Close out netting

What Is Close out Netting?

Close out netting is a crucial risk management technique used in financial markets, particularly within the realm of derivatives and other financial contracts. It is a process that occurs when one party to a bilateral agreement experiences a default or specified termination event. Upon such an event, all outstanding transactions between the two parties under a single master agreement are terminated, their market values are determined, and these individual values are then consolidated into a single net amount, payable by one party to the other. This mechanism significantly reduces potential credit risk exposure.

History and Origin

The concept of close out netting gained prominence with the standardization of over-the-counter (OTC) derivatives markets. The proliferation of complex financial instruments in the late 20th century highlighted the need for robust risk mitigation strategies. A pivotal development was the introduction of the ISDA Master Agreement by the International Swaps and Derivatives Association (ISDA) in 1992, with a revised version in 2002. This agreement provides a standardized legal framework designed to govern privately negotiated derivatives transactions and includes comprehensive provisions for close out netting,¹⁴.

Before such agreements, if a counterparty defaulted, each individual transaction might have to be settled separately, potentially leading to lengthy and complex legal battles and increased exposures. The ISDA Master Agreement, by legally affirming that all transactions form a single agreement, ensures that in the event of an insolvency, obligations are netted down to a single sum¹³. This framework has been instrumental in reducing systemic risk by providing financial institutions with the legal certainty needed to manage their exposures effectively across multiple transactions¹²,¹¹. Jurisdictions worldwide have progressively adopted legislation to support the enforceability of close out netting, often driven by the need to align with international banking regulations and reduce regulatory capital requirements¹⁰,⁹.

Key Takeaways

• Close out netting aggregates all outstanding financial obligations between two parties under a master agreement into a single net payment upon a default event.
• It is primarily used in over-the-counter (OTC) derivatives markets, governed by agreements like the ISDA Master Agreement.
• This mechanism drastically reduces counterparty risk and systemic risk within the financial system.
• Legal enforceability of close out netting is critical and often requires specific legal opinions in relevant jurisdictions.
• It allows financial institutions to calculate their capital requirements on a net exposure basis rather than a gross one.

Formula and Calculation

Close out netting involves a three-step process following a default: early termination, valuation, and calculation of a single net sum.

1. Early Termination: All outstanding transactions governed by the master agreement are terminated.
2. Valuation: Each terminated transaction is assigned a fair market valuation as of the termination date. This value can be positive (an amount owed to the non-defaulting party) or negative (an amount owed by the non-defaulting party).
3. Netting Calculation: All positive and negative values, along with any unpaid amounts due, are summed up to arrive at a single, final net payment.

The general concept can be represented as:

Where:

• (\text{Net Amount Due}) is the single aggregated payment.
• (\text{Value of Transaction}_i) is the fair market value of each individual terminated transaction (i).
• (\text{Unpaid Amounts}) includes any interest or fees that were due but not yet paid before the termination event.

The sum will result in either a net amount owed by the defaulting party to the non-defaulting party, or vice versa.

Interpreting Close out Netting

The interpretation of close out netting centers on its effectiveness in mitigating financial exposure. For financial institutions engaged in numerous bilateral contracts, the ability to net down exposures means that in a default scenario, they are exposed only to the single net amount, rather than the sum of all gross positive values owed to them. This dramatically reduces potential losses and simplifies the resolution process in times of financial stress.

The enforceability of close out netting provisions is paramount. If these provisions are not legally sound in a given jurisdiction, financial institutions may be required to hold capital against their gross exposures, rather than their net exposures, which would significantly increase their capital requirements. Therefore, the presence of robust legal opinions supporting netting is a key factor in assessing counterparty risk and financial stability⁸.

Hypothetical Example

Consider two financial entities, Bank A and Bank B, who have entered into a master agreement governing several derivative transactions.

Suppose Bank B defaults. At the time of default, the outstanding transactions have the following market values from Bank A's perspective:

• Transaction 1 (Interest Rate Swap): Bank B owes Bank A $10 million
• Transaction 2 (Currency Swap): Bank A owes Bank B $5 million
• Transaction 3 (Equity Option): Bank B owes Bank A $7 million
• Transaction 4 (Credit Default Swap): Bank A owes Bank B $3 million

Without close out netting, Bank A might have to pay Bank B $8 million (from Transactions 2 and 4) while attempting to recover $17 million (from Transactions 1 and 3) through potentially lengthy insolvency proceedings. This would leave Bank A with a significant gross exposure.

