The Need for an International Instrument on the Enforceability of Close-Out Netting in General and in the Context of Bank Resolution

UNIDROIT S78C – Doc. 2, 2011

80 Pages Posted: 15 Feb 2013

See all articles by Philipp Paech

Philipp Paech

London School of Economics - Law Department

Date Written: February 1, 2011

Abstract

Close-out netting is typically applied to transactions such as derivatives, repurchase and securities lending agreements, and other kinds of transaction that tend to carry a high counterparty and/or market risk. Regulatory authorities strongly encourage the use of such close-out netting provisions (alongside collateral) because of their beneficial effects on the stability of the financial system. The reason is that referring market participants’ claims in the event of default of the counterparty to regular insolvency proceedings on a gross basis instead of on a net basis might expose the non-defaulting party to levels of credit risk and market risk that are difficult to calculate and manage for the relevant types of contract due to rapid changes in market values and uncertainty regarding the risk of repudiation of contracts during the proceeding. However, these beneficial effects can be particularly felt in the event of the insolvency of a party. In that case, the use of close-out netting assumes that the legal effects stipulated to that end by the parties (the close-out netting provision) will be recognised by and be enforceable under the applicable insolvency law. However, the current situation is that, even if about 40 jurisdictions recognise netting in insolvency, the extent to which they do so and the scope and legal effects of close-out netting provisions differ significantly. Furthermore, some jurisdictions do not clearly recognise netting, and the legal practice in such jurisdictions often resorts to the principles governing set-off, failing to recognise the fundamental differences between the two mechanisms. This patchwork is unsatisfactory in cross-jurisdictional situations, since it exposes the financial market participants’ risk management to unnecessary legal uncertainty and may even jeopardise it. An additional aspect of the enforceability of netting provisions has come to the fore since the beginning of the recent financial crisis: regulatory authorities, while underlining the usefulness of netting, have contemplated the need for a brief stay on the netting mechanism in pre-insolvency or insolvency situations affecting a financial institution, so as to allow the regulator the time needed to decide if and how to resolve an ailing financial institution in an orderly fashion so as to mitigate risks to financial stability. The paper analysis the commercial and insolvency law issues arising in relation to close out netting as well as the interplay with regulatory rules. This paper is the first in a series of four paper which the author produced for the International Institute for the Unification of Private Law (Unidroit).

Keywords: close-out netting, set-off, settlement netting, insolvency, collateral, master agreement, bank resolution, harmonisation, principles, Unidroit

Suggested Citation

Paech, Philipp, The Need for an International Instrument on the Enforceability of Close-Out Netting in General and in the Context of Bank Resolution (February 1, 2011). UNIDROIT S78C – Doc. 2, 2011, Available at SSRN: https://ssrn.com/abstract=2216665

Philipp Paech (Contact Author)

London School of Economics - Law Department ( email )

Houghton Street
London WC2A 2AE, WC2A 2AE
United Kingdom

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