48

Law in transition 2012

05
Close-out netting
and the world of derivatives
in central and eastern
Europe and beyond –
ISDA’s perspective

DR PETER M WERNER

Legal certainty as to the enforceability of close-out netting and

financial collateral arrangements is crucial for any cross-border
derivatives transaction in over-the-counter (OTC) derivatives. A
number of related issues (for example, conflict of law rules) have
become more relevant in recent years as well. The International
Swaps and Derivatives Association (ISDA) currently focuses its law
reform work on around 30 emerging market jurisdictions across
Europe, the Middle East and Africa in order to improve the local
legal and regulatory framework. Particular emphasis is given to
jurisdictions in central and eastern Europe, the south-eastern
Europe/Commonwealth of Independent States region, that is,
the EBRD’s countries of operations. This article summarises
the ISDA’s views on recent developments in this region.
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Focus section: Developing capital markets

Introduction: the importance of been one of ISDA’s core missions since it was
close-out netting chartered in 1985. ISDA publishes the ISDA
Master Agreement, which is the standard
ISDA is the global trade association documentation template used for cross-border
representing leading participants in the transactions in OTC derivatives across the
privately negotiated derivatives industry, a globe. Along with standard documentation
business that includes interest rate, currency, ISDA publishes industry legal opinions on
commodity, credit and equity swaps, options the enforceability of close-out netting as
and forwards, as well as related products well as financial collateral arrangements.
such as caps, collars, floors and swaptions.
The main starting point for every law reform
ISDA has over 830 member institutions from effort aimed at improving legal certainty
60 countries worldwide. These members for OTC derivatives transactions entered
include most of the world’s major institutions into with counterparties from emerging
that deal in privately negotiated derivatives, as market jurisdictions is the enforceability of
well as many of the businesses, governmental close-out netting and financial collateral
entities and other end-users that rely arrangements (in a very limited number
on (OTC) over-the-counter derivatives to of jurisdictions the issue of anti-wagering
efficiently manage the financial market risks provisions needs to be addressed also).
inherent in their core economic activities.
Close-out netting is the primary means of
Promoting legal certainty for cross-border mitigating credit risks associated with OTC
financial transactions through law reform has derivatives transactions. The risk mitigation
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Law in transition 2012

benefits of netting are substantial: according risk effectively. The first section describes the
to the Bank for International Settlements’s mechanics of close-out netting. The second
regular surveys, netting benefit, measured as section reflects the situation in central and
the difference between gross mark-to-market eastern Europe, south-eastern Europe and
By the middle value and credit exposure after netting, has the Commonwealth of Independent States
been over 85 per cent for many years now.1 (CEE/SEE/CIS) region in particular.
of 2011 over 40
countries had Support for netting is practically universal What is netting?
in the financial industry as well as among Master agreements are regularly used as
enacted legislation policy-makers; by the middle of 2011 over contracts under which over-the-counter
that provides 40 countries had enacted legislation that derivative transactions between two
explicitly for the provides explicitly for the enforceability of counterparties take place. Each transaction
close-out netting (several more jurisdictions is not a separate contract, but is incorporated
enforcement of allow for the enforceability of close-out netting by reference into a single agreement. Most
close-out netting without the need for specific statues). The cross-border transactions in OTC derivatives
longstanding consensus among industry transactions worldwide are documented under
and policy-makers suggests that addressing the ISDA Master Agreements. Netting takes
close-out netting is one of the more successful two forms in the ISDA Master Agreement
examples of international legal and regulatory (as well as several of national equivalents
harmonisation. Most recently, in July 2011 for domestic transactions). Payment netting
and November 2011, respectively, the Basel takes place during the normal business
Committee on Banking Supervision (BCBS) and of a solvent firm, and involves combining
the Financial Stability Board (FSB) reaffirmed offsetting cash flow obligations between two
their support for close-out netting.2 parties on a given day in a given currency into
a single net payable or receivable; payment
In reaffirming its support, however, both BCBS netting is essentially the same as set-off.
and FSB called for short delays to termination
and close-out of insolvent financial institutions The other form of netting is close-out netting,
in order to allow time to transfer the insolvent which applies to transactions between a
firm’s financial contracts to a solvent firm. The defaulting firm and a non-defaulting firm.
general suggestion is to have such delays limited Close-out netting refers to a process involving
to two business days at most. While highlighting termination of obligations under a contract with
the importance of netting and financial collateral a defaulting party and subsequent combining
as part of systemic risk reduction, there is the of positive and negative replacement values
perceived need for a temporary stay in connection into a single net payable or receivable. Chart 1
with the exercise of transfer powers. A delay is shows how netting works. The defaulting and
said to be for the purpose of giving resolution non-defaulting party are engaged in two swap
authorities time to decide which assets or transactions: for the non-defaulting party,
liabilities of a failing firm should be transferred, Transaction 1 has a negative replacement cost of
and also to effect the transfer. This perception USD 1 million while Transaction 2 has a positive
arises from the belief that the ability to close- replacement cost of USD 800,000. If close-
out early will lead financial creditors to make out netting is enforceable, the non-defaulting
a “disorderly rush for the exits”. The effect is a party is obliged to pay the net difference of
temporary stay of the initiation of the close-out USD 200,000 to the defaulting party. Had the
netting process, namely, the early termination net amount favoured the non-defaulting party,
of transactions following an event of default. the non-defaulting party would become a
general creditor to the defaulting party for the
The need for cross-border coordination in net obligation. But if close-out netting were not
matters around bank resolution provides enforceable, the non-defaulting party would be
more reasons to ensure that a sound obliged immediately to pay USD 1 million to the
legal framework underlies netting of defaulting party but then wait, possibly months
financial contracts in every jurisdiction. or years, for whatever fraction of the USD
800,000 gross amount it recovers in bankruptcy.
The objective of this article is to show the The result of close-out netting is to reduce
necessary conditions for netting to mitigate credit exposure from gross to net exposure.
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Focus section: Developing capital markets

