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."
BREAKING DOWN 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.
While the convenience of reduced transactions is a benefit, the primary reason two parties engage in netting is to reduce risk. These include the following:
Another major reason for bilateral netting is that it adds additional security in the event of a 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 payment 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 former must be greater than the value of the latter in order for the bankrupt company to get any payments.
Types of Netting
There are several ways to accomplish netting.
Payment Netting - 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.
Novation Netting - This method actually cancels offsetting swaps and replaces them with the new master agreement.
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.