What is Credit Netting
Credit netting is a system whereby the number of credit checks on financial transactions is reduced by entering into agreements that simply net all transactions. These agreements are made between large banks and other financial institutions and place all current and future transactions into one agreement, removing the need for credit checks on each transaction.
BREAKING DOWN Credit Netting
Most financial transactions that deal with credit involve credit checks to ensure that the borrowing party can meet the obligation of the transactions. Checking the borrowing party’s credit lowers counterparty risk, or the risk that the counterparty, or borrowing party, will default on the loan.
However, due to the active nature of large market participants, the constant checking and rechecking of credit is not only time consuming, but also has the potential to create missed opportunities. The process becomes more efficient for all parties involved if they enter into larger-scale agreements.
For this reason, credit netting is typically used by large financial institutions that extend credit in numerous transactions. Credit netting helps these institutions save money, since it reduces the costs associated with running credit checks by allowing them to bundle all transactions into one for the purposes of a credit check. This makes running counterparty credit checks much less cumbersome for the institution extending the credit, makes obtaining credit easier for large-scale borrowers, and makes it easier for financial institutions to capitalize on opportunities to form trade relationships with borrowers.
Types of Netting
Three types of netting can be used to reduce counterparty risk. They are:
- Close-out netting;
- Netting by novation; and
- Settlement or payment netting.
Close-out netting is a form of netting used in counterparty bankruptcy in order to prevent liquidators from cherry-picking which contracts to enforce or not enforce. In close-out netting, all transactions with the defaulting counterparty, or all transactions of a given type with a defaulting counterparty, are netted, or bundled together, either at market value or, if a market value can’t be obtained or the contract specifies otherwise, at an amount equal to the non-defaulting party’s financial loss.
Netting by novation is a form of netting by which one or more related transactions can be canceled, along with the counterparty’s obligation to pay them, in order to create a new payment obligation related to a net payment bundling the sum of all transactions. Settlement or payment netting is a system by which the counterparty settles its entire obligation via one payment.