Netting is a process by which an exposure or obligation is reduced by combining two or more positions. The value of multiple positions is analyzed and offset, and eventually, the parties that need to be paid and pay are determined.
Multilateral netting involves more than two parties. Netting is used for several purposes in financial markets, including trading, credit agreements, or inter-company transactions.
Types of Netting
There are several types of netting or ways in which the concept of netting can be used. Below, we examine the four types of netting:
1. Close-out netting
Close-out netting typically occurs in the event of a default. In such a situation, any existing transactions are terminated, and the values of the transactions are calculated. The values are then netted, and the remaining value is paid as a lump-sum amount to the party that is owed the payment.
2. Settlement netting
Settlement netting is also referred to as payment netting. In settlement netting, the concerned party will aggregate and offset all the amounts it owes/receives, and the difference – or the netted amount – will be paid to the party with the larger exposure or obligation.
It is typically completed a couple of days before the actual payments are due; otherwise, the netting process may take longer, and the party may need to face a penalty on the delayed payment.
3. Netting by novation
Novation netting cancels or nullifies an existing obligation and replaces it with a new one. If two parties owe certain amounts to each other and the transactions come with the same settlement date, instead of netting the amounts and paying the difference, novation netting cancels the existing contracts and replaces it with a new transaction that amounts to the net amount. Novation netting is used in currency transactions.
4. Multilateral netting
Bilateral netting is when there are two parties involved. If there are more than two parties, it is known as multilateral netting. When multilateral netting occurs, the parties employ the use of a clearinghouse or central exchange to regulate the transactions and impact of netting. Some companies with multiple subsidiaries can also use multilateral netting to offset the payments received and owed to its various divisions.
Here, we provide a simple example of how netting is used in the real world. Investor A owes $50,000 to Investor B, and Investor B owes $110,000 to Investor A. In such a case, we are assuming the settlement date of both transactions and the currency of exchange is the same. Instead of Investor A and B making two separate payments to each other, the transaction values can be netted.
As a result, Investor B would pay $60,000 (net amount) to Investor A, whereas Investor A does not need to pay anything to Investor B. It is an example of settlement or payment netting. It is important to note that if the currencies in our example were different, then such a type of netting would not be used.
Benefits of Netting
1. Less risk exposure
One of the key benefits of netting is to reduce the risk exposure to a certain party. If an investor owes money on one trade position and is supposed to receive money on another trade position, netting will allow him to reduce the risk of interacting with two counterparties and help him offset the loss with the gains (or vice versa).
2. Simplified transactions
Netting also provides the advantage of simplifying transactions where multiple parties are involved. Instead of dealing with numerous invoices or accounts, netting allows you to convert them into a single invoice or transaction.
If used for foreign currency transactions, netting can reduce the number of transactions generated per month (which saves costs as each transaction is charged) and also reduces the foreign exchange conversion charge on various transactions.
Building on the example above, in the case of foreign currency exposure, the company can employ exposure netting, which is a method of hedging currency risk by offsetting the exposure of one currency with another similar currency.
To hedge the risk, the company first needs to find the correlation of exposures of the various currencies it transacts in. If the correlation between two currencies is positive, a long-short approach would be feasible (use gains from one currency to offset losses from the other). If the correlation is negative, a long-long strategy would be appropriate.
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