Both payment netting and close-out netting are methods of settlement between two or more parties, used to reduce risk exposure. They differ primarily in the fact that payment netting is viewed as reducing settlement risk, while close-out netting reduces pre-settlement risk.
Netting is the consolidation of multiple payments, transactions or positions with the goal of creating a single value. This process involves offsetting the values of many positions and can be utilized to determine the owed party and amount in a multiparty agreement.
The concept of netting can be specified for a number of different uses. In the case of bankruptcy, entities that do business with the defaulting company offset money owed to the company with money owed by the company. The remaining value is representative of the amount that is either owed to or owed by the company in default.
Netting can also be used in trading. Investors can offset positions in a security with another position in the same security or in a different security. The goal for investors is to offset losses in one position with gains in another.
Payment Netting Vs. Closeout Netting
When counterparties are in the process of exchanging multiple cash flows during a given day, the parties can agree to net those cash flows into one payment per each currency. This is defined as payment netting. The utilization of payment netting streamlines processing and reduces settlement risks.
When counterparties have a number of obligations to each other, they can agree to offset and net those obligations. This is known as close-out netting. In the event of some kind of termination event, such as one counterparty defaulting on obligations, any outstanding contracts are terminated at the point in time of default. The remaining obligations are then marked to market and settled with a net payment.
Other types of netting used include multilateral netting and bilateral netting.