Netting - 1992 ISDA Provision
1992 ISDA Master Agreement
Section 2(c) in a Nutshell™
Use at your own risk, campers!
Full text of Section 2(c)
Related agreements and comparisons
Content and comparisons
Section 2(c) is about “settlement” or “payment” netting — that is, the operational settlement of offsetting payments due on any day under the normal operation of the Agreement — and not the more drastic close-out netting, which is the Early Termination of all Transactions under Section 6.
If you want to know more about close-out netting, see Single Agreement and Early Termination Amount.
Our chief contrarian wonders what on earth the point of this section is, since settlement netting is a factual operational process for performing existing legal obligations, rather than any kind of variation of the parties’ rights and obligations. If you owe me ten pounds and I owe you ten pounds, and we agree to both keep our tenners, what cause of action arises? What loss is there? We have settled our existing obligations in different way.
To be sure, if I pay you your tenner and you don’t pay me mine, that’s a different story — but then there is no settlement netting at all. The only time one would wish to enforce settlement netting it must, ipso facto, have actually happened, so what do you think you’re going to court to enforce?
Multiple Transaction Payment Netting
“Multiple Transaction Payment Netting” is a defined term introduced in the 2002 ISDA in place of the more clunky 1992 ISDA language set out in Section 2(c).
In the 1992 ISDA, to specify that netting across transactions would apply, you must disapply Section 2(c)(ii). Counterintuitive, but true (because otherwise netting only applies in respect of the same Transaction).
That is partly why, in the 2002 ISDA they introduced the more intuitive Multiple Transaction Payment Netting concept. So now you can say “Multiple Transaction Payment Netting does (or does not) apply”.
Of course, the one person who is going to have no clue — or, for that matter, care — about how transaction netting works at an operational level is negotiator expected to thrash this out in the document.
Now, seeing as (per above) payment netting is an operational fact not a legal right as such, and it doesn’t need to be in the contract, and your negotiator will care not one row of buttons whether or not Multiple Transaction Payment Netting, or its 1992 predecessor, applies or not, you might think it wise to put something diffident like “The parties will agree to any Multiple Transaction Payment Netting arrangements separately as an operational matter.”
I know, I know: I’m a total Mr. Buzzkill. But look, it’s for the good of your own long-term mental health.
Transaction flows and collateral flows
In a fully margined ISDA Master Agreement, all other things being equal, the termination of a Transaction will lead to two equal and opposite effects:
- A final payment or exchange under the Transaction having a value more or less equal to the present value of that Transaction;
- A offsetting change in the Exposure under the CSA in exactly the same value.
The strict sequence of these payments ought to be that the Transaction termination payment goes first, and the collateral return follows, since it can only really be calculated and called once the termination payment has been made.
I know what you’re thinking. Hang on! that means the termination payer pays knowing this will increase its Exposure for the couple of days it will take for that collateral return to find its way back. That’s stupid!
What with the regulators’ obsession minimise systemic counterparty credit risk, wouldn’t it be better to apply some kind of settlement netting in anticipation, to keep the credit exposure down?
Now, dear reader, have you learned nothing? It might be better, but “better” is not how ISDA documentation rolls. The theory of the ISDA and CSA settlement flows puts the Transaction payment egg before the variation margin chicken so, at the moment, Transaction flows and collateral flows tend to be handled by different operations teams, and their systems don’t talk. Currently, the payer of a terminating transaction has its heart in its mouth for a day or so.
Industry efforts to date have been targeting at shortening the period between the Exposure calculation and the final payment of the collateral transfer.