What is a Master Netting Agreement?
A Master Netting Agreement (MNA) is a legal framework primarily employed in the financial services sector to manage the multifaceted economic relationships that arise in financial transactions. Designed to contain within a single, overarching document all of the transactions and cash flows between parties – generally, under a single credit facility – an MNA delineates and establishes the rights and obligations of each contracting party. There are two chief contractual obligations: first, the payment obligation – generally the obligation to pay the calculated net amount due as calculated under the terms of the MNA – and , second, the obligations which are conditional, contingent or otherwise only become payable after the occurrence of some future event, generally where a party or parties default. An MNA may be signed by market counterparties in various contexts whether in the context of interbank transactions or the collateralization of master contracts for OTC derivatives. While generally governed by contract and formed independently of any regulatory authority, an MNA is often influenced by legal and quasi-legal frameworks and is sometimes required by prudential regulations.
Elements of a Master Netting Agreement
Master netting agreements should contain terms and conditions related to the property subject to the netting regime, the scope of the parties, the procedures for calculating netting amounts, termination and collateral management. These components should be closely examined with counsel to ensure that they achieve the desired outcome and reconcile with existing industry practice.
Property Subject to Netting Regime
The Property Subject to Netting Regime defines the pool of collateral assets which are subject to the master netting agreement (MNA). These provisions will identify the relevant collateral within the framework of the underlying trading and custody agreements with the parties. Specificity is usually necessary with respect to the accounts and the documents which create a right of collateral over those accounts.
Scope of the Parties
This section should identify the relevant parties to the MNA. Trading entities which are either parent or subsidiary entities of the entities in the MNA should be clearly identified.
Calculation of Netting Amounts
This section should specify the procedures to manage the close out and netting of exposures. Procedures for the calculation of the close out amount should be specified together with the valuation of any outstanding securities (if applicable), whether substitutes or proxies are permitted in the valuation process, whether interest is payable under the MNA and to what extent. Consideration should be given to the timing of the relevant payments under the MNA.
Termination
The master trading agreement should contemplate a termination mechanism. In practice, the time period for termination is often limited to what is available under the underlying trading agreements between the parties but parties should give careful consideration to the consequences of stretching the time period in terms of the management of the relevant positions. The right to terminate the MNA should be explicitly contained within the MNA and the triggering mechanism, if any, for that right to be exercised should be carefully set out.
Collateral Management
Where collateral is managed by an agent, the MNA should state how the relevant collateral is managed by the agent and any rights the agent has (including the right to substitute collateral).
Advantages of Master Netting Agreements
Master netting agreements offer several key benefits for institutions that use them. These benefits include risk management, efficiency, and legal protection.
Risk management is the primary benefit of entering into a master netting agreement. In the face of counterparty default, master netting agreements allow counterparties to set off debts owed to and by their counterparty and to settle the agreement with one net payment. In doing so, a master netting agreement eliminates the threat that a default would leave the solvent party to the transaction with a large, unsecured claim against a defaulting counterparty and allows the solvent party to obtain all the collateral it holds. This reduced exposure reduces credit and default risk. Additionally, in the event of a disagreement about the amounts owed by the parties, the parties may speed settlement by netting out the amounts owed and evading litigation.
Another commonly cited prong of the value of master netting agreements to parties is efficiency. By its terms, a single agreement governs multiple transactions. The agreement reduces the need to memorialize every transaction in a separate bilateral instrument. Because the agreement is a contract between multiple parties, it may avoid the necessity of entering into a new agreement with each new party. The agreement will also require periodic settlement of obligations, which will prevent ever-increasing loops of obligations with no time for settlement. A master netting "chain" enables netting of obligations among multiple parties in a multi-national and multi-jurisdictional environment.
