Opinion of the European Central Bank of 7 January 2021 on the enforcement of close-out netting agreements (CON/2021/1)

OPINION OF THE EUROPEAN CENTRAL BANK of 7 January 2021 on the enforcement of close-out netting agreements (CON/2021/1) Introduction and legal basis

On 17 November 2020 the European Central Bank (ECB) received a request from the Ministry of Finance of the Republic of Latvia for an opinion on a draft law on the enforcement of close-out netting in qualified financial transactions and on draft laws containing related amendments to the Law on credit institutions and to the Law on insolvency (the ‘draft laws’). The ECB’s competence to deliver an opinion is based on Articles 127(4) and 282(5) of the Treaty on the Functioning of the European Union and the third and sixth indents of Article 2(1) of Council Decision 98/415/EC , as the draft laws concern Latvijas Banka, rules applicable to financial institutions insofar as they materially influence the stability of financial institutions and markets and the specific tasks conferred on the ECB concerning the prudential supervision of credit institutions pursuant to Article 127(6) of the Treaty. In accordance with the first sentence of Article 17.5 of the Rules of Procedure of the European Central Bank, the Governing Council has adopted this opinion.

1. Purpose of the draft laws

1.1 The purpose of the draft laws is threefold: first, to ensure financial market stability by limiting systemic risk that might be caused by legal protection, insolvency or winding-up proceedings against a financial market participant; second, to protect the parties to a close-out netting agreement in the event that legal protection, insolvency or winding-up proceedings are carried out in relation to any of the parties; and third, to contribute to the development of the financial instruments market in Latvia, consolidating Latvia’s position as a regional hub for financial services. 1.2 As set out in the explanatory memorandum to the draft laws, at present close-out netting in Latvia is applicable only to transactions where both counterparties are regulated credit institutions or other financial market participants or public entities, pursuant to the transposition of the relevant provisions of Directive 98/26/EC of the European Parliament and of the Council , Directive 2002/47/EC of the European Parliament and of the Council and of Directive 2001/24/EC of the European Parliament

and of the Council . The draft laws establish a legal framework governing close-out netting applicable to derivative and spot transactions with regard to currency, securities and commodities where one of the contractual parties, although not a regulated financial market participant, falls within a list of eligible entities, as described in paragraph 1.4. Latvia is one of the last Union jurisdictions in which the enforcement of close-out netting transactions with unregulated entities has not yet been implemented. The lack of relevant legislation subjects the financial sector in Latvia to a greater domino effect when a financial crisis arises. This lack of legislation also hinders Latvian financial market participants and large enterprises in attracting cheaper financing in situations where the other counterparty is from a jurisdiction in which such legislation exists, because the lack of close-out netting is a risk that is included in the price of any financial instrument. Introducing such legislation will reduce the costs of complying with capital adequacy requirements for Latvian credit institutions and financial market participants, as it will allow them to hold less capital relative to their risk-weighted assets. 1.3 The draft laws aim to ensure the enforceability of close-out netting in qualified financial transactions . Finanšu un kapitāla tirgus komisija (FKTK, the Latvian Financial and Capital Market Commission) may issue regulations to designate any other type of transaction, in addition to those specified by the draft laws, as qualified financial transactions. For the purpose of the draft laws, an agreement is deemed to be a close-out netting agreement notwithstanding the fact that such agreement may contain provisions relating to transactions that are not qualified financial transactions, provided, however, that such agreement is deemed to be a close-out netting agreement only with respect to the qualified financial transactions. 1.4 The draft laws regulate the enforcement of close-out netting where the parties to the close-out netting agreement fall into one of the following three categories: first, where both parties to the close-out netting agreement are Latvian or foreign State authorities, Latvijas Banka, the ECB, central banks of other States, the Bank for International Settlements (BIS), the International Monetary Fund (IMF), specified multilateral development banks, or credit institutions, a wide range of financial market

