How do netting agreements reduce credit exposure and what is close-out netting?

Netting is arguably the most impactful credit risk mitigation technique in the derivatives market. Under an ISDA Master Agreement with a netting provision, it transforms how exposure is calculated upon default.

Types of netting:

1. Payment netting (settlement netting):

• On any given day, if both parties owe each other cash flows in the same currency, only the net amount is exchanged
• Reduces settlement risk (Herstatt risk) but doesn't change credit exposure significantly

2. Close-out netting (the big one):

• Upon default, ALL transactions under the ISDA Master Agreement are terminated simultaneously
• Each transaction is marked to market
• Positive and negative MTM values are netted into a single amount
• Only this net amount is owed — either to the surviving party or to the defaulter's estate

Why it matters — the numbers:

Consider Sentinel Bank with 10 interest rate swaps against Apex Corp:

Without netting (gross exposure):

Sum of positive MTM = $12 + $5 + $20 + $7 + $2 = $46M at risk

With close-out netting (net exposure):

Total MTM = $12 - $8 + $5 - $15 + $20 - $3 + $7 - $11 + $2 - $6 = $3M at risk

Reduction: 93.5% — from $46M to $3M

Legal requirements for netting to be enforceable:

1. An enforceable ISDA Master Agreement must be in place
2. The netting provision must be legally valid in the counterparty's jurisdiction
3. The agreement must include a single agreement clause — all transactions form one legal agreement
4. Legal opinions confirming enforceability in relevant jurisdictions

Netting ratio — measuring effectiveness:

Netting Ratio = Net Exposure / Gross Exposure

For Sentinel: 3/46 = 0.065 (93.5% reduction)

Industry average netting ratios for major dealers: 0.10-0.20 (80-90% reduction)

Impact on regulatory capital (Basel):

• Netting reduces Current Exposure in the current exposure method
• Reduces exposure under SA-CCR (Standardized Approach for Counterparty Credit Risk)
• Banks must have legal certainty of netting enforceability to claim capital benefits

Exam tip: FRM Part II tests the calculation of gross vs. net exposure, the legal requirements for enforceable netting, and the netting ratio concept.

Practice credit risk calculations on AcadiFi.