Bilateral Close-Out Netting is a legal and operational framework allowing two counterparties to offset all obligations arising from their various transactions upon the occurrence of a default by one party. This process reduces the gross financial exposures between them to a single net claim or obligation. Its purpose is to significantly limit counterparty credit risk.
Mechanism
Upon a specified default event, all open contracts between the two parties are terminated and valued at their current market rates. The positive and negative values of these terminated positions are then aggregated. This aggregation results in a single net amount owed by one party to the other. This process relies on pre-agreed master agreements that specify netting procedures and legal enforceability across relevant jurisdictions, including those governing digital asset transactions.
Methodology
The strategic approach involves establishing robust legal agreements and computational systems capable of accurately calculating and applying netting principles in real-time or near real-time. This is particularly relevant within high-frequency crypto trading environments where counterparty risk accrues rapidly. It functions as a critical risk mitigation tool for managing credit exposure across a portfolio of bilateral crypto derivatives or lending arrangements.
A central clearing model supplants bilateral netting for cleared trades by transforming counterparty risk into a standardized, centrally managed process.
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