participants and central counterparties regulated by Latvia or other Union, European Economic Area (EEA) or Organisation for Economic Co-operation and Development (OECD) member states; second, where one of the parties is one of the aforementioned entities and the other party is a legal entity or private individual who is not a consumer ; and third, where both parties are legal entities which, at the moment of entering into the close-out netting agreement, meet two of the following size requirements: (1) a total balance sheet of EUR 40 million, (2) a net turnover of EUR 50 million and (3) 250 employees. 1.5 The scope of the draft laws is limited in a number of respects. First, the draft laws clarify that legal relationships concerning financial collateral are regulated by the Law on financial collateral. Second, the draft laws do not apply to systems operated by Latvijas Banka or which the FKTK has notified to the European Securities and Markets Authority (ESMA) under the Law on settlement finality in payment and financial instruments settlement systems, or to participants in such systems, or to collateral provided to participate in such systems. Third, the draft laws do not apply to collateral used by central banks in transactions related to the performance of their central bank functions. 1.6 The draft laws clarify that close-out netting can be enforced and is not affected by legal protection, insolvency or the winding-up of any of the parties, which includes any related statutory provisions, such as those on relationships with creditors, the management or retention of funds or any other steps taken in insolvency. After enforcement of close-out netting, the only obligation or claim of either party will be equal to its net obligation to or claim on the other party as determined in accordance with the terms of the close-out netting agreement. To ensure the enforceability of close-out netting, the draft laws eliminate the powers of the administrator in insolvency proceedings to unilaterally terminate a close-out netting contract concluded in the six months prior to the opening of proceedings under the Law on insolvency with regard to a company insolvency and under the Law on credit institutions with regard to the insolvency of a credit institution. The legal effect of the provisions of a close-out netting agreement are not affected by the limitations of set-off, discharge of claims and liabilities or equivalent limitations provided under the Law on insolvency or the Law on credit institutions. Close-out netting may not be declared invalid or cancelled merely because it has taken place before the commencement of the relevant winding-up or insolvency proceedings. Close-out netting is valid and binding vis-à-vis third parties. 1.7 According to the explanatory memorandum, the issue of potentially fraudulent transactions prior to an insolvency has been carefully analysed and the outcome is to presume that certain specified eligible entities, such as Latvian or foreign State authorities, Latvijas Banka, the ECB, central banks of other States, the BIS, the IMF, specified multilateral development banks, or credit institutions, a wide range of financial market participants and central counterparties regulated by Latvia or other Union, EEA or OECD member states, are reasonably reliable counterparties which are highly unlikely to enter into fraudulent transactions.

1.8 Finally, the draft laws implement Article 7(6) of Directive (EU) 2019/1023 of the European Parliament and of the Council , which states that Member States may provide that a suspension of individual enforcement measures in preventive restructuring does not apply to netting mechanisms, including close-out netting mechanisms, in financial markets, energy markets and commodity markets.

2. Observations

2.1 The ECB notes that the purpose of the draft laws is to provide a legal framework governing closeout netting applicable to derivative and spot transactions with regard to currency, securities and commodities where one of the contractual parties is not a regulated financial market participant. Such legal standardisation is an important element of facilitating organised platform trading and central clearing in line with the 2009 Pittsburgh G20 commitments to reform over-the-counter (OTC) derivatives markets . Further, legal certainty regarding close-out netting is an important element for reducing counterparty credit risk and to ensure the adequacy of the amount of any collateral exchanged . As such, the enforceability of close-out netting is an important element for the risk management of firms and a prerequisite for the development of safe and sound OTC derivatives markets as well as covered spot transaction markets. 2.2 The adoption of the draft laws could have practical implications for Latvian credit institutions as well as for other credit institutions dealing with Latvian counterparties. In particular, close-out netting is an important risk mitigation tool for credit institutions which allows for effective reduction of counterparty credit risk, and thus contributes to sound risk management practices of credit institutions. Due to the broader application of close-out netting provided for in the draft laws, meaning that it will also apply to transactions where one of the contractual parties is not a regulated financial market participant, provided that the party falls within the list of eligible entities, the draft laws may contribute to credit institutions dealing with Latvian counterparties meeting the conditions for contractual netting arrangements to be recognised as an eligible form of credit risk mitigation and risk reduction under Regulation (EU) No 575/2013 of the European Parliament and the Council . 2.3 With regard to operations conducted by Latvijas Banka or the ECB with Latvian credit institutions, the draft laws should enhance the enforcement of close-out netting arrangements that central banks have with such counterparties arising out of financial transactions that are not based on collateral arrangements, e.g. foreign exchange swap transactions. In this respect, the precise interaction between the enforcement of close-out netting provisions contained in financial collateral arrangements under the Law on financial collateral, the enforcement of collateral used by central

banks in transactions related to the performance of their central bank functions under the Law on settlement finality in payment and financial instruments settlement systems, and the enforcement of close-out netting provisions contained in qualified financial transactions subject to the draft laws could be more clearly articulated. The draft laws provide that legal relationships related to financial collateral are regulated by the Law on financial collateral, that the draft laws do not apply to collateral used by central banks in transactions related to the performance of their central bank functions, and that an agreement is deemed to be a close-out netting agreement notwithstanding the fact that such agreement may contain provisions relating to transactions that are not qualified financial transactions, provided, however, that such agreement is deemed a close-out netting agreement only with respect to qualified financial transactions. The ECB understands that it is intended that closeout netting provisions contained in a single agreement covering both collateral arrangements and qualified financial transactions not having a collateral element are intended to be enforceable. An explicit clarification of this understanding would be welcomed, for the sake of legal certainty. 2.4 Finally, as regards the clarification that the draft laws do not apply to participants in systems operated by Latvijas Banka or which the FKTK has notified to ESMA under the Law on settlement finality in payment and financial instruments settlement systems, legal certainty could be further enhanced by explicitly clarifying, for the avoidance of doubt, that participants in such systems are exempt from the draft laws only regarding their actions, rights and obligations arising in connection with such systems.

This opinion will be published on EUR-Lex.

Done at Frankfurt am Main, 7 January 2021.

[signed]

The President of the ECB

Christine LAGARDE