Parliament Clears Bill To Permit Netting of Qualified Financial Contracts [Read Bill]

The Bill provides a legal framework to enable two counterparties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to other in the event of default.

It was passed by the Lok Sabha last week.

"In the absence of a legal framework for bilateral netting, banks are forced to measure credit exposure to a counterparty for over the counter derivative contracts based on gross basis and not net basis.

This situation significantly increases credit risk exposure and systemic risk in financial market in the event of default of a counterparty, besides trapping significant amount of capital unproductively by banks. An unambiguous legal framework for enforceability of close-out netting would reduce credit exposure of banks and other financial institutions," Finance Minister Nirmala Sitharaman said.

She informed the House that the estimated financial savings under the Bill will be around Rs. 46,000 crore yearly. She also assured the House that the Bill was drafted keeping in mind the model netting act of the International Swaps and Derivatives Association.

Salient Features

Bilateral netting

Netting refers to determination of "net claim" after setting off all the claims/ obligations arising from mutual dealings between two parties to Qualified Financial Contracts (as notified by the relevant authorities which may be RBI, SEBI, IRDAI, etc.). Netting also includes Close-out netting (discussed later).

The parties to a QFC must ensure that all obligations owed by one party to the other, under the contract, are replaced by a single net amount.

Applicability

The provisions of the Bill will apply to QFCs between two qualified financial market participants, where at least one party is an entity regulated by the specified authorities (RBI, SEBI, IRDAI, PFRDA or the IFSCA).

Qualified financial market participant

The relevant authority may, by notification, designate an entity regulated by it as a qualified financial market participant to deal in QFCs. This would include entities such as non-banking finance companies (NBFCs), insurance companies and pension funds.

Enforceability of netting

Netting of QFCs shall be enforced by a netting agreement, included in the contract between the parties. Inclusion of non-qualified financial contracts in a netting agreement will not invalidate the enforceability of netting of QFCs under the agreement.

Close-out netting arrangement

Close-out netting refers to the termination of all obligations arising out of relevant QFCs. The process may be initiated by a party to the QFC in the case of:

• failure to honour the obligations of a QFC by the other party
• termination event, as specified in the netting agreement that gives one or both parties the right to terminate transactions under the agreement.

The net amount payable/receivable under the close-out netting would be determined:

• in accordance with the netting agreement entered into by the parties, or
• through an agreement between the parties on the sum with regard to the net amount payable, or
• through arbitration.

Enforceability of close-out netting

Close-out netting is enforceable against:

• an insolvent party
• against the person providing collateral
• a party placed under administration, notwithstanding any injunction, moratorium, insolvency, resolution, winding up or order of a court issued under any law.

Limitations on powers of administration practitioner

The administration practitioner cannot render ineffective, any transfer of cash, collateral or other interests made in connection with a netting agreement between the insolvent party and the non-insolvent party to a QFC.

[With Inputs from PRS Legislative Research]

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