The case for close-out netting
Close-out netting is a widely-recognised contractual alternative to the traditional statutory insolvency regime as the means by which a financial institution would manage the risk posed by the insolvency of a financial counterparty with whom it has large portfolios of outstanding repos, securities loans, derivatives and similar transactions.
At a firm level, close-out netting is intended to be more efficient than traditional statutory insolvency in minimising the losses arising from a counterparty insolvency. At the level of the financial system, the purpose of close-out netting is to contain the contagion across the market that would arise if a major financial institution were to become insolvent. Substantial losses might drag the immediate counterparties of the failing institution towards insolvency, threatening their counterparties in turn and setting off a “domino effect” of subsequent failures. The result would be instability in the financial system and, ultimately, damage to the real economy.
The inadequacy of traditional statutory insolvency regimes and the need for close-out netting is the result of a paradigm shift in underlying financial market structure that has been taking place over last three or four decades. This has moved financial markets away from traditional bank and relationship-based finance to market and transaction-based finance. The economic benefits of market finance are well-documented and it is therefore a common policy objective to encourage the shift from bank finance.
In market finance, borrowers raise capital by selling securities to savers, rather than relying on banks to make loans to borrowers and collect deposits from savers. Because borrowers and savers tend to lack established relationships and are usually remote from each other, they have to be connected by market intermediaries. In the process of making end-to-end connections across the market, chains of intermediaries are often formed, which frequently extend cross-border in search of diversification. Chains form when contracts with one counterparty are funded and hedged with opposite contracts with other counterparties.
A critical role is played in intermediation by repos, securities lending and derivatives. Securities financing transactions (repo and securities lending) supply the working capital and securities required to make markets in securities. Derivatives allow intermediaries to transfer across the market in order to hedge themselves and their customers.
Traditional statutory insolvency regimes have been designed to manage insolvency in the context of bank-based financial systems and naturally struggle to cope with the challenges posed by increased intermediation involving securities financing and derivatives in market-based financial systems.
The challenges of market finance for traditional statutory insolvency regimes
The first challenge posed by market finance for traditional statutory insolvency regimes is that the overall scale of potential contagion is now much larger than in the past with bank finance. This is in part a consequence of the fact that chains of intermediation in market finance multiply the number of transactions and systemic leverage. The cumulative gross flows of securities financing transactions and derivatives therefore tend to be much larger than the underlying stock of securities and can exceed the underlying economy in size.
The second challenge for traditional statutory insolvency regimes is that increased intermediation intensifies interconnectedness between financial institutions, establishing new channels of contagion along which the domino effect of sequential counterparty failures can be propagated much faster and further than in the past.
Intensified interconnectedness also poses a challenge to individual market intermediaries. This is because intermediaries enter into multiple financial contracts with each other in a single course of dealing, often within the same day, as customer demand, market conditions, expectations, trading opportunities and other business drivers evolve. The gross exposures of individual intermediaries are therefore also much larger than in a traditional bank-based financial system and, in the event of a counterparty default, much more challenging to resolve under traditional statutory insolvency regimes.
The final challenge for traditional statutory insolvency regimes from market finance is a consequence of the pervasive use of securities. Securities are not only the principal form of asset and liability in market finance but are also required as collateral by intermediaries to substitute for the assurance about customers that was previously provided through relationships and also as collateral to mitigate the credit risk of dealing with other intermediaries. Reliance on securities means that counterparty credit risk exposures on transactions like securities financing and derivatives are a function of the market value of the securities which underlie these transactions --- the securities sold in a repo, the securities loaned in securities lending and the securities underlying the pricing of derivatives --- as well as the securities given as collateral. The market value of securities can fluctuate widely, especially during the period of market stress which follows a major default. Such the impact of wide swings in value on market intermediaries will rapidly become apparent through mark-to-market accounting rules and regulation.
In the normal course of business, intermediaries will naturally mitigate their market risk exposure to one counterparty with matched transactions with another counterparty. But should a counterparty become insolvent and default, one side of the intermediary’s previously-matched positions will disappear, turning transactions with other counterparties into unhedged and possibly volatile open risk positions. If these sudden exposures are not to spiral out of control, and perhaps push the intermediary into default --- in other words, if domino-effect contagion is to be stemmed --- their value needs to be promptly crystallised, so that the exposure to the insolvent counterparty can be swiftly hedged against further fluctuations in value. However, in order to crystallize the value of exposures to the insolvent counterparty, there must be certainty over whether contracts with that counterparty will be performed or repudiated and whether pre-insolvency transfers will be honoured, and the intermediary must have the right to immediately liquidate collateral. As explained below, this certainty is rarely available in a traditional statutory insolvency regime.
