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FRM Exam Part I · Central Clearing

OTC Derivatives Markets and Bilateral Clearing Explained

Updated 11 October 2026 · Fact-checked

In bilateral clearing, two parties trade an OTC derivative directly and carry each other's default risk. They manage it with an ISDA Master Agreement, which allows close-out netting, and a CSA, which sets collateral. To solve questions, net exposures by netting set, subtract collateral, and take the positive remainder.

Understand OTC Derivatives Markets and Bilateral Clearing

An over-the-counter (OTC) derivative is a contract negotiated directly between two parties, not on an exchange. Swaps, forwards and many options trade this way. Terms can be tailored to the exact need: amount, maturity, payment dates. The cost of that flexibility is that each side faces the other's credit risk.

Bilateral clearing means the two counterparties settle and manage the contract between themselves. There is no central counterparty (CCP) in the middle. If one party defaults, the other may lose the positive market value of the contract, which is the replacement cost. Only the party with a positive value is exposed. The party with a negative value owes money and has nothing to lose from the default except what it must pay.

Two tools cut this risk. The first is netting. Under the ISDA Master Agreement, all trades between two parties are covered by one legal contract. If a default occurs, close-out netting lets the non-defaulting party combine all trade values, positive and negative, into one single net amount. Without enforceable netting, a liquidator could demand payment on trades that are worth money to the defaulter (cherry-picking) while refusing to pay on the others. Netting is only as good as its legal enforceability in the relevant jurisdiction.

The second tool is collateral. The Credit Support Annex (CSA) is a schedule to the ISDA that sets the rules for posting collateral: which assets are eligible, the threshold (unsecured exposure allowed before collateral is called), the minimum transfer amount (MTA), haircuts and how often values are called. Collateral reduces exposure but does not remove it. Exposure can grow between the last call and the close-out, which is the margin period of risk. Collateral can also create liquidity risk for the poster.

Contrast this with central clearing, where a CCP becomes the buyer to every seller through novation and applies standardised margining. Bilateral markets keep flexibility but leave a web of exposures between dealers and weaker standardisation.

Key formulas to remember

Exposure of one trade
Exposure = max(V, 0)
V is the market value to you. Only a positive value is at risk if the counterparty defaults.
Exposure without netting
Exposure = Σ max(Vi, 0)
Each trade is treated separately. Negative trades give no offset.
Exposure with close-out netting
Exposure = max(Σ Vi, 0)
Applies to trades in one legally enforceable netting set.
Exposure after collateral
Uncollateralised exposure = max(Net value − Collateral held, 0)
With a threshold H, collateral called is roughly max(Net value − H, 0), subject to the MTA.
Netting benefit
Netting benefit = Exposure without netting − Exposure with netting
Always zero or positive. It is zero when all trades have the same sign.
Net-to-gross ratio (NGR)
NGR = Net exposure ÷ Gross exposure
Lower NGR means more benefit from netting. Gross exposure is the sum of positive values.

How to solve OTC Derivatives Markets and Bilateral Clearing questions

Use this order for any numerical or conceptual question on bilateral OTC exposure.

  1. 1Identify who is asking: exposure is always measured from one party's side. Value each trade from that party's view.
  2. 2Group trades into netting sets. Trades under one enforceable ISDA are one set. Trades with different counterparties never net with each other.
  3. 3Check enforceability. If the question says netting is not enforceable, treat each trade separately.
  4. 4Compute gross exposure by summing only the positive values, and net exposure by summing all values and flooring at zero.
  5. 5Apply collateral. Subtract collateral held from the net exposure, considering any threshold or MTA, and floor at zero.
  6. 6Consider the margin period of risk. If the question asks about residual risk, note that values can move before close-out.
  7. 7State the answer and, for conceptual items, name the mechanism: close-out netting, CSA collateral or the absence of a CCP.

Quickest way: Positive parts, then sum

When to use it: Numerical questions with several trades and perhaps collateral.

  1. Write each trade value with its sign from the asker's side.
  2. Gross = add the positives only. Net = add everything, then floor at zero.
  3. Subtract collateral from net and floor at zero.
  4. For multiple-choice, eliminate options where net exceeds gross, since that cannot happen.

