Now that this bilateral compensation law has come into force, it is expected that the economy will be more lubricated instead of sitting and waiting for frozen assets to be released. Trading in the financial markets is usually associated with many risks. As a result, financial market participants use a number of methods to mitigate these risks. Bilateral compensation is one such method. It is a legally binding agreement that allows two counterparties in a financial contract to consolidate/set off all claims against each other under a single, global legal obligation of receivables or liabilities. Clearing helps financial institutions measure credit risk for a counterparty on a net basis rather than on a gross basis. This increases the security of transactions, especially in the event of bankruptcy, by ensuring that all swaps are executed, rather than just those profitable for the bankrupt company. The Finance Minister introduced the bill in Loksabha and said it was drafted with the aim of ensuring the financial stability and competitiveness of the Indian financial market. It has been argued that this bill seeks to make bilateral compensation subject to the law, which has so far been only a commercial practice. It is seen as beneficial for banks and financial institutions.
It provides a legal basis for closing netting agreements between the parties and improves solvency. Criticisms of the bill were that it contains only the type of closure compensation and excludes other forms such as novation. It can also lead to a means of tax evasion and money laundering, leading to regulatory problems. The Statute does not include multilateral treaties as it is regulated by the Clearing Corporation of India. Clearing allows two counterparties in a bilateral financial agreement to set off claims against each other in order to determine a single net payment obligation owed by one counterparty in the event of default to others. He assessed how much money would have been available in banks if this law had been available for onward transfer without keeping it unproductively set aside due to regulatory capital requirements. In 2017, banks reportedly had ₹42,194 crore available for loans. As this law was not available, this amount was kept secret. This would not have been necessary if the bilateral compensation had taken place a few years ago. Novation Netting removes the opposing swaps and replaces them with the new framework agreement. Literally, bilateral means having both sides of a thing, while the net is an act of combining or merging different threads to form a single meeting.
Bilateral clearing provides for the reduction of total transactions between two parties, as all transactions are cleared in a single transaction. One of the main advantages of bilateral set-off is that it is possible for two parties in a legal contract to set off claims against each other and to determine the net payment of the obligation to which a particular counterparty is entitled or responsible. Bilateral clearing allows both counterparties involved in the agreement to reduce risks, including liquidity risks, settlement risks, systemic risks and credit risks. Bilateral clearing also provides counterparties with a guarantee in the event of insolvency. For example, if a counterparty goes bankrupt, that party cannot receive a swap in the currency if swaps outside of swaps are not paid in full. This means that all swaps outside the currency must be paid in full before a party can collect swaps in the currency. In 2018, up to ₹45,956 crore would have been available for the loan. In 2019, ₹ 67,792 crore would have been available and in March 2020 ₹ 58,308 crore are blocked due to the absence of a bilateral compensation law. This calculation was based on actual data from 31 public, private and foreign banks, Finance Minister Nirmala Sitharaman recently told parliament.
If these swaps were cleared bilaterally, instead of sending two payments to Company A, Company B would only be able to send one larger payment. In addition to supporting the stability of financial markets, this bilateral clearing will help assess risks in much more real time, and the actual risk assessment will be more likely to take place than a fictitious assessment based on the gross figure, experts said. Previously, India`s legal framework prohibited the clearing of bilateral financial contracts and required banks to provide capital on a gross basis, unproductively trapping large amounts of bank capital. If B1 and B2 make their transactions “net”, only B2 has to pay 5 crores to B1 each year. It would also mean that instead of the 300 crores previously planned by the two banks, only 1,100 crore of B should have been allocated, thus freeing up capital worth 200 crore. This can lead to a boost to credit and investment, thereby strengthening the financial sector and our economy. Among the contracts that fall into the QFC category, over-the-counter (OTC) derivative contracts are popular. OTC refers to securities contracts that are not traded on a central exchange. It is negotiated bilaterally between the parties. Derivative contracts refer to the value of the security, which depends on an underlying asset.
It is considered preferable to negotiate over-the-counter as the terms of the contract can be adjusted based on the negotiations between the parties, which could reduce the risk in the future. It also makes it possible to trade multiple OTC derivatives at a single price without impacting the transactions that take place on the controlled exchange. OTC derivatives trading is carried out through traders. Currently, this is being converted into an electronic platform where all transactions are recorded and offers are displayed. This article attempts to explain the nuances of bilateral compensation in the simplest way. To do this, it uses an example of a greatly simplified credit risk swap (hereinafter referred to as “CDS”) between two banks. The article then analyses the application of bilateral set-off to insolvencies and shows its advantages. All the while, the authors have struggled to break down certain terms and concepts, recognizing that financial derivatives can be difficult for the average law student to understand. Bilateral clearing is the process of consolidating all swap agreements between two parties into a single arrangement or framework arrangement. Therefore, instead of any swap agreement that results in a flow of individual payments by one of the parties, all swaps are cleared against each other, so that a single net cash flow is paid to a party based on the combined swap flows. It is recognised that corporate bond markets have been hampered by a lack of liquidity, transparency and competitiveness. Liquidity is an issue because it is not easy for investors to buy the bond and sell it on the secondary market.
Due to the different ratings of credit rating agencies, there is a lack of information about the market. Competitiveness is lower compared to other markets such as equities because it is dominated by public sector companies. .