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Netting, Close-Out and Related Aspects

Netting, Close-Out and Related Aspects

After completing this reading you should be able to:

  • Explain the purpose of an ISDA master agreement.
  • Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages and describe how they fit into the framework of the ISDA master agreement.
  • Describe the effectiveness of netting in reducing credit exposure under various scenarios.
  • Describe the mechanics of termination provisions and trade compressions and explain their advantages and disadvantages.
  • Identify and describe termination events and discuss their potential effects on parties to a transaction

A Quick Recap on Netting and Close-out

Cross-product netting, often known simply as netting, refers to a process where cashflows are offset and combined into a single net amount. Netting occurs when a set of bilateral contracts have both positive and negative values.

Following a default event, a counterparty cannot demand payments on positive value contracts while stopping payments on negative value contracts. Netting reduces the exposure to the net value for all the contracts covered by the netting agreement. It is an effective way of preventing “cherry-picking” by the administrator of the defaulted counterparty.

Close-out is the immediate cancellation of all contracts with the defaulted counterparty. At the point of default, all the remaining contractual obligations are terminated, and the final positive or negative positions are combined into a single net payable or receivable. The result is an immediate realization of net gains or losses.

What’s the need for Netting and Close-out?

The OTC derivatives market is fast-moving, with participants taking multiple positions regularly. A single derivative portfolio can have a large number of transactions. Considering that all these transactions involve the exchange of cash flows and may require the posting of collateral, netting can help simplify the transactions into a single payment where possible.

A single counterparty can have hundreds or even thousands of separate derivatives transactions with a party. In the event of default, such a party would make a huge loss. For that reason, it is important to have a mechanism that can quickly terminate such transactions and replace (re-hedge) their position.

The Purpose of an ISDA Master Agreement

The ISDA Master Agreement is the standard document that sets out the provisions that govern the over-the-counter (OTC) derivatives market. It was developed by the International Swaps and Derivatives Association (ISDA). There have been several versions of the Master Agreement, driven by the need to update the guidelines to take into account emerging issues.

While developing the provisions, the ISDA consults and works closely with industry experts from around the globe. This is informed by the need to harmonize the application and enforceability of the provisions, particularly with regard to key issues such as netting and close-out. However, differences still persist. In some jurisdictions, for example, netting is not enforceable in a default scenario.

The ISDA Master Agreement is divided into two sections:

  • A common core section that must be adhered to by both parties at all times
  • A flexible section that contains adjustable terms to be agreed by both parties

In summary, therefore, the ISDA Master Agreement serves the following purposes:

  • It provides standard documentation that governs the OTC derivatives market to increase efficiency and reduce counterparty risk, and
  • It specifies the legal contractual terms to all major issues that arise in the OTC market, including netting, collateralization, termination, the definition of default, and close-out.

A Summary of Netting and Close-out Procedures

Netting takes two forms: payment netting and close-out netting

Payment Netting

Payment netting involves the netting of payments between two counterparties in the same currency and in respect of the same transaction. The goal of payment netting is to reduce settlement risk (it is sometimes referred to as settlement netting).

On a given day, counterparties may be mandated to exchange multiple cashflows. Underpayment netting provisions, the parties are allowed to combine all the cash flows into a single payment per currency. Let’s say Party A and Party B have engaged in an interest rate swap denominated in British pounds and at the end of the day, A owes B a fixed payment of 500 pounds, and B owes A 400 pounds. With a payment netting provision, A would simply pay B 100 pounds to settle their accounts.

An Illustration of Payment NettingClose-out Netting

Close-out is the immediate cancellation of all contracts with a counterparty after a termination event. It usually happens following a default event, and the goal is to reduce counterparty risk. Transactions between counterparties are tallied up and reduced to a single net amount that is paid by one party to the other.

Let’s go back to our example above involving parties A and B, but this time let’s assume that there are hundreds of transactions between them. Assume party A in can’t make good on its obligations. At that point, all outstanding contracts are terminated, and the final replacement values of A’s positions are marked to market and combined into a single net payable or receivable. A makes this payment to B (or receives an amount from B, should A actually come out ahead).

If the contract between A and B does not allow close-out netting, then B would have to join the ranks of other creditors to A. In such circumstances, reimbursement might take years and result in a smaller amount since proceedings usually drag out in court, and a final verdict can be subjected to multiple appeals.

Illustration on Close-out NettingIn the event of the default of party A, without netting, party B would need to pay 1,000 to party A and would not receive the full amount of 1,200 owed. With netting, party B would simply receive 200 from party A and suffer no loss.