With close out netting, all these transactions are terminated and valued. The calculation would be:

• Amounts owed to Bank A: $10 million (T1) + $7 million (T3) = $17 million
• Amounts owed by Bank A: $5 million (T2) + $3 million (T4) = $8 million

The net amount is $17 million - $8 million = $9 million.

Bank B, as the defaulting party, would owe Bank A a single net payment of $9 million. This simplifies the claims process and substantially reduces Bank A's overall exposure and settlement risk.

Practical Applications

Close out netting is extensively applied across various facets of finance:

• Derivatives Trading: It is the bedrock of risk management in the OTC derivatives market, enabling active trading by allowing participants to manage the vast number of individual exposures.
• Repo Markets: Agreements like the Global Master Repurchase Agreement (GMRA), used in the repurchase agreement market, also incorporate close out netting provisions to reduce credit risk exposures arising from multiple repo transactions. This structure is similar to how the ISDA Master Agreement functions for derivatives⁷, ICMA - Global Master Repurchase Agreement (GMRA).
• Regulatory Capital Calculation: Banking regulations, such as those derived from Basel Accords, permit banks to calculate their capital requirements based on net exposures rather than gross exposures, provided that the netting agreements are legally enforceable in all relevant jurisdictions⁶,⁵. This significantly frees up capital for lending and other activities.
• Interbank Market Stability: By streamlining the process of resolving defaults, close out netting contributes to the overall stability of the interbank market, preventing a cascading failure of obligations from a single counterparty default.
• Collateral Management: The effectiveness of close out netting often works in conjunction with collateral agreements, where collateral posted by a counterparty is applied against the net exposure.

Limitations and Criticisms

Despite its benefits, close out netting faces certain limitations and criticisms:

• Jurisdictional Enforceability: The primary limitation is the legal enforceability of netting provisions across different jurisdictions. While ISDA commissions legal opinions for numerous countries, some jurisdictions may have insolvency laws that do not fully recognize or may challenge the effectiveness of contractual netting, potentially forcing a gross settlement⁴,³. This creates uncertainty and requires ongoing legal analysis. For example, India's Bilateral Netting of Qualified Financial Contracts Act 2020 was a significant step towards clarifying enforceability, highlighting the need for specific legislation in many countries².
• Systemic Risk Concerns: While netting reduces bilateral counterparty risk and overall exposure for individual firms, some critics argue that the interconnectedness fostered by vast netting sets could still pose systemic risks if a very large financial institution were to default, potentially triggering complex valuation and settlement issues across numerous counterparties simultaneously.
• Valuation Disputes: In a default scenario, agreeing on the fair market valuation of terminated transactions can be contentious, especially for illiquid or complex derivatives. Disputes over valuation could delay the final settlement, even if the netting principle is legally sound¹.

Close out Netting vs. Payment Netting

Close out netting and payment netting are both methods of netting, but they differ significantly in their trigger and purpose.

Close out netting is a crisis-driven mechanism, designed to provide a quick and legally enforceable method to resolve exposures when a counterparty fails. Payment netting, conversely, is an operational efficiency tool, streamlining routine payments between parties with multiple ongoing obligations, without necessarily terminating the underlying contracts.

FAQs

What is the primary benefit of close out netting?

The primary benefit is the significant reduction of counterparty risk and the streamlining of default resolution in complex financial contracts. It reduces multiple gross exposures to a single net amount, minimizing potential losses.

How does close out netting relate to the ISDA Master Agreement?

The ISDA Master Agreement provides the standardized legal framework that explicitly allows for and governs close out netting for over-the-counter derivatives transactions. Its provisions ensure that all covered transactions are treated as a single agreement for netting purposes.

Why is legal enforceability important for close out netting?

Legal certainty ensures that the close out netting provisions will be upheld in the event of a counterparty's insolvency or bankruptcy. Without it, financial institutions might be forced to settle individual transactions on a gross basis, significantly increasing their exposure and affecting their regulatory capital calculations.

Does close out netting eliminate all risks?

No, while close out netting significantly reduces credit risk, it does not eliminate all risks. Valuation disputes can arise, and systemic risks, though mitigated, are not entirely removed. Its effectiveness also depends on the legal recognition of netting in all relevant jurisdictions.

Is close out netting only for derivatives?

While predominantly associated with derivatives under the ISDA Master Agreement, close out netting principles are also applied in other financial markets, such as the repurchase agreement (repo) market and securities lending, through their respective master agreements.