Close-Out Netting
Close-out netting is a legal mechanism that terminates all outstanding derivatives contracts between two counterparties upon the default of one, calculates the net mark-to-market value of all terminated contracts, and requires only a single net payment — eliminating the risk that a bankruptcy administrator could selectively enforce contracts favorable to the defaulted party.
Close-out netting is one of the most important legal innovations in derivatives markets and a cornerstone of the ISDA Master Agreement framework. It addresses a specific and devastating risk: cherry-picking, also known as the walkaway risk. Without close-out netting, a bankruptcy administrator for a defaulted counterparty could selectively honor contracts that are in-the-money for the estate while refusing to pay out on contracts that are out-of-the-money — heads the estate wins, tails the solvent counterparty loses.
The ISDA Master Agreement, which governs the majority of global OTC derivatives transactions, contains standardized close-out netting provisions in Section 6. Upon a default or certain other termination events, all transactions under the agreement are automatically terminated, and their net present value is calculated according to market quotation or loss methodologies specified in the agreement. The result is a single net amount owed by one party to the other — the only claim that needs to be settled.
The legal enforceability of close-out netting across jurisdictions is critical because OTC derivatives markets are global. The enforceability of ISDA netting in US bankruptcy proceedings is established under the Bankruptcy Code safe harbor provisions. ISDA publishes enforceability opinions covering major jurisdictions globally, providing legal certainty to counterparties about the treatment of their ISDA agreements in the event of a cross-border insolvency. As of 2024, ISDA netting enforceability opinions cover over 60 jurisdictions.
From a capital and risk management perspective, close-out netting allows banks and derivatives dealers to recognize netting benefits in their regulatory capital calculations. Under Basel III rules implemented by US banking regulators (the Fed, OCC, and FDIC), banks can calculate derivatives exposures on a net rather than gross basis when a legally enforceable netting agreement is in place. This can reduce the reported credit exposure — and therefore the required capital — by 60-90% for bilateral derivatives portfolios with many offsetting transactions.
Close-out netting also interacts with the central clearing regime. Centrally cleared derivatives are subject to CCP close-out procedures, which are governed by each CCP's rulebook rather than bilateral ISDA agreements. The OCC, CME Clearing, and other US clearinghouses have detailed default management procedures specifying how positions are valued and auctioned in the event of a clearing member default.