I believe in netting – mostly December 22, 2011 at 5:45 pm

FT alphaville has a post on derivatives netting, which is mostly reasonable, although it links to a piece by (self-proclaimed?) expert Das, which isn’t.

To begin with, it is important to understand what a properly executed master agreement does. I think of it as glue: it binds up all the contracts between two parties, so that instead of many little contracts, there is one big complicated contract. As a result of this glueing, the parties owe each other whatever the net value of the big contract is. Thus we get two forms of netting: payment netting on everyday cash movements, reducing the number of cashflows between parties; and close out netting, which means that if one of the parties is in contractual default, then only a single net amount is payable.

In jurisdictions where this works (which is most of them – Russia and China being the most prominent examples where it may fail), this means that there is a single claim against the estate of a failed bank (or a single payment to it if the defaulter is in the money on the big contract).

Now, the really delicate thing is how this close out amount is determined. Unsurprisingly, a standard methodology is not imposed as part of the standard master agreement as this agreement has to deal with both bank-to-client relationships, where there are often a small number of derivatives which are easy to value, and bank-to-bank relationships, which may be much more complex. Of course, the vast majority of close-outs are of bank-to-client relationships – and you don’t hear anything about these proceeding without disputes (which they do, all the time).

A big bankruptcy like that of Lehman Brothers generates litigation on pretty much everything. The amounts of money at stake are large enough that it is worth sueing. So people do, on whatever can reasonably be disputed – and often on something things that can’t. Derivatives are part of this, but they are not especially problematic. Indeed, as Kimberly Summe points out, Lehman’s derivatives have received a lot of unnecessary and unwarranted stigma. The unpalateable truth is that it was real estate lending and bonds that broke Lehman, combined with liquidity risk, not swaps.

So far, we have noted that derivatives are not unusual in creating court cases, and that most close outs are simple and effective. But there is an issue that remains: how can it be that reasonable people differ on what the close out amount on a derivatives portfolio is? The answer is that while bankruptcy law usually has a simple idea of what you can claim, determining that amount is not straightforward. Thus for instance in UK law, broadly, if I suffer a loss of £10 because of your bankrupcty, I have a claim of £10 against the estate of the bankrupt. The obvious example is that I have lent the tenner to the bankrupt. But with a derivatives portfolio, what have I lost? Clearly it depends on how much it costs me to close out the risk. I can’t – especially if I want to look good in front of the judge – just use my own valuation: I have to actually go into the market and close out the risk, then add up the cost of doing that. And what I do has to be ‘commercially reasonable’. Thus for instance getting separate bids on the equity, credit and commodity derivatives sub-portfolios might well be commercially reasonable, but doing separate trades on every derivative rather than offering a portfolio of mostly offsetting instruments to the market probably isn’t. (This is a point which Das gets wrong and which lies at the heart of the Nomura vs. Lehman case.)

The problem at the heart of close out, then, is figuring out what value a bank has been deprived of when one of their derivatives counterparties fails. This is often simple, but for a large multi-asset portfolio, it can be both complicated and sufficiently uncertain that it is worth going to court about. The real story isn’t that there is a problem with netting: it is that the valuation of big portfolios of financial instruments is difficult, especially when you have to do it in a crisis.

3 Responses to “I believe in netting – mostly”

  1. Fairly happy to accept DAS as expert on the mathematics – less so on the legal arrangements – and even less so on general macroeconomics.

    But on the maths – that is clear – and proven by his book on the subject…


  2. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1773631

  3. Reggie – many thanks, most useful.

    John – I see Das as like a theoretical cook: he knows what the best Bernaise recipe is, but he has never made a sauce in his life, and it might curdle if he tried. That might be unfair, but honestly a guy who thinks you close out a derivatives portfolio one transaction at a time really isn’t going to make a lot of sense talking about netting…

    Kind regards to all.