This mechanism comes up when estimating the loss from a counterparty's failure and when checking whether a master agreement works inside bankruptcy proceedings.

What happens when a counterparty fails

When a petition to start bankruptcy or similar proceedings is filed against one party that trades under a master agreement, close-out netting adds up the values of all transactions under that agreement and turns the net amount into a single claim or obligation. For transactions under a master agreement that contains a close-out netting provision, Japanese law gives this effect at the time of the petition, regardless of the intentions of both parties1. A master agreement is a contract made so that two or more transactions can be carried out continuously with the same counterparty, and it sets out basic matters such as how obligations are performed2. The structure of the contract documents is covered in The ISDA Master Agreement and Schedule.

The steps are as follows.

  1. A petition to start bankruptcy, rehabilitation, or reorganization proceedings is filed against one of the parties (a close-out netting event).
  2. The value of every transaction under the master agreement at that time is calculated transaction by transaction (the method of calculation is set by a Cabinet Office order).
  3. The values are added up to get the net total.
  4. The net total becomes a single claim or a single obligation between the parties. The payments and receipts of the individual transactions are replaced by this single claim or obligation1.

Consider a hypothetical example in which a company and its counterparty have made three transactions under one master agreement. The values when a close-out netting event occurs at the counterparty are shown below from the company's side in two cases. A positive value is an amount the company receives, and a negative value is an amount it pays.

Transaction Value in case A (billion yen) Value in case B (billion yen)
Transaction 1 +1.0 +0.2
Transaction 2 −0.6 −0.6
Transaction 3 −0.2 −0.2
Net total +0.2 −0.6
What remains after close-out netting A claim of 200 million yen of the company against the counterparty An obligation of 600 million yen of the company to the counterparty

A positive net amount becomes a single claim, and a negative one becomes a single obligation. Which of the two it is depends on the sum of the values at that time. Figure 1 shows case A.

↑ Receive　↓ PaySeen by the non-defaulting companyTransaction 1Transaction 2Transaction 3Net+1 bn yenValue−0.6 bn yenValue−0.2 bn yenValue+0.2 bn yenNet claim
Figure 1Three transactions become one claim through close-out netting
Figure description

Arrow lengths are a guide to size. The figure shows that the state with three payments and receipts is replaced by one claim.

A numerical example of how much close-out netting reduces exposure is covered in Risk Reduction through Netting and Collateral.

Why close-out netting is needed

Take a bilateral contract that neither the bankrupt party nor its counterparty has finished performing when bankruptcy proceedings begin. For such a contract, Japan's Bankruptcy Act provides that the bankruptcy trustee may either cancel the contract or perform the bankrupt party's obligation and demand performance of the counterparty's obligation3. The provisions alone do not settle whether the transactions under a master agreement can be treated as separate contracts for this choice. This point requires confirmation by a Japanese legal expert. What follows is an explanation on the assumption that the trustee can choose transaction by transaction.

If the trustee can choose transaction by transaction, the trustee can demand performance of the transactions in which the counterparty (the bankrupt party) is the receiver and cancel the transactions in which it is the payer. In case A of the example above, this means demanding performance only of transactions 2 and 3, where the company pays, and canceling transaction 1, where the company receives. The company would then pay 800 million yen for transactions 2 and 3 while not receiving the 1 billion yen of transaction 1. Although the company would be in the position of receiving 200 million yen once everything is added up, it ends up paying 800 million yen, a difference of 1 billion yen. How the company's claim on the canceled transaction is treated depends on a different provision of the Bankruptcy Act, so this comparison is a simple one that does not consider that claim.

This act of the bankrupt party's trustee, keeping the favorable contracts and refusing the unfavorable ones, is called cherry-picking4. "Refusing" here means not taking on performance of the contract. A 2004 paper of the Federal Reserve Bank of Chicago sorts the approaches of national bankruptcy laws into pro-creditor and pro-debtor. The pro-debtor approach, in order to maximize the value of the bankrupt firm, recognizes the claims the firm holds and refuses the claims against the firm4. The pro-creditor approach regards it as unfair for a trustee to demand payment from a counterparty under one contract while refusing payment to the same counterparty under another5. The paper lists Japan, together with Germany, Italy, and China, among the countries whose approach is close to the pro-creditor one4.

To address this problem, Japan's close-out netting act provides that the transactions under a master agreement become a single claim or obligation6. For the FDIC in the United States, there is a paper that concludes that it cannot pick and choose which transactions to take over.

