A Comprehensive Overview of Netting Contracts: Key Requirements and Advantages

Everything You Need to Know About Netting Contracts

Netting agreements are formal agreements in which two or more parties agree to merge their positions and thereby offset any payment obligations they may have to one another. In the context of over-the-counter derivatives and securities financings, netting agreements often take the form of so-called "close-out netting agreements", an important variation on the basic idea mentioned above.
"Close-out netting agreements" are a standard industry practice in over-the-counter derivatives and securities lending. These agreements provide that upon the occurrence of an "event of default", one party may terminate, close-out or accelerate its dealings with the other party in respect of all or some transactions entered into by them and set-off all amounts owing to or by one party against one another .
Close-out netting provisions have four essential components: Close-out netting agreements provide certainty as to the amounts that will be owed on the final payment date and limit the exposure for all parties concerned. While the application of a close-out netting agreement would be subject to the law governing the agreement (including bankruptcy and insolvency laws), the certainty that arises from the enforceability of these types of close-out netting agreements has made them an industry standard, accepted by most regulators nationally and internationally.

The Different Types of Netting Contracts

There are various types of netting contracts, but generally speaking, netting contracts can be broken down into the following four types:
Payment Netting: Payment netting is the practice of offsetting two counterparties’ payment obligations to one another. A payment netting agreement allows specific future payments owed between those counterparties to be settled through an offset. The parties agree that all payments will be netted on a set date (the netting date), and only the difference between what each party owes to the other on the netting date must be paid to the net payee.
Close-out Netting: Close-out netting occurs when one party to a derivatives transaction with a counterparty terminates all existing derivatives transactions with that counterparty. One party is benefited by the closeout netting, because that party ends up with a single claim to all amounts owed by the other party, after netting all amounts owed by it to the defaulting party.
Multicurrency Netting: Multicurrency netting is where the parties to a transaction agree that any amounts they owe one another in different currencies can be combined and netted against each other.
Cross-Border Netting: Cross-border netting is where the parties agree that they can combine and net transactions with a counterparty in another jurisdiction where they do business.

The Legal and Regulatory Aspects of Netting Contracts

The legal framework and regulations surrounding netting contracts are a consideration in jurisdictions where netting is an established financial practice. A netting contract made under the aegis of the Financial Collateral Arrangements (No. 2) Regulations 2003, as amended (FCAs), governed by UK law, must be in writing and signed by the parties and must identify the obligations to be secured (either by description or by reference to a formula). Where there is an insolvency event concerning a counterparty to a netting contract entered into under the FCAs, if certain conditions are satisfied, the netting contract can immediately be enforced without the need for any stay, prohibition or restriction by the relevant insolvency official. The requirements for the operation of the FCAs netting regime in the event of counterparty insolvency include that: In addition, certain States in the United States have adopted local U.S. law provisions designed to support netting. The choice of law of a netting contract may also, in some cases, be relevant to the enforceability of netting. Parties entering into a netting contract should therefore consider whether it needs to satisfy any of those requirements, and whether there are any other legal requirements for the enforceability of netting in the relevant jurisdiction. Any party entering into a netting contract may want to contact a lawyer who is familiar with netting in its local jurisdiction, and to ask a lawyer in the relevant jurisdiction to consider the enforceability of such netting (if not governed by the FCAs). However, the regime in which netting sits is well established and, provided that careful drafting and jurisdictional analysis when entering into a netting contract is undertaken, netting is a robust tool for parties to use.

The Advantages of Using Netting Contracts

The primary benefit of a netting contract is the reduction of credit risk. This is because the netting agreement allows us to either owe a single amount or receive a single amount from our counterparty, rather than possibly having one or more debts outstanding to our counterparty at the same time. As a consequence, we know immediately whether our net position against our counterparty nets into an asset or a liability. If the net credit exposure at any particular point in time is in our favor (i.e., it gives us the right to receive a specified amount from the counterparty), then this should not be subject to any regulatory capital or margin requirements.
The benefits of a netting agreement can also provide enhanced financial efficiency. They do so by converting a series of gross payments of interest into a single net payment. Contracts with a single net payment are often easier to value than contracts with multiple cash flows; so a netting contract should reduce the cost of calculating the current value and/or margining of the underlying contract. Additionally, our lawyers may take a more favorable view on the enforceability of a netting contract where there is only a single obligation to either pay or receive a specified amount, rather than there being multiple obligations.
Another benefit of a netting agreement is that it can assist with simplifying the accounting for a contract. For example, it is possible for the parties to a netting agreement to jointly elect to account for the netting agreement on a net basis under Accounting Standard Codification ASC 815. This means that we may be able to elect to account for the amounts to be paid and received under our netting agreement as a single amount (rather than as a series of gross payments).

