Rethinking OTC Derivatives: The Imperative for Legal Reform in India’s Financial Landscape

Over-the-counter (OTC) derivatives have transformed financial markets, offering customised ways for firms to manage risk. However, this flexibility also creates complex legal challenges, particularly in cases of insolvency. In India, these challenges are aggravated by the moratorium imposed under section 14 of the Insolvency and Bankruptcy Code, 2016 (IBC), which can prevent parties from enforcing protections such as close-out netting. This article critically examines the gaps in the current legal framework governing OTC derivatives, the role of the Bilateral Netting of Qualified Financial Contracts Act, 2020 (Bilateral Netting Act), and the need for further reforms to bring India in line with global best practices.

Close-out netting is a critical risk management tool in OTC derivatives contracts. It allows counterparties to terminate all mutual obligations in case of default, calculating a single net payable or receivable amount. For instance, if a bank is owed ₹200 million in one derivative contract but owes ₹150 million in another, close-out netting allows the bank to settle only the ₹50 million difference, rather than handling each contract separately. Without this mechanism, counterparties could face excessive financial exposure during insolvency, especially if they are required to settle gross amounts, as they would have to pay out large sums on certain contracts while waiting to recover what is owed on others. The Bilateral Netting Act enabled ‘qualified financial market participants’ (QFMP) (i.e., financial institutions like banks, non-banking financial companies, insurance companies, pension funds, and entities regulated by International Financial Services Centre) to enforce netting rights, reducing systemic risk and arguably stabilising India’s financial markets.

Despite these improvements, the Bilateral Netting Act is limited in scope. Currently, it excludes non-financial entities, which are also significant participants in OTC derivatives markets. Corporates, for instance, often use derivatives for hedging purposes. The lack of legal protection for non-financial entities leaves them vulnerable to counterparty defaults. The central government, under Section 4(b), could expand QFMP to include such non-financial entities.

The broader issue lies in the IBC’s moratorium provision. When a company enters insolvency, the IBC imposes a moratorium that freezes all enforcement actions, including the right to close out and net derivative contracts. This means that, even under the Bilateral Netting Act, counterparties may not be able to enforce their netting rights if the debtor enters insolvency. Moreover, set-off rights, which are generally protected under the Indian Contract Act, 1872, also fall within the scope of the IBC moratorium, compounding the uncertainty for creditors (for instance, see Viswanathan Committee Report, 2015, section 6.4., Volume I). Without the ability to net, creditors are left to pursue claims through the general insolvency process, which is both time-consuming and fraught with uncertainty. The process often takes months, and creditors face the risk of significantly reduced recoveries, especially if the company enters liquidation. Netting would have provided immediate resolution by allowing parties to set off mutual claims at the outset.

In contrast, other jurisdictions have adopted more robust frameworks to ensure the enforceability of netting and set-off rights during insolvency. The Dodd-Frank Act in the United States, for instance, explicitly protects close-out netting rights in derivative contracts even during the insolvency of one counterparty. Title II of the Act allows the Federal Deposit Insurance Corporation (FDIC) to act as a resolution authority, ensuring that counterparties can terminate and net positions swiftly. This prevents prolonged financial exposure.

Similarly, the European Union employs the European Market Infrastructure Regulation (EMIR) and the Bank Recovery and Resolution Directive (BRRD) to govern OTC derivatives. These regulations prioritise creditor protections, allowing close-out netting during insolvency and cross-border recognition of netting rights. The UK, post-Brexit, continues to uphold similar standards through the Financial Services Act, 2021. These comparisons do not imply that India should adopt the exact frameworks regarding netting rights. Instead, it underscores the primacy of protecting closing-out netting rights, even amidst insolvency.  

Further, India's Bilateral Netting Act does not address cross-border transactions, which is a significant limitation given the global nature of derivative markets. International transactions often involve counterparties from multiple jurisdictions, where legal frameworks must align to allow for effective risk management. For instance, under the Dodd-Frank Act, the US recognises and enforces netting rights for cross-border derivatives contracts through agreements with other jurisdictions. This ensures that non-US entities can still enforce their netting rights even if insolvency occurs in the US.

India lacks similar cross-border enforceability mechanisms, leaving Indian parties at a disadvantage when engaging with foreign entities in derivative transactions. Without such agreements, Indian financial institutions are exposed to significant risks if a foreign counterparty enters insolvency. To rectify this, India should consider aligning with international conventions like the Hague Securities Convention or entering into bilateral agreements to ensure cross-border enforceability of netting and set-off rights. Aligning with the Hague Securities Convention would ensure enforceability of rights from financial instruments across jurisdictions (Article 3), maintain the validity of netting and set-off agreements during insolvency (Article 12), prioritises these rights over conflicting claims (Article 9), and protect against foreign counterparty insolvency (Article 12).

To further protect participants in the derivatives market, India should expand the Bilateral Netting Act to include non-financial entities. Corporations such as hedge funds, brokerage houses, and especially small and medium enterprises (SMEs) are major players in the derivatives market. For instance, consider a small-scale exporter relying on currency hedging against exchange rate fluctuations. After entering into multiple derivative contracts, its counterparty—a large multinational bank—goes bankrupt. Without netting rights, the exporter is left vulnerable, forced to pay out on contracts while awaiting recovery on others. This delay could jeopardise the SME’s survival, emphasising the need for legal protections similar to those granted to financial institutions. Non-financial entities remain exposed to counterparty defaults, potentially destabilising sectors. In an interconnected market, these defaults can have cascading effects on financial stability. Granting netting rights to a broader range of entities will mitigate credit risks and enhance market stability by reducing capital requirements for counterparties. However, such reform should include safeguards to ensure that expanding netting rights does not inadvertently increase systemic risk, particularly in the SME sector, which serves as the backbone of the economy.

In conclusion, the urgent need for reforms to safeguard netting rights during insolvency is clear. Amending section 14 of the IBC to exempt qualified financial contracts from the moratorium would empower creditors to swiftly terminate derivative contracts and evaluate net obligations. This is not just about aligning with global standards; it is about fostering a more resilient financial ecosystem. Furthermore, enhancing cross-border enforceability of netting rights will bolster Indian firms’ confidence in international markets.

Debarshi Chakraborty is an Advocate at the High Court of Delhi, India.