Advantages and Disadvantages of Netting

Exposure reduction

By reducing multiple exposures into a single net amount, netting reduces risk and improves the operational efficiency in OTC markets. On the downside, however, netted exposures can be volatile and move from positive to negative frequently, something that can make it difficult to control exposure.

Financial Discipline

It introduces discipline into the OTC market settlement process and achieves transparency of payment flows

Unwinding positions

A party may wish to exit a rather illiquid trade with one counterparty so as to remove market risk. On the one hand, the party could enter into an offsetting position with another counterparty, but this would bring in operational risk and counterparty risk. On the other, the party can take advantage of netting and execute a reverse trade with the initial counterparty, removing both market and counterparty risk. On the downside, however, the initial counterparty may not offer favorable terms for the offsetting transaction when it’s clear that the other party “wants out.”

Multiple Positions

An entity can reduce counterparty risk by executing multiple trades with a single counterparty (which possibly has a proven track record), rather than holding many positions with different counterparties. A single counterparty would also make it possible to extract more favorable trade terms, particularly on matters collateral.

Stability

If trading rules didn’t allow for netting, counterparties in financial distress would barely do business. That’s because their counterparties would feel inclined to cease trading and terminate all at-risk contracts immediately the distress becomes evident, throwing the distressed counterparty deeper into financial trouble. With netting, the risk of losing out on multiple contracts is significantly reduced and the financially healthy counterparty can trade assured that the total multi-contract exposure will be reduced to a net single amount.

Multilateral Netting

Up to this point, we have looked at netting under the rather convenient assumption that there are only two parties, and netting arrangements are bilateral. In reality, however, a single counterparty gets into tens or even hundreds of trades with different counterparties. Given four parties, A, B, C, and D, for example, A can have an exposure to B, B may have an exposure to C, and C may have an exposure to A and D. If any one of these entities defaults, the settlement, and termination process would be much more complicated than in the bilateral scenario.

Multilateral netting works quite seamlessly when a central counterparty (CCP) is involved. The CCP serves as an intermediary between trading entities, effectively acting as the counterparty to the buyers and sellers. The CCP guarantees the terms of the trade even if one of the counterparties defaults. In other words, it is the CCP that bears the lion’s share of the total counterparty risk. The obvious disadvantage of his arrangement is that it results in less incentive for the counterparties to monitor each other’s credit quality. Multilateral netting also requires trading disclosure; all entities must disclose all their positions and have to channel transactions through the central counterparty. That way, it is very difficult to keep proprietary information confidential.

Illustration on Multilateral NettingAcceleration Clause

Besides close-out, some OTC contracts contain an acceleration clause, which permits the creditor to accelerate (make immediately due) future payments if a predefined event such as default or rating downgrade occurs. Rather than an acceleration, close-out is the termination of all contracts between the solvent and insolvent counterparty. Termination implies that all contracts are canceled and a compensation claim immediately launched based on the cost of replacing the contract on identical terms with another counterparty.

Effectiveness of Netting

For a netting clause to be useful in a derivatives contract, there must be some chance that an instrument will have a negative MTM at some point in its lifetime. If the instrument can only have positive values, it can never a beneficial impact on the overall exposure. A good example of such instruments would be long option positions where the premium is paid upfront (at the onset of the contract). These include swaptions, FX options, and equity options. Other instruments do have a chance of having a negative MTM, but it can be extremely low. These include long option positions without an upfront premium and receiver interest rate swaps with a downwards sloping yield curve and payer interest rate swaps with an upward sloping yield curve.

Even if all trades with a given counterparty can only have positive values, there are several reasons why an institution would still put them under a netting agreement:

  • An institution may have one eye on the future; they may enter into trades with negative MTM at some point in the future. Such trades would provide some netting benefits for the current trades.
  • Inclusion of all trades can help an institution get favorable collateral terms
  • If the option position for some reason needs to be unwound at some point in the future, netting will be necessary so as to execute the mirror trade and eliminate all counterparty risk.

Mechanics of Termination Provisions and Trade Compressions

Termination Provisions

Termination provisions allow a party, say a bank, to terminate (bring an end to) a trade if (I) there’s evidence that the counterparty is on the brink of bankruptcy, or (II) if there happens to be a breach of contract by the counterparty, for instance by defaulting on payments.

The current exposure of a long-dated derivative position can be relatively small and manageable. As time goes, however, the exposure can increase significantly o unmanageable levels, increasing the probability that the counterparty will not honor their obligations. Termination provisions help to reduce exposure in such circumstances.

