Close-Out Netting

Close-out netting is a mechanism, written into master agreements for derivatives, repos and securities lending, under which the occurrence of a default or other termination event allows the non-defaulting party to terminate all outstanding transactions with its counterparty, calculate the replacement value of each, and offset them into one net sum. If the net sum is owed by the defaulter, the non-defaulting party has a single claim in the insolvency; if it is owed to the defaulter, the non-defaulting party pays that one amount.

It is the strongest and most important form of netting in financial markets. Unlike advisory netting, it changes legal rights; unlike payment netting, which nets amounts due on the same day, it covers all future obligations at once. Its value depends entirely on being enforceable under the insolvency law that applies to the defaulting party, which is why lawmakers and regulators in many countries have legislated to protect it.

Two businesses have a dozen open deals with each other, some due next month and some in five years. Some deals would make money for one side, some for the other. Then one business collapses.

Without close-out netting, the survivor might be forced to keep paying on every deal that favours the collapsed firm while waiting in line, maybe for years, for anything owed back. With close-out netting, all the deals are ended at once, each is given a current value, and they are added together. The result is one number, owed one way. That turns a mess of exposures into a single, much smaller one.

1. A trigger occurs, such as a failure to pay, insolvency or a cross-default, as defined in the master agreement.
2. The non-defaulting party designates an early termination date, or termination happens automatically for some insolvency events.
3. Each transaction is valued, typically at the cost of replacing it in the market, based on mark-to-market prices or dealer quotations.
4. Positive and negative values are combined with any unpaid amounts, and collateral is applied or set off, producing one net sum in a single currency.

The ISDA Master Agreement, in its 1992 and 2002 versions, is the standard document for OTC derivatives. Similar provisions appear in the Global Master Repurchase Agreement for repos and in securities lending agreements.

Close-out netting reduces gross exposures between active counterparties to a fraction of their size. That cuts counterparty risk and replacement cost risk, and reduces the risk that a single failure spreads through the market. Prudential rules recognise this: under the Basel framework, banks can calculate derivatives exposures on a net basis only where netting agreements are legally enforceable, supported by reasoned legal opinions. Netting also underpins the calculation of margin under bilateral margining rules.

The main threat to close-out netting is cherry-picking: an insolvency administrator choosing to enforce profitable contracts and reject unprofitable ones. Many jurisdictions have netting statutes or insolvency carve-outs that prevent this for qualifying financial contracts. In the United States, the Bankruptcy Code contains safe harbours for swaps, repos and similar contracts. In the European Union, the Financial Collateral Directive protects close-out netting provisions linked to financial collateral arrangements. ISDA commissions netting opinions for dozens of jurisdictions so members can confirm enforceability.

Bank resolution regimes add a nuance. To give authorities time to transfer a failing bank's contracts, many regimes allow a short temporary stay on termination rights. Industry protocols, such as ISDA's resolution stay protocols, have extended these stays to cross-border contracts. Close-out netting remains enforceable, but its timing can be suspended briefly in resolution.

Close-out netting usually operates between two parties, as a form of bilateral netting. A central counterparty applies a similar logic multilaterally: on a member's default it closes out or auctions the member's portfolio through its default management process. Payment systems use multilateral netting of same-day payment obligations, which reduces liquidity needs but does not deal with longer-dated contracts.

Valuation after default can be disputed, especially in volatile or illiquid markets, and legal uncertainty persists in some emerging jurisdictions. Close-out netting also concentrates selling pressure: when a large firm fails, its counterparties may all rush to replace hedges at once, as seen when Lehman Brothers collapsed in 2008.

• International Swaps and Derivatives Association (ISDA)