Close-Out Netting and Risk Management in Over-the-Counter Derivatives

Abstract

Close-out netting is a credit risk mitigation process that applies to over-the-counter derivative transactions between a defaulting party and a non-defaulting party. It also applies to repurchase agreements and clearing houses. The process consists of three steps: termination of obligations under a contract with a defaulting party, calculation of replacement values, and combining of positive and negative replacement values into a single net payable or receivable. The rationale for close-out netting is the nature of market risk management for over-the-counter derivatives and other financial contract, which involves maintaining a hedged, balanced portfolio by means of offsetting transactions with other counter parties. If a counter party defaults, the portfolio is no longer balanced, so it is necessary either to replace the defaulted transactions or unwind the offsetting transactions. Failure to do so would in effect create open positions that are vulnerable to market fluctuations. Close-out netting makes it possible for intermediaries to manage risks following a default by facilitating the reestablishment of a balanced book. As a result of its credit risk management benefits, close-out netting has enjoyed almost universal support from policy makers as well as from the financial industry. In order for close-out netting to function effectively, however, it is necessary to create exceptions to bankruptcy statute; these exceptions are often called “safe harbors.” Recently, some regulators have called for some discretion over the close-out netting process in resolving failed financial institutions. But there have also been proposals in the United States to remove the safe harbors entirely. While the regulatory proposals will not likely hamper the functioning of the close-out netting process, removing the safe harbors could have significant adverse consequences for financial stability.