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Sum up netting and close-out procedures, multilateral netting included, with their pros and cons, and show where they sit in the ISDA master agreement framework.

FRM® Part II · Credit Risk Measurement and Management · Netting, Close-out and Related Aspects · FRM2.CR.16.b

The idea

Close-out netting is the central procedure of the ISDA framework. When an Early Termination Date is designated under Section 6, all transactions under the agreement are terminated and each is valued at its replacement cost. The values are added into one net amount owed by one party to the other, so exposure is the larger of zero and the net sum. Payment netting under Section 2(c) is different and weaker. It only offsets amounts due on the same date in the same currency, which reduces settlement risk. Multilateral netting extends the idea to three or more participants, usually through a clearing house that becomes the counterparty to each, so every participant ends with one net position. The advantages are lower exposure, capital and settlement flows. The drawbacks are dependence on legal enforceability, concentration of risk in the central entity and possible sharing of a defaulter's losses among survivors. Do not confuse close-out netting with payment netting on the exam.

Formulas

Exposure under close-out netting

Net exposure = max(ΣV, 0)

ΣV
the sum of all trade values to you in the netting set

Needs an enforceable master agreement. Collateral held is then deducted from the net claim before applying the recovery rate.

A practice question

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

Which statement best describes multilateral netting?

  1. Positions of three or more parties offset through a central entity, one net position each - correct
  2. All transactions between one pair of counterparties are valued and combined into a single amount at defaultWhy not: Describes bilateral close-out netting, which involves only two parties.
  3. Two offsetting trades between a pair are cancelled and replaced by one smaller tradeWhy not: Describes bilateral trade compression, which has no central entity.
  4. Payments due on the same day in the same currency are offset into one paymentWhy not: Describes payment netting under Section 2(c).

Multilateral netting typically works by novation to a clearing house, so each participant faces only the central entity with one net position.

A harder one

Which part of the ISDA Master Agreement sets out how the termination amount is calculated and paid once an Early Termination Date has been designated?

  1. Section 2(c), Netting of Payments in the Same CurrencyWhy not: Covers only same-day, same-currency payments, not termination amounts.
  2. Section 6, Early Termination; Close-Out Netting - correct
  3. Section 5(a), Events of DefaultWhy not: Lists the events that allow termination; it does not set out the calculation.
  4. Section 1(c), Single AgreementWhy not: Establishes that all trades form one agreement, a precondition, not the calculation procedure.

Section 5 identifies Events of Default and Termination Events; Section 6 provides for designating the Early Termination Date and for the calculation and payment of the net amount.

The hardest tier

Three banks have payment obligations due on the same date, all in USD: A owes B 100, B owes C 80 and C owes A 60 (USD million). No two banks owe each other directly. With multilateral netting through a clearing entity, closest to the total amount paid into the clearing entity is:

  1. USD 40 million - correct
  2. USD 240 millionWhy not: The sum of all gross obligations; no netting is applied.
  3. USD 80 millionWhy not: Adds the net payers and the net receivers, counting each net amount twice.
  4. USD 100 millionWhy not: Takes the largest single bilateral obligation instead of the net positions.

Net positions: A pays 100 and receives 60, so -40; B receives 100 and pays 80, so +20; C receives 80 and pays 60, so +20. Only A pays in, 40, and the entity pays 20 to B and 20 to C.

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