Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

4.2 Netting

Consider a holder of a debt security from a bankrupt company. Not only do they expect to make a substantial loss due to the default, but they also must expect it to be some time (often years) before they will receive any recovery value linked to the notional amount of their claim. Whilst this is problematic, it has not been considered a major problem, for example, in the predominantly buy-to-hold, long-only, cash bond market.

Derivatives markets are fast moving, with participants regularly changing their positions and where many instruments offset (hedge) one other. When a counterparty defaults then the market needs a mechanism whereby participants can replace (re-hedge) their position with other counterparties. Furthermore, it is desirable for an institution to be able to offset what it owes to the defaulted counterparty against what they themselves are owed. The following two mechanisms facilitate this:

• Payment netting. This gives an institution the ability to net cash flows occurring on the same day. This typically relates to settlement risk.
• Closeout netting. This allows the termination of all contracts between the insolvent and a solvent counterparty, together with the offsetting of all transaction values (both in an institution's favour and against it). This typically relates to counterparty risk.

Netting legislation covering derivatives has been adopted in most countries with major financial markets. ISDA has obtained legal opinions supporting the closeout ...