Close-out netting
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Regulatory Capital Anatomy™
The JC’s untutored thoughts on how bank capital works.
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Close-out netting is the process of doing that under a master agreement such as the ISDA Master Agreement when one party defaults. Because an ISDA Master Agreement may have many Transactions under it, some with positive and some with negative mark-to-market exposures, the ability to “net down” all these exposures to a single net sum is important when calculating risk weighting.
In order to achieve that “net” treatment under relevant regulations — there are a lot of them; locally, regionally, and under the Basel banking accords etc — one must have legal opinions from all relevant jurisdictions that the “close out netting” would be effective in the insolvency of the counterparty.
It is useful to think of netting as a multi-step process of reducing exposures under a series of unrelated transactions down to a single unidirectional liability, payable one way of another, using a method which assiduously avoids set-off or the discharge of liabilities under one transaction by means of forgiveness of ones claims under another one. This is so even though that is exactly what close-out netting looks like it is doing, and indeed is doing. Form is everything.
Say you have five Swap Transactions outstanding and your counterparty goes bankrupt. Let’s keep this really easy and say they are all denominated in pounds sterling. Here are the market values:
Transaction 1 expires on 1 January: You are in-the-money by £1m.
Transaction 2 expires on 1 February: You are out-of-the-money by £2m.
Transaction 3 expires on 1 March: You are in-the-money by £3m.
Transaction 4 expires on 1 April: You are out-of-the-money by £4m.
Transaction 5 expires on 1 May: You are in-the-money by £5m.
Under the CSA you have received £2m collateral.
In sum, your counterparty owes you £8m under Transactions 1, 3 and 5, and you owe your counterparty £8m (£6m under Transactions 2 and 4, and £2m in return of credit support it posted you under the CSA). You have closed out your hedges and your ideal scenario is to walk away without paying or receiving anything: the ISDA has done its job. To do this you net down your respective gross exposures of £8m and everyone is happy.
This depends on counterparty’s bankruptcy rules working as you would like and respecting the contractual set-off (or insolvency set-off) between your transactions. But, problem: the Transaction debts are not due immediately, nor are they due on the same day, so a normal set-off might not work. And who knows what local bankruptcy rules the counterparty is subject to? If it regards the transactions as unrelated, the liquidator might be able to cherry-pick valuable Transactions, enforce those, and set aside the others. You might have to pay your counterparty £8m and prove in its bankruptcy for your £8m claim, even though the net amount you owed under the Transactions was only £6m.[1]
How does close-out netting solve this? Through the magic of the Single Agreement. At the point of close-out, the Transactions are not performed or set off: they are terminated altogether, wiped from the horizon as if by a sponge and replaced by abstract numbers — not payables, not receivables, not debts, just abstract valuations under the single master agreement. These valuations are not due, they have no payment date; they are simply operands. Because they are not debts, there is nothing to cherry-pick. The Transactions they represented, remember, are already gone. All that remains is that Single Agreement.
We are amidst an ongoing calculation process. Once all Transactions have been valued, those valuations are summed — a mathematical operation, not any kind of formal set-off — to arrive at a single amount payable under the Single Agreement: in the vernacular of the ISDA Master Agreement, an Early Termination Amount. At this point, an awkward Bankruptcy Administrator discovers her guns have been spiked: there is only one sum, it is more or less zero. There is no cherry-picking left to do.
The industry of obtaining a netting opinion is, essentially, to confirm that the Single Agreement mechanism works: there are no magical powers, mystical discretions, or fouling principles of local jurisprudence that could upset the righteous goal of capital optimisation.
Not the same as settlement netting
Be careful to distinguish between settlement netting (also known as “payment netting”) - which is an operational convenience gladly applied during the life of a derivatives trading relationship — really rather better described as contractual set-off — and close-out netting which is applied, with a heavy heart, by a non-defaulting party under Section 6 of the ISDA Master Agreement when things have turned to custard.
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See also
- For a discussion of what “closing out” is and how it works in various types of Master Agreement, see Early Termination under the ISDA Master Agreement and GMSLA Netting under the 2010 GMSLA
- Red Flag Act
- Automatic early termination
- Close-out Amount
References
- ↑ Ironically, here the CSA makes your position worse.