LO 25.2: Summarize netting and close-out procedures (including multilateral

LO 25.2: Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages, and describe how they fit into the framework o f the ISD A m aster agreement.
N etting and Close-O ut Between Two Counterparties
Netting, often called set-off, generally refers to combining the cash flows from different contracts with a counterparty into a single net amount. This is referred to as payment netting, which acts to reduce settlement risk while enhancing operational efficiency. A related concept is close-out netting, which refers to the netting of contract values with a counterparty in the event of the counterpartys default. The concepts of both netting and close-out incorporate two related rights under a single contract: (1) the right to terminate contracts unilaterally (by only one side) under certain conditions (close-out) and (2) the right to offset (net) amounts due at termination into a single sum.
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Before we examine close-out closer, it is important to discuss netting in more detail. Netting has enabled an explosive growth in credit exposures and notional values of trades, and it now covers most derivatives transactions. Institutions often have multiple trades with a counterparty, and these trades can constitute hedges whose values move in opposite directions, or they may constitute unwinds where a reverse trade of equal and opposite value has been executed with the same counterparty. Without netting, an entitys exposure of two equal and opposite trades is the positive mark-to-market exposure. For example, if an entity has two equal and opposite trades with a counterparty with mark-to-market values of + 10 and 10, without netting the total exposure is +10. This means that if the counterparty defaults, the value of the two trades is not netted, with the surviving entity having to make a settlement under the negative mark-to-market trade, while unable to collect on the positive one. Therefore, without netting, overall exposure is additive as the sum of the positive mark-to-market values. With netting, exposures of trades are not additive, which significantly reduces risk.
Netting has several advantages and disadvantages:

Exposure reduction: By offsetting exposures with parties managing net positions only, netting reduces risk and improves operational efficiency. Nevertheless, netted exposures can be volatile, which may result in difficulty in controlling exposure.
Unwinding positions’. If an entity wishes to exit a less liquid OTC trade with one
counterparty by entering into an offsetting position with another counterparty, the entity will remove market risk; however, it will be exposed to counterparty and operational risk. Netting removes these risks through executing a reverse position with the initial counterparty, removing both market and counterparty risk. The downside is that the initial counterparty, knowing that the entity is looking to exit a trade, may impose less favorable terms for the offsetting transaction.
Multiple positions’. An entity can reduce counterparty risk, obtain favorable trade

terms, and reduce collateral requirements by trading multiple positions with the same counterparty. Stability: Without netting, entities trading with insolvent or troubled counterparties would be motivated to cease trading and terminate existing contracts, exacerbating the financial distress of the counterparty. With netting, this risk is significantly reduced, and an agreement with a troubled counterparty is more achievable.
Netting agreements (specifically close-out netting) are legal agreements that become effective in the event of a counterpartys bankruptcy. As mentioned, netting agreements are often governed by the ISDA Master Agreement, which serves to eliminate legal uncertainties and reduce counterparty risk under a single legal contract with an indefinite term. A single universal agreement also helps avoid problems that may arise from different treatments of bankruptcy in different jurisdictions. For example, ISDA has obtained legal opinions for the Master Agreement in most jurisdictions. Agreements often cover bilateral netting, which is used for OTC derivative and repo transactions, and balance sheet loans and deposits. When no legal agreement exists that allows netting, exposures do not offset each other and are considered additive.
Close-out and netting become advantageous in derivatives transactions following the default of a counterparty when cash flows cease because these rights allow an entity to execute new replacement contracts. It is clear then that close-out arrangements protect the solvent, or surviving, entity. Note that close-out differs from an acceleration clause, which allows the creditor to accelerate (i.e., make immediately due) future payments given a credit event,
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such as a ratings downgrade. In contrast to acceleration, close-out clauses allow all contracts between a solvent and insolvent entity to be terminated, which effectively cancels the contracts and creates a claim for compensation. If the solvent entity has a negative mark- to-market exposure (it owes the insolvent entity), then the full payment is made to the insolvent entity. If the mark-to-market exposure is positive, the solvent entity becomes a creditor for that amount and can terminate and replace the contracts with another entity.
Both acceleration and close-out clauses have been criticized for making a debtors refinancing more difficult. Both clauses cause payment amounts to be immediately due and may speed up the financial distress of the insolvent entity. For this reason, courts may impose a stay (temporary suspension) on the agreements to allow for a short period of time out while maintaining the validity of the termination clauses.
Despite these criticisms, close-out clauses can be very advantageous to parties. Close-out limits the uncertainty in the value of an entitys position with an insolvent counterparty. Without close-out, an entity would have difficulty estimating to what degree positions offset each other because recovery of exposure is not known. With close-out, however, the solvent entity can fully re-hedge transactions with the insolvent entity while waiting to receive a claim. As a result, although the solvent entity may experience some risk loss, it would minimize market risk and trading uncertainty. In addition, close-out allows entities to freeze their exposures. Because these exposure amounts are known and will not fluctuate, the solvent entity can then better hedge this exposure.
Netting and Close-O ut Between M ultiple Counterparties
Up until this point, we have been discussing bilateral netting; that is, netting arrangements between two entities. Bilateral netting is important in reducing credit exposure; however, it is limited to two entities only. In reality, trades are often structured in a way where an entity trades with multiple counterparties (known as multilateral netting). For example, entity A can have exposure to B, entity B has the same exposure to entity C, and entity C has an identical exposure to entity A. The default of any of these entities would give rise to questions on how to allocate losses.
Under multilateral netting, netting arrangements would involve multiple counterparties to mitigate counterparty and operational risk. Typically, multilateral netting is achieved with a central entity, such as an exchange or clearinghouse, handling the netting process, including valuation, settlement, and collateralization. A disadvantage, however, is that this type of netting arrangement mutualizes counterparty risk and results in less incentive for entities to monitor each others credit qualities. In addition, multilateral netting can enable redundant trading positions to accumulate in the system, resulting in higher operational costs (this risk is reduced by firms that use algorithms to detect and reduce redundant positions). Finally, multilateral netting requires trading disclosure, which may be disadvantageous to firms wishing to keep proprietary information confidential.
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