Netting

What is netting?

Netting is the process of offsetting multiple financial obligations between two or more parties to arrive at a single net amount owed. It reduces the number and size of payments, lowers settlement and credit risk, and simplifies accounting and cash management.

How netting works

Parties with reciprocal obligations compare and aggregate amounts due. Instead of each party making every individual payment, the obligations are offset so only the net difference is paid. Netting can be bilateral (between two parties) or multilateral (among many parties, often through a central clearinghouse or netting center).

Common settings for netting:
– Securities and derivatives trading
– Foreign-exchange (FX) operations
– Bankruptcy and insolvency proceedings (set-off)
– Intercompany transactions and treasury operations

Netting saves time and transaction costs, reduces the number of FX conversions, and improves cash-flow predictability.

Types of netting

• Close-out netting
  Occurs after a default. Existing contracts are terminated, an aggregate terminal value is calculated, and one lump-sum payment is made to settle the net obligation.

• Settlement (payment) netting
  Aggregates scheduled payments and nets cash flows so only the net difference is exchanged on settlement. Requires an agreement in place before settlement dates.

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• Novation netting
  Cancels offsetting contracts and replaces them with a single new contract for the net amount. Unlike payment netting, novation creates a new booked obligation.

• Multilateral netting
  Involves more than two parties. A central party or clearinghouse pools obligations, nets them across participants, and issues/receives the single net payments. Often used by corporates with multiple subsidiaries or in cleared markets.

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Benefits

• Fewer transactions and lower processing costs
• Reduced settlement and credit exposure
• Fewer FX conversions and larger consolidated FX trades (better pricing)
• Simpler invoicing and reconciliations
• More predictable and manageable cash flows

Example

Two counterparties in a swap owe each other amounts at settlement:
– Investor A is due to receive $100,000 from Investor B
– Investor B is due to receive $25,000 from Investor A

Netting offsets the obligations so only the difference is exchanged:
– Investor B pays Investor A $75,000
– Investor A pays nothing to Investor B

Note: In some currency swaps, payments are made in different currencies and full-gross exchanges may be required rather than netting, depending on contract terms and applicable law.

Key takeaways

• Netting reduces multiple obligations to a single net payment, lowering costs and risks.
• It is widely used in trading, FX, bankruptcy set-offs, and intercompany settlements.
• The main forms are close-out, settlement, novation, and multilateral netting; each serves different operational and legal needs.