FRM Exam Part II · Netting, Close-out and Related Aspects

Cherry Picking, Set-off and Insolvency Issues in Netting

Updated 11 October 2026 · Fact-checked

Cherry picking is when an insolvent firm's administrator keeps contracts that are in the money for the estate and rejects those that are out of the money. Close-out netting prevents this by turning all trades into one net amount. It works only if the law enforces it on insolvency.

Understand Cherry Picking, Set-off and Insolvency Issues

Start with a simple case. Bank A and Firm B have many derivatives with each other. Some are worth money to B, some to A. If B becomes insolvent, an administrator may want to collect on the trades where B is owed money and walk away from the trades where B owes money. This is cherry picking. The solvent bank A would then pay in full on its losing trades but receive only a fraction (a claim in the insolvency) on its winning trades.

Close-out netting is the contractual fix. On a default, all transactions under the master agreement terminate. Each is valued, and the values are combined into a single net sum owed by one party. The administrator cannot split the portfolio. Credit exposure falls from the sum of the positive values to the net value, floored at zero.

Set-off is a related but different idea. It is the right to deduct a debt you owe a counterparty from a debt it owes you. It can arise by law, by contract or by court rules, and the conditions differ by jurisdiction (for example, mutuality of the debts or whether they are due). Netting is the broader process of combining many obligations, often terminating and valuing contracts first. Set-off is often the legal tool used to apply the result.

The key risk is enforceability. Insolvency laws in some jurisdictions may stay (freeze) contracts, allow the administrator to cherry pick, or restrict set-off. Many jurisdictions therefore give derivatives and similar contracts safe harbour: the stay and avoidance rules do not stop termination, close-out and netting. Where the law is uncertain, legal opinions are needed per jurisdiction and per counterparty type. Under Basel, a bank can recognise netting for capital only if it has a well-founded legal basis that the netting is enforceable in all relevant jurisdictions.

Limits matter. Netting is usually enforced within a single master agreement and a single legal entity. It may fail across different entities, across branches in different jurisdictions, or for certain counterparty types. Cross-product netting is only as strong as the law and documentation behind it. Resolution regimes for banks may also impose a short temporary stay on termination rights.

Key formulas to remember

Gross exposure: Gross exposure = Σ max(Vi, 0); Sum of positive trade values. This is what a cherry-picking administrator would aim to collect, while the solvent party must pay its out-of-the-money trades.
Net exposure with enforceable netting: Net exposure = max(Σ Vi, 0); Vi is the value of trade i to you. Valid only if close-out netting is legally enforceable.
Netting benefit: Netting benefit = Gross exposure − Net exposure; Never negative. It is zero when all trades have the same sign.
Net-to-gross ratio (NGR): NGR = Net exposure ÷ Gross exposure; Between 0 and 1 for positive gross exposure. Lower means more netting benefit.
Cherry-picking loss to solvent party: Loss = Σ max(−Vi, 0) paid in full − recovery on Σ max(Vi, 0); Here Vi is value to the solvent party. It pays its negative trades in full and recovers only a percentage on its positive ones. Loss is the amount paid in full on negative trades minus the recovery on positive ones, compared with the net claim.
Rule for capital recognition: Netting recognised only if legal basis is well founded in all relevant jurisdictions; Typically supported by written, reasoned legal opinions.

How to solve Cherry Picking, Set-off and Insolvency Issues questions

Use this order for any question on cherry picking, set-off or insolvency treatment of netting.

1Identify the parties, the legal entities and the jurisdictions involved. Enforceability depends on them.
2Check whether there is a single master agreement with a close-out netting clause covering all the trades.
3List each trade value from the point of view of the party asked about. Mark positives and negatives.
4Compute gross exposure (sum of positives) and net exposure (sum, floored at zero).
5If netting is not enforceable, assume cherry picking: the solvent party pays negatives in full and recovers only a fraction on positives. Apply the stated recovery rate.
6If netting is enforceable, use the single net amount. Check whether collateral held should be deducted.
7Test the limits: different entities, branches, product types, or a resolution stay. Say which assumption fails.
8State the interpretation: how much exposure, how much capital or loss, and the legal risk driving it.

Quickest way: Gross, net, then legal check

When to use it: Use for numerical or conceptual MCQs where trade values and an enforceability fact are given.

Sum positives for gross. Sum all values for net and floor at zero.
Ask one question: is netting enforceable here? If yes, use net. If no, use gross.
If no, compute loss as negatives paid in full minus recovery on positives, or simply exposure at gross with recovery applied.
For concept questions, match the term: cherry picking means selective performance by an administrator, set-off means deducting mutual debts, safe harbour means exemption from stay and avoidance.

