What is Bilateral Netting?
Bilateral netting is the process of consolidating all swap agreements between two parties into one single, or master, agreement. As a result, instead of each swap agreement leading to a stream of individual payments by either party, all of the swaps are netted together so that only one net payment stream is made to one party based on the flows of the combined swaps.
The term bilateral itself means "having or relating to two sides; affecting both sides." Net or netting refers to finding the difference between all the swap payments, producing one (net) total.
- Bilateral netting is when two parties combine all their swaps into one master swap, creating one net payment, instead of many, between the parties.
- Bilateral netting reduces accounting activity, complexity, and fees associated with more trades and payments.
- In the event of a bankruptcy, bilateral netting assures that the bankrupt company can't only take payments while opting not to payout on out-of-the-money swaps.
Understanding Bilateral Netting
Bilateral netting reduces the overall number of transactions between the two counterparties. Therefore, actual transaction volume between the two decreases. So does the amount of accounting activity and other costs and fees associated with an increased number of trades.
While the convenience of reduced transactions is a benefit, the primary reason two parties engage in netting is to reduce risk. Bilateral netting adds additional security in the event of bankruptcy to either party. By netting, in the event of bankruptcy, all of the swaps are executed instead of only the profitable ones for the company going through the bankruptcy. For example, if there was no bilateral netting, the company going into bankruptcy could collect on all in-the-money swaps while saying they can't make payments on the out-of-the-money swaps due to the bankruptcy.
Netting consolidates all swaps into one so the bankrupt company could only collect on in-the-money swaps after all out-of-the-money swaps are paid in full. Basically, it means that the value of the in-the-money swaps must be greater than the value of the out-of-the-money swaps for the bankrupt company to get any payments.
Types of Netting
There are several ways to accomplish netting.
Payment netting is when each counterparty aggregates the amount owed to the other on the payment date and only the difference in the amounts will be delivered by the party with the payable. This is also called settlement netting. Payment netting reduces settlement risk, but since all original swaps remain, it does not achieve netting for regulatory capital or balance sheet purposes.
Close-Out Netting: After a default, existing transactions are terminated and the values of each are calculated to distill a single amount for one party to pay the other.
Example of Bilateral Netting Between Companies
Assume that Company A has agreed to enter into two swaps with Company B.
- For the first swap, Company A agreed to pay a 3% fixed rate on $1 million, while Company B pays a floating rate of LIBOR plus 2%. Assume that LIBOR is currently 2%, so the floating rate Company B pays is 4%.
- For the second swap, Company A agreed to pay a 4% fixed rate on $3 million, while Company B pays a floating rate of LIBOR plus 2.5%. LIBOR is 2%, so the floating rate is 4.5%.
If these swaps were bilaterally netted, instead of Company B sending two payments to Company A they could just send one larger payment.
- For the first swap, Company B owes Company A 1% on $1 million. If paid yearly, that is $10,000 or $833.33 monthly.
- On the second swap, Company B owes Company A 0.5% on $3 million. If paid yearly, that is $15,000 or $1,250 monthly.
Instead of sending two payments, with bilateral netting Company B would send $2,083.33 ($833.33 + $1,250) monthly or $25,000 ($10,000 + $15,000) yearly.
As LIBOR changes so will the payment amounts. If more swaps are taken between the parties, these too can be netted out in the same way.