It can be seen therefore that, to be effective in stemming contagion in a market-based financial system, the rules governing the management of the insolvency of a major financial institution need to be able to cope with the potential scale, extent and urgency of the threat. In addition, the speed with which collateral can be liquidated needs to match the speed with which contagion might spread. These requirements cannot be met by traditional statutory insolvency regimes.
The inefficiencies of traditional statutory insolvency regimes
Traditional insolvency regimes have been designed primarily to ensure the equal treatment of all creditors with the same ranking. The first task of an insolvency official is to maximise the assets available for liquidation and the distribution of realised funds to all creditors. His aim is therefore to minimise any outflow of assets from the estate of the insolvent. This means a time-consuming assessment and ranking of each claim on the assets of the insolvent, including purported rights to collateral.
To give the insolvency official time to trace the assets of the insolvent and test the claims on its assets, traditional statutory insolvency regimes usually impose an automatic stay of enforcement, which prevents creditors from seizing or liquidating collateral, commencing or continuing litigation or taking other action to collect what they are owed, including use of contractual insolvency provisions such as an early termination of contracts. Such stays can be of considerable duration. In the case of an insolvent bank, there may also be a moratorium on payments.
To give the insolvency official the ability to retain or recover assets, he is also endowed with powers such as the right to repudiate onerous contracts while enforcing profitable ones (“cherry-picking”) --- which effectively allows the insolvency official to speculate on the value of collateral --- and the right to clawback suspected fraudulent and preferential pre-insolvency transfers (a power which poses a particular threat to margin transfers, which are a mainstay of modern financial risk management).
On the other hand, secured creditors may be disadvantaged by the preference typically given under traditional statutory insolvency regimes to certain unsecured creditors (eg unpaid employees or general creditors as a whole, who may be entitled to some percentage of realised assets).
If and when secured creditors are permitted to sell collateral posted by the insolvent, it will often have to be enforced by sale at a public auction, notwithstanding the impracticability of such forms of sale for financial collateral and the risk of exacerbating market stress and damaging the value of collateral by triggering a fire sale. Other creditors may try to delay or frustrate a sale by claiming that the collateral was given by way of a security interest and the insolvent estate therefore retains a property interest. If such an argument were to be successful, it would preclude the disposal of collateral in the event of a quasi-insolvency situation such as administration.
And while the statutory insolvency process is in train, the costs and expenses of the insolvency official will be given absolute priority over the assets of the insolvent.
In summary, there are multiple drawbacks to traditional statutory insolvency regimes. These regimes tend to be slow. The cost of the insolvency process erodes the value to creditors of the assets being recovered on their behalf. Stays of enforcement render it impossible to manage the potentially volatile exposures to an insolvent counterparty and may allow that risk to spiral out of control. Stays also prevent collateral being used to immediately fulfil its contractual function of protecting secured lenders. Cherry-picking and clawback powers allow collateral to be ignored or even confiscated. And the method of eventual disposal of collateral may damage its value.
Close-out netting as a solution to insolvency [1] [2]
Close-out netting of financial contracts is triggered by the occurrence of certain predefined events of default in relation to one of the contracting parties. This can be automatically or at the election of the other party. Once triggered, the affected contracts are terminated, the mutual obligations owed by the parties to each other, whether or not due and payable, are accelerated to the same date and are aggregated in order to reduce or replace these gross obligations by a single net obligation representing their aggregate value. This amount thereupon becomes due and payable by one party to the other.
The efficacy of close-out netting as a means by which a financial institution can staunch losses due to a counterparty insolvency is recognised in the Basel Framework, which is the primary global standard for the prudential regulation of banks and other financial intermediaries. These institutions are able to claim relief from regulatory risk capital requirements if they can meet certain prudential conditions, including a legal framework and recognised bilateral documentation that provide certainty that collateral and netting agreements are binding and legally enforceable.
The efficiency of close-out netting as a means of implementing the speedy and orderly management of a major insolvency reflects:
· the structural nature of eligible transactions such as securities financing and derivatives;
· the two-way use of these types of transactions;
· the bilateral nature of close-out netting; and
· the general flexibility of contractual arrangements.
The structure of securities financing transactions and derivatives
Securities financing transactions and derivatives are reciprocal obligations, in that the component parts are executed in consideration of each other. For example, in a repo, a purchase is made at the same time and as part of the same transaction as the repurchase. In a swap, one stream of future payments is offered in exchange for the receipt of a different stream of future payments. There is therefore a natural offset between the legs of these types of transaction. Splitting such transactions in an insolvency to try to recover assets from one leg lacks legal and business logic and opens up large gross exposures.
