Net Benefits

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Cheuk-Yin Cheung, Net Benefits, 37 INT'l FIN. L. REV. 26 (2018).

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Cheuk-Yin Cheung, Net Benefits, 37 Int'l Fin. L. Rev. 26 (2018).

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Cheung, C. (2018). Net benefits. International Financial Law Review, 37(1), 26-31.

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Cheuk-Yin Cheung, "Net Benefits," International Financial Law Review 37, no. 1
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Cheuk-Yin Cheung, "Net Benefits" (2018) 37:1 Int'l Fin L Rev 26.

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Cheung, Cheuk-Yin. "Net Benefits." International Financial Law Review, vol. 37, no.
1, February 2018, pp. 26-31. HeinOnline.

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Cheuk-Yin Cheung, 'Net Benefits' (2018) 37 Int'l Fin L Rev 26
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NETTING

Net benefits
The legal recognition of close-out netting provisions in financial contracts is
increasingly significant to parties in the UAE as the region advances
implementation of Basel III principles

lose-out netting is one of the primary means of mitigating


credit risks associated with over-the-counter (OTC)
derivatives trading between two counterparties. Close-out
netting provisions are typically incorporated into a master-level
ragreement (a Master Agreement) regulating all the relevant individual
transactions between the two parties and providing for a single net
Close-out netting isa key tool amount to be payable between the parties in the event of a close-out.
in mitigating credit risks for A close-out netting process involves three steps:
OTC derivatives trading. Termination - where the non-defaulting party calls an end to all
Regulators are increasingly the transactions covered by the relevant Master Agreement;
discouraging of OTC trades Valuation - where the value of the unperformed obligations under
with counterpartes in non- the outstanding transactions nder the Master Agreement is
netting jurisdictions through determined; and
uncleared margin rules under . Determination of net balance - where the values owed to the non-
the G20 OTC reforms. defaulting party and the values owed to the defaulting party are
In the UAE, despite the aggregated and netted against each other to determine a single close-
existence of recognised out amount owed by one party to the other.
netting laws in the financial Close-out netting therefore has the potential to limit exposure
free zones (FFZs), these don't which one party has in the insolvency of its counrerparry by enabling
cover counterparties that are the valtue of what the first party owes to the insolvent counterparty to
incorporated outside of the be used in reducing the value of what the insolvent counterparty owes
FFZs. The effects of netting to the first party (see figure 1 for an illustration).
recognition have an For close-out netting to be valuable as a credit risk mitigation tool
increasing significance for in this way, it needs to be enforceable in the insolvency of the
UAE counterparties through counterparty (a concept generally referred to as positive netting or, in
drivers such as the the case of the laws of the counterpartys jurisdiction, a netting
implementation of Basel III jurisdiction).
which confers regulatory Further, financial institutions will typically use the post-insolvency
capital relief for positive exposure as the measure to set its counterparty credit limits meaning
netting OTC trades, and that, if a counterparty is in a jurisdiction where its insolvency laws
cross-border OTC trades with recognise netting, then that credit limit is calculated on the assumption
swap dealers who need to of a net exposure. However, if a counrerparty is in a jurisdiction where
comply with uncleared margin its insolvency laws may nor recognise netting, then the credit limit is,
rulesn and may be required by that financial institutions regulator to be,
calculated on the assumption of gross exposures.

FEBRUARY 2018 1 FLR.COM 126


261 IFLR.COM IFEBRUARY 2018
NETTING

discouraging of OTC trades with the Abu Dhabi Global Market (ADGM).
counterparies in non-netting jurisdictions, Both the DIFC and the ADGM have passed
particularly following the implementation of laws which closely follow the ISDA 2006
A thriving financial services sector requires uncleared margin rules. Model Netting Act to specifically recognise
legal certainty on close-out netting following the enforceability of netting agreements,
counterparty insolvency. close-out netting and related collateral
There has been much work done at arrangements.
international level to prescribe standards and There are industry-level netting opinions
recommendations for national legislators and
published by ISDA for its members in respect
regulators in order to achieve cross-border In jurisdictions which are generally considered of these financial free zone jurisdictions.
harmonisation of financial markets legislation, to be netting jurisdictions, close-out netting
for example: is usually supported by other domestic
* the Unidroit Principles on the Operation legislation such as insolvency laws and laws on Federal Law on Bankruptcy
of Close-out Netting Principles; collateral arrangements. Set out in Figure 2 is
* the recommendations under the Uncitral an illustration of the legal framework to The UAE enacted a new law on bankruptcy
Insolvency Legislative Guide; and support a positive netting analysis, as well as which came into effect in December 2016
* the Financial Stability Board's Key how this impacts the relationship of the (the UAE Bankruptcy Law) that expanded
Attributes of Effective Resolution Regimes market participants in that jurisdiction with and modernised aspects of the available
for Financial Institutions. wider international standards in the context insolvency procedures such as the protective
At the industry level, trade associations of financial transactions. composition procedure and also provided for
such as the International Swaps and a balance sheet test element to the insolvency
Derivatives Association (ISDA) and the test.
However, the UAE Bankruptcy Law does
not cover governmental bodies, commercial
C os- out nettlnis usuly supported by banks, insurance companies and those