Common mistakes in Cherry Picking, Set-off and Insolvency Issues

Treating netting and set-off as identical.
Both reduce amounts owed between two parties.
Fix: Remember close-out netting terminates and values all trades into one sum. Set-off is the right to deduct mutual debts, with conditions set by law or contract.
Assuming netting always works.
Contracts say it does, so students stop there.
Fix: Enforceability depends on insolvency law of the relevant jurisdictions. Always look for a legal opinion or a jurisdiction flag.
Using the sum of all trade values when the signs differ and netting is unenforceable.
Netting becomes a reflex.
Fix: Without enforceability, exposure is the sum of positive values only. Net is used only when the law supports it.
Forgetting to floor net exposure at zero.
A negative sum looks like a valid number.
Fix: Exposure is max(net value, 0). A negative net value means you owe, not that you have negative credit exposure.
Thinking safe harbour removes all insolvency risk.
The term sounds absolute.
Fix: Safe harbour exempts certain contracts from stays and avoidance rules in specific laws. Coverage, counterparty types and resolution stays still vary.
Assuming netting works across different legal entities of one group.
Group exposure is viewed economically.
Fix: Netting is normally between two legal entities under one agreement. Cross-entity netting usually needs special structures and legal support.

Worked examples

Example 1

A bank has three trades with Firm X under one master agreement. Values to the bank: +USD 12 million, +USD 5 million and −USD 9 million. Firm X defaults. Recovery on unsecured claims is 40%. Compare the bank's loss if close-out netting is enforceable versus if the administrator can cherry pick. Ignore collateral and costs.

Show the solution

Gross positives = 12 + 5 = USD 17 million. Negative = USD 9 million.
With netting: net = 12 + 5 − 9 = USD 8 million owed by X to the bank.
Recovery at 40% = 0.40 × 8 = USD 3.2 million. Loss = 8 − 3.2 = USD 4.8 million.
With cherry picking: the bank pays the USD 9 million in full. It recovers 40% × 17 = USD 6.8 million on the positive trades.
Net cash position = 6.8 − 9 = −USD 2.2 million, so the bank is out of pocket by USD 2.2 million.
Compare to no default: the bank's net economic position was +8 million. Loss under cherry picking = 8 − (−2.2) = USD 10.2 million.

Answer: Loss is USD 4.8 million with enforceable netting and USD 10.2 million with cherry picking. Netting saves USD 5.4 million.

Example 2

A bank holds two trades with a counterparty under one master agreement, valued at +EUR 20 million and −EUR 14 million to the bank. Which statement is correct? A) Net exposure is EUR 34 million. B) Net exposure is EUR 6 million and the netting benefit is EUR 14 million if netting is enforceable. C) Net exposure is EUR 20 million in all cases. D) Net exposure is −EUR 6 million.

Show the solution

Gross exposure = max(20, 0) + max(−14, 0) = EUR 20 million.
Net exposure with enforceable netting = max(20 − 14, 0) = EUR 6 million.
Netting benefit = 20 − 6 = EUR 14 million.
Check A: 34 adds absolute values, which is not exposure. Check C: true only without enforceable netting. Check D: exposure cannot be negative.

Answer: B

Exam tips

Read for the enforceability clue: legal opinion, jurisdiction, entity or branch. It decides whether to use gross or net.
Know the vocabulary precisely: cherry picking, set-off, close-out netting, safe harbour, stay.
In loss questions, write both scenarios side by side and compare them. It avoids sign errors.
Expect a conceptual MCQ on limits: netting across entities, jurisdictions without legal certainty, or a resolution stay.
Do not state that a safe harbour applies everywhere. Choose the answer that ties it to specific laws and contract types.

Practice questions from Netting, Close-out and Related Aspects

Cherry Picking, Set-off and Insolvency Issues: frequently asked questions

What is cherry picking in bankruptcy for derivatives?

It is when an insolvent firm's administrator enforces contracts that are valuable to the estate and refuses those that are costly. The solvent counterparty is then hurt, because it pays on its losing trades but only claims on its winning ones. Close-out netting is designed to stop this.

What is the difference between netting and set-off?

Close-out netting terminates all trades under an agreement, values them and combines them into one net sum. Set-off is the right to deduct a debt you owe from a debt owed to you. Set-off rules vary by law and contract, and netting often relies on set-off to apply the result.

What is a safe harbour for derivatives in insolvency?

It is a legal exemption that lets counterparties terminate, close out and net certain financial contracts even when a stay or avoidance rule would normally block them. Its scope depends on the jurisdiction, the contract type and the counterparty.

Why does netting enforceability matter for regulatory capital?

Under Basel, a bank may reduce counterparty exposure for netting only if it has a well-founded legal basis that netting is enforceable in all relevant jurisdictions. Without that, exposure is measured on a gross basis, which raises capital requirements.