The net effect

Netting arrangements were previously prohibited in Malaysia. However, the Netting of Financial Agreements Act 2015 currently provides legal certainty to the enforceability of a close-out netting mechanism under the Malaysian law.

Close-out netting is an important risk management tool used by financial institutions and financial market participants to reduce risk exposure should there be a counterparty default for bilateral financial transactions entered into.

The netting provision The close-out netting mechanism is now embedded in financial contracts, in what is known as a ‘netting provision’.

A netting provision, as defined by the Act, is a provision in a qualified financial agreement¹ which provides that, upon the occurrence of the events specified by the parties in the agreement (eg, by default or insolvency of a counterparty), all obligations owed by one party to another party under a qualified transaction are reduced to, or replaced with, a single net amount in accordance with the qualified financial agreement.

The close-out netting mechanism essentially allows all transactions, upon the trigger of events specified by the parties in the agreement, to terminate the transactions, determine the value for each transaction and the sum value to be aggregated to come to a single net amount payable by one party to another, instead of the gross amount for each individual transaction under the financial contract.

Period of stay Although close-out netting is a good risk management mechanism, exercising the close-out netting against a troubled financial institution may result in challenges, thus a brief deferral on the close-out netting mechanism is needed in order to afford time to the relevant authorities to decide whether and how to resolve such institution. In such cases, the Act gives power to the Minister of Finance to impose a period of stay on the rights of the close-out netting under the Act for the purposes of the provisions specified in Part II of the Schedule, namely, subsections 115(3) and 180(1) of the Malaysia Deposit Insurance Corporation Act 2011; subsection 209(2) of the Financial Services Act 2013; subsection 220(2) of the Islamic Financial Services Act 2013; and section 41 of the Pengurusan Danaharta Nasional Berhad Act 1998.

Importance and benefits Close-out netting allows parties in the financial market to perform financial transactions with reduced exposure to credit and market risks as well as confining counterparty credit risk to a single net amount payable, instead of on a gross basis upon termination of transactions.

It also reduces the cost of conducting business and effecting transactions in Malaysia, since lower capital may now be set aside to meet regulatory requirements which will then lower the cost of transactions, effectively enabling financial institutions to undertake more transactions, trade in financial instruments more efficiently, and develop the capacity to provide new and innovative financial products to consumers. This will also enable banks to deal more competitively with foreign counter parties worldwide, consequently improving the efficiency of financial markets.

Legal impediments Despite all efforts to ensure legal certainty on the enforceability of the Act, there are several impediments to close-out netting, and these are found in section 29A² and section 41³ of the Pengurusan Danaharta Nasional Berhad Act 1998, and section 346C⁴ of the Capital Markets and Services Act 2007.

Conclusion It is hoped that the recognition of Malaysia as a netting-friendly jurisdiction would give confidence to international financial institutions to deal with Malaysian financial institutions, thus facilitating further development and competition in the local financial markets.