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Analysis

Bilateral Netting of Qualified Financial Contracts Act, 2020

09 Oct 2020

To reduce credit risk exposure and systemic risk in the financial market, the Bilateral Netting of Qualified Financial Contracts Act, 2020 has been notified on 1 October 2020. The legislation provides a regulatory framework to offset claims between two parties to a financial contract and to determine a single net payment obligation.

Introduction

Netting is an important aspect of determination of exposure arising out of financial contracts and has received due attention from multi-lateral organisations and individual regulators alike, as financial and derivative products have only become more complex over time. Many advanced economies already have a legal framework to govern bilateral netting of financial contracts. Netting helps financial institutions measure credit exposure to a counterparty on net basis (as opposed to gross basis). This helps reduce credit risk exposure and systemic risk in the financial market in the event of default of a counterparty, contributing to overall financial stability.

The Indian Government has notified the provisions of the Bilateral Netting of Qualified Financial Contracts Act, 2020 (Act) on 1 October 2020. The Act provides a regulatory framework for offsetting claims between two parties to a financial contract in order to determine a single net payment obligation due from one counterparty to the other.

The Act is based on the Model Netting Act by the International Swaps and Derivatives Association (ISDA), with modifications and customisations to suit the Indian legal and regulatory framework. Interestingly, India has adopted ISDA’s advisory to take a more flexible and principle-based approach instead of enumerating the categories of contracts or agreements that will be covered under the Act. Also, a significant leeway is provided to parties to agree upon the scope of concepts of ‘event of default’ and ‘termination event’, instead of prescribing a rigid statutory threshold.

While further notifications are currently awaited from various authorities identified in the Act, this update attempts to examine the construct and scope of the Act and its potential impact.

Key Features of the Act

Qualified Financial Contracts

At its heart, the Act provides legal validity to and confirms enforceability of bilateral netting. Bilateral netting refers to determination of net claim or obligations between parties to the relevant contract, after setting off or adjusting all the claims or obligations based or arising from mutual dealings between the parties to the relevant contract.

The Act covers Qualified Financial Contracts (QFCs), which will be notified by the Central Government, or the following regulators:

  • the Reserve Bank of India,
  • the Securities and Exchange Board of India,
  • the Insurance Regulatory and Development Authority of India,
  • the Pension Fund Regulatory and Development Authority, and
  • the International Financial Services Centres Authority.

The Act allows the regulators flexibility in identifying the QFCs. It would be interesting to see if the regulators also follow a similar principle-based approach or prefer to set out a more circumscribed list of contracts which may fall within this head.

Applicability of the Act

The Act applies to QFCs entered on a bilateral basis between ‘Qualified Financial Market Participants’ (QFMP), either under a netting agreement or otherwise, where at least one of the participants is regulated by any of the regulators mentioned above.

The definition of QFMP itself is very wide and apart from enumerating certain regulated entities (such as banks, insurance companies, pension funds, etc), also includes an individual, partnership firm, company, any other person or body corporate and includes any international or regional development bank or other international or regional organisation. Further, regulators may specify any other regulated entity as a QFMP.

Exclusions

The Act clarifies that contracts entered on a multilateral basis in accordance with the Securities Contracts (Regulation) Act, 1956 and the Payment and Settlement Systems Act, 2007 are excluded from the purview of the Act. As such, these laws deal with netting and settlement in specific situations (i.e. functioning of stock exchanges and central counterparties, and payment systems, respectively) and are well served by the exclusion in the Act.

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