Indian banks struggling to make gains from close-out netting law

Lawyers say undocumented derivatives trades hinder the audit trail needed to secure capital benefits

Banks in India are failing to set up the correct procedures to benefit from close-out netting of derivatives, say lawyers.

A law passed in 2020 gave banks a legal framework to enforce close-out netting in bilateral over-the-counter derivatives contracts in the event of default. However, many banks have been slow to identify their exposures and put in place proper documentation for their OTC derivatives transactions.

“That is a struggle for many of them, given the large volumes of exposures involved,” says Jayesh H, co-founder of Mumbai-based law firm Juris Corp. “Many domestic banks are doing this for the first time. All these require a significant amount of time and effort.”

The Netting Act in India, which came into force on October 1, 2020, allows foreign and local banks to apply netting to their derivatives trades with Indian counterparties. This could provide capital benefits by allowing derivatives exposures to be netted together under the leverage ratio and the standardised approach to counterparty credit risk (SA-CCR), thereby reducing the amount of capital that needs to be held against the total portfolio.

“Previously, exposures had to be computed on a gross basis and could not be netted,” says Jayesh.

Close-out netting allows a derivatives dealer outside the country to collapse offsetting trades into a single net payment if its local counterparty defaults. Without netting, the foreign firm may face a claim for its gross exposure. Regulators widely regard close-out netting as an effective risk mitigant.

Also, collateral posted into a jurisdiction that does not have a netting law might not be properly segregated, meaning it could be considered part of the defaulted firm’s estate and dragged into onshore bankruptcy proceedings. In countries where close-out netting is enforceable, banks have to hold capital only against their net exposure, rather than gross.

However, market participants need to have a master netting agreement in place with the counterparty for netting to be available. Jayesh says this is not the case for a large number of OTC derivatives transactions in India, which tend to be short-term.

“If you do transactions up to 13 months, you don’t need to have a master agreement in place,” he says. “A significant volume of the transactions in the domestic market are not documented, and they are not even supported by the Isda master agreement or similar.”

Assistance required

Smrithi Nair, the principal associate at Juris Corp who heads the firm’s derivatives practice, says many domestic banks have asked for assistance in setting up internal processes. Putting together documentation covering existing trades has also required significant work.

“All these tasks, including the documentation we had to do for our clients, are extensive, given the volumes of exposures banks had with various counterparties,” she says. “The documents with many counterparties were heavily negotiated. This means the same approach for all the documents did not work and [they] had to be dealt with on a case-by-case basis.”

Nair adds that if banks have a proper audit trail – “documents which speak for themselves” – they will be able to substantiate the basis for netting the derivatives exposures with counterparties.

The Netting Act has also had an impact on global banks, including a requirement for them to seek approval from their internal netting committees when dealing with Indian counterparts. “This required extensive communications [with global banks], including making presentations and [giving] opinions to the satisfaction of the committee,” says Jayesh.

A Mumbai-based tax and regulatory consultant agrees that putting documentation in place is critical, and that the inclusion of collateral protections in the law means more counterparties might be willing to margin their trades. The consultant believes this could help to bring down derivatives exposures and further reduce capital requirements: “If more collateral is posted, obviously that’s going to be better. The netting benefits would be realised and so will the capital benefits.”

In a commentary published on October 20, 2020 on the impact of the law on OTC derivatives market participants, Switzerland-based international legal consultant Lakshmi Babu wrote that the act would bring India in line with the most advanced jurisdictions with respect to margin requirements. She added that it would help domestic banks involved in OTC derivatives to achieve savings in regulatory capital.

She pointed to the Indian government’s 2019–20 economy survey, which claimed bilateral netting arrangements could have helped 31 major banks in the country that were participating in the OTC derivatives markets to save approximately INR 22.58 billion ($302 million) in regulatory capital in the 2017–18 financial year.

The Netting Act, Babu says, also has the effect of reducing hedging costs and liquidity requirements for market participants, thus encouraging greater participation in credit default swaps.

Although she questions whether close-out netting can indeed contribute to financial stability, Babu says the passage of the act represented significant progress for the development of India’s financial markets. She expects the government to introduce further regulatory changes over the coming months.

Among the changes that are likely to be introduced imminently will be implementation of the rules requiring variation margin for non-cleared derivatives. At the end of 2020, the Indian government began a public consultation on such rules, which had come into effect in the US three years previously.

The related draft regulation on the exchange of initial margin for non-cleared derivatives is still in progress.

Editing by Daniel Blackburn