In the U.S., as in most countries with well-developed securities markets, derivative
securities enjoy special protections under insolvency resolution laws. Most creditors are
“stayed” from enforcing their rights while a firm is in bankruptcy. However, many
derivatives contracts are exempt from these stays. Furthermore, derivatives enjoy netting
and close-out, or termination, privileges which are not always available to most other
creditors. The primary argument used to motivate passage of legislation granting these
extraordinary protections is that derivatives markets are a major source of systemic risk
in financial markets and that netting and close-out reduce this risk. To date, these
assertions have not been subjected to rigorous economic scrutiny. This paper critically reexamines
this hypothesis. These relationships are more complex than often perceived.
We conclude that it is not clear whether netting, collateral, and/or close-out lead to
reduced systemic risk, once the impact of these protections on the size and structure of
the derivatives market has been taken into account.