The close-out netting process involves three Why close-out netting is necessary
steps: termination, valuation and determination Close-out netting is an essential component of
of net balance. Termination means that the hedging activities of financial institutions
the non-defaulting party puts an end to the and other users of derivatives. For swap dealers,
The close-out obligations under the Master Agreement. who specialise in bringing counterparties
The second step, valuation, is the process together for transferring risk, the need for
netting process of determining the replacement cost of netting stems from the dealer’s central role in
involves three each transaction under the contract. Lastly, risk intermediation. Each time a dealer enters
determination of net balance means that positive into a transaction with a counterparty, the
steps: termination, values – those owed to the non-defaulting dealer takes on exposure to the transferred
valuation and party– and negative values – those owed by risk. The dealer does not normally wish to
determination of the non-defaulting party – are netted against retain the exposure however, so it enters into
each other under the single agreement in offsetting hedge transactions. By maintaining a
net balance order to determine a final close-out amount. matched book – or more accurately, a balanced
book – of offsetting transactions, the dealer
What happens next depends on which party avoids unwanted exposure to movements in
owes the netted close-out amount to the interest rates, currencies and other sources
other. If the defaulting party owes the close- of market risk. The result of this hedging
out amount to the non-defaulting party, the activity is that, over time, the aggregate of
non-defaulting party can apply the value of derivatives activity includes a large number of
collateral posted by the defaulting party to the inter-dealer and other hedge transactions that
net obligation. Collateral in excess of the net function largely to adjust risk positions and
obligation must be returned to the insolvency limit exposure to market movements. Indeed,
administrator; alternatively, the non-defaulting the trillions of dollars of derivative notional
party’s residual claim after netting and amounts outstanding are largely the result of
application of collateral will be treated the same this ongoing hedging and rebalancing process.
as other unsecured claims, and will be paid
at the same time as other unsecured claims Dealer hedge transactions involve many
as determined by a bankruptcy court. But if counterparties, all of which pose some risk of
the non-defaulting party owes the close-out default. If the counterparty were to default, the
amount to the defaulting party, it may set off dealer can no longer assume its exposures are
the amount that it owes against the amount hedged. The dealer will consequently find himself
owed to it by the defaulting party under other, exposed to unanticipated market movements.
non-derivative contracts. The non-defaulting In order to neutralise the exposures, the
party will pay to the insolvency administrator any dealer needs to adjust the portfolio to bring
net close-out amount remaining after set-off. it back into balance by either replacing the
defaulted transactions or by unwinding the

Chart 1
Payment obligations with and without close-out netting
Close-out netting under Sec. 6 of 2002 ISDA Master Agreement
Transaction 1 = US $1,000,000
Non-defaulting Defaulting
Transaction 2 = US $800,000
party party
Net payment = US $200,000

