Netting, Financial Contracts, and Banks: The Economic Implications
Derivatives and certain other off-balance sheet contracts enjoy special legal protection on
insolvent counterparties through a process referred to as "close-out netting." This paper
explores the legal status and economic implications of this protection. While this
protection benefits major derivatives dealers and derivatives markets, it is less clear that
other market participants or markets in general are better or worse off. While we are not
able to conclude whether or not these protections are socially optimal, we outline the
wide range of issues that a general consideration of the pros and cons of netting
protection should take into cognizance, and analyze some of these issues critically.
Ultimately the question becomes one of quantifying complex trade-offs.
