Netting · RiskAtoms Academy

By the end you will be able to

1Explain close-out netting under the ISDA Master Agreement and why it matters in a default.
2Compute gross and net exposure for a netting set, on one scenario and across the book's paths.
3Explain how correlation between trades sets the netting benefit, using the variance of a sum.
4Describe what limits netting: legal enforceability, netting opinions, jurisdictions and contract terms.

Why it matters

At mid-2025 the OTC derivatives in the BIS statistics had a gross market value of $21.8 trillion. After legally enforceable netting, the credit exposure was $3.0 trillion: netting removed 86.4% of the mark-to-market exposure (ISDA research note, January 2026, on BIS data). No other tool in this module does as much. At RiskAtoms Bank it almost halves the exposure to Corriemoor, from £8.65m to £4.45m of one-year EPE. It rests entirely on a contract, and on courts enforcing it.

Core explanation

One agreement, one number

Illustrative dataRiskAtoms Bank plc's OTC derivatives book

Eight trades with four invented counterparties, in pounds, on one made-up valuation day, valued on 2,000 simulated paths (seed 34040) of a flat GBP rate (4.00% today), GBPUSD (1.30) and an equity index (8,000) every half month out to ten years. The firms, trades and market model are made up for teaching; none is real data. The same book runs through every lesson in Module 3.4, so the figures agree.

The problem: cherry-picking

Suppose Corriemoor fails a year from now while its three trades with the bank are worth £24m, −£7m, −£11m to the bank (one of the simulated paths). Without netting, each trade is a separate contract. Corriemoor's liquidator would collect the £18m the bank owes on the two losing trades in full, and the bank would join the queue of unsecured creditors for its £24m, recovering perhaps 40%. That is cherry-picking, and the bank's exposure is the sum of the positive values: £24m. With netting, the three values are added first: the bank is owed £5.8m, and that is all it has at risk.

Close-out netting under the ISDA Master Agreement

Most bilateral OTC derivatives are traded under an ISDA Master Agreement, usually the 1992 or 2002 version. The printed form is never changed; the two parties tailor it in a Schedule and confirm each trade separately. Two clauses make netting work. Section 1(c) says the master agreement and all confirmations form a single agreement, so a liquidator cannot keep some trades and reject others. Section 6 sets out close-out netting:

ExploreFrom default to one net amount

Click a box to see what happens there.

Event of Default

The agreement lists Events of Default: failure to pay or deliver after a short grace period (one local business day after notice in the 2002 version, three in 1992), breach, default under other trades, bankruptcy and others. The surviving party, here the bank, decides whether to act.

Payment netting is a different thing: on an ordinary day, payments in the same currency under the agreement are combined so only the difference moves. It cuts settlement risk (L3.4.01: What counterparty credit risk is), not the exposure if the counterparty fails.

Netting sets and the book

The trades covered by one enforceable netting agreement form a netting set. Each of the bank's four counterparties is one netting set. Exposure is computed on the sum of the set's values on each path; the netting benefit compares it with the sum of each trade's own exposure.

One-year EPE, uncollateralised, 2,000 paths. Gross: each trade's exposure on its own.
Netting set	Trades	Gross EPE	Net EPE	Benefit
Halvergate Manufacturing plc	2	£2.60m	£2.12m	18.6%
Corriemoor Bank AG	3	£8.65m	£4.45m	48.6%
Saltney Capital LP	2	£20.09m	£19.26m	4.2%
Ebbsworth Pension Trustees Ltd	1	£5.67m	£5.67m	0.0%
The book	8	£37.02m	£31.50m	14.9%

Corriemoor, net EECorriemoor, gross EE (no netting)

The benefit depends on how the trades move together. Corriemoor's pay-fixed and receive-fixed swaps are almost perfect opposites, so they offset: 49%. Halvergate's swap and forward depend on different markets (the GBP rate and GBPUSD, correlation 0.3), so they offset only partly: 19%. Saltney's put is always an asset, so there is little for the swap to offset: 4%. Ebbsworth has a single trade: nothing to net.

ExploreNetting two trades

Trade A's value has standard deviation 1; trade B's has k. Both start at market.

Correlation of their values, ρ0.00

Size of B relative to A, k1.0

Or pick a case

Net EE as a share of gross EE70.7%

Netting benefit 29.3%. Net EE = φ(0)·√(1 + k² + 2ρk), gross EE = φ(0)·(1 + k).

What limits netting

Netting is only as good as its enforcement in the court that will hear the insolvency. A bank therefore relies on netting opinions: ISDA publishes them for its members, covering over 90 jurisdictions, generally updated each year. Netting can fail or fall short when:

the counterparty's insolvency law does not respect close-out netting, or the opinion is missing or qualified;
trades sit outside the agreement: booked with a different legal entity, under another master, or in products the agreement does not cover;
a branch in another country brings a second insolvency law into play;
bank resolution regimes allow a short stay on termination rights while a failing bank is restructured;
the contract contains a walkaway clause, which regulators do not accept.

