The result of the close-out compensation is the reduction of credit risk from gross to net. Policymakers are strongly committed to the applicability of close-out clearing, as it reduces overall risk and enhances the systemic stability of the financial sector. This is the reason why most of the main countries of the non-market market (about fifty countries) have already established a legal framework for the bilateral compensation of financial agreements, which generates billions in savings. Many wonder what bilateral compensation means and how important it is. In the absence of bilateral clearing, Bank A Rs 10 and Rs 15 fired Bank B, while Bank B Rs 30 transferred to Bank A. Now, with bilateral clearing, Bank B only has to transfer Rs 5 to Bank A. This is the only transfer that takes place under the new regime. For example, in the case of a close-out clearing, both defaulting and non-defaulting parties are involved in two interest rate swap operations: for the non-defaulting party, transaction 1 includes a payment of ₹10 Lakh, while transaction 2 includes a claim of ₹8 Lakh. If the close-out compensation is applicable, the non-defaulting party is required to pay the net difference of ₹ 2 Lakh to the defaulting party.
But if the closed-out compensation were not applicable, the non-defaulting party would be required to immediately pay 10 Lakh to the defaulting party, but then wait, perhaps months or years, for the fraction of the gross amount of ₹8 Lakh that it recovers in bankruptcy. Financial institutions and other financial intermediaries use a number of risk reduction mechanisms to reduce their exposure to risk in their business transactions. The two most widely used mechanisms are guarantee agreements and close-out compensation . Those risk mitigation mechanisms shall ensure that the risk arising from a party`s exposure to the solvency of the counterparty and the volatility of the value of the assets concerned is strictly controlled. Both mechanisms help financial institutions manage counterparty and market risk. (i) reducing the counterparty`s credit risk through clearing will strengthen the resilience of the financial sector. There are two types of nets . Payment Netting refers to a process that consolidates the offsetting of cash liabilities between two parties into a single net liability or receivable in the normal course of their business, when both parties are solvent.
Close-out compensation applies to transactions between a failing company and a non-defaulting company. Close-out set-off is a process involving the termination of commitments with a defaulting party under a bilateral contract and the subsequent merging of positive values (receivable) and negative replacement values (liabilities) into a single net liability or receivable. Policymakers and international standard-setting bodies have strongly recommended the creation of a legal framework for close-out clearing, in the interest of financial stability. The Financial Stability Board recommended in its recommendations on the main resolution arrangements of financial institutions  that the legal framework governing rights of clearing, contractual clearing and guarantee arrangements be clear, transparent and applicable in the event of a crisis or resolution of undertakings and that it does not impede the effective implementation of resolution measures. Several global insolvency law standards require specific recommendations for the adoption of guarantees on financial contracts, including netting  and security arrangements, in order to ensure the security of financial transactions and preserve financial stability. . . .