Master netting may also provide parties with a more reliable legal status than they would otherwise enjoy individually. For example, the agreement may improve a party’s treatment in insolvency. Under Article 558 of the Bankruptcy Code, master netting agreements afford their counterparties special treatment. Specifically, when a debtor defaults on such an agreement, parties may net all of their obligations and treat them as if there had been a single transaction. Bankruptcy courts give effect to these agreements, entitling the non-defaulting party to the benefit of netting. Additionally, master netting agreements may provide eligible safe harbor protections to parties under section 362(b)(7) of the Bankruptcy Code. That provision permits a repossessor or seller to proceed with a sale of a repurchase agreement or reverse repurchase agreement notwithstanding a stay being in place under Chapter 11.
Sectors Commonly Using Master Netting Agreements
The common themes that run across the industries that rely heavily on the use of master netting agreements are frequent and relatively large transactions, a desire to alleviate the administrative burden of tracking multiple open transactions, and a heightened need to capture and allocate credit risk. Given the sophisticated nature of these industries, the use of netting opportunities to calculate an amount subject to risk is both a convenience and a necessity.
Some of the most common industries where netting agreements are found include:
Hedge Funds. Hedge fund netting agreements are almost always linked to ISDA Master Agreements or CSA’s. They are infrequently between two or more hedge funds, as one hedge fund’s ability to pay is often tied to its parent fund or other funds under common control. However, there are some multi-layered hedge fund structures that use netting agreements to consolidate positions.
Commercial Trade. Many commercial transactions, including those between publicly traded companies, are done on a "net payment" basis and thus are effectively netting agreements. Some commercial arrangements are documented as netting agreements, but this is the exception rather than the rule.
Interbank. The most sophisticated and elaborate netting arrangements are found in interbank arrangements, such as a bank’s trading book or clearing operations. Interbank netting agreements are also used in single or multi-nation clearing arrangements, such as the World Savings banks Clearing House (WSCH) or the US government Treasury Bill Service facility.
Legal Issues and Considerations
The interplay of master netting agreements with the bankruptcy code creates a unique set of challenges for both practitioners and economists. Probably the most important issues for a practitioner to be aware of are those which involve the formalities necessary to create a master netting agreement and the jurisdictional prerequisites to those formalities. For example, the written agreement required by the Bankruptcy Code will probably need to be signed by both parties (i.e., the creditor and the debtor) and include the signature of a witness, in order to comply with the Statute of Frauds. Also, because "the creation of a master netting agreement is a retreat from the Code’s ‘first in, first out’ approach," it is critical to consider that "when a party holds collateral under a pre-existing security agreement, the holder may not be able to create a security interest with respect to the same collateral pursuant to a master netting agreement , without altering the terms of the pre-existing security agreement." Finally, the question of whether the claim the master netting agreement purports to secure exists will likely end up being raised. Matters that tend to be addressed in a master netting agreement as a matter of practical sense, but which could be considered a material modification of an existing loan agreement, could face stiff opposition from opponents who would argue that the "material modification" voids the prior loan agreement as a matter of law. In addition to these considerations when arranging a master netting agreement, there are also issues related to the practical application of the master netting agreement provisions (regarding the secured creditor’s right to set-off perfecting its claim under the UCC) vis-à-vis the provisions of the Bankruptcy Code.
Comparison with Related Financial Agreements
Master Netting Agreements are often compared to other financial agreements, most notably ISDA Master Agreements. The ISDA Master Agreement and accompanying Credit Support Annex (the "ISDA Master Agreements") are the main documents in the market for over-the-counter derivatives transactions. However, unlike Master Netting Agreements, ISDA Master Agreements do not provide for the netting of settlement amounts across different products.
The ISDA Master Agreements do not provide for netting in the default situation. Specifically, the ISDA Master Agreement provides that an early termination amount (the "Early Termination Amount") is to be determined for each transaction and, where there are multiple transactions, all these Early Termination Amounts are aggregated. The netting contemplated in the ISDA Master Agreement is therefore only for the purposes of returning collateral and does not extend to the set-off of cross-product liabilities. In contrast, the Master Netting Agreement generally provides for the netting of amounts owing by and to both parties across different products. Further, the netting contemplated in the Master Netting Agreement does not take into account the different analytical divisions in the ISDA Master Agreement.
