Bilateral netting

Bilateral netting is an agreement between two counterparties to offset their mutual obligations, reducing the gross exposure to a single net amount that must be paid in the event of default. It is the pre-2008 architecture of derivatives markets: thousands of dealer pairs maintaining thousands of bilateral agreements, each netting pair-wise but not system-wide. The efficiency of bilateral netting is real — it reduces gross notional exposures by orders of magnitude — but its fragility is equally real. Netting agreements are only as strong as the legal framework that enforces them and the solvency of the counterparty that owes the net amount. When Lehman Brothers failed, the limits of bilateral netting became visible: close-out procedures triggered fire sales, collateral disputes froze markets, and the netting that was supposed to prevent systemic risk became the mechanism by which it propagated. CCPs replaced this architecture with multilateral netting, but the transition was incomplete and the old bilateral infrastructure remains active in the shadows.