Analysis of the Bilateral Netting of Qualified Financial Contracts Act, 2020

Bhumika Indulia

4 years ago

Bilateral Netting of Qualified Financial Contracts Act was introduced in the Parliament and received the parliamentary assent on 28-09-2020 and was made effective from 1-10-2020; it is also known as the Netting Act. This Act was created by the Parliament in order to reduce the credit risk exposure and systematic risk prevailing in the financial markets. The purpose of this Act is to “ensure stability and promote competitiveness in Indian financial markets by providing enforceability of bilateral netting of qualified financial contracts and for matters connected therewith or incidental thereto.”[1] The key purpose of the Act is to consolidate, regulate and establish a legal foundation for the bilateral netting of qualified financial contracts, which have been the major instruments of the OTC (over-the-counter) derivatives market in India.

This Act is based on the Model Netting Act created by the ISDA (International Swaps and Derivatives Association) with specific changes and adaptations in compliance with the legal and regulatory system prevailing in India. India has adopted the ISDA’s advisory to take a more flexible and principle-based approach.

Applicability of the Act

If we look at Section 3 of the Act2, it says that this Act will apply to the qualified financial contracts between two qualified financial market participants where one party must be regulated by the specific regulatory authorities mentioned under Schedule I of the Act3.

Key concepts

Netting

The term netting is defined under Section 2(1)(j) of the Act as—

“netting” means 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;4

In simple terms, netting allows two parties in a bilateral financial arrangement to balance their charges/claims against each other in order to assess a single net payment due from one party to another in the case of default.

In the absence of a regulatory mechanism for bilateral netting, the banks are required to calculate the credit exposure of the counterparty for the over-the-counter (OTC) derivative contracts on a gross basis rather than on a net basis.

(i) Qualified financial contracts

It is a simple term which means a financial contract which is notified by the appropriate authority.5 The appropriate authority or regulators under the Act6 are:

“Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority of India (IRDAI), Pension Fund Regulatory and Development Authority (PFRDA), International Financial Services Centres Authority (IFSCA) and through notification, the Central Government can exempt contracts with certain parties or with certain terms from being designated as QFCs.”

(ii) Close-out netting

It is defined under Section 2(1)(e) of the Act as—

“close-out netting” means a process involving termination of obligations under a qualified financial contract with a party in default and subsequent combining of positive and negative replacement values into a single net payable or receivable as set out in Section 6;7

Basically, it gives the party the right to cancel its obligations under the contract and to blend positive and negative substitution amounts in order to determine the net sum payable of receivable. Section 6 of the Act8 talks about the invocation of close-out netting. Under Section 6, the process can be triggered by a party to the QFC in the event of9 (i) default (failure to comply with the obligations of the QFC) by the other party; or (ii) termination, as defined in the netting agreement, which grants either or more parties the right to cancel transactions under the agreement.

(iii) Qualified financial market participant

The authorities to be regarded as qualified financial market participant are defined under Section 2(1)(o) of the Act which is as follows:10

“qualified financial market participant” includes: —

(i) a banking institution, or a non-banking financial company, or such other financial institution which is subject to regulation or prudential supervision by the Reserve Bank of India;

(ii) an individual, partnership firm, company, or any other person or body corporate whether incorporated under any law for the time being in force in India or under the laws of any other country and includes any international or regional development bank or other international or regional organisation;

(iii) an insurance or reinsurance company which is subject to regulation or prudential supervision by the Insurance Regulatory and Development Authority of India established under the Insurance Regulatory and Development Authority Act, 199911;

(iv) a pension fund regulated by the Pension Fund Regulatory and Development Authority established under the Pension Fund Regulatory and Development Authority Act, 201312;

(v) a financial institution regulated by the International Financial Services Centres Authority established under the International Financial Services Centres Authority Act, 201913; and

(vi) any other entity notified by the relevant authority under clause (b) of Section 4;14

As per this sub-section the authorities mentioned under Schedule I of the Act are to be considered as the qualified financial contract participants and any other agency as notified by the appropriate Government under the given Act.

Importance of this law

Previously, when RBI used to set norms for the derivative markets or the qualified financial contracts, it has been regularly observed by the Central Bank that there is certain irregularity or ambiguity in the enforceability of the bilateral netting from the legal perspective.

The existing law would offer a major incentive for productive marginalisation, legislative reforms to RBI and allow financial firms to measure their market worth not on a gross basis but on a net basis.

The interaction of the Act with the Insolvency and Bankruptcy Code, 201615

One of the main benefits of this Act is that it has been granted the authority to circumvent other legislations, especially the Insolvency Code, which creates greater safety netting for the parties. This is made in accordance with the International Swaps and Derivatives Association’s suggestion that the key aim of the netting regulation should be to guarantee the enforceability of a netting arrangement against a party that is subject to insolvency proceedings. Similar guidance is set out in the rules regulating the financial markets dealing with the functioning of the central clearing counterparties. The Model Netting Act created under the shadow of the ISDA also makes a special reference to the cases of the insolvency resolution of the financial institutions and highlights the need to reconcile the goals of netting law with the need to assure that the resolution mechanisms are reliable. However, no specific mention is made under this Act.

If we look previously, the market participants have expressed questions over the unequal netting treatment under various legislations relating to the insolvency of the statutory entities and banking institutions, as opposed to the corporations established under the company law. Other than this, the Act also expressly overrides the rules of such enumerated laws and any legislation by which the market participants i.e. the RBI, SEBI, IRDAI, PFRDA, IFSCA has been incorporated, constituted or governed.

Critical analysis

This law, no doubt is a big government financial initiative, particularly in this pandemic period, when we can only hear stories relating to how our banking system is collapsing in these difficult times. This law will help the financial institutions of the country to participate more freely in the derivative markets or the corporate bonds market. It will not only strengthen the corporate bond market in India but it will help the country to achieve financial stability as it is a tested method which is used by almost all the countries in the world. This Act will offer more funding to the businesses through the purchasing of bonds as they obtain a sense of security through a credit swap contract or a netting agreement.

As said earlier, this Act will give life to the dull Indian corporate bond market. Previously, RBI noted that one of the major reasons for lack of interest in the credit defaults was the restriction on the netting position of the mark on the market for capital adequacy and exposure standards. The modification brought by the Act will make a positive impact on the bond market. However, in my view, the Act will not be in a capacity to transform the dynamics of the corporate bond industry by itself and may need more reforms and changes, including the simplification of the corporate bond operating rules, optimisation of pricing and expanded long-term investor engagement.

The issue which can be attracted in this Act is that this Act says that the contracts which are entered on a multilateral basis with the Securities Contracts (Regulation) Act, 195616 and the Payment and Settlement Systems Act, 200717 are excluded from the preview of the Act.18 As such, these rules deal with netting and settlement in particular cases (i.e. the operation of the stock markets and centralised counterparties, and the payment processes, respectively) and are better served by the exemption of the statute.19

† 4th year student BBA LLB (Hons.) School of Law, UPES.

[1]Preamble, Bilateral Netting of Qualified Financial Contracts Act, 2020

2 http://www.scconline.com/DocumentLink/ozOzrYs7

3 http://www.scconline.com/DocumentLink/JDn3ql97

4 S. 2(1)(j) of Bilateral Netting of Qualified Financial Contracts Act, 2020

5 Id., at S. 2(1)(n).

6 Id., at Sch. 1.

7 Id., at S. 2(1)(e).

8 <http://www.scconline.com/DocumentLink/YO47Q1ui>.

9 Supra note 4 at S. 6.

10 Id., at S. 2(1)(o).

11 <http://www.scconline.com/DocumentLink/Q43JYv8R>.