Collateral and netting · RiskAtoms Academy

By the end you will be able to

1Calculate counterparty exposure with and without close-out netting.
2Calculate a collateral call and the exposure left, given a threshold and a minimum transfer amount.
3Explain the roles of the ISDA Master Agreement and the Credit Support Annex.
4Explain what netting and collateral cannot remove: legal, timing and collateral risks.

Why it matters

A bank has a hundred trades with a hedge fund. Some are worth money to the bank, some to the fund. If the fund fails tomorrow, does the bank lose the sum of what it is owed, or only the difference? Two pieces of paper decide: a master agreement and its collateral annex.

Core explanation

Owed, owing, and what is left

Counterparty risk (L2.2.03: Credit and counterparty risk) is the risk that the other side of a contract defaults while it owes you money. The amount at risk is your exposure. For a derivative it is the trade's market value to you if positive, and nothing if negative. L1.7.11: Clearing, margin and collateral showed how central clearing nets trades across many members. Most trades between two firms that are not cleared rely on two bilateral tools instead.

Netting. Firms trade OTC derivatives under an ISDA Master Agreement, published by the International Swaps and Derivatives Association. Every trade under it is part of one agreement. If one side defaults, the other can end all the trades at once and add up their values into a single amount owed one way. This is close-out netting, and the trades covered form a netting set. Without it, a liquidator could cherry-pick: demand payment on every trade the defaulted firm wins and leave the bank to claim, as an unsecured creditor, on every trade the bank wins.

\text{No netting: } E = \sum_i \max(V_i,\,0) \qquad \text{Netting: } E = \max\Big(\sum_i V_i,\,0\Big)

Collateral. Netting shrinks the exposure; collateral covers what is left. The Credit Support Annex (CSA) to the ISDA Master Agreement sets the rules. As the net value moves, the side that is owed money calls variation margin from the other, usually cash or government bonds. Two settings stop collateral moving back and forth for small amounts:

a threshold: exposure up to this level is left uncollateralised, and only the amount above it is called;
a minimum transfer amount (MTA): calls smaller than this are not made.

Some agreements also require initial margin, an extra cushion posted up front, as L1.7.11: Clearing, margin and collateral described for uncleared trades between large firms.

Does it raise or lower the bank's exposure?

4 cards

A new trade with a negative value to the bank is added to an existing netting set with this counterparty.
The CSA threshold is raised from $2m to $10m.
The counterparty is in a country where courts may not enforce close-out netting.
The counterparty agrees to post cash daily with a zero threshold.

What is left. Collateral arrives after the value has moved, and when a counterparty defaults it takes days to replace its trades, while prices keep moving. Non-cash collateral can fall in value, so it carries a haircut. And the exposure can be at its largest exactly when the counterparty is weakest. These risks come back in M3.3: Counterparty credit risk.

The formal version

Write $V_i$ for the value of trade $i$ to the bank, $V = \sum_i V_i$ for the net value, $H$ for the threshold, $M$ for the minimum transfer amount and $C$ for the collateral already held. The collateral the bank should hold, and the call, are

C^{\text{due}} = \max(V - H,\,0) \qquad \text{call} = C^{\text{due}} - C \;\text{ if } \; |C^{\text{due}} - C| \ge M, \text{ otherwise } 0

E_{\text{after}} = \max(V - C_{\text{after}},\,0)

A negative call means the bank returns collateral. When the net value is below $-H$ , the same rules run the other way and the bank posts collateral. Right after a call the exposure is at most the threshold plus the minimum transfer amount.

Conventions here

Values in US$ millions from the bank's side; one threshold for both parties; cash collateral, so no haircut. Real CSAs can set different thresholds for each side, round calls to set amounts, and specify which collateral is eligible.

Try it

Five trades with one hedge fund. Start with netting off and read the exposure. Turn netting on, then the CSA. Move the market a few points either way and watch the call change direction. Finally, set the threshold to zero.

Try itOne counterparty, five trades

5-year interest rate swap
+12.0
EUR/USD forward
−7.5
10-year interest rate swap
+4.0
Cross-currency swap
−6.0
Oil swap
+2.5

Value to the bank, US$ millions. Green: the counterparty owes the bank. Red: the bank owes the counterparty.

Market move0.0 points

Sum of positives18.5

Net value+5.0

Exposure18.50

Without netting, a liquidator could demand every red trade in full while the bank claims every green one.

