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| | {{a|glossary|}}''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 {{isdaprov|6}} of the {{isdama}} when things have turned to custard.'' |
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| == Introduction == | | ''See — for a grossly cynical view — the [[Red Flag Act]]'' |
| | === Introduction === |
| | [[Close-out netting]] is the process of doing that under a [[master agreement]] such as the {{isdama}} when one party defaults. Because an {{isdama}} may have many {{isdaprov|Transaction}}s 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. |
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| 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.
| | In order to achieve that “net” treatment under relevant regulations — there are a lot of them; locally, regionally, and under the [[Basel Accords|Basel banking accords]] etc — one must have [[legal opinion|legal opinions]] from all relevant jurisdictions that the “[[close out netting]]” would be effective in the [[insolvency]] of the counterparty. |
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| ==Close Out Netting==
| | {{set-off and netting}} |
| ===Close-out Netting: an [[ISDA]] Research Notes brief===
| | {{assignment and set off}} |
| 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 {{tag|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.
| | {{netting between english entities}} |
| | | For a discussion of what “closing out” is and how it works in various types of Master Agreement, see: |
| 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 {{tag|insolvency}} proceedings.
| | *{{isdaprov|Early Termination}} under the {{isdama}} |
| | | *[[GMSLA Netting]] under the {{gmsla}} |
| 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 {{tag|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.
| | {{sa}} |
| | | *[[Automatic early termination]] |
| For the process to be effective in an {{tag|insolvency}} proceeding, three things are necessary.
| | *{{Isdaprov|Close-out Amount}} |
| #First, non-defaulting parties must have the right to terminate contracts with the nondefaulting party based solely upon the defaulting party’s {{tag|insolvency}} filing.
| | {{ref}} |
| #Second, nondefaulting parties must be exempt from automatic stays or other provisions of [[bankruptcy]] laws that delay exercise of a creditor’s rights.
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| #Finally, there must be restrictions on [[cherry picking]], that is, an {{tag|insolvency}} administrator’s right to reject [[out-of-the-money]] transactions while demanding payment of [[in-the-money transactions]].
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| 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.
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| Contact: [mailto:dmengle@isda.org David Mengle]
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| {{isdaanatomy}} | |