If close-out netting is not enforceable

Non-defaulting Pay US $1,000,000 Defaulting

party Recovery ≤ US $800,000 party
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Law in transition 2012

offsetting hedge transactions, or both. Netting than 40 jurisdictions have enacted – and
and collateral facilitate this rebalancing several more are considering – legislation
process; netting, by reducing the exposure that explicitly provides for the enforceability
that needs to be rebalanced and collateral, by of close-out netting. ISDA also collects legal
Across the CEE/ providing resources that can be offset against opinions regarding enforceability of the close-
replacement costs. Even when derivatives are out netting provisions of the ISDA Master
SEE/CIS region there cleared through a central counterparty, it is Agreement with counterparties located in
have been major necessary to balance market risks; if a default a particular jurisdiction. ISDA currently has
occurs under clearing, close-out netting is netting opinions for almost 60 jurisdictions.
developments in the essential to the ability of the clearing house And similarly, ISDA has obtained opinions
legal frameworks to manage its risks through rebalancing. regarding the enforceability of ISDA Credit
for OTC derivatives Support Documents in around 50 jurisdictions.
Similar considerations apply to users of
transactions derivatives. In contrast to dealers, derivatives Country-specific developments
users such as corporations or hedge funds do in the CEE/SEE/CIS region
not maintain a matched book, yet they do seek
to attain a desired risk profile. A corporation, In 2011 a large number of jurisdictions across
for example, might use derivatives to control the CEE/SEE/CIS region have experienced
its exposure to currency fluctuations, while a significant developments regarding the
hedge fund might use derivatives in arbitrage legal and regulatory framework that affects
or relative value trades. If a dealer were to transactions in OTC derivatives. The
default, these counterparties would need to paragraphs below summarise and assess
replace the defaulted transactions in order developments as of December 2011.
to return to their desired risk positions.
As with dealers, netting would facilitate Those jurisdictions in the region that are also
returning to the desired exposures. EU Member States had to implement the EU
directive amending the settlement finality
Necessary conditions for netting directive and the financial collateral arrangements
In some jurisdictions, most notably England directive (2009/44/EC; Amending Directive)
and other jurisdictions that follow English in 2011. The main feature of the Amending
legal traditions, established insolvency law Directive from the derivatives point of view is the
supports the right of creditors to pursue addition of credit claims as an eligible type of
the close-out netting process following the collateral to financial collateral arrangements.
insolvency of a counterparty. But in many A number of EU Member States have used the
jurisdictions, insolvency laws and other statutes opportunity of implementing the Amending
place restrictions on a creditor’s ability to Directive to also improve the existing legislation
implement the process. In the United States, on netting and collateral arrangements.
for example, the Bankruptcy Code does not
normally recognise ipso facto clauses that allow In Slovenia, the legislator broadened the scope
termination of a contract as a consequence of of counterparties eligible for financial collateral
bankruptcy. Further, the United States and many arrangements to include corporates. This
other jurisdictions place “stays” on the ability brings the local collateral regime in line with
of most creditors to pursue their claims against the new Slovenian netting legislation that was
a debtor that files for bankruptcy and to apply adopted in 2010. As a result of this, positive
collateral posted by the debtor. Lastly, insolvency industry legal opinions can now be obtained.
administrators might engage in cherry picking,
which involves an insolvency administrator Thus far, the relevant EU legal framework does
demanding performance of contracts not provide for any substantive provisions on
favourable to the bankrupt firm but rejecting close-out netting. Neither the EU directives on
contracts burdensome to the bankrupt firm. Settlement Finality (98/26/EC), Winding-up of
Credit Institutions (2004/EC), Financial Collateral
In most countries, it has been necessary to Arrangements (2002/47/EC) nor the EU Banking
enact specific netting legislation in order to Directive (2006/48/EC) or Insolvency Regulation
achieve statutory recognition of the elements (1346/2000) contain any such provisions. They
of the netting process described above. More merely make reference to netting agreements.
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Focus section: Developing capital markets

