An Anecdote of Blocked-up Capital: The Code of Bilateral Netting and the Art of Simplification
Here follows a conversation from one of the greatest books of the 20th century, The Catcher in the Rye by JD Salinger:
Man: One short, faintly stuffy, pedagogical question. Don't you think there's a time and place for everything? Don't you think if someone starts to tell you about his father's farm, he should stick to his guns, then get around to telling you about his uncle's brace? Or, if his uncle's brace is such a provocative subject, shouldn't he have selected it in the first place as his subject—not the farm?'
Holden: “Yes—I don't know. I guess he should. I mean I guess he should've picked his uncle as a subject, instead of the farm, if that interested him most. But what I mean is, lots of time you don't know what interests you most till you start talking about something that doesn't interest you most. I mean you can't help it sometimes. You don't know my old teacher, Mr Vinson. He could drive you crazy sometimes, him and the goddamn class. I mean he'd keep telling you to unify and simplify all the time. Some things you just can't do. I mean you can't hardly ever simplify and unify something just because somebody wants you to.”
But here’s the catch, this is the year of exceptional happenings, and so you wouldn’t be surprised if you found out that there has been an introduction of elements of unification & simplification in the way say, qualified financial transactions are carried out. Yes, I’m talking about the recent bill on Bilateral Netting, introduced by Indian Finance Minister, Nirmala Sitharaman, after arguing that it would help big banks and other financial intermediaries to save costs and transact more efficiently. Puzzled? Let’s take it from the top.
The Government of India on October 1, 2020, passed the Bilateral Netting of Qualified Financial Contracts Act, 2020. The Act promises to provide a regulatory framework for offsetting claims between two parties to a financial contract to determine a single net payment obligation due from one counterparty to the other. How does it have anything to do with what Mr Holden just concluded? Well, bilateral netting in very simple terms is a method of reducing credit, settlement, and other risks of financial contracts by unifying two or more obligations to achieve a more simplified reduced net obligation. As a result, bilateral netting reduces the number of overall transactions between the two counterparties, thereby reducing the actual volume of transactions, accounting activity, along with costs and fees associated with an increased number of trades.
The act covers bilateral contracts notified as Qualified Financial Contracts (QFCs) by a relevant authority such as Reserve Bank of India (RBI), Securities Exchange Board of India (SEBI), Insurance Regulatory and Development Authority of India (IRDAI), Pension Fund Regulatory and Development Authority (PFRDA), and International Financial Services Centres Authority (IFSCA). The QFC definition is very broad and includes any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the aforementioned authorities determine by regulation, resolution, or order to be a QFC.
Let’s assume that you are an investment trust and you own a $1 million corporate bond issued by a private housing firm. You think that there is a risk in the event the housing firm defaults on repayment, so you decide to buy a Credit Default Swap (CDS) worth $1 million from a hedge fund. You have agreed to pay interest on this credit default swap of say 5%, which amounts to $50,000 a year. If the housing firm defaults, you get the compensation equal to the value of the CDS from the hedge fund in exchange for the pre-decided interest amount. On the other hand, if the housing firm doesn’t default, you end up losing the interest amount, kind of like sunk cost. In either case, you hedge the loan amount against the risk of default. While you are at it, you need to set aside some amount depending upon the terms of the contract because the Central Bank mandates you to keep a fraction of the loan amount as a reserve to protect yourself in case the loan gets bad or subprime. The hedge fund will have to keep a certain percentage of the amount that it has promised to make good for the same reasons as you.
Now, imagine that the hedge fund that sold you CDS enters into a completely new qualified financial contract with you to downsize its risk on a different contract and you agree to invest in it because you think it can work out in your favour and you can end up earning a bounty. By law, you are both required (yet again) to keep aside a certain sum of money. The problem is, you may enter into a lot of swap agreements with the counterparty, and each that happens, you both block in a certain sum of money to honour your other commitments.
Do you get the problem now? This act allows the parties to the qualified financial contracts to release the large amounts of locked-up capital in the banking system for the onward lending by employing a tool called “bilateral netting” which is nothing but offsetting the claims arising from dealings between the two parties to determine the net amount payable or receivable from one party to another. These QFCs take place directly between the two parties without involving any regulatory authority like SEBI or RBI; in finance, we call them Over-the-Counter (OTC) transactions. The thing about OTC transactions is that they are less transparent & are subject to fewer regulations, which increases the chances of default without any Clearinghouse in action.
And while India allows netting of multilateral over-the-counter financial derivative contracts, the same wasn’t allowed for bilateral contracts until now. And to my surprise, as per RBI, the value of bi-lateral contracts as estimated by Clearing Corporation of India amounts to ₹5,633,257 crores as of March 2018. And if bilateral netting was made available in FY 2017-18, the banks could have freed up around 2.14 lakh crore till 2020 which could have been made available for lending. So, by introducing this act, not only banks get to reduce their regulatory capital burden, but it also enables a reduction in hedging costs and liquidity needs for banks, primary dealers, and other market-makers, thereby encouraging participation in the OTC derivatives market to hedge against risk, and the added bonus is better employment of the blocked-up capital. From that point of view, allowing netting of financial contracts is a very important milestone that will reduce the cost of market players who are consistently entering into contracts to hedge against risk.
Bilateral netting of QFCs is a common practice in economies like the USA, UK, Europe, Japan, etc. and has been proposed in India by the Ministry of Finance several times over the past few decades. Nirmala Sitharaman said that this particular legislation is extremely necessary for the stability of the financial market. Money locked up in banks is not available when the economy is starved for funds. This will enhance liquidity and the economy will get lubrication and I think we can all agree with that. This bill has been brought in to address the lessons learned from the 2008 global financial crisis; it took us a lot of time to get here, some might even say a worldwide pandemic and yet another global crisis, but we are here nonetheless, and it’s a win-win for everybody. Perhaps, we can simplify and unify things, after all, just because somebody (here, the nation) wants us to.
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