In recent years, the Kingdom of Saudi Arabia (the Kingdom) has increasingly sought to position itself as a Middle Eastern jurisdiction that is open for global business. Key to this is establishing robust, competitive and liquid domestic banking and financial markets. However, the lack of legal certainty surrounding key financial markets infrastructure has been a limiting factor for the development of the over-the-counter derivatives, repurchase arrangements, and stock lending arrangements markets in the Kingdom.
This situation is now changing. The Saudi Central Bank (SAMA) has issued netting legislation (SAMA Netting Regulations),See Close-out Netting and related Financial Collateral Arrangements Regulation; Governor’s decision number (1/46) dated 18/08/1446H. and the Kingdom’s Capital Market Authority (CMA) has concluded a consultation in respect of a draft of its own netting regulations (CMA Draft Netting Regulations, together with the SAMA Netting Regulations, the KSA Netting Framework).See Draft Regulatory Framework for Close-out Netting for Capital Market Institutions.
As one of the final G20 countries to consider adopting close-out netting legislation, the KSA Netting Framework represents a fundamental shift in the Kingdom’s financial markets by aligning its legislative framework (governing derivatives, repurchase arrangements, stock lending arrangements, and other financial transactions reliant on close-out netting provisions) closely with international standards.
In this Client Alert, we unpack the KSA Netting Framework and its potential impact in the Kingdom.
Close-out netting is a contractual mechanism that allows parties that have entered into multiple transactions to mitigate their credit risk to one another by compressing those transactions into a single net payment due by one party to the other. As a refresher, close-out netting fundamentally involves three steps: (i) the termination of some or all outstanding transactions; (ii) the valuation of such transactions; and (iii) the netting or set-off of such valuations to determine a single, final net amount payable by one party to the other.
Examples many financial market participants will be familiar with are the close-out mechanics included in the International Swaps and Derivatives Association’s (ISDA’s) 1992 and 2002 Master Agreements, the close-out mechanics seen in the 2000 and 2011 forms of the Global Master Repurchase Agreement (GMRA) published by the International Capital Market Association (ICMA) in conjunction with the Securities Industry and Financial Markets Association (SIFMA), and the 2000 and 2010 forms of the Global Master Securities Lending Agreement (GMSLA) published by the International Securities Lending Association (ISLA).
Being able to rely on contractual close-out netting is particularly valuable for a party in the event that its counterparty enters insolvency and a statutory framework that recognises the enforceability of close-out netting in insolvency is typically necessary. This is because three common features of insolvency regimes around the world are problematic for those needing to rely on contractually agreed close-out netting; namely that insolvency regimes commonly:
Statutory close-out netting regimes, including those based on ISDA’s 2018 Model Netting Act (Model Netting Act), are generally intended to provide robust protection against these common features of insolvency law by expressly providing for the operation of contractual close-out netting despite the ordinary effects of the insolvency regime applicable to the relevant party.
The Model Netting Act has become an internationally recognised standard adopted elsewhere, including in the Abu Dhabi Global Market, and was expressly intended to provide a base for legislators looking to ensure the enforceability of bilateral close-out netting (including on a multibranch basis) and enforceability of related financial collateral or margin arrangements in their own jurisdictions. Both the SAMA Netting Regulations and the CMA Draft Netting Regulations are heavily influenced by the Model Netting Act.See 2018 Model Netting Act and Guide.
As noted above, the SAMA Netting Regulations now form part of Saudi law. The CMA Draft Netting Regulations are currently being updated to reflect industry comment.See The Capital Market Authority Calls for Public Consultation on the Regulatory Framework for Close-out Netting for Capital Market Institutions. However, outside of the scope of their application, the CMA Draft Netting Regulations are effectively identical in substance to the SAMA Netting Regulations, and the CMA is required by Saudi law to coordinate with SAMA in connection with proposed procedures that may have a substantive impact on the Saudi market. Accordingly, limited changes are expected to the form of the CMA Draft Netting Regulations. The scope of the SAMA Netting Regulations and the CMA Draft Netting Regulations does differ, and each are considered in further detail below.
