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.

Multilateral Netting - Whereas bilateral netting is between two parties, multilateral netting involves more than two parties, likely using a clearing house​​​​​​​ or central exchange.

RELATED TERMS
  1. Forward Swap

    A forward swap is an agreement between two parties to exchange ...
  2. Master Swap Agreement

    A basic, standardized swap contract created by the International ...
  3. Liability Swap

    A liability swap is a financial derivative in which two parties ...
  4. Cross-Currency Swap

    An agreement between two parties to exchange interest payments ...
  5. Floating Price

    The floating price is a leg of a swap contract that depends on ...
  6. Foreign Currency Swap

    A foreign currency swap is an agreement to exchange currency ...
Related Articles
  1. Managing Wealth

    An In-Depth Look at the Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  2. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  3. Trading

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  4. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  5. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  6. Investing

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  7. Trading

    Hedging with currency swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it with currency swaps.
  8. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  9. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  10. Investing

    Is Your Mutual Fund Safe?

    You might be carrying more risk than you think if your fund invests in derivatives.
RELATED FAQS
  1. What is the difference between derivatives and swaps?

    Swaps comprise just one type of the broader asset class called derivatives. Read Answer >>
  2. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  3. What is the difference between payment netting and close-out netting?

    Learn about the risk reduction practice of netting, and specifically the differences between payment netting and close-out ... Read Answer >>
  4. How does an entrepreneur choose a business structure?

    Learn more about interest rate swaps and currency swaps, how these swaps are used and the difference between interest rate ... Read Answer >>
  5. What are some examples of risks associated with financial markets?

    Find out about the different types of risks for different classes of assets including volatility, counterparty risk and default ... Read Answer >>
Trading Center