The two-way use of repo and similar contracts
As explained earlier, intermediaries contracting securities financing and derivatives with one counterparty typically fund and hedge themselves with opposite contracts with other counterparties as part of a chain of intermediation. In addition, intermediaries enter into multiple financial contracts with each other in a single course of dealing, creating large gross exposures. Such significant gross exposures are only accepted on the basis that, being two-way, they naturally net down into smaller and manageable cumulative positions in each asset. This intention is clearly expressed in master agreements like the GMRA (see paragraph 13 on Single Agreement) and is ultimately back-stopped by the right to close-out netting.
The bilateral nature of close-out netting
Unlike the traditional statutory insolvency process, close-out netting is contractual and therefore does not rely on enforcement but is “self-effecting” (for which reason, it is sometimes described as a “self-help remedy”). This means the process of dealing with the debts of the insolvent happens through the operation of agreed contractual procedures by the non-defaulting party and does not depend on a third party (the insolvency official). Close-out netting can therefore cope much more rapidly with very large numbers of obligations arising from very large numbers of contracts.
The general flexibility of collateral arrangements
The contractual nature of close-out netting gives the parties scope to pre-agree on practicable and relatively speedy methods of valuing collateral for the purpose of netting. Moreover, these procedures are standardised in master agreements that incorporate industry best practice, for example, the GMRA. Thus, in addition to valuation at sale prices, the GMRA allows the non-defaulting party to apply meaningful market quotes and, in the case of illiquid collateral, permits the use of mark-to-model methods of estimating value. The efficiency of these flexible valuation methods was compellingly demonstrated in the market response to the bankruptcy of Lehman Brother in 2008 and has been expanded subsequently with the publication of the GMRA 2011.
Conclusions
Traditional statutory insolvency regimes usually prohibit close-out netting and restrict the operation of the similar process of set-off. They are also obstructive to the operation of collateral and undermine confidence in collateralisation.
The inability to rely on close-out netting in the event of a financial counterparty becoming insolvent has adverse consequences for the stability of the financial system. However, the business case of close-out netting rests on the fact that, in the normal course of business, this legal right is one of the foundations of market finance. Close-out netting permits exposure to the risk of loss to be measured on a net basis and ensures the full effectiveness of collateral. It therefore allows market intermediaries to extend more credit, as they would not otherwise have the balance sheet capacity to take significant gross exposures in securities financing and derivatives. Such markets would simply not develop and the transition to market finance would flounder, which would mean that broad and liquid markets in securities, money and risk management tools would not develop. The resulting impairment in price discovery and inefficient capital allocation would feed through to the real economy as higher costs and reduced access to capital for borrowers and as lower returns and greater risk for investors.
[1] In order to limit the impact of the special treatment of close-out netting on general creditors, it is not typically offered as a universal right but is restricted to certain types of financial and public institution in respect of certain types of financial transaction and certain types of collateral:
· Eligible parties. On financial stability grounds, these will usually include ‘qualifying financial market participants’, meaning regulated market intermediaries and professional users of the wholesale financial markets whose default may pose systemic risk. In order to protect public funds, eligible parties often include ‘public authorities’, meaning the central government, the executive agencies of the government, the central bank, foreign governments and central banks, and supranational institutions.
· Eligible obligations. These typically include: repo; securities lending; derivatives; purchases and sales of securities, currency and precious metals; and transactions in shares in certain type of fund and money market instruments; but not retail deposits (which have special protection). Moreover, the right to close-out netting may be restricted to collateral underlying or applied to eligible obligations which qualify as high-quality liquid assets that can maintain their value in periods of market stress, in particular, when counterparties to insolvent institutions liquidate collateral. The inclusion of less creditworthy and liquid securities risks exacerbating the volatility of the value of exposures and collateral (consider the impact of mortgage-backed securities in the Global Financial Crisis of 2008). The concern is that special treatment of lower-quality securities would replace the traditional contagion channel --- the domino effect of sequential counterparty failures as losses are passed down chains of intermediaries --- with a new contagion channel --- that of volatility in the market value of the securities underlying exposures as a result of fire sales or the threat of fire sales by secured lenders.
[2] Stays of enforcement are also a feature of the recovery and resolution regimes created to address the risk posed by the potential failure of systemically-important financial institutions. In these cases, the operation of close-out netting should not entirely override the recovery and resolution regime but needs to be protected by appropriate safeguards that meet recognised international standards, which include a short temporary stay of enforcement.