Putting aside these differences in scope, with the implementation of the KSA Netting Framework, the Kingdom has provided for robust protection in respect of close-out netting arrangements entered into with certain counterparties based in the Kingdom. In particular, the SAMA Netting Regulations and the CMA Draft Netting Regulations expressly provide that:
The KSA Netting Framework applies only to qualified financial contracts (QFCs), which are defined in a similar manner across the SAMA Netting Regulations and the CMA Draft Netting Regulations (see “Contracts Covered” below) by ensuring the enforcement of close-out netting in the event of a default or insolvency of a party to a QFC, provided that at least one party to that QFC is a financial institution that is regulated by SAMA or the CMA.
SAMA Netting Regulations: The legislative basis for the issuance of the SAMA Netting Regulations originated in:
CMA Draft Netting Regulations: The legislative basis for the CMA Draft Netting Regulations can similarly be found in the CMA LawCapital Markets Law promulgated pursuant to Royal Decree No. M/30 dated 2/6/1424H (corresponding to 31 July 2003) (CMA Law). and the KSA Bankruptcy Law:
While the operative provisions of the SAMA Netting Regulations and the CMA Draft Netting Regulations are identical in most respects, they differ as to their scope of application.
The SAMA Netting Regulations apply to QFCs if at least one party is supervised by SAMA, and the CMA Draft Netting Regulations apply to QFCs if at least one party is supervised by the CMA (i.e., a Capital Market Institution or CMI). In other words, to benefit from the KSA Netting Framework, at least one party to a QFC must be supervised by SAMA or the CMA.
The scope of entities that SAMA supervises is broad, and includes all banks, finance companies, payment services providers, credit information service providers, and certain other ancillary service providers.
The scope of entities that the CMA supervises is also broad, and includes financial advisors, arrangers, dealers, custodians, and asset managers, as well as financial market infrastructure service providers (i.e., the Kingdom’s securities exchanges, clearing houses, and depository centers).
One of the notable limitations of the KSA Netting Framework is that offshore counterparties to non- SAMA- or CMA-regulated parties (e.g., large corporates and sovereigns) will not benefit from the KSA Netting Framework’s protections (to the extent that the CMA Draft Netting Regulations are promulgated in their current form) when they enter into contracts that would otherwise qualify as QFCs.
The SAMA Netting Regulations and CMA Draft Netting Regulations both cover netting agreements and related collateral arrangements entered into in connection with one or more QFCs.
The definition of QFCs closely follows the approach set out in the Model Netting Act and notably includes various types of derivative transactions, as well as repurchase and stock lending arrangements. SAMA and the CMA will be able to revise the scope of coverage, but the current list of QFCs expressly within scope is set out below:
Currently Covered QFCs |
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| Currency, cross-currency, or interest rate swap, or profit rate swaps | Basis swaps | Spot, future, forward, or other foreign exchange transactions |
| Cap, collar, or floor transactions | Commodity swaps | Forward rate agreements |
| Currency or interest rate futures | Currency or interest rate options | Equity derivatives (e.g., equity or equity index swaps, equity forwards, equity options, or equity index options) |
| Derivatives relating to bonds, to other debt securities, or to a bond or debt security index, such as total return swaps, index swaps, forwards, options, or index options | Credit derivatives, such as credit default swaps, credit default basket swaps, total return swaps, or credit default options | Energy derivatives, such as electricity derivatives, oil derivatives, coal derivatives, or gas derivatives, including derivatives on physical transmission rights, financial transmission rights, or transmission capacity |
| Weather derivatives, such as weather swaps or weather options | Bandwidth derivatives | Freight derivatives |
| Emissions derivatives, such as emissions allowances or emissions reduction transactions | Economic statistics derivatives, such as inflation derivatives | Property index derivatives |
| Spot, future, forward, or other securities or commodities transactions | Securities contracts, including margin loans and agreements to buy, sell, borrow, or lend securities, such as securities repurchases or reverse repurchase agreements, a securities lending agreement, or a repurchase based on sale/ purchase of securities or a securities buy/sell-back agreement | Agreements to clear or settle securities transactions or to act as a depository for securities |
