Close-out Netting In International Derivative Transactions

With the unique risk management function, since their creation in 1970s, financial derivatives have been widely used in the world with trenmendous growth of trading volume and remarkable evelopment of new products. Derivative business has already become one of the core businesses of the current financial market.However, as derivative is traded at nominal amount and such trading is highly leveraged, while playing the role of risk management for the market, it may by itself incur great potential risk. As demonstrated in the past practice, if without proper control of such derivative trading risk, collapse could be a reality in a minute even for a hundred year old prestigious company with substantial capital scale. Again, since participants at derivative market are mainly financial institutions which normally conduct repeated trading among themselves and therefore the trading positions and the exposures will naturally concentrated on such small number of institutions. In this circumstance, if any one of such market participants becomes insolvent due to its improper risk control, it will bring negative impact to its counterparties and even worse a chain of financial risk reaction and collapse might be caused to such counterparties and the counterparties of such counterparties, and eventually lead to disruption and systemic risk at the whole financial market, the economy of a country or even the worldwide economy.In order to reduce the risk of derivative trading and avoid the occurrence of systemic risk, a unique contractual arrangement is adopted at international market, i.e. close-out netting. By close-out netting, in the case a risk event (default events and termination events) occurs to one party, the counterparty will have the right to immediately designate a date to terminate all the unperformed transactions (or all affected transactions) under the master agreement between the parties, or such transactions will be deemed terminated immediately upon the occurrence of certain default events, and then after termination, a termination amount (either negative or positive) will be calculated for each terminated transaction, and all the termination amounts will be netted and one final net amount will be obtained which constitutues a payable obligation. The function of close-out netting is that the parties to derivative transactions could by using it effectively control and substantially reduce the credit exposure they may have from each other. Close-out netting mechanism has two core components; one is the right to terminate the transaction, i.e. termination right, the other is to net the termination amounts, i.e. netting. Close-out netting being a contractual arrangement, realization of its designed function and value very much depends on whether it is always legally valid and enforceable. In normal circumstance (i.e. in situation of no insolvent proceeding), close-out netting is legally valid and enforceable. However, in the event of compulsory insolvent proceeding, there will be some uncertainty with the legal validity and enforceability of close-out netting as the termination right and netting mechanism of close-out netting are by nature in direct conflict with the cherry-picking right of administrator and limitation on insolvency set-off. In order to ensure the legal validity and enforceability of close-out netting and facilitate the realization of its designed function and value, many countries in the world have by amending their bankruptcy law explicitly recognized that close-out netting can apply without being subject to bankruptcy law restriction. Now, close-out netting as an important financial system has been widely adopted at international market and recognized by many countries of strong financial economy.However, there is a lack of basic understanding of close-out netting in China at both market and theory research level, and among both finance circle and legal academics. There is no such legal provision in current Chinese law. Apparently, it will be detrimental to the long-term development of Chinese financial market and financial derivative market in particular.The purpose of this paper is to study on close-out netting at derivative market. Firstly, based on the introduction of financial derivatives and derivative market situation this paper analyzes the legal implication of close-out netting, illustrates that it is such a unique system with a different nature of set-off, and demonstrates its significant value in risk management of financial derivative market. This paper focuses its analysis from the perspective of both contract law and bankruptcy law on the legal validity and enforceability of close-out netting, discussing the conflict between close-out netting and bankruptcy law principles, and then explaining why legislative efforts are necessary for recognition of the legal validity and enforceability of close-out netting, why a special treatment within bankruptcy law regime shall be given to derivatives, and meanwhile by using methodologies of economic analysis and case analysis explaining why the special treatment can be given to close-out netting, and further displaying the economic implication and cost efficiency of close-out netting. Furthermore, this paper gives comparative study on the legislation regarding close-out netting in some financially developed countries. Finally, this paper discusses on the current derivative market in China, and points out that although the Chinese market has by referring to international practice introduced the close-out netting as a contractual arrangement, there is actually no such legal concept of close-out netting under the current law in China. Then this paper focuses on analyzing the legal validity and enforceability of close-out netting under the current Contract Law and Bankruptcy Law of China, explaining the necessity and significance of close-out netting legislation and exploring the approaches of such close-out netting legislation in China.Selection of this paper subject is based on the author's experience, thinking and study in the past over ten years in legal practice with respect to derivatives. So far close-out netting has not been really researched in China, and therefore this is a unique and new topic for research. And meanwhile, due to the increasingly importance of financial derivative market in the whole Chinese financial market and the substantial role the financial derivatives will play in the future development of Chinese financial market, research on the close-out netting—the most important mechanism of derivative market-- will then be of significant value in practice.