ater dornestuce sation suhas inolvency companies incorporated within free zones that
have their own comprehensive insolvency laws

daw swon co te an e ets that provide for composition, restructuring or


bankruptcy procedures (such as the DIFC and
the ADGM). UAE established entities that are
wholly or partially owned by local or federal
International Capital Markets Association
government, and are not incorporated
(ICMA) are playing a significant role in pursuant to the UAE Commercial Companies
facilitating the recognition of close-out Law are only covered by the UAE Bankruptcy
netting, for example: The UAE has already taken a number of Law if they had opted to be under their
* ISDA's 2006 Model Netting Act and policy-driven steps to create an environment constitutional documents.
explanatory guide for legislators, which conducive to the development of a financial Similar to the previous bankruptcy
include the fundamental principles for services sector within its geographical legislation, the Bankruptcy Law envisages a
enforceable netting and related collateral territory. form of statutory insolvency set-off as
arrangements; and commonly found in most civil law systems
* the publication of netting opinions by which:
ISDA and the ICMA on jurisdictions Financial free zones: DIFC and * allows set-off between a creditor and
which are commonly considered to be ADGM debtor if it had been contractually agreed
positive netting for reliance by their between the parties prior to insolvency, but
respective members. There are two financial free zones already not in respect of debts which arise after the
Under the G20 OTC reforms, established in the UAE: the Dubai commencement of an insolvency
international legislators are increasingly International Financial Centre (DIFC) and procedure; and
* provides for a creditor to submit a claim
for the post set-off amount against the
insolvent party's estate or, if the creditor
owes the insolvent party the post set-off
sum, then the creditor would pay this sum
to the insolvency estate.
In the absence of further clarity on the
nature of the sums which can be used as part
of this statutory insolvency set-off under the
UAE Bankruptcy Law, the UAE Civil Code
provisions governing mandatory set-off also
remain relevant to a legal analysis on post-

FEBRUARY 2018 1 IFLR.COM 1 27


NETTING

Figure 2 The framework for netting: the legal elements transactions, with the effect that the
creditor has to pay the gross amount of all
or some of the 'in the money' transactions
Domestic laws
to the insolvency estate, whilst filing a
claim separately for the claims under the
out of the money transactions.
Valuation of close-out transactions: as
mentioned above, the valuation of close-
Reduced regulatory
out amounts includes ascribing values to
capital costs for
counterparty exposures amounts which may not yet have become
due (for example, on unperformed
obligations) such as those in international
Credit risk
rrmtigation on net template Master Agreements, which may
exposures otherwise be subject to challenge by a
UAE insolvency officer.
The provisions of netting-specific
MM
legislation such as those in the ISDA 2006
Model Netting Act would provide
considerable clarity to these issues.