Sort itNet or not?

Can the bank count these trades in one netting set?

Three swaps with a German bank under one 2002 ISDA Master Agreement, with a clean netting opinion for Germany.
A swap with a US bank's London branch and an FX forward with its Tokyo subsidiary, each under its own master.
Swaps with a corporate in a jurisdiction where the netting opinion says close-out netting may not survive insolvency.
A payer and a receiver swap with the same pension fund, both under its ISDA Master Agreement, opinion in place.

The formal version

Net never exceeds gross. For any numbers, $\max(a + b, 0) \le \max(a, 0) + \max(b, 0)$ . So on every path and date

\begin{aligned} E^{\text{net}}(t) &= \max\Bigl(\sum_i V_i(t),\ 0\Bigr) \;\le\; \sum_i \max\bigl(V_i(t), 0\bigr) = E^{\text{gross}}(t) \\ \text{EE}^{\text{net}}(t) &\le \text{EE}^{\text{gross}}(t), \qquad \text{with equality when all } V_i \text{ have the same sign on every path} \end{aligned}

How much it saves. Netting works on the sum of random values, so the variance of a sum (M-C11: Combining random variables) sets the benefit. For trades with standard deviations $\sigma_i$ and correlations $\rho_{ij}$ :

\begin{aligned} \operatorname{Var}\Bigl(\sum_i V_i\Bigr) &= \sum_i \sum_j \rho_{ij}\,\sigma_i\,\sigma_j = \boldsymbol\sigma^{\top} \mathbf R\, \boldsymbol\sigma \\ \text{at market, } \mu = 0:\quad \text{EE}^{\text{net}} &= \varphi(0)\sqrt{\boldsymbol\sigma^{\top} \mathbf R\, \boldsymbol\sigma}, \qquad \text{EE}^{\text{gross}} = \varphi(0)\sum_i \sigma_i \\ \text{two trades, } \sigma_2 = k\sigma_1:\quad \frac{\text{EE}^{\text{net}}}{\text{EE}^{\text{gross}}} &= \frac{\sqrt{1 + k^2 + 2\rho k}}{1 + k} \end{aligned}

The ratio is 1 when $\rho = 1$ (no benefit), $1/\sqrt 2$ for two equal, unrelated trades, and $|1 - k|/(1 + k)$ when $\rho = -1$ : equal, opposite trades cancel completely. For $n$ equal, independent trades it is $1/\sqrt n$ . The worked example applies this to Corriemoor's three trades with their full 3 × 3 correlation matrix.

Try it

Suppose some of Corriemoor's trades were not covered by an enforceable agreement: booked with another entity, or in doubt under the netting opinion. Take them out of the netting set and watch EPE and EAD rise.

Try itBuild Corriemoor's netting set

Covered by the enforceable master agreement?

EE with your netting setEE with no netting at all

One-year EPE£4.45m

Netting benefit on EPE48.6%

With no netting£8.65m

EAD = 1.4 × effective EPE£6.24m

Trades in the agreement are added before the max is taken; the rest each count max(V, 0) separately. Illustrative: the book's 2,000 paths, no collateral.

Worked example

Corriemoor: gross against net

From one path to the whole book

Step 1 of 4

1
One scenario in a year
On path 3 of 2,000, rates have risen a year from now and the dollar has strengthened. Values to the bank:
Trade Value to the bank Exposure on its own
T3 pay-fixed £250m 10y £23.76m £23.76m
T4 receive-fixed £150m 5y −£7.17m £0.00m
T5 sell $130m 3y −£10.83m £0.00m
$\begin{aligned} E^{\text{gross}} &= \text{£}23{,}762{,}077 + 0 + 0 = \text{£}23{,}762{,}077 \\ E^{\text{net}} &= \max(\text{£}23{,}762{,}077 - \text{£}7{,}166{,}893 - \text{£}10{,}828{,}497,\ 0) = \text{£}5{,}766{,}687 \end{aligned}$
Netting cuts the loss-if-default on this path by 76%. On path 22 it does more: the values are £3.50m, −£1.03m, −£5.56m, so gross exposure is £3.50m and net exposure is zero.

Trade	Value to the bank	Exposure on its own
T3 pay-fixed £250m 10y	£23.76m	£23.76m
T4 receive-fixed £150m 5y	−£7.17m	£0.00m
T5 sell $130m 3y	−£10.83m	£0.00m

Netting first, then collateral

Collateral under a CSA is called on the net value of the netting set, so netting also shrinks how much collateral moves. That is the next lesson, L3.4.05: Collateral and the CSA.

