In today's Finshots, we talk about Bilateral Netting.

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The Story

In his best selling book, The Laws of Simplicity, John Maeda, a reputed designer and technologist makes a rather compelling case for simplicity.

On the one hand, you want a product or service to be easy to use; on the other hand you want it to do everything that a person might want it to do.

The process of reaching an ideal state of simplicity can be truly complex, so allow me to simplify it for you. The simplest way to achieve simplicity is through thoughtful reduction. When in doubt, just remove.

The argument here is that removing things could help you reach an ideal state that’s just simple enough but not simpler. And while Maeda’s arguments are restricted to products and services, you could apply the same principles to processes as well. Take for instance the recent bill on Bilateral Netting. The Finance Minister introduced the Bilateral Netting of Qualified Financial Contracts Bill, 2020 after arguing that its introduction would help big banks and other financial intermediaries to save costs and transact more efficiently. But at the heart of it all, the government is telling you that it wants to remove overheads that might actually be redundant. Let me explain.

An example with derivative contracts

“Lending” is risky business. When you loan money to big corporates there is always the threat of default. So it would be prudent to hedge your risks and limit your downside. Now banks may choose to pursue this agenda in many ways. The most popular way, however, is to find a counterparty (another bank) that can take some risk off of you. They could provide you with protection in the event that the borrower defaults for a small monetary consideration. It’s sort of like insurance, you know?

In banking parlance, they call it a Credit Default Swap. Anyway, once both parties sign the contract, they might have to set aside some money depending on the nature of the arrangement. The idea is to make sure you’ll always have enough money to honour your end of the bargain. Now imagine a few days later, the counterparty walks up to you and asks you if you’re interested in providing them protection i.e. helping them limit their downside on a completely different transaction. Now if you see money making potential here, you might choose to take up the offer. And by law, both of you will be mandated to set aside money once again in lieu of this new contract.

So technically there are two parallel streams of cashflows going in and out of your bank considering you are engaging in two different transactions. But what if you could simply net the two? You know how much is expected to come in. You know how much is expected to go out. So you compare the two transactions and see who has to make a net payment. This eliminates a lot of overhead. More importantly, remember how we talked about both parties having to set aside money each time they sign off on a contract. Without bilateral netting, you’ll be forced to do this exercise each time you enter into such agreements. And as the contracts add up, both of you will have to set aside increasing amounts of money. However, if you net all transactions, you can see how much you owe each other and set aside funds based on the final net consideration.

The ultimate outcome is that you’ll have a lot of extra cash lying around that you could potentially put to good use. According to RBI estimates, bilateral netting would have freed up close to ₹2000 crores, back in 2017–2018 if the 31 banks in the sample survey had implemented it. So in all likelihood, this should lubricate the cogs within the financial ecosystem a bit.

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Also don't forget to check our daily brief. In today's issue we talk about the government's decision regarding 'interest on interest', the future of multiplex theatres and Changi Airport's future outlook. Do read the full draft here.

Until then…