Lithuania, for the first time, adopted substantive of netting agreements, other concerns raised
netting legislation while implementing the by market participants remain unresolved
Amending Directive. Thus far, the relevant for the time being. The main concerns are
EU legal framework does not provide for any about the scope of eligible counterparties for
Amendment to substantive provisions on close-out netting. both netting and collateral agreements as
Previously, the country had been one of the corporates remain outside the scope. This
the Bankruptcy four remaining EU Member States without any limited scope is contrary to the trend across
Act in Poland has substantive law on netting. Previously and all Member State jurisdictions. An additional
similar to Bulgaria, Estonia and Latvia, only concern stems from new requirements to
done away with the initial EU Directive on Financial Collateral disclose financial contracts entered into with
uncertainty regarding Arrangements had been implemented. Slovakian public entities. The new provisions
enforcement of However, this directive does not provide for stipulate that non-disclosed transactions may
substantive provisions on close-out netting. become unenforceable (as of January 2012).
financial collateral It only assumes that netting agreements
arrangements are enforceable in each EU Member State In Hungary, several pieces of legislation have
based on previously existing local law. been adopted which are not necessarily in
sync with the existing wider local regime for
In Bulgaria, besides no netting legislation being netting and collateral agreements. A new law
in place, the existing framework for collateral on the insolvency of certain enterprises that
transactions continues to be sub-optimal. The are deemed “of national importance” has been
implementation of the Amending Directive introduced. Thus far, the legislator has not
led to increased uncertainties as to the adopted any list of entities that are considered
inclusion of non-EU based entities that enter to fall within this group. Neither has it been
into financial collateral transactions. These expressly clarified if the new provisions are
issues need to be addressed in the future. meant to be outside of the existing (positive)
legal framework for netting and collateral
Significant progress has been made in Poland in arrangements in Hungary. Another law adopted
2011. Amendments to the Bankruptcy Act have with effects on derivatives transactions deals
done away with uncertainty, which had so far with loans and mortgages denominated in
prevented market participants from obtaining foreign currency. The new provisions allow
positive industry opinions on the enforceability repayment of foreign currency-denominated
of financial collateral arrangements. The loans and mortgages at exchange rates that are
latest amendments expressly state that way below market rates. The aforementioned
collateral transactions (and securities lending new laws raise several issues as to the
transactions) fall within the scope of eligible compatibility with EU law. As the new laws
transactions under the existing netting regime. override existing contractual arrangements
agreed upon by the counterparties, a degree
In early 2011 a new Law on Collateral entered of legal uncertainty is being introduced. The
into force in the Czech Republic. It consolidates economic terms of these contracts were used
the various pieces of collateral-related as a guideline for the economic conditions
provisions scattered across a number of laws of the hedging transactions related to the
into a single Act. However, some ancillary relevant mortgage and loan agreements.
provisions outside of the new law regarding the
conflict of law rules relating to securities held In Romania, the local legal regime for netting and
as collateral are out of sync with international collateral transactions has been subject to some
standards. Industry has approached the local reservations expressed by market participants.
authorities about this. Such international Existing inconsistencies were not removed
standards include the conflict of law provisions at the time of implementing the Amending
in, inter alia, the Hague Securities Convention. Directive. However, certain developments
that stem from draft provisions prepared for
While in the Slovak Republic the existing more general purposes of the Civil Code (for
insolvency regime has been clarified to example, proposals to introduce the concept
expressly state that measures applied under of “economic hardship”) and the Insolvency
the so-called involuntary administration do not Act (for example, acceleration upon insolvency
negatively impact the validity and enforceability of the debtor) may cause additional problems.
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Law in transition 2012

These issues have to be clarified before legal regulations are in force, market participants
certainty for transactions with Romanian and industry will be able to obtain netting
counterparties increase and market participants opinions on Russia. This is significant progress.
will be able to obtain positive legal opinions. One major issue that needs to be addressed
Attempts to draft is an upgrade of the Russian legal framework
CEE/SEE jurisdictions outside of the EU for collateral transactions (in particular, the
comprehensive area where significant developments recognition of title transfer arrangement).
legislation to cover relating to derivatives have occurred
include Serbia and Croatia. In Kazakhstan, the current legal regime does
all issues related to not provide for the enforceability of netting
derivatives in a single In Serbia, new provisions have been added to and collateral arrangements. Amendments
law have failed the Bankruptcy Act that allow for “insolvency to the Bankruptcy Code, adopted in 2009 to
set-off”. From the current wording in the law address restructuring of financial institutions,
it is not entirely clear if this terminology is did not address this issue. A draft law currently
meant to include forms of netting other than under consideration to achieve what is
by way of set-off as well. The latter is just one referred to as “risk minimisation in the banking
among several ways of achieving netting. sector” does not include any such provisions
Furthermore, the new Foreign Exchange Act has either, despite legislating for capital market
not clarified a number of existing uncertainties transactions that include OTC derivatives.
around currency trading. Market participants This draft law certainly requires heightened
will continue to work with local authorities. attention from market participants.