Termination provisions take the form of a walkaway feature of reset agreement

A walkaway feature is a clause that effectively allows an institution to cancel transactions in the event that the counterparty defaults. Institutions would have an incentive to take this route only if they are in debt to the counterparty. While the walkaway feature does not reduce credit exposure, it allows the surviving party to cut short all payments and allows them not to settle any amounts owed to the counterparty. Walkaway clauses were quite common prior to the 1992 ISDA agreement but have since been removed from the standardized ISDA documentation. Walkaway features do not mitigate counterparty risk per se, but they do result in potential gains that offset the risk of potential losses.

A reset agreement is a clause which avoids a transaction becoming strongly in-the-money (to either party). It does this by adjusting product-specific parameters that reset the transaction to be more at-the-money. Sometimes the reset coincides with payment dates specified in the contract. Other times, a reset may be activated following a breach of some market value.

In a cross-currency swap, for example, the MTM on the swap is exchanged at each reset time in cash. In addition, the FX rate is reset to (typically) the prevailing spot rate. The reset implies that the notional on one leg of the swap will change. The reset works pretty much like closing out the transaction and executing a replacement transaction at market rates and consequently reduces the exposure.

Additional Termination Events (ATEs)

Additional termination events are events whose occurrence allows a party to terminate OTC derivative transactions if the creditworthiness of their counterparty declines to the point of bankruptcy. A commonly quoted ATE in derivative contracts is a rating downgrade of one or both counterparties. For parties that are usually not rated, such as hedge funds, metrics such as market capitalization, net asset value, or key man departure may be used.

ATEs can be particularly useful when the counterparty has relatively good credit quality. They may also be useful for long-dated transactions as the creditworthiness may change at some point in the future, however “rosy” the current financial standing is.

ATEs may be mandatory, optional, or trigger-based, and may apply to one or both parties in a transaction.

In recent years, ATEs have been found to have potential dangers because of two main reasons:

  • Although the rating downgrade of a counterparty may reflect an increase in idiosyncratic risk that can easily be mitigated against, the rating downgrade of large financial institutions such as systematically important banks may be indicative of systematic risk that cannot be mitigated against even if the contract is terminated and replaced.
  • Because ATEs are often activated following a rating downgrade, they may not reduce a party’s exposure significantly because changes in ratings are generally reactive. In other words, the counterparty’s credit quality may have declined significantly by the time the ATE is activated. ATEs can be compared to the act of “closing the stable door when the horse has already bolted.”

Trade Compression

As we saw earlier, multilateral netting works in the presence of an intermediary (such as an exchange or CCP), and it also tends to mutualize and homogenize counterparty risk, reducing the incentive for parties to monitor the credit quality of the party on the other side of a trade. Trade compression presents an attempt to achieve multilateral netting without involving an intermediary.

By definition, portfolio compression is a risk reduction technique where two or more counterparties terminate some or all of their derivative contracts and replace them with a single derivative contract whose market risk is the same as the combined notional value of all of the terminated derivatives.

For example, assume that a party has three contracts on UK sovereign debt, all maturing in 5 years, but transacted with different counterparties – A, B, and C. It would be worthwhile to “compress” the three into a net contract, which represents the total notional of the long and short positions. This may naturally be with counterparty A as a reduction of the initial transaction. The coupon of the new contract is taken to be the weighted average of the three original ones.

frm-part-2-trade-compressionSeveral entities currently offer trade compression services mostly covering major OTC derivatives such as credit default swaps, interest rate swaps, and energy swaps. A good example would be TriOptima. Compression has enabled institutions to reduce credit exposures considerably.

Practice Question

In the quest to define the close-out amount, market quotation was developed by the concept of replacement cost with an alternative called the loss method. Which of the following best defines the loss method as a feature of the concept of replacement cost?

A. The process of obtaining a minimum of three quotes from the market, and use their average to compute the close-out amount by the determining party

B. The method used by an institution to lend money to a counterparty under a credit contract, and through interest rate swap, hedge the interest rate risk

C. The fallback mechanism in case the determining party finds it difficult to achieve the minimum three quotes required by the market quotations for all relevant transactions

D. The method used to offset the value across transaction and determine a net balance

The correct answer is C.

Through the loss method, in case it is not easy for the determining party to obtain the three quotes which are the minimum required by the market quotation, a fallback mechanism is provided for all relevant transactions. The determining party is required to calculate its loss by using reasonable assumptions.

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