What close-out netting needs to be valid

For close-out netting to work inside bankruptcy proceedings, two things are needed. One is a contract that provides for close-out netting. Japan's close-out netting act covers transactions under "a master agreement with a close-out netting provision" (our translation)6. The other is that the law of the jurisdiction that governs the counterparty's insolvency recognizes that close-out netting. The approach of bankruptcy law differs by jurisdiction. How the law of each jurisdiction treats it must be checked jurisdiction by jurisdiction.

One condition for a bank on the standardized approach to use the effect of a netting contract is a check of validity. The bank must have appropriately confirmed that the contract is valid under all relevant laws, including foreign laws7.

Japan's close-out netting act

Japan's "Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc." (the Close-out Netting Act) was promulgated on June 15, 1998 and came into force on December 1 of that year8. Its purpose is to settle how the close-out netting of specified financial transactions by financial institutions, etc. is treated in bankruptcy and similar proceedings, so as to secure the stability of settlement and to invigorate specified financial transactions9.

  • The covered transactions are specified financial transactions. These are, among transactions that promise payments of money calculated from changes in indicators such as interest rates, currency prices, and prices in financial instruments markets, the over-the-counter derivative transactions under the Financial Instruments and Exchange Act and others set by Cabinet Office order10.
  • The parties are a financial institution, etc. and its counterparty. Financial institutions, etc. include banks and long-term credit banks, financial instruments business operators engaged in Type I financial instruments business (with some exceptions), and corporations that a Cabinet Order designates as conducting specified financial transactions on a considerable scale10.
  • The close-out netting event is the filing of a petition to start bankruptcy, rehabilitation, or reorganization proceedings10.
  • The effect is that, for all specified financial transactions under the master agreement, the net total of the values at that time becomes a single claim or a single obligation between the parties. This effect is recognized inside proceedings under the Bankruptcy Act, the Civil Rehabilitation Act, and the Corporate Reorganization Act1.

In reorganization proceedings, there are also provisions on the attribution of property that serves as collateral and on the settlement of its value11.

The US Bankruptcy Code exceptions

The US Bankruptcy Code provides that a trustee may, with the court's approval, assume or reject the debtor's executory contracts (contracts that neither side has finished performing)12. Separately, there is a provision that protects the contractual rights of parties to swap agreements. The rights belong to a swap participant or a financial participant, as the Code defines them. They can liquidate, terminate, or accelerate a swap agreement because of a bankruptcy filing or the like, and can offset (net) termination values or payment amounts. The exercise of these rights is not stayed, avoided, or limited by any provision of the Code or by any order of a court or administrative agency13. As for the automatic stay triggered by a bankruptcy filing, the exercise of rights of setoff and of rights over collateral relating to swap agreements and similar contracts is also excluded from the stay14.

The provision on offset across different types of contracts is in a separate section. Likewise, the exercise of contractual rights to terminate, liquidate, accelerate, or offset is not stayed. This covers rights in connection with one or more of securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements, and master netting agreements. However, for the individual contracts under a master netting agreement, termination, liquidation, and acceleration are allowed only to the extent that the same rights can be exercised under other sections (sections 555, 556, 559, and 560)15.

As background, in 1997 the G7 finance ministers agreed, where necessary and appropriate, to introduce legal measures to ensure the effectiveness of sound netting contracts in relation to bankruptcy rules16. The US Bankruptcy Code allowed the termination of repurchase transactions in 1984, and the termination and netting of swap agreements in 1990, as exceptions to the automatic stay17.

The failure of a bank is handled by the deposit insurance agency (the FDIC) under the Federal Deposit Insurance Act (FDIA). A 2004 paper concludes that when the FDIC takes over the derivative transactions under the same master agreement, it must take over all of them. When it rejects them, it must reject all of them, so it cannot reject transactions selectively18.

Why it is used in capital regulation and credit risk management

Close-out netting reduces the amount that can be lost when a counterparty fails (counterparty credit risk). The 1999 congressional testimony of the Board of Governors of the Federal Reserve System explains that netting reduces credit exposure to a failed debtor and limits cascading failures19.

In the capital adequacy notice for banks, the credit equivalent amount is calculated for each netting set. The transactions under a legally valid bilateral netting contract form a single netting set20. A bank using the standardized approach can use the effect of a netting contract in its capital ratio calculation. This is limited to cases where all the conditions listed in the notice are met. One example of a condition is that, when an event occurs, all transactions can be terminated in a timely way and turned into a single claim or obligation. Confirming validity under the relevant laws is also one of the conditions7.

