The Evolution, Impact and Future of Israeli Netting Legislation: Enhancing Financial Certainty and Market Efficiency

Efficient netting legislation is integral to managing systemic risk in financial markets; it facilitates the close-out netting of financial contracts in the event of a counterparty default. This paper explores the development, implementation, and impact of netting legislation in Israel. Beginning with an overview of the global context of netting, the article delves into Israel’s regulatory framework, examining key legislative milestones, regulatory considerations, and practical implications for financial institutions and the broader economy. Furthermore, it assesses the effectiveness of Israeli netting laws in enhancing financial stability and fostering a robust derivatives market. It further discusses potential future developments.

Introduction

Netting, particularly close-out netting, plays a crucial role in modern financial markets by enabling financial institutions, as well as other counterparties, to offset obligations arising from different transactions with a single counterparty. This practice not only reduces credit risk, but also enhances market liquidity and promotes efficient capital allocation. Globally, the adoption of netting legislation has been pivotal in providing legal certainty for such agreements, thereby bolstering investor confidence and fostering market stability in jurisdictions where such legislation is adopted.

As a dynamic financial hub, Israel has embarked on a journey to implement netting legislation in order to align its financial infrastructure with international standards, and enhance systemic resilience. This article explores the evolution and impact of Israeli netting legislation, analysing its development, regulatory framework, practical implications, and broader implications for financial stability and market integrity.

Now is an interesting time for such analysis, as the Bank of Israel and the Ministry of Finance are currently considering the introduction of amendments to the legislation to expand its scope to transactions and instruments not already covered.

The global context of netting legislation

The evolution of netting legislation globally reflects a concerted effort to mitigate systemic risks inherent in financial markets. Netting agreements, particularly in derivatives and other financial transactions, enable parties to consolidate their exposure and minimise the impact of default by a counterparty.

Countries worldwide have enacted comprehensive netting laws to provide legal certainty and enforceability for netting agreements. International bodies, such as the International Swaps and Derivatives Association (ISDA), the International Capital Market Association (ICMA) and the International Securities Lending Association (ISLA), have standardised netting agreements for transactions in derivatives, securities repurchase (repo) transactions, and lending of securities, contributing to the harmonisation of legal frameworks across jurisdictions. These organisations seek legal opinions from counsels in various jurisdictions regarding the enforceability of the close-out and netting arrangements under standard agreements, thereby ensuring certainty for the market players in this industry.

The development of netting legislation in Israel

Israel’s journey towards implementing netting legislation began in the early 2000s, following extensive lobbying by Israeli banks. These institutions complained to the Bank of Israel that they were unable to become active players in the international derivatives transactions market, since foreign banks were reluctant to enter into ISDA and other master agreements with them, due to the major legal uncertainties that prevailed in Israeli law at the time with respect to such transactions.

The initial steps involved extensive consultation with industry stakeholders (ISDA in particular), legal experts and regulatory authorities, to tailor the framework to Israel’s financial landscape. The culmination of these efforts was the enactment of the Financial Assets Agreements Law in 2006, which laid the foundation for recognising and enforcing netting agreements between Israeli counterparties.

These efforts aimed to align the legislation with international standards set out by organisations such as the Basel Committee on Banking Supervision and the Financial Stability Board, thereby addressing specific legal risks and the uncertainties that existed. The evolution of Israeli netting legislation underscored the country’s commitment to fostering a resilient and efficient financial market infrastructure.

When the Financial Assets Agreements Law (the “Law”) was enacted and published, its legislative simplicity, elegance and accuracy surprised the market and the few legal practitioners then active in this field. With only four brief sections, the Law completely solved legal concerns relating to the enforceability of netting and recharacterisation of collateral transfer, for the types of transactions covered. It also clarified that the Law applies in the event of insolvency as well, and essentially prevails over the relevant insolvency rules.

Key legal considerations underpinning the Israeli netting legislation include the treatment of netting agreements in insolvency proceedings and protection of creditors’ rights, providing market participants with the legal certainty necessary for effective risk management and financial stability.

Several years later, when ISDA and ICMA commissioned the netting and collateral Israeli industry opinions, they were able to obtain good and robust opinions, thus enabling more and more Israeli players to enter this market and trade derivatives with foreign counterparties. Other than the banks, who were the traditional players, we now see ISDA and GMRA-based agreements signed by most of Israel’s institutional investors (mainly pension funds), as well as large commercial companies that have particular hedging needs (such as electricity and aviation companies).

The main provisions of the Financial Assets Agreements Law

Definition and scope of the “framework agreement”

The Financial Assets Agreements Law applies to any “framework agreement”, which it defines as an agreement governing a series of transactions involving derivatives (as defined by the Law) or securities repurchase transactions, provided that the following conditions are met:

• Inclusion of Close-Out Provisions: The agreement must incorporate all the provisions outlined in sub-paragraphs (1) through (4) of the definition of close-out provisions.
• Parties to the Agreement: The parties to the agreement must be corporate entities, with at least one party being either a financial institution or the State of Israel. The Minister of Finance has the authority to expand the list of regulated entities to include additional types of entities.

