Diverse netting approaches create OTC headache

A lack of legal statutes over netting in several Asian countries means OTC trades could become prohibitively expensive in a post-Basel III world, potentially pushing international banks out of some markets in the region

Diversity in Asian capital markets has prompted a slew of issues that are not present for their European or North American peers – the lack of a centre for derivatives trading such as the role London plays in the European Union’s market means there will be a number of clearing houses to emerge. Separate institutions in Seoul, Sydney or Singapore – to name just three examples – will lead to replication of business lines and a fragmentation of collateral.

But the problems don’t stop there and one issue that dealers are now wrestling with is the lack of uniformity in the netting of over-the-counter trades in Asia. An absence of a legal framework for netting means banks face the choice of either not conducting the trades or instead shouldering the increased capital burden applicable to non-netted transactions under Basel III, according to Oliver Bettin, head of credit products group, Asia-Pacific at Deutsche Bank in Singapore. “Basel III will have a very significant impact on whether you will do the trade or not,” he says.

Close-out netting in relation to OTC derivative transactions is the ability to net the mark-to-market values of all existing transactions under a master agreement upon insolvency of a counterparty. Under Basel II, close-out netting is recognised as a risk-reduction tool with transactions entered under netting agreements granted favourable treatment for capital adequacy purposes.

But in order to obtain this capital relief, the regulatory authorities of the relevant financial institutions must be satisfied that close-out netting will be enforceable under the insolvency laws governing the counterparty. This allows institutions to enjoy reduced capital reserve requirements against their transactions, freeing up capital for other uses. However in Asia, the laws surrounding close-out netting in many countries are ambiguous, with the ability to net down to the legal opinion of each country’s laws.

Only Japan, South Korea, Australia and New Zealand have adopted specific netting legislation. However, a country does not necessarily need specific netting laws to be considered a netting friendly jurisdiction. For example, many former British colonies such as Hong Kong and Singapore are clean netting jurisdictions without having specific netting laws by virtue of being UK common law countries under which netting is enforceable. However, this is not the case for former colonies such as Malaysia and India.

Despite being based on common law, the ability to close-out net in Malaysia is uncertain due to laws that directly challenge the ability to close-out net. The Pengurusan Danaharta Nasional Berhad Act 1998 (Danaharta Act), the Malaysia Deposit Insurance Corporation Act 2005 (MDIC Act) and the Central Bank of Malaysia Act 2009 (CBA) prohibit close-out netting and allow government agencies to take any action they deem necessary in the event of an insolvency.

This issue is further exacerbated by the Capital Markets and Services (Amendment) Act 2011, which now confers similar powers to the Securities Commission Malaysia. In the event of default, parties will have to deal with each one of these laws individually and would not have any legal certainty on the enforceability of close-out netting as their positions would be challenged by the liquidator.

In India, close-out netting is recognised under common law. The problem is that while there is netting certainty around privately owned banks, this is not the case for state-owned banks, which are governed by separate statutes that may prohibit close-out netting if a government-owned bank defaults.

In countries based on civil law such as Indonesia, the ability to net is also problematic. According to legal opinion commissioned by the International Swaps and Derivatives Association, the problem is that the conclusions on netting are not of a sufficiently high standard for legal certainty. There is a lack of legal precedent and thus only the view that close-out netting “should” be upheld. In addition, Article 36 of the Indonesian Bankruptcy Law may oblige the non-defaulting party to give the defaulting party’s receiver in bankruptcy the right to say whether they want to continue to perform the contract.

Collateral damage

The lack of netting clarity also impacts the ability for parties to collateralise a trade, says Jacqueline Low, senior counsel for Asia at Isda in Singapore. According to Low, the most widely used collateral agreement in Asia is the English law credit support annex (CSA) which relies on close-out netting to be effective. Thus, close-out netting needs to be enforceable in order to mitigate counterparty credit exposure by holding collateral.

Under Basel III, the capital charge for an OTC derivatives trade will be much higher for non-netting friendly countries

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Diverse netting approaches create OTC headache

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