Worked example

A bank and a hedge fund

A bank has five trades with a hedge fund under one ISDA Master Agreement, with a CSA: threshold $2.0m, minimum transfer amount $0.5m. The bank already holds $1.0m of cash collateral. Values to the bank today, US$ millions:

Trade	Value to the bank
5-year interest rate swap	+12.0
EUR/USD forward	−7.5
10-year interest rate swap	+4.0
Cross-currency swap	−6.0
Oil swap	+2.5
Net	+5.0

From gross to collateralised exposure

Step 1 of 6

1
Without netting
The bank is owed 12.0 + 4.0 + 2.5 = $18.5m, and would still owe $13.5m on the other two trades.

Regulatory lens

Banks may count netting in their capital only if they have well-founded legal opinions that it would be enforced in the relevant countries; ISDA commissions such netting opinions for many jurisdictions. The Basel standardised approach for counterparty credit risk (SA-CCR) measures exposure per netting set and gives credit for collateral, thresholds and minimum transfer amounts. For uncleared derivatives between covered firms, the BCBS-IOSCO margin rules require variation margin with a zero threshold, and allow a minimum transfer amount of at most €500,000. M4.4: Counterparty, operational and large exposures covers the capital side.

Sparks

SparkWhy one agreement matters

The ISDA Master Agreement makes every trade between two firms part of a single contract. That design is what lets close-out netting work: a liquidator faces one agreement with one net balance, not hundreds of separate contracts to pick from. ISDA first published master agreements in the 1980s; the 1992 and 2002 versions are still the market standards.

SparkWrong-way risk

Collateral and netting assume the exposure and the counterparty's health are unrelated. Sometimes they are not: a bank that buys protection against a country's default from a bank in that same country is owed the most exactly when its counterparty is most likely to fail. This is wrong-way risk.

Key takeaways

Without netting, exposure is the sum of the positive values; with close-out netting it is the positive part of the net value.
The ISDA Master Agreement makes all trades one contract; the CSA sets the collateral rules.
Collateral due is the net value above the threshold; calls below the minimum transfer amount are not made.
Right after a call, exposure is at most the threshold plus the minimum transfer amount.
Netting must be legally enforceable; collateral leaves timing, haircut and wrong-way risk.

Reaction

Check what stuck

Question 1 · objective 1

A bank has four trades with one counterparty, worth +8, −5, +3 and −2 (US$ millions, from the bank's side). With no netting agreement, what is its exposure?

$m

Question 2 · objective 1

The same trades are under one ISDA Master Agreement with close-out netting. What is the exposure now?

$m

Question 3 · objective 2

The net value of a netting set is +9. The CSA has a threshold of 3 and a minimum transfer amount of 0.5. The bank already holds 2 of collateral. How much does it call?

$m

Question 4 · objective 2

Next day the net value is +5.3. Threshold 3, minimum transfer 0.5, collateral held 2. What happens?

AThe bank calls 0.3BNo call: 0.3 is below the minimum transfer amountCThe bank returns 2DThe bank calls 5.3

Question 5 · objective 3

Why does a bank need legal opinions before it counts netting in its capital calculations?

ABecause netting is only allowed for exchange-traded derivativesBBecause netting only helps if a court in the counterparty's country will enforce it in insolvencyCBecause legal opinions replace collateralDBecause supervisors require the bank to publish its trades

Glossary

Exposure: What a firm would lose if its counterparty defaulted today and nothing were recovered: what it is owed, net of anything it can set off or keep.
ISDA Master Agreement: The standard contract, published by ISDA, under which two firms trade OTC derivatives. All trades under it form one agreement.
Close-out netting: On a default, ending every trade under the agreement and combining their values into one net amount payable one way.
Netting set: The group of trades that are netted together on a default: usually all trades under one master agreement.
Cherry-picking: A liquidator enforcing the contracts that favour the defaulted firm and refusing to pay on the others.
Credit Support Annex: The Credit Support Annex: the part of the ISDA documentation that sets out how collateral is exchanged.
Variation margin: Collateral exchanged as market values change, so the side that is owed money holds collateral for it.
Threshold: The exposure a party is allowed to run before collateral must be posted. Only the amount above it is called.
Minimum transfer amount: The smallest amount of collateral worth moving. Calls smaller than this are not made.
Initial margin: Extra collateral posted at the start to cover how far values could move before a defaulter's trades are closed out.

Deep Dives & Origins

Deep Dives

Jon Gregory, The xVA Challenge: Counterparty Risk, Funding, Collateral, Capital and Initial Margin, 4th edition (Wiley, 2020), the chapters on netting and collateral. Advanced.
John C. Hull, Risk Management and Financial Institutions, 6th edition (Wiley, 2023), the chapter on OTC derivatives and counterparty credit risk. Intermediate.

Origins

International Swaps and Derivatives Association, 2002 ISDA Master Agreement.
International Swaps and Derivatives Association, 2016 Credit Support Annex for Variation Margin (VM).
Basel Committee on Banking Supervision, The standardised approach for measuring counterparty credit risk exposures, March 2014.
BCBS and IOSCO, Margin requirements for non-centrally cleared derivatives (BIS, latest revision 2020).

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