The central government recently notified the Qualified Financial Contracts Bilateral Clearing Act, 2020 (“Act”), which provides a regulatory framework for offsetting claims between two parties to a financial contract to determine a single net payment obligation. The law will come into force on October 1, 2020. Prior to this law, participants were required to withhold a certain amount of money each time they made a different transaction, i.e. on a “gross basis”. Now, participants can aggregate all transactions between themselves to assess a final amount to be paid or received on a “net basis”. This leads to greater liquidity in the market and increased stability in the financial sector, thereby reducing systemic risk. This legislation is undoubtedly a major financial initiative of the government, especially in this time of pandemic when we can only hear stories about how our banking system is collapsing in these difficult times. This law will help the country`s financial institutions participate more freely in derivatives markets or corporate bond markets. Not only will this strengthen the corporate bond market in India, but it will also help the country achieve financial stability, as it is a proven method used by almost every country in the world.
This law will provide more funds to companies by buying bonds, as they will get a sense of security through a credit exchange agreement or clearing agreement. The valuation resulting from a single net amount will result in the dissolution of the parties` rights and liabilities in respect of all CFQs. According to Article 7, the method to be used for the valuation must be in accordance with the compensation agreement between the parties. In the event that the contract does not provide for this, the dispute over the net amount will be settled by arbitration. This value must be determined in a single currency. The party is obliged to pay the net amount for the promotion of this contract. In addition, this applies notwithstanding other applicable laws and to other qualified market participants such as banks, insurance companies, pension funds, companies and partnership companies. The powers to be considered qualified participants in capital markets are defined in paragraph 2(1)(o) of the Act as follows:10 The meaning of QFC is specified in sections 2(n) and 4(a) of the Act. It stipulates that the competent authority designated by the Act may designate a particular bilateral treaty as a QFC unless it does not comply with central government instructions or is a multilateral treaty under the Securities Contracts Regulation Act (1956) and the Payment and Settlement Systems Act (2007).
It should be noted that that definition is exhaustive and does not specify the precise meaning of the nature of the contracts covered by QFC. Previously, when the RBI set standards for eligible derivatives markets or financial contracts, the central bank regularly observed that there was some irregularity or ambiguity in the applicability of bilateral clearing from a legal point of view. In the United States, set-off is governed by federal law, and states have made specific provisions in this regard. Bilateral and multilateral clearing houses are responsible for enforcing these agreements. The amendment to the Bankruptcy Act in 2005 provides for safe haven provisions for framework compensation agreements that exclude the automatic suspension of such agreements. This means that agreements that fall within the scope of the Safe Harbor provisions are not affected by the moratorium and that the suspension imposed due to the insolvency of the party and the contract must be enforced. According to the 2019-2020 Economic Survey, bilateral compensation agreements could have saved INR 22.58 billion from banks included in regulatory capital. Because of this law, this blocked fund could be better used to create liquidity and more investment in the economy. As mentioned earlier, this law will bring to life the boring corporate bond market in India. Previously, the RBI had concluded that one of the main reasons for the lack of interest in loan defaults was the limitation of the brand`s clearing position in the capital adequacy and exposure standards market. The change brought about by the law will have a positive impact on the bond market. However, in my view, the law alone will not be able to change the dynamics of the corporate bond industry and may require further reforms and changes, including simplifying corporate bond operating rules, optimizing prices and expanding long-term investor participation.
In the absence of a bilateral clearing regulatory mechanism, banks are required to calculate the counterparty`s credit risk for over-the-counter (OTC) derivative contracts on a gross basis rather than on a net basis. While the convenience of reduced trading is an advantage, the main reason two parties engage in clearing is to reduce the risk. Bilateral netting provides one of the parties with additional security in the event of insolvency. Netting executes all swaps in the event of insolvency, rather than just those profitable for the bankrupt company. For example, if there were no bilateral clearing, the bankrupt company could collect all exchanges in the currency, while saying that it cannot make payments for out-of-money exchanges due to bankruptcy. It stipulates that the netting agreement is no longer applicable after the commencement of insolvency proceedings. The parties may fix the date on which the amount will be determined in accordance with the agreement. If the date is not set, the amount will be paid on the second day of the insolvency proceedings. Even if the parties have decided that a particular law is applicable to a derivatives transaction, it becomes inapplicable if it deviates from the law governed by the netting agreement. If the law applicable to the derivative transaction is German, the insolvency proceedings must also be conducted in accordance with German law.
Suppose there are two banks – Bank 1 (“B1”) and Bank 2 (“B2”) – that both want to lend their deposits and charge interest to make a profit. A company (“C1”) wants to develop its business and turns to B1 and asks for a loan of Rs. 100 crores. But C1`s financial records aren`t impressive and its creditworthiness is A. B1 certainly doesn`t look to lend money to companies with a credit rating below AA. However, C1 offers an attractive interest rate of 16% versus the usual 12%, and B1 thinks its expansion plan could work. The Bilateral Clearance of Qualified Financial Contracts Act, 2020, also known as the “Clearing Act”, was recently passed by Parliament on 1 October 2020, which can be described as the first step towards simplifying India`s financial and derivatives market. This decision is also linked to India`s commitment in the G20 and FSB to adhere to global standards. India will be the 10th country to legislate on the compensation agreement, after the United States, the United Kingdom, Australia, Canada, Japan, France, Germany, Singapore and Malaysia. .
