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Netting is a procedure that is commonly used by organizations all over the world to reduce their counterparty credit default risk. However, in order for the netting procedure to be carried out, companies should have contracts in place prior to the default event taking place.
There is another procedure called close-out which is closely related to netting. In this article, we will have a closer look at what netting and closeout mean as well as what are the advantages related to these procedures.
Netting refers to the right that a lending company has to combine all the cash flows with their counterparty in order to reach a net receivable or payable figure.
For instance, a company may have given a loan of $150 to another company. However, they are also holding $100 in deposits from that same company. If the netting agreement were not in place, the lending company would lose its $150 loan in the event of a default and would still have to pay back the $100 in order to avoid being shown as the defaulting party. This is because the two separate transactions are considered to be two separate contracts with terms and conditions which are not related to one another.
However, the netting procedure allows the different contracts to be set off against one another. This is done in order to reduce or eliminate the settlement risk. The end result of netting is that contracts with negative mark to market values as well as the ones with positive mark to market values are combined together. The end result is a single net payable or receivable which would offset all the open items between the two parties.
A closeout is a procedure that is closely related to netting. The only difference is that closeout can happen before an actual default takes place. A closeout allows the company to stop servicing all contracts with a counterparty as soon as it is close to default. For instance, if a company is close to defaulting on its debt, the counterparty can stop shipping any more goods even though the sale may have happened.
The closeout procedure allows the company to void the contract if certain pre-defined events take place. Hence, a close-out is a contract that reduces the pre-settlement risk. The idea behind a closeout is that if a company is reaching close to default, the credit exposure to it should be minimized. In such a scenario, continuing to fulfill the obligations of an old contract would increase the exposure and aggravate the risk.
A closeout netting contract may also have a clause wherein the defaulting party may be under obligation to find a suitable counterparty for the contract. They may be legally required to pay the additional transaction costs as well as the difference which are arising because of the closeout. This additional cost is recovered using what is known as a compensation claim.
The closeout agreements may also have an accelerated clause inbuilt into them. As per this clause, companies can push forward the date of future payables and make them due immediately. This is done with the intent of recouping as much cash as possible before the company actually goes into default. However, it often results in bringing the company closer to the brink of disaster. There is a difference between close-out and acceleration. The difference is that under the acceleration clause, the underlying contracts still remain valid whereas in a closeout the contracts become voidable at the discretion of one party.
The netting procedure is often mentioned in the derivatives contract. However, it is only useful if the derivative contract has the possibility of having a negative mark to market value. For some derivative instruments like options, there is no possibility of having a negative mark to market value. Hence, in such cases, the netting procedure is not of much use. However, even in such cases, companies still include netting in their contracts. This may happen because of the following reasons:
These companies intend to execute more agreements with the same counterparty over a period of time. Hence, there is an assumption that at some point of time in the future, they might execute a contract that might have a negative mark to market value and the netting provision might become useful
The netting contract can also be used to reverse the option contract. When companies use netting, they can ask the counterparty to enter into a reverse contract. This contract will have exactly the reverse terms as compared to an earlier contract. Because of netting provisions, these two contracts can be set off against each other and all credit, as well as market risks, can be eliminated
The fact of the matter is that netting, close-out, and acceleration clauses in contracts are very useful for companies who are trying to manage their credit risk better.
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