Close-out 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, 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.

Introduction

Netting is generally defined in financial terms as when we allow a positive value and a negative value to set-off one another, partially or entirely cancelling one another out.

Close-out netting is the process of doing that under a master agreement such as the ISDA Master Agreement when one party defaults or goes insolvent. 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 agregate all these exposures down to a single net sum - known as "netting down" - is very important when calculating risk weighting. (the alternative is to treat all positive exposures as creditors claims subject to allocation in the insolvency and all negative exposures as unconditional obligations).

In order to achieve that "net" treatment the FCA's BIPRU Rules (see BIPRU Template:Bipruprov) stipulate that we need legal opinions from all relevant jurisdictions that the concept of "close out netting" would be effective in the insolvency of the counterparty. In most developed legal jursidictions such opinions are available, but in emerging jurisdictions it is ofen more challenging. Template:Bipruquote

Close Out Netting

Close-out Netting: an ISDA Research Notes brief

Close-out netting following default is one of the key elements of risk management for OTC derivatives, allowing businesses, investors, and governments to manage their risks in a precise and safe manner. According to the Bank for International Settlements, by 2009 closeout netting reduced counterparty credit exposure by 85 percent. Despite these results, some have suggested a review of legal provisions that are essential to the enforceability of closeout netting in an insolvency proceeding. While some involve brief delays to the process in connection with insolvencies, in the US there have been more radical proposals, mostly from academics, to repeal legal protections altogether. What follows is a brief on the provisions that are necessary for close-out netting to be enforceable.

In common parlance, netting is used interchangeably with the legal term set-off, which is the combining of offsetting obligations between two or more parties into a single net payable or receivable for each party. Close-out netting under the ISDA Master Agreement goes beyond set-off, however, and involves the termination of transactions between a defaulting and a non-defaulting party; followed by determination of mark-to-market values and summing these to a net “close-out amount”; and finally the payment of the close-out amount from one party to the other. If the non-defaulting party owes the close-out amount, it is due immediately, while if it is owed to the non-defaulting party, it becomes subject to the insolvency proceedings.

The necessity of this procedure is inherent in the OTC derivatives business, which is based on the transfer and hedging of risks. When a dealer enters into a new transaction, the risk taken on is hedged in some way, often with other derivatives dealers. As deals mature and markets change (through interest rates, credit spreads and other variables), dealers continually adjust their hedges to protect themselves from adverse market movements. In such a model, the insolvency of a counterparty means that a dealer’s book is no longer balanced, and must be rebalanced by either replacing the defaulted transactions or unwinding hedge transactions. In order to manage such risks with certainty, dealers need the ability to close out defaulted transactions -- and thus the reason for close-out netting.

For the process to be effective in an insolvency proceeding, three things are necessary.

1. First, non-defaulting parties must have the right to terminate contracts with the nondefaulting party based solely upon the defaulting party’s insolvency filing.
2. Second, nondefaulting parties must be exempt from automatic stays or other provisions of bankruptcy laws that delay exercise of a creditor’s rights.
3. Finally, there must be restrictions on cherry picking, that is, an insolvency administrator’s right to reject out-of-the-money transactions while demanding payment of in-the-money transactions.

These three conditions are already in place in England and other jurisdictions that follow English legal traditions. Elsewhere, ISDA has had to pursue enforceability in two ways. The first is through netting legislation containing provisions such as those described above; as of February, 37 jurisdictions have enacted netting legislation and four more are considering doing so. The second is through legal opinions regarding the enforceability of netting under local laws, including those jurisdictions that have enacted netting legislation; as of February, ISDA has obtained netting opinions on 54 jurisdictions. Along with legislation and legal opinions, ISDA will continue its education outreach to policy makers to ensure that the risk reduction benefits remain well understood.

Contact: David Mengle