Croatia has undertaken efforts to implement Over the last couple of years, several
various pieces of EU legislation before its attempts have been made in Ukraine to draft
accession to the European Union in 2013. comprehensive legislation to cover all issues
However, inconsistencies across various related to derivatives in a single law. However,
pieces of Croatian legislation with regard to these attempts have failed and not surprisingly
the definition of close-out netting remain. no such attempt has succeeded in any other
Industry has made several submissions to jurisdiction. It usually is more efficient and
the authorities to highlight the issues. practical to address derivatives-related issues
in a number of different laws. Previous drafts
In the CIS region the three jurisdictions most have shown insufficient reflection of market
relevant to the derivatives markets in terms of realities and structures and were therefore
volumes are Russia, Kazakhstan and Ukraine. abandoned. In June 2011, another attempt
Jurisdictions with nascent market activities has been undertaken to revive this draft
include Armenia, Azerbaijan and Georgia. bill. It remains to be seen if comments from
the markets will be reflected in any re-draft
After several years of debate, Russia has or may lead to an approach that addresses
enacted substantive netting legislation that the issues in a more appropriate way.
entered into force in the summer of 2011.
For the first time, netting with certain Russian It appears worthwhile to mention several law
counterparties will be enforceable. However, reform projects at regional and global levels,
netting will become operational and enforceable which are likely to have an impact on jurisdictions
only once two pieces of secondary legislation across all regions. With regard to the legal
have entered into force. The lead regulator framework for netting and collateral transactions
needs to enact a regulation on eligible in all EU jurisdictions, one would look with great
documentation used for transactions with attention to the EU initiatives on cross-border
Russian counterparties as well as a regulation crisis management and bank resolution, the
on trade repositories and reporting of these proposed netting directive/ regulation (both
transactions. At this stage the scope of the latter due in early 2012), as well as the forthcoming
regulation remains unclear. It will be crucial to review of the EU Insolvency Regulation (in mid-
define the reporting requirements in a way that 2012). Global projects initiated in 2011 by the
is manageable from an operational perspective FSB (Financial Stability Board) and UNIDROIT
and in line with emanating global standards (International Institute for the Unification of
(for example, CPSS-IOSCO). Once these two Private Law) on cross-border banking resolution
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Focus section: Developing capital markets

Notes

1
and global principles for close-out netting, The Bank for International Settlements (BIS) publishes statistics on
respectively, will provide useful guidance for volumes in OTC derivatives on a regular basis, for example, BIS, Semiannual
further law reform affecting the derivatives OTC derivatives statistics end-June 2011, published in November 2011,
markets in the CEE/SEE/CIS region. www.bis.org/statistics/derstats.htm (last accessed 6 January 2012)
2
Basel Committee on Banking Supervision, Report and Recommendations of the
Conclusion Cross-Border Bank Resolution Group, March 2010, pp.36 et seq, Recommendation
9; Financial Stability Board, Key Attributes of Effective Resolution Regimes for
Significant progress has been made in emerging Financial Institutions; October 2011, pp. 10, 41 et seq; European Commission,
market jurisdictions across the CEE/SEE/CIS DG Market Working Document, Technical details of a possible EU framework
region in 2011. Against a backdrop of ongoing for bank recovery and resolution, January 2011; chapter G11/part 4.
multi-layered activities at the global, regional
and national levels, market participants
sometimes observe the lack of a great degree
of coordination. Looking ahead, market Author
participants will have to keep an eye on any
inconsistencies between the various projects.

Dr Peter M Werner
Senior Director
ISDA International Swaps and Derivatives Association
Tel: +44 (0) 20 3088 3550
Tel: +44 (0) 20 3088 3555
Email: pwerner@isda.org
www.isda.org
ISDA International Swaps and Derivatives Association
One Bishops Square,
London E1 6AD
United Kingdom