The Importance of Bilateral Netting

CONTEXT: The Government of India has placed a very important financial sector reform in Parliament — the Bilateral Netting of Qualified Financial Contracts Bill 2020.

Significance of Bilateral Netting

• Reduces the capital requirements of banks: Bilateral netting allows financial institutions to consolidate all of their agreements (exposures) into a single agreement 

• Alternatively, this means “netting” out their exposure exposures against each other rather than have to manage exposure on a gross basis.
• For, E.g. If bank A and B have exposure of Rs 100 and Rs 90 respectively to one another, while the gross capital requirement is Rs 190, bilateral netting reduces the capital requirement to just Rs 10.

• Use around the world: Around 50 countries already have similar arrangements based on a model law designed by the International Swaps and Derivatives Association (ISDA).
• Freedom to the financial sector to expand: It also allows the development of a credit default swap (CDS) market.

• The existence of a CDS market is critical for a vibrant corporate bond market.

• Complementing the Basel norms: By adopting Basel norms without a bilateral netting arrangement, India ended up making the capitalisation requirements unnecessarily tight.
• Makes the share market more liquid: In the CDS market, an ordinary share of a company is exactly the same as another and can be traded freely in the secondary market.

Associated Risks:

• Opening up the CDS market could also lead to unduly complex derivatives like those that contributed to the Global Financial Crisis 2007-08.

Conclusion: 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.