Examples of Master Netting Agreements in Practice
One of the best ways to understand master netting agreements is to look at how they work in practice. Consider the following examples:
ABC Inc. and XYZ Corp. are two companies that engage in the business of foreign exchange trading, and they routinely enter into numerous foreign exchange transactions. ABC Inc. executes a number of currency trades for XYZ Corp., which constitutes a receivable for ABC. From time to time, XYZ Corp. also owes a receivable to ABC Inc. in connection with different foreign exchange transactions. In such circumstances, the parties would have the ability to net the receivables and obligations associated with the separate trades and treat the net result as a single obligation between them. If XYZ Corp. owed ABC Inc. $5 million on one trade (i.e., ABC was the creditor of that amount) and ABC Inc. owed XYZ Corp. $8 million under a separate trade (i.e., XYZ was the creditor of that amount), then under their master netting agreement, they could net the $3 million difference, which would result in a $3 million payable from XYZ Corp. to ABC Inc.
Suppose now that instead of entities, the above foreign exchange trades involved a mortgage lender and a mortgage borrower. The mortgage lender performs a number of transactions, including advances of loan proceeds to the mortgage borrower, and each with a different interest rate. The mortgage lender may determine that it would be commercially reasonable to net the receivables and obligations arising out of the separate transactions with the mortgage borrower and treat the net result as a single obligation. As an example, the mortgage borrower could owe the lender $1 million on an advance of loan proceeds bearing a 3% interest rate. Separately, the mortgage borrower could also owe the lender another $2 million on an advance of loan proceeds bearing an interest rate of 4%. Under a properly-structured master netting agreement, the mortgage lender would have the ability to net the $1 million receivable bearing a 3% interest rate with the $2 million receivable bearing a 4%, resulting in a $1 million receivable as of the date of the advance of loan proceeds accruing interest at 4%. Then, all future advances of loan proceeds could be made to the mortgage borrower pursuant to one master loan, with one maturity date, and at one interest rate. This result would substantially simplify the record keeping and tracking obligations of the lender and reduce transaction costs as the parties could avoid preparing and recording separate mortgage instruments for each advance of loan proceeds.
Future Trends in Netting Agreements
As markets continue to evolve, the application and sophistication of netting agreements will follow suit. Notably, there are two important future trends to consider when thinking about netting agreements: 1) the development of distributed ledger technology and the corresponding shift from central clearing to over-the-counter ("OTC") trading for some types of trades, and 2) expected future developments to the scope of netting agreements impacted by the Dodd-Frank Act.
We have previously written about the possible impact of distributed ledger technology and other financial technology on OTC derivatives. In particular, a decentralized process for managing the operation of imbalance prices, payments, and transaction tracing at a distributed ledger level could serve as an alternative to centralized tracking and accounting of price and payment balances between counterparties under a netting agreement and would thus offer a unique opportunity to integrate netting activity into the blockchain. However, whether such distributed ledger technology can actually take hold will depend on technological implementation and, significantly, on regulatory factors . As we have noted, because of the current complexity of netting laws, implementation may require unique state statutory or regulatory interventions or federal action on an appropriate resolution.
Another area of potential future activity in the area of netting agreements is the narrowing of application of netting agreements caused by the Dodd-Frank Act. The Dodd-Frank Act regulates standard transactions to help manage systemic risk and requires these transactions to be conducted, cleared, and reported to a swap repository. But as the market for nonstandard transactions continues to grow, having no choice but to clear and report them could place a considerable administrative burden on those trading entities. It is expected that, in line with the way the derivatives market was structured prior to the Dodd-Frank Act, dealers will continue to enter into netting agreements that govern both standard and nonstandard OTC products, including products that are well-hedged and without significant market risk. These netting agreements will act as ongoing contracts that govern the trades executed in accordance with them, but will not be explicitly subject to the requirements of the Dodd-Frank Act.