What Is Bilateral Netting And Why Is The Government’s Reform Of It Significant? Answered Here

Yesterday (23 September), Parliament passed the The Bilateral Netting of Qualified Financial Contracts Bill. With this, the government made changes to the legal framework allowing for bilateral netting.

Many are wondering what bilateral netting means and what is its significance.

What is bilateral netting?

Bilateral netting is an important concept for financial transactions between two parties. Consider a situation where there are two financial parties that are involved in a particular transaction and they have multiple swap agreements between them.

A swap is essentially a derivative contract between two financial institutions that allows them to exchange cash or liabilities from various instruments. Therefore, the two financial intermediaries or parties hold claims over each other’s income or liabilities through multiple financial instruments.

In the erstwhile regime, each contract was considered in isolation and thus the parties had to exchange the cash-flow from each of these contracts. Under bilateral netting, all these agreements are consolidated into a single agreement and there is only a single payment based on the net stream.

What is the reform?

Let us give a simple example to illustrate the reform. Suppose there are two banks A and B that happen to hold three financial contracts. Under the first two contracts, bank A is required to pay bank B Rs10 and Rs 15 respectively while the third contract requires bank B to pay bank A Rs 30.

In the absence of bilateral netting, bank A will transfer Rs 10 and Rs 15 to bank B while bank B will transfer Rs 30 to bank A. Now, with bilateral netting, bank B needs to transfer only Rs 5 to bank A. This is the only transfer that happens under the new regime.

The reform thus allows for simplification of the regulatory process allowing for financial intermediaries to reduce multiple such contracts into a single transfer.

Why is it significant?

The significance of the reforms comes from the fact that it simplifies the transactions and at the same time reduces the capital required by institutions to meet their obligations.

For instance, bank A will have to keep Rs 25 as reserve to meet the obligations towards bank B in the erstwhile regime while bank B will have to keep Rs 30 in reserves.

In total, Rs 55 is kept in reserves for a net transaction of only Rs 5. Bilateral netting thus makes it possible for more efficient allocation of capital which is critical for deepening our financial system.