Detailed definition of close-out provisions

The close-out provisions specified in the Financial Assets Agreements Law must include:

• Single Agreement: The Framework Agreement must constitute a single agreement concerning all transactions entered into under it.
• Early Termination Conditions: The agreement must stipulate conditions under which early termination of all transactions will occur (automatic early termination), or where one party is entitled to terminate all such transactions (optional early termination).
• Netting Upon Termination: In the event of early termination, the value of one party’s rights and obligations must be determined as the difference between the values of the rights and obligations of both parties.
• Value Calculation Methods: The agreement must outline methods for calculating the fair value of the parties’ rights and obligations upon early termination. This includes estimating the value of substitute transactions in the market, adhering to generally accepted rules of commercial valuation.

Collateralisation arrangements and re-characterisation risk

A critical provision of the Financial Assets Agreements Law, in Section 4(a), addresses collateralisation arrangements. Section 4(a) stipulates that the classification of a transfer of collateral in a Framework Agreement as a transfer of title will be upheld, thereby eliminating the risk that the transfer will be recharacterised as a pledge, which had been one of the major legal concerns prior to the enactment of the Law. This provision does not apply where the parties classify the transfer as a pledge (and therefore does not apply to transactions under the ISDA New York Law Credit Support Annex and ISDA Initial Margin Documentation).

Enforceability of netting provisions

Another significant provision of the Financial Assets Agreements Law is contained in Section 2, which addresses the enforceability of netting provisions in framework agreements. Section 2 provides that close-out provisions within a framework agreement remain valid even during insolvency proceedings. This is particularly important with respect to provisions conferring the right to terminate all the transactions under the master agreement upon insolvency of a counterparty, or providing for automatic early termination upon insolvency as, under general insolvency law, such termination provisions are generally not enforceable.

Practical implications for financial institutions

The practical implications of Israeli netting legislation for financial institutions operating in Israel are significant. By allowing banks, institutional investors, and other financial entities to net derivative contracts and various financial obligations, as well as the collateral they provided, this legislative framework enhances the efficiency of risk management and capital allocation. The adoption of netting agreements enables institutions to optimise their balance sheets, streamline operational processes, and improve liquidity management.

Furthermore, netting legislation contributes to market efficiency by reducing transaction costs and bolstering market liquidity; during periods of financial stress, the capacity to swiftly close out transactions through netting mechanisms mitigates systemic risk and reinforces market resilience. This operational resilience is particularly crucial in Israel, where it is essential to maintain financial stability, due to the market’s relatively small size and high level of interconnectedness.

Transactions out of the scope of the netting legislation

It is important to note that the scope of the Financial Assets Agreements Law is relatively narrow, applying only to a specific set of transactions. Since the Law introduced a total revolution with respect to transactions in derivatives compared to the general provisions applicable to collateral, set-off and insolvency, the legislature at the time preferred to limit the scope of the Law to certain specific transactions, at least initially, with the intention of considering the practical implications of the Law from time to time, and whether it makes sense to expand its coverage. For this purpose, the Minister of Justice was granted the authority to expand the coverage of the Law to additional types of transactions, subject to the approval of a parliamentary committee, but without the need for a full legislative process. Unfortunately, as of now, the Minister has not yet made use of this authority.

Notably, the following types of transactions fall outside the purview of the Law:

• transactions governed by the ISDA Master Agreement when the parties opt for the New York Law Credit Support Annex for collateralisation arrangements;
• initial margin transactions;
• securities lending transactions;
• repo transactions involving equity securities as the underlying assets; and
• repo transactions where the underlying securities are sovereign bonds other than those issued by the Israeli government.

Impact on financial stability and market integrity

The introduction of netting legislation in Israel has had a positive impact on financial stability and market integrity. By providing legal certainty for netting agreements, the framework has bolstered investor confidence, thereby enabling market participants to hedge risks more effectively and innovate new financial products, which has led to the significant growth of the derivatives market. From a regulatory perspective, Israeli netting legislation enhances the ability of the relevant authorities to effectively monitor and mitigate systemic risk.

Next steps

Israel’s netting legislation is currently in a developmental phase and requires further enhancement and expansion.

Specifically with respect to the types of transactions that were left outside the scope of the Law, foreign market players wishing to enter into such transactions with Israeli counterparties are forced to refrain from doing so, since it would expose them to major legal uncertainties. The current industry legal opinions regarding transactions outside the scope of the Law are not sufficiently robust on matters of close-out netting and collateralisation arrangements and do not provide sufficient legal certainty.

Consequently, over the past two years, regulators – including the Ministry of Justice and the Bank of Israel – have been approached by organisations such as the ISLA and ICMA with requests to amend the Financial Assets Agreements Law. These requests advocate for the inclusion of additional transaction types within the legislation. Furthermore, Israeli banks have expressed concerns, noting that the existing framework complicates their ability to execute transactions, particularly due to the somewhat artificial distinction between the type of transactions and instruments that are covered by the Law, and the type of transactions that are not. Informal discussions with regulatory officials and their apparent readiness to listen to the concerns raised by the market players suggest that there is potential momentum for legislative reforms aimed at broadening the scope of the Law’s applicability so that it will be in line with the standard coverage of netting legislation in most other modern jurisdictions.

Summary

In conclusion, the evolution of netting legislation in Israel represents a significant advancement in the country’s financial market infrastructure. The framework established under the Financial Assets Agreements Law has not only enhanced risk management practices, but also bolstered market efficiency and investor confidence. Looking ahead, ongoing regulatory oversight and expansion of the scope of the netting legislation will be essential to address the needs of the industry and maintain financial stability in Israel’s evolving financial landscape.