Book 2. Credit Risk

FRM Part 2

CR 16. Netting, Close-Out and Related Aspects

Presented by: Sudhanshu

Module 1. Netting and Close-Out Procedures

Module 2. Termination Provisions and Trade Compression

Module 1. Netting and Close-Out Procedures

Topic 1. ISDA Master Agreement

Topic 2. Netting & Close-Out Between Two Counterparties

Topic 3. Netting & Close-Out Between Multiple Counterparties

Topic 4. Netting Effectiveness

Topic 1. ISDA Master Agreement

• Definition: Standardized legal contract created by International Swaps and Derivatives Association (ISDA).

• Purpose:

  • Reduces legal uncertainty in OTC derivatives.

  • Provides a single governing contract instead of multiple bilateral agreements.

• Key Components:

  • Netting & Close-Out (reduces credit risk).

  • Collateral Agreements (e.g., CSA – Credit Support Annex).

  • Termination Events (standardized triggers).

• Scope: Covers multiple trades under one agreement with indefinite term.

• Global Importance: Legal opinions obtained in most jurisdictions → ensures cross-border enforceability.

• Why it matters? Without ISDA, each OTC derivative trade would have unique legal terms, creating inefficiency and higher risk.

Topic 2. Netting & Close-Out Between Two Counterparties

• Netting: Combines multiple payment obligations → one single net amount.

  • Example: Two trades MtM = +10 and -10.

    • Without netting: Exposure = +10.

    • With netting: Exposure = 0.

• Close-Out Netting: If counterparty defaults → terminate all trades & net the MtM values.

• Mechanics:

  • Right to terminate contracts unilaterally.

  • Right to offset obligations into single sum.

• Advantages:

  • Major reduction in counterparty credit risk.

  • Protects solvent party by allowing quick re-hedging.

  • Reduces margin/collateral requirements.

  • Stabilizes markets during financial distress.

• Disadvantages:

  • Netted exposure can still be volatile.

  • Unwinding illiquid trades may give counterparties pricing power.

  • Enforcement risk in certain jurisdictions.

Topic 3. Netting & Close-Out Between Multiple Counterparties

• Bilateral: One-to-one relationship.

• Multilateral: Many parties netting exposures through a central clearinghouse or exchange.

• How It Works:

  • Clearinghouse becomes the central counterparty (CCP).

  • Each trade nets through CCP, not directly between participants.

• Advantages:

  • Reduces systemic counterparty risk.

  • Increases market efficiency (fewer payments, fewer contracts).

  • Improves transparency in interconnected markets.

• Disadvantages:

  • Mutualized risk: Stronger firms may bear risk of weaker firms.

  • Less credit monitoring: Incentive to monitor counterparties decreases.

  • Confidentiality issues: Trades disclosed to clearinghouse.

• Example: A-B-C trade cycle (A→B, B→C, C→A). Without multilateral netting, 3 exposures exist. With netting, exposures cancel out.

Topic 4. Netting Effectiveness

• Key Idea: Netting reduces or eliminates exposures, but never increases them.

• Effective When:

  • Instruments can have both positive & negative MtM values.

  • Examples:

    • Interest rate swaps.

    • FX forwards & cross-currency swaps.

    • Futures.

• Less Effective When:

  • Instruments only generate positive MtM values.

  • Examples: Equity options, swaptions, FX options with upfront premiums.

• Still Valuable Because:

  • Future trades may offset exposures.

  • Required for effective collateralization.

  • Ensures no residual counterparty risk when unwinding.

Practice Questions: Q1

Q1. Riggs Resources, LLC, (Riggs) is a commodity trading firm. Riggs has numerous trades outstanding with several counterparties; however, it is concerned with presettlement risk. In order to reduce presettlement risk (the risk that Riggs’s counterparties would default before settlement), it would be most beneficial for Riggs to:
A. have payment netting.
B. have close-out netting.
C. analyze potential losses as the sum of exposures.
D. have netting but not set-off.

Practice Questions: Q1 Answer

Explanation: B is correct.

To minimize presettlement risk, Riggs should have close-out netting. Under closeout, contracts between solvent and insolvent counterparties are terminated and netted. Payment netting would reduce settlement and operational risk, but not presettlement risk. Netting also means individual positive exposures are nonadditive. The terms netting and set-off are synonymous.

Practice Questions: Q2

Q2. Entity XYZ is netting its trades with Entity ABC. Which of the following techniques best describe this type of netting arrangement?

A. Multilateral netting.
B. Bilateral netting.
C. Close-out netting.
D. Additive exposure netting.

Practice Questions: Q2 Answer

Explanation: B is correct.

Bilateral netting is a netting arrangement between two entities and is limited to two entities. Trades with multiple counterparties is known as multilateral netting. Close-out netting refers to netting contract values with a counterparty if the counterparty defaults.

