Bilateral and Multilateral Netting
Netting or “Intercompany Netting” is the process of reducing the risk of financial contracts by combing two or more swaps resulting in final payment between the parties.
Benefits of netting:
- Reduce credit risk
- Reduce settlement risk
- Reduce liquidity risk
- Reduce systemic risk
There are different types of netting like Payment Netting, Novation Netting, Bilateral Netting, Close-Out Netting, and Multilateral Netting. The types which will be discussed in detail are Bilateral and Multilateral Netting.
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Bilateral netting
Bilateral Netting involves two parties (supplier and the client). It the process of aggregating invoices between the parties to one single agreement so that only one net payment stream is made. It decreases the number of transactions between the parties and also reduces the cost of accounting activities like bank fees. It adds security by ensuring that both account payables (AP) and Account Receivables (AR) are paid and thus minimizes the risk. In the case of bankruptcy, it ensures that our invoices are executed and not only the profitable ones.
Example of bilateral netting:
Here as shown in the below figure for the first swap, Bank A has to pay 10 million Euros to bank B while for second swap bank B has to pay 5 million euros to bank A. If without netting the swaps would have taken place then the total amount would be (10+5 = 15m) and no of transactions will be equal to two. So, if the banks would have used bilateral netting there would be only one transaction i.e. from Bank A to Bank B (10-5 =5m). Thus, the amount involved in the transaction is half with immediate cost saving.
Bilateral Netting
Multilateral netting
Multilateral netting is a process that consolidates and reduces the number of inter-company funds transfer payments thus minimizing the cost of intercompany transactions.
Multilateral netting is set up between the internal group entities of internal companies so that they can settle their invoices and helps them to avoid multiple transactions. Netting can also be used for third party transactions. Thus, rather than settling each individual invoice that can lead to huge volumes of transactions, parties can consolidate invoices and agree upon one net payment stream. Almost all the methodologies of netting are either payables- or receivables-driven. The payables are netted against the other participant’s payables for payable driven system and same applies for the receivable driven system. The end must be a zero-game sum meaning that intercompany receivables = intercompany payables.
The netting process can be used to handle the following intercompany transactions
- Trade payments
- Interest payments
- Dividends
- Loan payments
- Investments
The below figure shows the difference between the intercompany process before and after the netting process.
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Example of Multilateral netting:
If the US company ABC wants to make payment to its subsidiary company XYZ which is located in Italy. Also, company XYZ has to make a payment to company PQR which is located in Germany, and in turn company, PQR wants to make a payment to company ABC. So instead of making individual payments, these companies can reach out to the central netting system and make payment which makes the process easy.
How Multilateral Netting Works?
Step 1: Collect the details of invoices from local entities:
The data can be collected and stored in the central database repository wherein the local entities can send their invoices to the netting centre.
Step 2: Calculating the netting amount and verify the invoices in the netting cycle
In this process, a calculation is done in order to determine the net position for each participant. If the amount in the invoices does not match then they are checked and the disputes are managed.
Step 3: Communicating the balance of netting to local entities
After the reconciliation of the invoices, the netting centre calculates and sends a netting statement which shows the balance that local entities will receive or needs to pay.
Step 4: Settlement process
In this process, the net payers pay netting centre for value settlement day in local currency The Netting centre pays net receiver in their local currency and settles FX trades with third party banks in order to settle the net position of each currency.
Advantages of Multilateral Netting:
- Bank fees are reduced as the use of bank account decreases.
- Centralizes the exchange rate risk and the process becomes faster.
- The disputes are solved quickly and enforce a strict payment schedule.
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Author: Trushali Hindocha
About the Author:
Trushali completed her graduation in Computer science and engineering, she has worked as Associate Consultant in Atos Syntel for 18 months. She is currently pursuing MMS in Finance from KJ Somaiya Institute of Management Studies and Research, Mumbai. She is also well acquainted with Tableau and programming languages like Python and R for Data Analytics.
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