Principles to further reduce counterparty risk in Close-Out Netting agreements under way

From 1 to 5 October, the International Institute for the Unification of Private Law (Unidroit) met to consider draft Principles on Close-Out Netting, a tool that South African institutions use to reduce exposures to the insolvency of a counterparty.

 

About 40 countries, including South Africa, do allow Close-Out Netting. However, it is done on different terms. This makes agreements complicated when parties sit in different jurisdictions with different laws and rules, increasing the risks associated to such agreements. As such, Unidroit has set up meetings with the aim to finalise the Principles, which will provide guidelines to legislators on how to amend national insolvency and Close-Out Netting laws so as to be compatible with each other.

 

Close-Out Netting Agreements

Financial institutions frequently use collateral to reduce their exposure to counterparty risks. However, they also have the option to use Close-Out Netting agreements, which allows a party to terminate all outstanding contracts between itself and the insolvent party, calculate the losses and gains on each contract and then offset them so that only a balance is owing.

 

According to Unidroit, the doubt as to the enforceability of Close-Out Netting agreements in a cross-jurisdictional context has negative repercussions on the risk assessment of financial institutions. “If a Close-Out Netting agreement were to be held to be unenforceable by a court, the other party might face severe financial losses and fall insolvent itself. If the same type of Close-Out Netting agreement is used in a wider market, such effects can even become systemic,” its report states.

 

The International Institute for the Unification of Private Law

Established in 1926 as an independent intergovernmental organisation, Unidroit studies private and commercial law and prepares uniform law instruments, principles and rules for the needs of different States and groups of States so that it can modernise and co-ordinate the laws to find harmony between the legislation of different territories.

 

As a member country, South Africa endorses various Principles set by Unidroit. It is to be expected that the country may adopt the Principles once they are finalised. Adopting the Close-Out Netting Principles is especially important considering the concerns globally of the stability in international markets. The over-reported stories of the financial crisis may have become stale, yet the reality is the financial sector is still suffering the consequences over four years later and markets continue their volatile journey of recovery. As such, Unidroit says that regulatory authorities (most recently, the Financial Stability Board and the Cross-border Bank Resolution Group of the Basel Committee on Banking Supervision) “strongly encourage the use of close-out netting arrangements (alongside collateral) because of their beneficial effects on the stability of the financial system. As these techniques are capable of reducing counterparty risk, both collateral and close-out netting are also taken into account to determine a financial institution’s capital ratio under the Basel II and III Accords.”

 

Committee of Governmental Experts to finalise Close-Netting draft

Following a number of study groups made up of legal experts in financial markets, Unidroit has endorsed the proposal of the Secretariat to convene a Committee of governmental experts for further consideration and finalisation of the Close-Netting draft Principles for adoption by the Governing Council. It plans to meet in March 2013 following its first session of the Committee of governmental experts that took place in the first week of October 2012 in Rome, Italy.

 

Dr Maria Vermaas, who is the head of the legal and regulatory division of Strate, serves as vice chairperson and a member of the drafting committee on the Unidroit convention on intermediated securities and was appointed the chairperson of a Unidroit Committee of Governmental Experts to consider the draft Principles on Close-Out Netting.

 

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