The Financial Services Authority has asked the Bank of England's Financial Markets Law Committee to review what impact an Australian court ruling could have on regulatory capital netting in the U.K. The court ruling calls into question the theory behind netting transactions, because it leaves the door open for a non-defaulting counterparty walk away from its liabilities. Australia and the U.K. have a similar legal system.
Gary Walker, partner at Field Fisher Waterhouse in London, said: "The commercial result is irreconcilable with certain fundamental principles relating to regulatory capital netting and fair value accounting." Robert McWilliam, head of counterparty exposure management at ABN AMRO in London and co-chair of the International Swaps and Derivatives Association's collateral committee, said, "Netting is the bedrock of risk management."
Banks are allowed to allocate regulatory capital in respect to net derivatives exposure on the basis that if a counterparty defaults the exposures are matched off against each other and only the outstanding balance is settled. The FSA rules do not allow netting when the documents include a so-called walkaway clause in the case of default. The 1992 ISDA master agreement made the walkaway clause an option, which most participants opted out of, and the 2002 agreement got rid of it altogether to allow netting agreements. The result of the Enron Australia/TXU Electricity case in Australia, however, shows that other aspects of the documents, such as the right of the non-defaulting party to stop making payments to the defaulted party and chooses whether to terminate the trade, reintroduces this clause via the back door, according to Walker.
The court ruling is also a major blow for the troubled International Accounting Standard 39, noted Walker. This is because in the case of default, profits from in-the-money trades may not be able to be realized.
Walker said the simplest way of ensuring the documents work as they are intended for netting purposes is to include a pre-trading amendment, which says that the trade will terminate a certain number of days after one of the parties defaults.
Lord Browne-Wilkinson, chairman of the Bank of England's Financial Markets Law Committee, told DW that it is in the process of setting up a preliminary working group, which will report its findings to the FMLC in September. The committee will then decide whether to undertake a full review.
