Netting of Payments - ISDA Provision
2002 ISDA Master Agreement
Section 2(c) in full
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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 close-out netting, see here:
I mean, what is the point?
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
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.
Relevance of Section 6 to the peacetime operation of the 1995 English Law CSA
The calculation of Exposure under the 1995 English Law CSA is modelled on the Section 6(e)(ii) termination methodology following a Termination Event where there is one Affected Party, which in turn tracks the Section 6(e)(i) methodology following an Event of Default, only taking mid-market valuations and not those on the Non-Defaulting Party’s side.
This means you calculate the Exposure as:
This is interesting because, as of its Termination Date the Transaction may be no more, but until those final exchanges are settled the obligations they represent — “Unpaid Amounts” in the argot of Section 6(e) — still exist and are included in the calculation of the Exposure.
Now, on the day you are meant to make that final settlement, which when (ahem — if) settled, would reduce your Exposure, you will call for your Delivery Amount or Return Amount assuming it has not (yet) been paid. By the time the Credit Support adjustment has been settled, that final settlement will have happened, meaning the person who paid the adjustment will be out of pocket, and will need to call it back (using the same process).
Transaction flows and collateral flows
- 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.