The importance of Bilateral Netting
The Government of India has just placed – the Bilateral Netting of Qualified Financial Contracts Bill, 2020 in the Parliament. The new law will allow financial institutions to ‘net’ out their exposures against each other rather than have to manage exposure on a gross basis.
What is ‘bilateral netting’?
- Netting enables two counter-parties in a bilateral financial contract to offset claims against each other to determine a single net payment obligation due from one counter-party to others in the event of default.
- Let us say there are two banks, A and B. Bank A has an exposure of Rs 100 to B, while B has an exposure of Rs 90 to A. Their gross exposure is Rs 190 and, without bilateral netting, the system will currently have to keep aside capital for Rs 190 worth of exposure. This is very costly and the banks will be soon forced to stop doing additional business with each other.
- However, the net risk for the system is only Rs 10 (i.e. Rs 100 minus Rs 90). In this example, the gross capital requirements are 19 times higher than the net requirements. If the banks are allowed bilateral netting, the capital requirements dramatically fall and they can do a lot more business.
- A bilateral netting framework is standard in all developed financial systems across the world. Around 50 countries already have a similar arrangements based on a model law designed by the International Swaps and Derivatives Association (ISDA).
- Note that the adoption of Basel norms on bank capitalisation presumes the existence of a bilateral netting framework. By adopting Basel norms without a bilateral netting arrangement, India ended up making the capitalisation requirements unnecessary tight. Note, however, that a system of multilateral netting was created that is also a required part of the netting ecosystem.
- The new law, therefore, is a major step towards freeing up the financial system to expand. It also allows the development of a credit default swap (CDS)* market, as financial institutions can now trade CDS without being quickly shut down by spiralling capital requirements. The existence of a CDS market is critical for a vibrant corporate bond market.
- Most people think that the corporate bonds is just the debt equivalent of the equity market. However, there is a big difference. An ordinary share of a company is exactly the same as another. Hence, they are fungible and can be traded freely in the secondary market. This is what makes share markets liquid.
- The problem is that a bond issued today is not the same as a similar bond issued by the same entity last week. Moreover, old bonds mature and new ones are issued constantly. Except for the government and, perhaps, a handful of corporates, therefore, no entity issues enough of a particular bond to provide liquidity. This is why the corporate market is inherently ill liquid.
- The way financial systems worldwide deal with this problem is to parallel trade in CDS as a proxy for the bonds. This is why bilateral netting is a pre-requirement for a vibrant corporate bond market.
*Note – A credit default swap market is is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.
What is the risk?
Opening up the bond CDS market could also lead to unduly complex derivates like those that contributed to the Global Financial Crisis in 2007-08. The RBI, SEBI and the Finance Ministry is aware of this risk.
The bilateral netting law took so long as it had to be carefully formulated, along with inputs from the ISDA, Bank of International Settlements and other global regulators. More regulations will be introduced as appropriate, but the new framework will now open up several new vistas for financial expansion.
Source – The Economic Times
QUESTION – The government of India has introduced ‘bilateral netting’ provisions to deal with capital requirements in offsetting a credit default. Discuss the meaning of ‘bilateral netting’ and examine its significance.