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

A bank has two trades with a counterparty that has just entered insolvency. Trade A has a mark-to-market value of +40 to the bank and Trade B has -25 to the bank. There is no enforceable netting agreement, and the liquidator may pursue 'cherry picking'. Assuming no collateral, what is the bank's likely loss exposure and payment position?

Without enforceable netting, the liquidator may cherry pick, so the bank must pay the 25 it owes while ranking as an unsecured creditor for the 40 it is owed. Exposure is the gross 40, not the net 15.

  1. AThe bank must pay 25 and can claim only 15 as a creditor
  2. BThe bank owes 25 in full and is an unsecured creditor for 40Correct
  3. CThe bank has a net claim of 15 and pays nothing
  4. DThe bank may keep 40 and is released from the 25 payable

Explanation

Without enforceable netting, the liquidator can demand payment on the trade that is out-of-the-money for the bank (25) while leaving the bank as an unsecured creditor for the in-the-money trade (40). The net claim of 15 is only available with netting, which is the wrong choice here.

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