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Define netting and walk through how a netting process operates.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.c

The idea

Netting replaces many obligations between two parties with one. Payment netting offsets same-day, same-currency payments, so if A owes B 10 and B owes A 7, only 3 moves, from A to B. Close-out netting, the form that matters for credit risk, works under a master agreement such as the ISDA Master Agreement. When one party defaults, all transactions under the agreement are terminated, valued and combined into a single net amount owed by one side. Credit exposure to the counterparty is therefore the net value of the trades, floored at zero: Exposure = max(sum of trade values, 0). Without netting, the exposure would instead be the sum of the positive trade values only, ignoring the trades with negative value. With a CCP, novation makes netting multilateral, so each member holds one net position against the CCP across all its trading partners in the cleared trades. Netting cuts exposure only where it is legally enforceable. It applies within a netting set, so a trade outside the agreement is not offset against the others.

Formulas

Credit exposure to a counterparty under close-out netting

exposure = max(Σ Vᵢ, 0)

Vᵢ
the value to you of trade i in the netting set

Only within one legally enforceable netting set. Without netting the exposure is Σ max(Vᵢ, 0), the positive trades alone, and a trade outside the set is not offset against the others.

Credit exposure to a counterparty without netting

exposure = Σ max(Vᵢ, 0)

Vᵢ
the value to you of trade i with the counterparty

Each trade stands alone, so trades with negative value are ignored rather than offset. It is never smaller than the netted exposure, which is why netting matters only where it is enforceable.

A practice question

From the question bank, with the reason each wrong option is wrong.

Under a master netting agreement, what does close-out netting do when one party defaults?

  1. It lets the non-defaulting party keep gains on winning trades and ignore losing trades.Why not: That is cherry-picking, which close-out netting exists to prevent.
  2. It settles each trade separately in the order they were executed.Why not: Trade-by-trade settlement is the gross treatment; netting gives a single net figure.
  3. It reduces each trade's value by the defaulter's expected recovery rate.Why not: Recovery affects the final payout on the net claim, not how the trades are netted.
  4. It terminates, values and nets all trades into one amount payable by one side. - correct

Close-out netting converts a portfolio of obligations into a single claim, so the non-defaulting party cannot be forced to pay on losing trades while queueing for recovery on winning ones.

A harder one

A bank has four trades with one counterparty under an enforceable master netting agreement, with values to the bank of +12, -5, +8 and -9 (USD million). If the counterparty defaults, what is the bank's credit exposure?

  1. USD 6 million - correct
  2. USD 20 millionWhy not: Adds only the positive values, ignoring the netting agreement.
  3. USD 34 millionWhy not: Adds the absolute values of all four trades instead of netting their signs.
  4. USD 12 millionWhy not: Takes the single largest trade rather than the net of all trades in the set.

Net value = 12 - 5 + 8 - 9 = 6, and exposure = max(6, 0) = 6. Without netting the exposure would be 12 + 8 = 20.

The hardest tier

Three dealers have bilateral net positions: B owes A USD 50 million, C owes B USD 40 million, and A owes C USD 30 million. All three novate their trades to a CCP, which nets each dealer's position across counterparties. By how much do the dealers' combined credit exposures fall?

  1. USD 120 millionWhy not: Assumes the net positions across the loop sum to zero, so all exposure disappears; the net positions are +20, -10 and -10, and A is still owed 20.
  2. USD 80 millionWhy not: Counts the negative net positions as exposures to the CCP, giving residual exposure of 40 rather than 20.
  3. USD 100 million - correct
  4. USD 20 millionWhy not: Reports the exposure that remains after clearing instead of the reduction.

Before clearing, exposures are A 50, B 40, C 30 = 120. At the CCP the nets are A 20, B -10, C -10, so only A's positive 20 is an exposure. The fall is 120 - 20 = 100.

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