Practice Questions: Q3

Q3. Assume the following current MtM values for five different transactions for Entity ABC: +5, −4, +2, +3, and −6. What is the total exposure with and without netting, respectively?
A. 0, 10.
B. 20, 10.
C. 10, 0.
D. 10, 20.

Practice Questions: Q3 Answer

Explanation: A is correct.

The total exposure with netting is 0 (5 − 4 + 2 + 3 − 6 = 0), and the total exposure without netting is 10 (5 + 2 + 3 = 10).

Practice Questions: Q4

Q4. Which of the following trading instruments would have the most beneficial effect on netting?
A. Options with up-front premiums.
B. Equity options.
C. FX options.
D. Futures.

Practice Questions: Q4 Answer

Explanation: D is correct.

A trading instrument will have a beneficial effect on netting if it can have a negative mark-to-market (MtM) value during its life. For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial. Instruments with only positive MtM values include options with upfront premiums such as equity options, as well as swaptions, caps and floors, and FX options. Futures can have negative MtM values.

Module 2. Termination Provisions and Trade Compression

Topic 1. Termination Provisions & Trade Compression

Topic 2. Advantages of Termination Provisions & Trade Compression

Topic 3. Disadvantages of Termination Provisions & Trade Compression

Topic 4. Termination Events

Topic 5. Trade Compression Example

Topic 1. Termination Provisions & Trade Compression

• Termination Provisions:

  • Reset Agreements: Reset trades to “at-the-money” periodically (limit in-the-money risk).

  • Break Clauses (Liquidity Puts): Right to exit at pre-specified dates/conditions.

  • Walkaway Clauses: Allow walking away from liabilities if counterparty defaults (rare post-1992 ISDA).

• Trade Compression:

  • Reduces number of redundant trades and notional exposure.

  • Keeps same net risk profile while simplifying portfolio.

  • Facilitated by vendors (e.g., TriOptima).

• Why Important? Helps banks reduce leverage, improve capital ratios, and manage operational risk.

Topic 2. Advantages of Termination Provisions & Trade Compression

• Termination Provisions:

  • Protects against deteriorating credit quality before bankruptcy.

  • Break clauses provide exit options in long-dated trades.

  • Resets reduce large MtM build-up → less credit exposure.

  • Enhances hedging certainty.

• Trade Compression:

  • Reduces gross notional exposure.

  • Lowers collateral & capital requirements (Basel III benefit).

  • Improves operational efficiency (fewer contracts to track).

  • Reduces systemic risk by cutting redundant exposures.

Topic 3. Disadvantages of Termination Provisions & Trade Compression

• Termination Provisions:

  • May accelerate financial distress (forcing early settlement).

  • Banker’s Paradox: Break clause most useful if exercised early, but usually delayed to maintain relationships.

  • Walkaway clauses → moral hazard & systemic risk concerns.

• Trade Compression:

  • Requires disclosure of trade details → confidentiality risk.

  • Complex operational process, dependent on algorithmic matching.

  • Not all trades compressible → residual risk remains.

  • Possible disruption if counterparties disagree on valuations.

Topic 4. Termination Events

• Types:

  • Mandatory: Trade ends automatically at pre-set date.

  • Optional: Either party may terminate at defined future date.

  • Trigger-Based: Linked to external event (e.g., credit rating downgrade).

• Examples:

  • Credit downgrade below investment grade.

  • Bankruptcy filing.

  • Change in law/regulation making trade unenforceable.

• Effects:

  • Allows risk exit before counterparty bankruptcy.

  • Reduces uncertainty in exposure.

  • Can strain business relationships if exercised too aggressively.

Topic 5. Trade Compression Example

• Scenario: Bank holds 3 CDS contracts for the same reference entity:

  • Contract A: Buy protection, $50 notional.

  • Contract B: Sell protection, $25 notional.

  • Contract C: Sell protection, $25 notional.

• Compression Result:

  • All 3 contracts replaced by 1 net contract.

  • Net Notional = $0 (or reduced if imbalanced).

  • Fewer contracts, same overall risk profile.

• Industry Practice:

  • TriOptima & other vendors run compression cycles.

  • Widely used in CDS, interest rate swaps, and FX derivatives.

• Benefits: Lower systemic exposure, easier portfolio management.

Practice Questions: Q1

Q1. Leverage, Inc., an investment bank, has numerous credit default swaps with XYZ Corp. Leverage has established a break clause with XYZ Corp. to reduce risk. The break clause is trigger-based and may be exercised once the trigger is satisfied. The CEO of Leverage is concerned about a banker’s paradox. Which of the following statements best describe the CEO’s concern?
A. To be effective, the break clause option should not be used too early.
B. The weak firm often recovers after the use of the break clause.
C. The break clause option is used too late, and the weak firm gets weaker.
D. The break clause option is used too early, and is unlikely to avoid systemic risk issues.

Practice Questions: Q1 Answer

Explanation: C is correct.

A break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Despite their advantages, break clauses have not been highly popular. One explanation is known as banker’s paradox, which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterparty’s credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.