| Commodities contracts, including agreements to buy, sell, borrow, or lend commodities, such as commodities repurchases or reverse repurchase agreements, commodities lending agreements, or commodities buy/sell-back agreements | Contracts and transactions of certificates of deposit | Preferred stocks contracts and transactions |
| Any other agreement, contract, or transaction similar to any agreement, contract, or transaction referred to in this table with respect to one or more reference items or indices relating to, without limitation, interest rates, currencies, commodities, energy products, electricity, equities, fund interest, weather, bonds and other debt instruments, sukuk, precious metals, quantitative measures associated with an occurrence, extent of an occurrence, or contingency associated with a financial, commercial, or economic consequence, or economic or financial indices or measures of economic or financial risk or value | Swap, forward, option, contract for differences, or other derivative in respect of, or combination of, one or more agreements or contracts referred to in this table | Any contract or transaction (including a murabaha, musawama, or wa’ad) which individually or together with any other such contract or transaction has been or is entered into with a view to having an economic effect similar to any instrument, contract, or transaction referred to in this table in a manner intended to take account of Shari’ah compliance requirements |
The protective benefit of the SAMA Netting Regulations and CMA Draft Netting Regulations also extends to collateral arrangements relating to or forming part of a netting agreement pursuant to which QFCs have been entered into. That is, the SAMA Netting Regulations and the CMA Draft Netting Regulations aim to provide robust protection to both title transfer and security interest-based collateral and margin arrangements. Unless otherwise agreed by two parties, the realisation, appropriation, and/or liquidation of collateral under a financial collateral arrangement are expressly provided to effect or occur without any requirement that prior notice shall be given to, or consent be received from, any party, natural or corporate person, or entity.
While this element of the SAMA Netting Regulations and CMA Draft Netting Regulations is helpful, market participants should be aware that the protective benefit does not, on its face, extend to collateral arrangements relating to or forming part of a netting agreement if neither party to the netting agreement is supervised by SAMA or the CMA. This appears to be the case even when there is a nexus to the Kingdom (such as securities lending arrangements over, or derivative transactions in respect of, securities issued in the Kingdom).
Both the SAMA Netting Regulations and the CMA Draft Netting Regulations expressly contemplate protections extending to trades which are Shari’ah-compliant, or were structured in a way intended to be Shari’ah-compliant. That protection comes in two ways:
Both the SAMA Netting Regulations and the CMA Draft Netting Regulations include the optional multibranch netting provisions found in the Model Netting Act. The multibranch netting provisions work to reconcile the local ring-fencing rules with the enforcement of multibranch close-out netting, ensuring the intended global operation of the netting framework.
That intention is ultimately effected, if a local branch of one party to a netting agreement is insolvent, by determining both a global and a local net obligation owed by one party to the other and:
As market participants will no doubt be aware, ISDA, ICMA, and ISLA each commission a wide range of legal opinions or memoranda, including in respect of the efficacy of close-out netting and collateral enforceability, in an extensive range of key jurisdictions. Generally, such opinions are only published in respect of jurisdictions that provide a sufficiently high degree of legal certainty as to those issues. We expect that the introduction of the KSA Netting Framework will allow market participants the comfort offered by a suite of opinions detailing the manner in which its netting regime operates. Such opinions have been commissioned from leading Saudi counsel.
The existing uncertainty as to the enforceability of close-out netting in the Kingdom has until now placed local banks at a competitive disadvantage when dealing with foreign financial institutions. As a result, many Saudi banks have been entering into transactions through their subsidiaries established in jurisdictions with more favorable treatment of close-out netting.
We expect that the KSA Netting Framework will result in greater activity through domestic entities in the Kingdom, and potentially even the novation of existing contracts from offshore subsidiaries to domestic entities in the Kingdom. Both the SAMA Netting Regulations and the CMA Draft Netting Regulations are a crucial step toward solidifying the Kingdom’s role as a top-tier financial services market, capable of competing on a global stage. The implementation of the KSA Netting Framework may well prove to be one of the most significant drivers of economic transformation in the Kingdom in the coming years.