The Challenges and Limitations of Netting Contracts

The challenges and limitations to be considered with netting contracts
Recognising the increasing economic importance of intra-group netting contracts, more jurisdictions (other than financial centres) are passing legislation to make them legally enforceable. As a result, increased netting activity is expected. However, there are still a number of issues that should be considered by those proposing to enter into netting contracts.
The first of these issues is the difficulty of enforcing netting contracts across jurisdictions. Although legislation is increasingly being passed to protect them, many jurisdictions still do not have any appropriate legislation to deal with netting contracts, leaving the enforceability of those contracts by the courts of those jurisdictions open to question.
Even in those jurisdictions which do have appropriate legislation, the manner in which the legislation is implemented may vary from jurisdiction to jurisdiction. Although courts are generally reluctant to declare netting contracts illegal, this is fundamentally because they consider such contracts to be beneficial to their jurisdictions.
Netting contracts can also be difficult to enforce because of the complex nature of the transactions involved. As the contracts may cover a wide range of transactions involving a large number of entities, enforcement would require the court to take into account numerous differing rights and obligations and competing claims. While many courts have taken pragmatic approaches in specific cases, such as allowing the netting of derivatives, this does not mean that netting contracts will be enforceable in all cases or all jurisdictions.
There may also be difficulties when trying to net contracts between entities in different jurisdictions. If one of those jurisdictions does not have appropriate legislation, or the netting contracts are otherwise unenforceable in that jurisdiction, this may restrict or prevent netting from occurring. Difficulties may also arise as the companies may not be able to agree on the legal basis for the proposed netting agreement , particularly if the companies operate under different civil law regimes. This may ultimately result in the decreased use of netting contracts.
A further issue is the manner in which netting contracts are enforced by a party insolvency. In many jurisdictions, although the contractual netting provisions would not be void as a matter of law in the event of an insolvency, claims which are the subject of a netting contract may be susceptible to avoidance. This may also give rise to difficulties when trying to enforce netting contracts, particularly since some jurisdictions do not accept judicial netting, meaning that parties may be forced to choose between the contraction risk of bilateral netting and the risk of losing out in a liquidation.
In addition, while the netting of future receivables is advantageous to netting parties, it carries the risk that the financial benefits may be outweighed by the costs of administering and running the netting contracts. This is particularly important since the costs of dealing with an insolvency may ultimately fall disproportionately on one party. For example, if a group or a counterparty enters into an insolvency proceeding, it may be extremely difficult for that party to continue to fulfil its obligations under the netting contract during the course of the insolvency. As a result, the party which is still able to carry out its obligations and continue to trade may have to incur substantial additional costs to do so.
Finally, although netting contracts can provide a substantive reduction in the amount of counterparty credit exposure in a group, they will not remove the risk of having to deal with potential insolvencies within the group. As netting contracts reduce loss to only one side and do not account for the risk of insolvency in estimating net asset values, those losses may not be recoverable. Furthermore, the credit-risk exposure to other parties may end up increasing as a result of the financial health of the legal entity within the group. This could lead to an insolvency crisis within the group if those parties subsequently become insolvent.

The Practical Application of Netting Contracts

As a practical example of netting, consider two banks, Bank A and Bank B. Bank A agrees to lend $100 million to Bank B for 30 days at an interest rate of 4%. The loan to Bank B would have been a bilateral transaction, but Bank A and Bank B have entered into a bilateral netting contract that allows them to net their obligations so that, rather than on the maturity date, the obligations will be for one net amount assuming no other obligations between the parties. Likewise, Bank A could have agreed to lend to Bank B $100 million for 30 days at 3%. Meanwhile, Bank B has agreed to sell to Bank A $75 million of bonds at 5%, and also has agreed to buy from Bank A $50 million of currency at 2%.
Assume that the price of bonds falls and interest rates rise by the end of the 30-day period. Also assume, though, that the currencies of the two parties’ home jurisdictions rise by the same amount against the dollar, and they both fall in value against each other. If Bank A chooses not to exercise a termination right, Bank B will owe $45 million, representing the net of obligations to Bank A of $50 million for currency and $75 million for the bonds, and obligations owed to Bank B of $25 million for the loan.
Now assume that Bank A’s board of directors decides that Bank B is more of a risk than it was a month ago and that its board of directors has decided to terminate the relationship. In that case, the net master agreement between the two banks might allow Bank A to declare as due and payable $50 million for the bonds and $75 million for the loan, while it can cancel the obligation to deliver the currency, causing a close-out gain for Bank A of $25 million in this example.
As another example of how netting has been used, assume that one bank in a financial group will be sold, causing a group netting contract to be terminated by its participating banks. Most participants in the group netting agreement will experience a cost from the termination of the group netting contract because, in most cases, each participating bank will owe to the counterparty bank an amount because its bilateral transactions with that counterparty bank will exceed its bilateral transactions with that counterparty bank.
Often it can be advantageous to a bank whose bilateral transactions with a particular counterparty exceed its counterparty’s bilateral transactions with the bank to justify breaching the netting contract and entering into a new netting contract with the bank that results in a net liability to the breaching bank. In the example of a bank being sold, one bank in a financial group may wish to breach the group netting agreement and enter into a new bilateral agreement with the bank that causes that bank to have a net liability under the netting contract. This can turn out to be profitable for the breaching bank because terminating the netting agreement will usually cause the breaching bank to owe the counterparty bank an amount approximating the full amount of its obligations under all of its bilateral transactions. Entering into a new netting contract with the breaching bank allows the bank to claim a close-out gain from having a greater claim on the breaching bank than the breaching bank has against the nonbreaching bank.

The Future of Netting Contracts

As the volume and complexity of financial transactions continue to rise, the role of netting contracts is expected to evolve significantly. In particular, technological advancements are anticipated to facilitate a more widespread adoption of netting practices across a wider range of transactions. Blockchain, in particular, could prove to be an industry game-changer: smart contracts may replace traditional netting contracts, automating the netting process and mitigating the risk of error. Even absent blockchain, the increasing interconnectivity and liquidity of global markets is likely to lead to a greater standardization of netting contracts , for example through standard form netting contracts that deal with specific asset classes as has been done for the International Swaps and Derivatives Association 2002 Master Agreement or certain templates published by the International Capital Market Association (ICMA). The European Market Infrastructure Regulation already recommends certain standards in relation to the calculation of netting. At the same time, the netting benefits afforded to parties have become the subject of intense development and abuse litigation in many jurisdictions, further incentivizing effects-based regimes and the appointment of new netting agents to ensure robust risk management. Even though some of these developments may not necessarily lead to more jurisprudence testing the validity of netting contracts, the result is nevertheless expected to be a more secure practice around netting contracts and a stronger focus on their enforceability and soundness in the years to come.