Financial institutions and other market participants use a number of mechanisms in their daily operations designed to reduce risk exposure, such as providing each other with security or collateral. In addition, participants may agree to include provision for close-out netting in the contracts they enter with each other.
Close-out netting is a relatively new addition to legal terminology and was, until recently, not particularly well defined. Generally speaking, a close-out netting mechanism is either triggered automatically when a predefined event occurs, such as default or insolvency of the counterparty, or it comes into operation upon a declaration by one of the parties when an event such as those mentioned above occurs. The mechanism, once triggered, extends to all outstanding transactions between the parties that are contractually included in the netting provision. In general, all transactions covered by the close-out netting provision once it is operational are terminated, and a value is determined for each under a predefined valuation mechanism. The sum value of all the transactions is then aggregated, resulting in a single net payment obligation due immediately after its determination, even if no debts were due and payable under the transactions covered by the close-out netting provision prior to its activation.
Close-out netting is often understood, in broad terms, as resembling the established concept of set-off, applied upon default or insolvency of one of the parties. Traditionally, set-off applies only to parties with mutual debts of the same type that are already due and payable, and that are legally distinct. Whether set-off occurs by contract, by unilateral declaration by one party or by operation of law, the parties’ existing debts are set off against each other, so that the party with the smaller debt owes nothing, and the party with the larger debt owes only the difference between the two obligations. While conceptual overlaps can occur between set-off and close-out netting, they are neither functionally nor conceptually identical, and the latter mechanism covers additional elements, such as providing for the netting of obligations not yet payable.
Close-out netting provisions are widely used in the financial market, and are typically applied to derivatives, repurchases, securities lending agreements and other transactions which tend to carry a high counterparty and/or market risk. Regulators strongly encourage its use, alongside collateral, because it adds to the stability of the financial system.
The benefits of close-out netting are particularly evident in the event of partial insolvency, when the legal effects of such provisions are recognised and enforced under the applicable insolvency law. However, in the current situation, even those few jurisdictions which recognise netting in insolvency do so to varying extents, and differ in their views on its scope and legal effects. Some jurisdictions which do not clearly recognise netting apply the principles that govern set-off, failing to recognise the fundamental differences between the two. In cross-jurisdictional situations this exposes financial market participants’ risk management to unnecessary legal uncertainty and may even jeopardise it. Establishing a common international standard is of utmost importance.
Legislators, regulators and other government officials in countries worldwide are seeking to implement netting legislation at a local level, to modernise their national financial markets and to ensure the competitiveness of their financial institutions and market participants in the global marketplace.
Recently, Bahrain adopted the International Swaps and Derivatives Association’s “Model Netting Act” pursuant to Resolution No. 44 of 2014. The resolution underlies a detailed legal framework for close-out netting. The promulgation of the resolution is a great leap towards building a more competitive and internationally compatible financial market in Bahrain.