The Importance of Bilateral Netting

The Economic Times     22nd September 2020     Save    
QEP Pocket Notes

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.

QEP Pocket Notes