Context

• Parliament has passed the Bilateral Netting of Qualified Financial Contracts Bill, 2020 with the Rajya Sabha approving it.

Key Details

• The bill provides a legal framework for bilateral netting of qualified financial contracts.
• The bill will be applicable to Qualified Financial Contracts 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.

Benefits of Bilateral Netting of Qualified Financial Contracts Bill, 2020

• Without bilateral netting, Indian banks have had to set aside higher capital against their trades in the over-the-counter market, which impacts their ability to participate in the market.
• Moreover, it also increases the systemic risk during defaults.
• Bilateral netting would also help reduce hedging costs and liquidity needs for banks, primary dealers and other market-makers, thereby encouraging participation in the over-the-counter derivatives market. 
• It would also help develop the corporate default swaps market, which, in turn, would provide support to the development of the corporate bond market.
• It would also improve investor confidence and to expand the scope of credit default swaps.

Back to Basics

• As of now, bilateral netting for financial contracts is not allowed in India. Instead, we practice ‘ gross netting ‘.
• Under gross netting method, banks measure credit exposure to the counterparty for Over the counter derivatives based on the gross market to market exposure. This increase credit risk for financial sector participants, especially in the case of insolvency, which then raises the systemic risk.
• The current system requires banks to divert greater capital towards collateral requirements.
• This has a negative impact on banks and other financial market participants.

• According to the Survey, “A bilateral netting agreement enables two counterparties in a financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to the other.”

Source: Economic Times, The Hindu, Bloombergquint