Federal Law on the Mortgage of


Domestic laws Moveable Property

insolvency set-off, namely that: netting analysis because there remain other The UAE recently enacted a new law on
'each of the parties must be both the obligor factors under which a lump sum close-out creating security over a new set of asset classes,
and the obligee of the other and the obligations amount can be undermined under UAE laws. including registration and enforcement
must be of the same type and description, must For example: procedures, which came into effect on March
be equally due and must be ofequal strength or Termination of contract: the first step to 15 2017 (the UAE Mortgage of Moveable
weakness'. effecting close-out netting is to terminate Property Law).
The key difference between close-out all outstanding transactions, which are Until that law was enacted, UAE laws on
netting and set-off is that close-out netting often contrary to the statutory creating security (other than over real estate)
could take place across a number of requirement for contracts to continue focused almost exclusively on possessory
transactions, regardless of when payments during a period of moratorium. Whereas pledges, thus creating difficulties with security
would otherwise have become due (in other the UAE Bankruptcy Law includes a over future property and fluctuating balances
words, values are calculated on unperformed carve-out to allow terminations required of secured assets.
In the context of collateral arrangements
used in conjunction with Master Agreements
that are reliant on close-out netting, the most
welcome developments in the UAE Mortgage
co bned wit ier prov ion do not of Moveable Property Law are:
* the recognition of cash collateral (by way
one provid eufint spotora of security) in bank accounts, provided
that such security is registered on the
register of security;
* the recognition of self-help remedies,
obligations such as future swap payments or to effect statutory insolvency set-off for provided that the realisation of the secured
deliveries under outstanding swap protective composition, an equivalent is property is provided for under the terms
transactions, which become part of the sums not expressly provided for all insolvency of the security agreement; and
procedures envisaged under the UAE * statutory timeframes for bringing court
being applied as part of close-out netting).
In the absence of any UAE legislation Bankruptcy Law. action for challenging the enforcement of
providing specific recognition of close-out Cherry-picking: in all of the three security.
netting, statutory insolvency set-off can - in procedures available under the UAE There remains some uncertainty over
some respects - go part of the way to enable a Bankruptcy Law, the insolvent party's whether security over dematerialised securities
similar effect to close-out netting upon officer has powers to review the sums (such as listed equities and bonds/sukuk) are
counterparty insolvency. However, insolvency which are submitted as claims on the covered under the UAE Mortgage of
set-off provisions, unless combined with insolvent estate. This power would make Moveable Property Law. The statutory
further provisions, do not alone provide it possible for lump sum close-out timeframes for court action are also some way
sufficient support for a conclusive positive amounts to be picked apart across multiple beyond the two days required under most

281 IFLR.COM FEBRUARY 2018


NETTING

international regulatory capital regimes to law for the UAE should also clarify that:
claim a more favourable regulatory capital * Any transactions under a netting
treatment. However, the move towards a more agreement will not be characterised as
modern legal framework for security taking is gambling or wagering, whether under civil There are macro-economic factors from global
significant progress in providing better legal laws or penal laws. and domestic financial markets which have
certainty on security interest over cash * Any collateral arrangements used in perhaps accelerated federal-level awareness by
collateral arrangements. connection with a netting agreement UAE financial services regulators of the
should be exempt from: (i) provisions of necessity of netting recognition.
the UAE Mortgage of Moveable Property The benefits of being a positive netting
Draft federal Law regarding Law which contemplate court procedures jurisdiction might be most simply understood
netting for enforcement of security over collateral through the cost implications for UAE
assets that are otherwise covered under the counterparties in the absence of positive
Following the enactment by the DIFC of the UAE Mortgage of Moveable Property netting recognition.
Netting Law, there has been a draft of a UAE Law; and (ii) any requirement to enforce
federal-level netting law based on the DIFC through a court order, in the case of
Netting Law which has been under review by collateral arrangements involving
a number of UAE governmental stakeholders. securities.
A UAE federal netting law would * Netting under a netting agreement is
significantly progress international enforceable notwithstanding that the
recognition of the UAE as a positive netting (UAE) counterparty is under an insolvency
jurisdiction, which will benefit not just UAE proceeding other than through the UAE
financial institutions, but also UAE corporates Bankruptcy Law.
and clearing houses (CCPs). * The parties' choice of governing law of the
For the co-existence of netting legislation netting agreement is enforceable.
with other UAE laws, a federal-level netting

FEBRUARY 2018 IFLR.COM 29


NETTING

Impacted Potentially impacted


Since 2013-2014, a number of UAE The added costs of back-to-back
financial institutions have incorporated hedging on the international OTC
wholly-owned special purpose markets through the UAE hedge
vehicles (swapco SPVs) in a positive providers' swapco SPV might, over
netting jurisdiction in order to trade time, have an impact on the pricing of
OTC derivatives contracts and spreads on hedges to domestic
repurchase transactions with corporates.
international swap dealers. The
swapco SPV's obligations are then
guaranteed by its parent company.

Although the incorporation and annual


corporate registration costs are
minimal, the main costs to a UAE
financial institution are:
* running two parallel swap books
between itself and its Swapco SPV;
* absorbing any basis risks which
might arise from the two swap books;
and
* uncertain regulatory capital of the
parent company's OTC derivatives
exposures under the UAE Central
Bank's regulatory capital rules.

301 IFLR.COM I FEBRUARY 2018


NETTING

Fostering greater awareness of the benefits of


achieving recognition of positive netting for
the UAE is needed, particularly in light of the
demand driven by the wider G20 global
financial market reforms. Further
development of laws and regulations to
provide certainty on netting enforceability is
needed so that the UAE can continue on its
trajectory to become one of the world's
leading Financial hubs.

Head of financial products


-

Middle East (Dubai)


Clifford Chance

FEBRUARY 2018 IFLR.COM 1 31

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