Finance

What is Netting?

What is netting?

  • A method of reducing credit, settlement, and other risks of financial contracts by aggregating (combining) two or more obligations to achieve a reduced net obligation.
  • To minimize net payments and save processing costs, netting offsets receivables against payments due.

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Example include-

  1. This system is used by clearinghouses.
  2. The Treasury Department uses it for cash management.
  3. Telecom uses netting to settle charges on foreign calls.
  4. It is also used in derivative markets such as swaps contracts.

How different types of netting work?

  1. Bilateral Netting
  • bilateral netting arrangement allows two counterparties to balance claims against each other in financial contract to assess single net payment liability owed to the other, which ensures the payables and receivables are netted off.

2.Multilateral Netting

  • A Multilateral Netting is similar to bilateral netting with the only difference is that bilateral involves two parties and multilateral involves more than two parties.

 

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  1. Close-Out Netting
  • It refers to a mechanism involving termination of obligations under a defaulting party contract and the resulting combination of positive and negative replacement values into a single net payable or receivable.
  • Existing transactions are terminated after a default, and the values of each are determined to distill a single amount for one party to pay the other.

 

  • If close-out netting is enforceable, the non-defaulting party is liable to pay the defaulting party the net difference of INR 20,000. The non-defaulting party will become a general creditor to the defaulting party for the net liability if the net sum favored the non-defaulting party.’
  • However, if it were not enforceable, the non-defaulting party would be required to pay the defaulting party INR 100,000 immediately, but then wait, maybe months or years, for whatever fraction of the INR 80,000 gross sum it recovers in bankruptcy.
  1. Netting by novation
  • The legal obligations of the parties to make required payments under one or more series of related transactions are canceled and a new obligation to make only
    the net payments are created.
  • By ovation, it can be bilateral or multilateral.

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Why use Netting?

  • It reduces the number of transaction, average size, and cost of payments (transactions costs)
  • It enables parties to decrease their exposure and thereby reduce their risk. Since only the net obligation is an exchange, it allows capital to be used more efficiently and leads to a reduction in:
  1. Credit Risk
  2. Settlement Risk
  3. Liquidity Risk
  4. Systemic Risk
  5. Cost of capital

 

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

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