The emergence of close-out netting in the Middle East
Monday 18 May 2020
An important provision contained within the ISDA Master Agreement provides for close-out netting. This comes into play when one of the parties to an agreement defaults and enters into an insolvency situation.
Contracting parties may have multiple trades going back and forth with varying exposures at any one time. Close-out netting allows the exposures between contracting parties to be net down, in other words, expressed as one final net figure. For example, Party A enters into an agreement with Party B, upon default if Party A owes Party B $100,000, and Party B owes Party A $25,000, the value after netting would be a $75,000 transfer from Party A to Party B ($100,000–$25,000). The ability to net payments in this way can mitigate the risk and impact of an event of default occurring to the party you are trading with.
However, the close-out netting provisions are not automatically enforceable as there may be complications relating to local netting legislation. This can relate to overly protective provisions that favour the local entity or, as is the case in certain developing markets, a lack of netting laws altogether. To ensure that the provisions are enforceable in an insolvency situation, it is desirable that a jurisdiction has enshrined appropriate netting legislation. This has a reciprocal benefit as robust netting laws encourage cross-border derivatives transactions and attract large firms to the country.
ISDA monitors which countries have netting and collateral legislation in force, and commissions legal opinions regarding the legislation in force in each jurisdiction. Over 30 European countries have netting legislation in force, within a list of 60 countries globally.
The Middle East is a region where the development of netting legislation has been ongoing in recent years. It was recognised that increased risk management across the region was required. Conventional and Islamic derivatives were developed across the Gulf Corporation Council (GCC).
However, the development of derivatives markets has been hindered by a lack of regulation. Whilst the interest in legislative reform has existed, progress has been slow. Israel and UAE are established netting jurisdictions and their neighbours are beginning to catch up.
The African Development Bank and Central Bank Egypt launched the new overnight rate, CONIA (Cairo Overnight Interbank Average benchmark). This was established for the development of financial markets and derivatives in Egypt. A review of existing capital markets law in the country has commenced with particular attention to be paid to derivatives. Progress is expected shortly, and it is anticipated that a timeline for the introduction of legislation will be produced.
In Qatar, there are two separate regulatory regimes at play: Qatar Law and the Qatar Financial Centre. The QFC has its own legal, regulatory, tax and business infrastructure independent of domestic law and has been recognised as an effective netting regime since 2018. ISDA produced a positive netting opinion for counterparties organised within the QFC. The second regulatory regime is for counterparties incorporated in Qatar, but outside the QFC. It is understood that netting legislation has been drafted but it has not yet been published, and there is little indication as to when there might be any further movement.
In Pakistan, whilst not strictly a Middle Eastern country by definition, the position is similar. It has been over 5 years since legislation was drafted which covers netting and collateral. The current advice is that the legislation is still making its way through the parliamentary process, without any meaningful legislative progress to report.
However, it is hoped that some momentum will be breathed into the legislation by the Asian Development Bank. The Bank has started a regional initiative in western Asia and has entered into discussions regarding the development of derivatives markets in Pakistan. There is a need for improved netting regulation in the region and the ADB has started a process and will be drafting a report detailing the specific measures required. It appears that Pakistan will be prioritised, which may help to expedite the implementation of legislation.
Potential for legislative reform also appears to exist in Kuwait. It is believed that regulators in Kuwait are developing plans for capital requirements law reform, but there has been no major progress as yet. Where a country expresses an interest in developing legislation, ISDA will provide assistance. ISDA has also published a Model Netting Act, which is an example of a draft of netting legislation which countries can use as a template. This sets out the basic principles necessary to ensure the enforceability of bilateral close-out netting. There are also suggestions that there is interest in Jordan and Lebanon to develop netting legislation, but nothing has been initiated as yet.
Oman does not currently have netting legislation in place and does not have any plans in the immediate future to draft any such legislation. However, Article 607 (of the Law of Commerce) allows for insolvency set off providing transactions are contracted.
The spread of the development of netting and collateral legislation has a number of benefits. It helps to reduce the credit exposure, capital shortfall and risk to market participants. This will make trading with Middle Eastern counterparties a more attractive proposition and should stimulate trade.
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