India: Hedging, repo and stock lending update

Recent Indian legislation provides a legal framework for the recognition of close-out netting. Previously, the legal position was uncertain. Close-out netting is a fundamentally important tool for reducing credit risk between counterparties to swaps, derivatives, repos and stock-lending agreements.

There are wide practical implications and benefits:

• Parties opposite an Indian counterparty can determine their credit exposure on a net basis rather than a gross basis.
• Banks can potentially trade more derivatives before an Indian counterparty’s credit limit is reached as credit limits are determined by reference to net credit exposure.
• The legislation will mean that parties opposite an Indian counterparty will potentially benefit from a reduction in the price of derivative products. Banks should have lower costs as they do not need to set aside as much capital.
• A party will have lower or no losses if its Indian counterparty enters into insolvency, depending on trade exposures.
• Negotiation of netting agreements will be more straightforward.
• A netting contract must be in place – inadequately documented trading will not benefit from close-out netting terms.
• It removes the risk of trades terminating automatically on the occurrence of certain insolvency events. Automatic early termination of trades can be highly problematic and commercially undesirable.

What is close-out netting?

Close-out netting is the process of terminating multiple trades between the same two counterparties under a single netting agreement, and subsequently combining the value of the positive and negative positions that each party has to the other under those trades so that a single net amount is payable by one party to the other party.

For example, if Party A and Party B enter into two trades under the same netting agreement. Under Trade 1, Party A has an exposure of US$100 to Party B. Under Trade 2, Party B has an exposure of US$100 to Party A.

On a gross exposure basis (no close-out netting), Party A and Party B both have a credit exposure of US$100 to the other party.

On a net exposure basis (benefitting from close-out netting), neither party has a credit exposure to the other party. On net credit risk is US$0.

Posted collateral to support positions commonly counts as a trade under a netting agreement. The value of that collateral is usually included in the close-out netting determination.

What documentation is required?

To benefit from the legislation, parties will need to ensure that their trades are clearly documented under a single netting agreement.

Template netting agreements for negotiations are provided by industry bodies such as the International Swaps and Derivatives Association for swaps and derivatives, and the International Capital Markets Association for repos. These bodies have drafted legally certain and tested netting agreements that are governed by English law or New York law. The netting agreement does not need to be governed by Indian law.

How we can help?

If you have queries relating to close-out netting, treasury management, trading or financial regulatory matters, we can help.

Our dedicated India desk team is experienced in supporting Indian banks, businesses and organisations with English law enquiries.

Further information contact Akhil Sharma or Jeremy Ladyman