Payment Netting vs. Close-Out Netting: An Overview

Both payment netting and close-out netting are methods of settlement (finalizing or completing agreements or payments) between two or more parties, used to reduce exposure to risk. 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 between two or more parties; the aim is to create a single amount out of all the exchanges to determine which party is due remuneration, and in what amount. It can be used in bankruptcy cases, offsetting money owed to the defaulting company with money owed by the company, and to determine an amount due to creditors. Netting can also be used in trading: Investors offset one position with an opposing one, to balance out losses from one with gains in another.

Payment Netting

When counterparties have a number of obligations to each other, they can agree to offset and net those obligations—a procedure called payment netting. Payment netting is also known as settlement netting

When counterparties are in the process of exchanging multiple cash flows during a given day, the parties can agree to combine all those cash flows into one payment per each currency. Only the difference in the combined amount will be paid by the party that owes it.

The utilization of payment netting streamlines processing and reduces settlement risks. This form of netting often happens in currency trading. Let's say Party ABC and Party XYZ are trading British pounds and at the end of the day, ABC owes XYZ seven pounds and XYZ owes ABC eight pounds. XYZ would simply pay ABC one pound to settle their accounts.

Combining obligations in netting procedures may result in a reduced payout, but it's considered worthwhile because it streamlines processes and increases the likelihood of payment.

Close-Out Netting

Close-out netting usually happens after some kind of termination event, like a default. The transactions between two parties are tallied up and consolidated to arrive at a single amount for one party to pay the other.

Assume one party in a derivatives transaction can't make good on its obligations. Any outstanding contracts are terminated at the time of its default, and the final replacement values of its positions are marked to market and combined into a single net payable or receivable. This rolled-up obligation is then settled with a net payment to the counterparty (or by it, should the defaulting party actually come out ahead).

Without close-out netting, the counterparty would have to join the ranks of other creditors to the defaulting company. Reimbursement might take years and result in a smaller amount.

Key Takeaways

  • Payment netting and close-out netting are settlement methods between two parties in a financial contract.
  • Both are methods of netting, which mitigate financial risks by combining multiple obligations into a single amount.
  • Payment netting aggregates the amounts due between two parties and nets the difference into one payment, to be paid by whichever party owes it.
  • Close-out netting happens when one party defaults: Its positions are terminated, priced, and then netted to arrive at a single amount due.