Close-out netting is a process which takes place following the termination of transactions. In summary, all transactions where a party owes its counterparty money are set-off against those transactions where the counterparty owes the first party money in order to produce a single, net, sum. The purpose is to reduce credit risk as well as the risk of “cherry-picking”, and to reduce administrative burden.
It is important to be sure that close-out netting is enforceable in the jurisdiction of your counterparty. If not, any exposure to that counterparty would have to be marked on a gross basis, rather than a net basis. The reason for this is that, on the insolvency of your counterparty you might be obliged to pay in full on your own obligations and yet, with respect to the obligations owed to you, prove as an unsecured credit against the insolvent estate of your counterparty.
At their heart, the close-out netting provisions of the GMRA describe the following sort of process:
- Following the occurrence of a set of factual circumstances which constitute an Event of Default, all transactions which are outstanding under the GMRA are terminated.
- On the date of termination, all cash becomes repayable and all securities become redeliverable. This means that (a) the “Purchased Securities” need to be returned by the Buyer to the Seller, (b) the “Repurchase Price” (calculated up to the date of termination) needs to be paid by the Seller to the Buyer, (c) all Margin Securities need to be returned to the ‘original owner’, and (d) all cash margin needs to be repaid to the ‘original owner’.
- The obligation to redeliver securities (whether “Purchased Securities” or “Margin Securities”) is replaced by an obligation to pay their “Default Market Value” instead.
- The resulting cash amounts that are then owed are set off against each other, leaving just a single net payment which is payable by one party to its counterparty.