According to the Group of Thirty's study on derivatives released in July, netting arrangements are "the most important means of mitigating credit risk" on swaps.
What are netting arrangements, and why are they so desirable?
Active swap market participants with hundreds or even thousands of separate swaps on their books may have engaged in more than a few of the arrangements with the same counterparty.
A netting agreement allows two or more parties to reduce the amount of credit risk they assume on mutual transactions. The agreement states that if one party cannot make good on its obligations to the second party, then the second party is freed from obligations it owes to the first.
At any one time, for example, a commercial bank might have 10 swaps with a Wall Street securities firm. Some of the swaps might be short term; others, long term. Some of the swaps might obligate the bank to pay the firm a fixed rate, others might require a floating rate.
As market conditions change, some of the swaps may become more profitable for the bank, while others become money losers. At the same time, each swap that creates a positive cash flow for the bank is creating a negative cash flow for the firm.
Hypothetically, four of the bank's swaps may be in the red for a total of $100 million, but on the other six, the bank could be in the black for a total of $110 million. The firm's position is the reverse, with four profitable swaps and six money losers.
Imagine the bank is rated AAA and the securities firm is rated A. How should the bank and the firm assess their credit risk on the swaps they have entered together?
Looked at separately, the bank could decide it had a possible loss of $110 million on assets due from the A-rated securities firm. It would have to set aside reserves from its capital based on a percentage of the $110 million it had at risk. The capital reserves would be based on the bank's internal policies and on assorted banking regulations.
But the bank owes the same entity, the securities firm, $100 million on other swap transactions. The bank could try to ensure that if the securities firm cannot make good on the $110 million, it will not have to fork over the $100 million.
A netting arrangement attempts to do just that. In this case, an agreement between the bank and the securities firm to "net" their swap transactions is called a bilateral netting agreement.
The agreement prohibits one party from selectively defaulting on some of the swaps, the money losers, while continuing to expect payment on the profitable swaps.
Amendments to federal banking regulations and to the bankruptcy code have recognized the validity of such netting agreements. In some countries, however, the legal status of netting agreements is less certain.
Under the netting agreement, the bank does not count the $110 million as an asset at risk in isolation. Instead, only the net amount - positive or negative - is at risk.
The agreement has, in effect, lowered the credit risk of the bank's swap portfolio with the securities firm.
According to a survey of major derivatives participants conducted by the Group of Thirty, "the enforceability of such netting provisions remains among the highest concerns of senior management of derivatives dealers."
And the 24 recommendations in the Group of Thirty report include improving the legal recognition of netting agreements as one of just four recommendations for regulators.
"Regulators and supervisors should recognize the benefits of netting arrangements where and to the full extent that they are enforceable, and to encourage their use by reflecting these arrangements in capital adequacy standards," the report says.