential assent on September 28, 2020, and has been published in the Gazette of India.[4] The provisions of the Act are yet to be notified.

Does the Netting Act address all market concerns?

· Recognition of close-out netting: The Netting Act recognizes validity and enforceability of close-out netting arrangements, under all notified[5] bilateral qualified financial contracts (“QFCs”), and provides such arrangement overriding powers, inter alia, in terms of any applicable insolvency laws, appointment of any insolvency/ administration professionals, moratorium, stay etc.

How does this help:

–  The Netting Act will help reduce the regulatory capital burden and credit risk for banks, helping them mark capital charge on a net basis (as opposed to current situation of marking on a gross basis), further lowering the cost of transactions as well. This Act will pave the way for further regulatory changes to “reduce credit exposure of banks and other financial institutions from gross to net exposure, resulting in substantial capital saving on such exposure and reducing the overall systemic risks, thus contributing to the financial stability.”[6]

– Current market apprehensions over powers of the government under government banks’ acts overriding the netting rights get addressed by the Netting Act. Similarly, concerns with respect to exercise of close-out netting rights in a moratorium event or similar events (including under central/ state legislations), also have been put to rest.

· Coverage for collateral arrangements: The definition of netting agreements under the Netting Act is wide and also includes any “collateral arrangement relating to or forming part of netting agreement.” Further collateral arrangements have also been broadly defined and will include variation margin, initial margin, guarantees, or other security interests.

How does this help: The Netting Act recognizes the right to take into consideration margin exchanged under any credit support documents including title transfer arrangements.

· Provision of close-out netting rights: The Netting Act also recognizes enforceability and provides the manner of undertaking close-out netting in scenarios where the QFC itself does not have a netting agreement.

How does this help: While the authorities are yet to notify the QFC that will be covered within the scope of the Netting Act, the Act provides for all such QFCs, where the agreement itself does not contain provisions in relation to netting rights.

· Qualified Financial Market Participant (“FMP”): The Netting Act provides a wide list of FMPs and covers all Indian participants, including individuals, banking entities, non banking financial companies, insurance entities, partnerships, etc. within its scope.

How does this help: The Insolvency and Bankruptcy Code, 2016, which applied to only limited kind of counterparties (Companies, limited liability partnerships, individuals, partnership firms), provides legal backing for close-out netting rights. However comfort vis-à-vis close-out netting in terms of certain other counterparties (not covered under IBC) is drawn from common law principles of mutual dealings and set-off, which are recognized under Indian laws. The Netting Act creates the level playing field in terms all market participants that undertake transactions under the QFCs.

· Banking units in International Financial Services Centre (“IBUs”): The Netting Act recognizes the financial institutions regulated by the International Financial Services Centres Authority as a permissible type of FMP.

How does this help: IBUs being set up as a branch of a banking institution, previously the netting assessment as applicable to the banking institutions (banking companies/ government banks) was extended to IBUs. This position has been bolstered with explicit recognition of IBUs as an FMP.

The Domino effect

The passing of the Netting Act does not come as an independent event, but this will certainly have a domino effect in terms of regulatory next steps/ deliberations to address other pending items on the Indian derivatives market’s to do list.

Action is already being witnessed on the margin front, where while the draft Variation Margin directions[7] have been released by the Reserve Bank of India (“RBI”) for public consultation, the regulator is also expected to release draft directions for Initial Margin as well[8].

Separately, changes are also expected on the prudential norms front in relation to derivative transactions. Per these changes, banks should be permitted to count their mark to market values for such contracts on a net basis, for the purposes of capital adequacy and for exposure norms.

2020 has certainly provided a reason to cheer for the Indian derivatives markets, but neither the year nor the reasons are over yet. What next in the final quarter of 2020? Let’s wait and watch…

Authors:

G Padmanabhan, Senior Consultant
Nikita Chawla, Senior Associate

Footnotes:

[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6023&Mode=0 https://www.rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=6667
[2]   https://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=12861
[3]   https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1020
[4]   egazette.nic.in/WriteReadData/2020/222064.pdf
[5]   QFCs to be notified separately by the Central government/ regulatory authorities.
[6]   Statement of Object and Reasons  – The Bilateral Netting of Qualified Financial Contracts Bill, 2020
[7] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=50322
[8] See Item 10 https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49343

Date: September 29, 2020