Notes

  1. "金融機関等が行う特定金融取引の一括清算に関する法律" (Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc., in Japanese), Article 2, paragraph 6 (definition of close-out netting) and Article 3 (relation between close-out netting and bankruptcy and similar proceedings). Article 2, paragraph 6 says "regardless of the intentions of both parties" (our translation). ↩ ↩2 ↩3

  2. Close-out Netting Act (in Japanese), Article 2, paragraph 5 (master agreement) and paragraph 6 (close-out netting; the values are calculated as set by Cabinet Office order). ↩

  3. "破産法" (Bankruptcy Act, in Japanese), Article 53, paragraph 1 (bilateral contracts). Paragraph 2 of the same article says that the counterparty may demand that the trustee state, within a set period, whether it will cancel or perform. ↩

  4. William J. Bergman, Robert R. Bliss, Christian A. Johnson and George G. Kaufman, "Netting, Financial Contracts, and Banks: The Economic Implications", Federal Reserve Bank of Chicago, Working Paper 2004-02 (2004), section 2.1 "Pro-creditor versus pro-debtor bankruptcy systems" (page 6; page 8 of the PDF). The classification of Japan and the paper's note that it is a simplification (footnote 11) are on the same page. ↩ ↩2 ↩3

  5. The same paper, page 7 (page 9 of the PDF). Under the pro-creditor approach, it is unfair for a trustee to demand payment from a counterparty under one contract while refusing payment to the same counterparty under another. ↩

  6. Close-out Netting Act (in Japanese), Article 3 (transactions under "a master agreement with a close-out netting provision" (our translation) are covered). ↩ ↩2

  7. Financial Services Agency, "銀行法第十四条の二の規定に基づき、銀行がその保有する資産等に照らし自己資本の充実の状況が適当であるかどうかを判断するための基準" (Standards for determining whether a bank's capital adequacy is appropriate in light of the assets it holds, under Article 14-2 of the Banking Act, in Japanese; our translation; FSA Notice No. 19 of 2006; the full version updated on August 24, 2026), Article 79-3, paragraph 16, items 1 to 4 (pages 211 to 212). ↩ ↩2

  8. Close-out Netting Act (in Japanese), the promulgation date under the title (June 15, 1998) and the first supplementary provision (in force from December 1, 1998). The act is Act No. 108 of 1998. ↩

  9. Close-out Netting Act (in Japanese), Article 1 (purpose). ↩

  10. Close-out Netting Act (in Japanese), Article 2, paragraph 1 (specified financial transactions), paragraph 2 (financial institutions, etc.), paragraph 3 (bankruptcy and similar proceedings), paragraph 4 (close-out netting events), and paragraph 5 (master agreement; a contract between a financial institution, etc. and its counterparty). ↩ ↩2 ↩3

  11. Close-out Netting Act (in Japanese), Article 4 (attribution of the property serving as collateral of a person against whom a decision to start reorganization proceedings has been made, and payment when the value exceeds the amount of the post-close-out claim). ↩

  12. 11 USC § 365(a) ("the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor"; the version viewed on October 2, 2026). ↩

  13. First sentence of 11 USC § 560. The grounds for the rights are the events listed in § 365(e)(1), and financial participant is defined in § 101(22A). ↩

  14. 11 USC § 362(b)(17) (an exception to the automatic stay; § 362(a) provides that a petition operates as an automatic stay). ↩

  15. 11 USC § 561(a) and (b)(1). ↩

  16. Oliver Ireland (Board of Governors of the Federal Reserve System), "The proposed Bankruptcy Reform Act of 1999," testimony before a subcommittee of the US House Committee on the Judiciary (March 18, 1999), section "Importance of Close-out, Netting, and Collateral." The testimony also cites the 1997 G7 agreement. ↩

  17. The same testimony, section "Statutory Recognition of Financial Market Transactions" (the descriptions of repurchase transactions in 1984 and swap agreements in 1990). ↩

  18. Bergman et al., the paper above (Working Paper 2004-02), page 20 (page 22 of the PDF), "Treatment of 'Master' Swap Agreements and Confirmations as One Agreement." The provisions are cited in footnotes 47 and 48: 12 USC § 1821(e)(9)(A) (taking over) and § 1821(e)(8)(D)(vii) (rejection). ↩

  19. Ireland's testimony above (March 18, 1999), section "Netting" (which says that netting reduces credit exposure to a failed debtor and limits "domino failures" and systemic risk). ↩

  20. Financial Services Agency, "Standards for determining whether a bank's capital adequacy is appropriate in light of the assets it holds" (the Notice above), Article 79, paragraph 7 (pages 189 to 190). ↩

  21. The same Notice, Article 79-3, paragraph 3, item 2 (page 207). Paragraph 3 sets the requirements for a bank that has received approval for the expected exposure method. ↩

  22. The same Notice, Article 79-3, paragraph 3, item 4 (page 207). ↩