Common mistakes in OTC Derivatives Markets and Bilateral Clearing

  • Treating a negative trade value as an exposure.

    Students add absolute values or forget that the party owing money loses nothing if the other side defaults.

    Fix: Use max(V, 0) for each trade. A negative value is zero exposure.

  • Netting trades with different counterparties.

    Students see a mix of positive and negative values and net them all.

    Fix: Net only within a single legal netting agreement with one counterparty.

  • Assuming collateral eliminates all counterparty risk.

    Collateral looks like a full guarantee.

    Fix: Remember thresholds, MTAs, haircuts, dispute delays and the margin period of risk leave residual exposure.

  • Confusing ISDA and CSA.

    They are often mentioned together.

    Fix: The ISDA Master Agreement is the legal framework and provides close-out netting. The CSA is the schedule governing collateral.

  • Thinking netting changes the value of the trades.

    Students think netting alters the contracts.

    Fix: Netting changes only the amount owed on default. Each trade keeps its value and cash flows.

  • Saying bilateral clearing involves novation to a CCP.

    Mixing it up with central clearing.

    Fix: In bilateral clearing the original parties stay counterparties. Novation is a CCP feature.

Worked examples

Example 1

Bank A has three OTC derivatives with Counterparty B, all under one enforceable ISDA with close-out netting. Values to Bank A are +$12 million, +$5 million and −$9 million. (a) What is the exposure without netting? (b) What is the exposure with netting? (c) What is the netting benefit?

Show the solution
  1. Without netting, sum the positive values only: 12 + 5 = $17 million.
  2. With netting, sum all values: 12 + 5 − 9 = $8 million. This is positive, so exposure is $8 million.
  3. Netting benefit = 17 − 8 = $9 million.

Answer: Exposure without netting is $17 million, with netting is $8 million, and the benefit is $9 million.

Example 2

Using the netted position in the previous example, Counterparty B has posted $6 million of collateral to Bank A under a CSA. Bank A's counterparty then defaults. Ignoring haircuts and any move in values since the last call, what is Bank A's uncollateralised exposure, and what is the net-to-gross ratio before collateral?

Show the solution
  1. Net exposure = $8 million.
  2. Uncollateralised exposure = max(8 − 6, 0) = $2 million.
  3. Net-to-gross ratio = 8 ÷ 17 = 0.47 (about 47%).

Answer: Uncollateralised exposure is $2 million, and the net-to-gross ratio is about 0.47.

Exam tips

  • Always check whose perspective the values are quoted from before computing exposure.
  • Look for the words 'enforceable' or 'legal opinion'. If netting is doubtful, compute exposure gross.
  • Know the CSA terms: threshold, MTA, haircut, eligible collateral and margin period of risk. Questions often test them by definition.
  • Be ready to compare bilateral and central clearing: flexibility and tailored terms versus standardisation, novation and mutualised default resources.

Practice questions from Central Clearing

OTC Derivatives Markets and Bilateral Clearing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

OTC Derivatives Markets and Bilateral Clearing: frequently asked questions

What is the difference between bilateral and central clearing?

In bilateral clearing the two trading parties face each other and manage credit risk through ISDA netting and CSA collateral. In central clearing a CCP steps between them through novation and applies standardised margin. Bilateral allows tailored trades, while central clearing concentrates and standardises risk.

What is an ISDA Master Agreement and what is a CSA?

The ISDA Master Agreement is a standard legal contract covering all OTC derivatives between two parties. It allows close-out netting on default. The CSA is a schedule to it that sets collateral rules such as thresholds, eligible assets and call frequency.

How does netting reduce counterparty risk?

Netting combines positive and negative trade values with one counterparty into a single amount on default. You are exposed only to the net positive balance, not the sum of the positive trades. It works only where the netting agreement is legally enforceable.

Does collateral remove counterparty risk completely?

No. Thresholds, minimum transfer amounts, haircuts and delays in calling and receiving collateral leave some exposure. Values can also move during the margin period of risk before positions are closed out.