Why in News ?

Lok Sabha passed the Bilateral Netting of Qualified Financial Contracts Bill, 2020, which allows for enforcement of netting for qualified financial contracts.

Aim of the Bill : To provide a legal framework for bilateral netting of qualified financial contracts.

What is Bilateral Netting : Netting refers to offsetting of all claims arising from dealings between two parties, to determine a net amount payable or receivable from one party to other. The Bill allows for enforcement of netting for qualified financial contracts. In case of Banking, Bank’s obligation in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.

Bilateral Netting of Qualified Financial Contracts Bill, 2020

• Qualified financial contracts (QFC) : QFC means any bilateral contract notified as a QFC by the relevant authority.
  • The authority can be 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) or International Financial Services Centres Authority (IFSCA).
• Qualified financial market participant : The relevant authority designate an entity regulated by it as a qualified financial market participant to deal in QFCs.
• Enforceability of netting :
  • The Bill provides that netting of QFCs is enforceable if the contract has a netting agreement.
  • Netting agreement is an agreement that provides for the netting of amounts involving two or more QFCs.
  • A netting agreement may also include a collateral arrangement.

Limitations of the gross netting system

• In the absence of bilateral netting, India’s central bank regulations require banks to measure credit exposure to a counterparty for Over-the-counter (OTC) derivatives contracts based on gross marked-to-market (MTM) exposure instead of net MTM exposure.
• This increases credit risk for financial market participants during the event of insolvency of a counter-party which may in turn raise systemic risk, according to the latest Economic Survey.
• The current system of higher obligations requires banks to divert more capital toward collateral requirements than what would be required if bilateral netting is permitted.

Significance

• It brings in a firm legal basis for bilateral netting for two counter parties.
• Value of bilateral derivative contracts is estimated by the Clearing Corporation of India to be Rs. 56,33,257 crore as of March 2018.
• Bilateral contracts constitute 40 per cent of total financial contracts, while multilateral contracts constitute 60 per cent.
  • Multilateral netting has already been taken care of.
• It would also improve investor confidence and to expand the scope of credit default swaps.
• Reducing credit risk and regulatory capital burden for banks.

Terms for Extra Read

Credit Exposure : Measurement of the maximum potential loss to a lender if the borrower defaults on payment.

Over-the-counter (OTC) : Derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary.

Source : The Hindu

Topic

GS II : Government policies and interventions for development in various sectors and issues arising out of their design and implementation

Current Affairs Compilation : 24 September 2020