Indonesia readies close-out netting after passing P2SK Law

Indonesia’s new omnibus law, introduced to regulate the financial sector, may pave the way for legal clarity on the enforceability of close-out netting for derivatives transactions in the country.

The Financial Sector Omnibus Law, or ‘P2SK Law’, enacted on January 12, is a sweeping reform that amends 17 laws in Indonesia’s financial sector, including those on banking, capital markets, insurance, futures trading and bankruptcy proceedings. Once regulators implement new rules reflecting the changes made to its bankruptcy law – and clarify rules around bank resolution – the International Swaps and Derivatives Association may be able to recognise Asia’s fourth largest economy as a jurisdiction in which close-out netting can be applied.

The country’s Financial Services Authority (OJK) and Bank Indonesia will have up to two years to implement the provisions within the legislation, says Arie Armand, partner at Armand Yapsunto Muharamsyah & Partners in Jakarta, a law firm advising Isda.

Close-out netting allows banks to collapse multiple exposures to a defaulting counterparty into a single net payment. By doing so, they can free up large amounts of regulatory capital on account of being able to measure their credit risk exposures on a net basis instead of a gross basis.

It’s the classic cherry-picking rights of the receiver. They can basically pick and choose whether they want to terminate or continue the contract

Arie Armand, Armand Yapsunto Muharamsyah & Partners

Indonesia is just the latest country in Asia to pass legislation addressing close-out netting in recent years. India’s Bilateral Netting of Qualified Financial Contracts Act came into force in October 2020, leading Isda to issue a revised opinion declaring India to be an effective netting jurisdiction. Meanwhile, China’s Futures and Derivatives law took effect on August 1, 2022, and Isda published an opinion recognising the enforceability of close-out netting in China on the same day.

In Indonesia, the implementation of close-out netting regulations after changes to bankruptcy law has been a strategic goal of the country’s central bank, Bank Indonesia, for over a decade. The issue was first highlighted as a policy objective of the bank in a 2010 strategy document titled ‘Indonesia’s National Strategy for Financial Development 2018–2024’.

In 2020, Bank Indonesia renewed its focus on close-out netting enforceability and was participating in a cross-agency working group discussing required changes to bankruptcy law.

According to the Bank for International Settlements’ (BIS) 2022 triennial survey, almost $5.5 billion of over-the-counter FX instruments – accounting for 97% of all OTC trades – are traded per-day.

Legislative fix

Armand says two articles had prevented the recognition of close-out netting within Indonesia’s former law governing bankruptcy proceedings.

Article 51, for instance, previously included several provisions pertaining to the set-off rights of creditors. Set-off is similar to close-out netting, as it allows a settlement of mutual debt between a creditor and a debtor through offsetting transaction claims. In scenarios where set-off is applied, Article 51 stipulated that the receiver has the right to examine any offsets that are executed to ensure they are not detrimental to the bankruptcy estate, and financial contracts are not excluded.

Another problem was the provisions under Article 36 of Indonesia’s bankruptcy law. This is because it allowed the insolvency administrator to cherry pick transactions favourable to the bankrupt firm and reject other contracts deemed burdensome.

“It’s the classic cherry-picking rights of the receiver,” says Armand. “They can basically pick and choose whether they want to terminate or continue the contract. And if it is detrimental to the bankruptcy estate, they can terminate the contract and the other party has to claim for losses and stand in line together with all the other creditors.”

The P2SK Law directly addresses the impediments to close-out netting enforceability under Articles 51 and 36, says Armand. It applies to contracts for FX, interest rate, equity and credit derivatives. However, commodity derivatives are not covered under the provisions of the legislation.

“The new law allows for one termination of financial contracts that have been agreed by the party under a master agreement,” he says. “They can terminate the contracts both before or after declaration of bankruptcy, and the receiver and the bankruptcy court cannot allow the terminations based on the closed-out contracts and the right of set-off is no longer available for the receiver.”

However, the P2SK law does not clear every impediment to the close-out netting of derivatives transactions, only those that could arise in bankruptcy proceedings. Bank resolution, says Armand, is another area of uncertainty which the P2SK law does not address.

In the bank resolution process, the Lembaga Penjamin Simpanan (LPS) – a deposit insurance corporation equivalent to the US’s FDIC – can step in and amend or terminate contracts based on their view of whether the contracts are detrimental to the failing bank.

“But there are already discussions between the Indonesian regulators to fix that,” says Armand. The LPS is a self-regulatory organization, so it can issue its own regulations, “which can basically clarify their position with respect to financial contracts. But it’s still being discussed, nothing has been issued or formalised as yet”.

Armand cautions that the industry will have to wait to see how the legislative changes are formalised through the implementing regulations for certainty that the close-out netting can be enforced.

“We will have to wait to see the mechanics – whether they have a minimum threshold in terms of value that determines who can benefit from it, whether it applies to only financial institutions or also to non-financial institutions. We will have to see the detail of the regulations that are passed by the regulators.”

Jing Gu, Isda’s head of legal, Asia Pacific, says that Isda has been working with authorities across the region, including in Indonesia, to explain the benefits of close-out netting.

“By allowing counterparties to reduce their obligations to a single net payment, close-out netting significantly reduces credit risk in the event of a default. It also creates greater efficiencies for market participants, deepening liquidity and increasing credit capacity. This helps to create robust local derivatives markets, enabling effective risk management and supporting economic growth.”

“We welcome the passage of the Financial Sector Omnibus Law, which marks a positive step toward the recognition of netting enforceability,” Gu adds. “We are in the process of assessing the changes introduced by the law and the impact on ISDA’s Indonesian netting and collateral opinions.”