The government has proposed to formulate a legislation for laying down a mechanism for netting of financial contracts which it believes will improve investor confidence as well as expand the scope of credit default swaps (CDS). The Economic Survey has a detailed explanation on the benefits of enabling bilateral netting. A bilateral netting agreement enables two counterparties in a financial contract to offset claims against each other to determine a single net payment obligation due from one counterparty to the other.
As of now, bilateral netting for financial contracts is not permitted in India. In the absence of a bilateral netting, RBI's regulations require banks to measure credit exposure to a counterparty for over-the-counter (OTC) derivative contracts based on gross marked-to-market (MTM) exposure instead of net MTM exposure.
Higher regulatory capital burden makes trading activity for financial contracts more capital-intensive, translating into higher cost of transaction, the Survey stated. For CDS - an instrument used to hedge credit risk exposure - that has remained dormant in the Indian market, the announcement is seen as a big positive. Independent fixed income and forex expert Manish Wadhawan said there is a dire need of products like CDS to succeed because of what has happened in the last year or so in the credit markets.
"We have seen highly rated papers suddenly turning into defaults. From that point of view, allowing netting of financial contracts is a very important milestone that will reduce the cost of market players who choose to hedge their exposures to debt papers," Wadhawan said.
The Survey further said establishing a legal framework for bilateral close-out netting would help cut credit risk and regulatory capital burden for banks, freeing up capital for other productive uses, cut 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.
However, market participants also indicated a main issue still remains unaddressed. Independent market expert MS Gopikrishnan said, as of now, it is only the market makers that are permitted to buy and sell CDS. "The investing community so far is only allowed to buy credit default swaps on their exposures and are not permitted to write/sell a CDS. As a result, this reduces the interest of market makers in dealing in CDS instruments as they would be stuck with one side of the deals. If the investing community is also allowed to sell CDS, I think one of the biggest bottlenecks of this market would be removed," he said.