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

A bank has a portfolio of trades with a counterparty in a jurisdiction where no legal opinion on close-out netting exists. The gross positive MTM is USD 80 million, the gross negative MTM is USD 70 million, and the net MTM is USD 10 million. The counterparty becomes insolvent and the local liquidator can cherry-pick. What is the bank's most likely loss exposure, ignoring recoveries and collateral?

The exposure is about USD 80 million, the gross positive value. If netting is unenforceable the liquidator can cherry-pick, so the bank cannot offset its 70 million of negative trades against the positives and bears the full gross positive exposure, before any recovery.

  1. AUSD 10 million, since the ISDA automatically nets
  2. BUSD 70 million, the negative trades
  3. CUSD 80 million, since the bank pays its liabilities but loses the positive tradesCorrect
  4. DUSD 0, since negatives offset all positives

Explanation

With cherry-picking, the liquidator keeps the contracts valuable to the estate and disclaims the others. The bank must still pay on its negative trades but loses the 80 million of positive value before any recovery. The 10 million net applies only if netting is enforceable.

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