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Compare how netting operates in centrally cleared markets and in bilateral ones.

FRM® Part I · Financial Markets and Products · Central Clearing · FRM1.FM.6.f

The idea

Netting reduces exposure by offsetting what a party owes against what it is owed. In bilateral markets netting is available only within one pair of counterparties, and only inside a master agreement whose close-out netting is legally enforceable. So a dealer facing three counterparties computes three separate net amounts, and exposure is the sum of the positive ones. At a CCP, netting is multilateral. All of a member's trades in a product class with the CCP collapse into one net position, so offsetting trades done with different counterparties cancel. The benefit disappears if trades are split across several CCPs, between cleared and uncleared sets, or between house and client accounts. Exam point: central clearing gives wider netting within one CCP but can fragment netting across CCPs, and netting is worthless where its enforceability is in doubt.

A practice question

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

How does netting work in bilateral OTC markets?

  1. Positions are netted across all counterparties automaticallyWhy not: This describes multilateral netting at a CCP, not bilateral netting.
  2. Netting is applied by the regulator at the end of each dayWhy not: Netting is done by the parties under their legal agreement, not by regulators.
  3. Positions are netted only within the same trading desk of each bankWhy not: Bilateral netting is by counterparty pair and master agreement, not by desk.
  4. Positions are netted only between the same two counterparties - correct

Bilateral netting is done pair by pair under a legal master agreement. A dealer with many counterparties has many separate netting sets.

A harder one

For bilateral netting to reduce the credit exposure a bank must hold capital against, which condition is required?

  1. The two counterparties must have exactly equal gross exposures to one anotherWhy not: Netting does not require equal exposures; it reduces whatever the difference is.
  2. The trades must all be in the same currency and same productWhy not: A master agreement can net across products and currencies; the key requirement is enforceability.
  3. Close-out netting must be legally enforceable in the relevant jurisdictions - correct
  4. The counterparties must both be clearing members of a CCPWhy not: Bilateral netting does not involve a CCP at all.

Netting benefits depend on legal certainty: if a court might not enforce close-out netting on default, the exposure must be treated gross. Legal opinions on enforceability are therefore central.

The hardest tier

A member has two offsetting positions with a P&L correlation of -0.9 whose stand-alone initial margins are USD 10 million each. At a single CCP, margin is computed on the portfolio. If the positions are split between two CCPs, each CCP margins one position alone. How much more initial margin must the member post when the trades are split, in USD million, closest to?

  1. 5.5Why not: Compares the split margin with only one stand-alone margin instead of 20, using 10 - 4.47.
  2. 0.5Why not: Applies the correlation with the wrong sign (+0.9), so almost no diversification benefit is lost.
  3. 20.0Why not: Reports the total split margin and not the extra relative to the single-CCP portfolio margin.
  4. 15.5 - correct

Single CCP: sqrt(10² + 10² + 2 x (-0.9) x 10 x 10) = sqrt(20) = 4.47. Split: 10 + 10 = 20. Extra = 20 - 4.47 = 15.5. Fragmenting netting across CCPs destroys the offset benefit.

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