Regulatory lens

Banking rules let a bank compute exposure on a net basis only for a recognised netting set: “a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement” (Basel Framework, CRE50.15). Recognition requires a contract that creates a single legal obligation, so that on default the bank is owed or owes only the net sum; written and reasoned legal opinions that courts would agree, under the law where the counterparty is incorporated, where any branch involved is located, and that governs the trades and the netting agreement; procedures to keep that under review; and no walkaway clause (for example, the UK and EU Capital Requirements Regulation, Articles 296 and 297). The Basel Committee first broadened its recognition of bilateral netting in amendments to the 1988 Accord in the mid-1990s. SA-CCR and the internal model method both work netting set by netting set (M4.4: Counterparty, operational and large exposures).

Spark Atoms

Spark AtomThe walkaway option that was dropped

The 1992 ISDA Master Agreement let parties choose a “First Method” of close-out, under which a surviving party could walk away without paying a defaulter it owed money to. Regulators would not recognise netting under such terms, and the 2002 agreement dropped the First Method altogether.

Spark AtomFifty changes in ten years

One practitioner counted more than 50 substantive changes in the 2002 ISDA Master Agreement over the 1992 version, drawing on experience such as the Russian debt and Malaysian currency crises and Enron's collapse: among them shorter grace periods, a new Close-out Amount, a force majeure termination event and a set-off clause in the main text (G. Walker, The Treasurer, May 2003). Take-up was slow, and much of the market stayed on the 1992 form.

Key takeaways

Close-out netting turns all trades under one master agreement into a single net amount on default; without it, a liquidator can cherry-pick.
Exposure of a netting set is max(ΣV, 0), never more than Σ max(V, 0).
On the book, netting cuts one-year EPE from £37.0m to £31.5m; Corriemoor's by 49%.
The benefit depends on correlation: offsetting trades cancel; one trade, or trades that are always assets, gain nothing.
Two equal, unrelated trades net to 1/√2 of gross; n of them to 1/√n.
Netting counts only if it is legally enforceable: one agreement, clean netting opinions, no walkaway clause.

Reaction

Check what stuck

Question 1 · objective 2

A counterparty defaults with four trades worth +£5m, −£3m, +£2m and −£1m to the bank. What is the bank's exposure with no netting, in £m?

£m

Question 2 · objective 2

The same four trades under one enforceable ISDA Master Agreement. What is the exposure now, in £m?

£m

Question 3 · objective 3

Two at-market trades have values with equal standard deviations and zero correlation. Net EE is what percentage of gross EE (one decimal)?

%

Question 4 · objective 4

Which of these would stop the bank counting its trades with a counterparty as one netting set?

ANo reasoned legal opinion that netting would hold in the counterparty's home jurisdictionBThe trades are in two currenciesCSome trades are worth more than othersDThe counterparty has a credit rating below A

Question 5 · objective 3

Ebbsworth has one swap with the bank. What is its netting benefit?

AZero: there is nothing to net it againstBAbout 50%CIt depends on the swap's maturityD100%, because the swap is at market

Glossary

Close-out netting: Close-out netting: on a default, all trades under one master agreement are terminated, valued and added up into a single net amount owed one way.
Payment netting: Payment netting: on any day, payments due in the same currency under the same agreement are combined, so only the difference changes hands. It reduces settlement risk, not default exposure.
ISDA Master Agreement: ISDA Master Agreement: the standard contract, published by the International Swaps and Derivatives Association, under which two parties trade OTC derivatives. Widely used versions date from 1992 and 2002.
Schedule: Schedule: the part of an ISDA Master Agreement where the two parties choose options and add or amend terms.
Single agreement: Single agreement: the master agreement and every trade's confirmation form one contract, so a liquidator cannot accept some trades and reject others.
Cherry-picking: Cherry-picking: a liquidator enforcing the trades that are assets of the bankrupt firm while refusing to pay on those that are liabilities.
Netting set: Netting set: the trades with one counterparty under one legally enforceable netting agreement. Exposure is computed on their sum.
Netting benefit: Netting benefit: 1 − net exposure / gross exposure, the share of exposure that netting removes.
Netting opinion: Netting opinion: a reasoned legal opinion that close-out netting would be enforced in a given jurisdiction, including in the counterparty's insolvency.
Walkaway clause: Walkaway clause: a term letting the surviving party stop paying a defaulter that is owed money. Netting with such a clause is not recognised for capital.

Deep Dives & Origins

Deep Dives

J. Gregory, The xVA Challenge, 4th ed., Wiley, 2020, the chapter on netting, close-out and related aspects. Intermediate.
ISDA, “Netting and Collateral Opinions” (overview page), isda.org. Introductory.

Origins

ISDA, “Key Trends in the Size and Composition of OTC Derivatives Markets in the First Half of 2025”, research note, January 2026.
G. Walker, “Master class in ISDA”, The Treasurer, May 2003, pp. 17–19.
Basel Committee on Banking Supervision, Basel Framework, CRE50: Counterparty credit risk definitions and terminology, BIS.
Regulation (EU) No 575/2013 (Capital Requirements Regulation), Articles 296 and 297, as retained in UK law.
Basel Committee on Banking Supervision, Basel Capital Accord: the treatment of the credit risk associated with certain off-balance-sheet items, BIS, July 1994.

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