What Is Netting?
Netting entails offsetting the value of multiple positions or payments due to be exchanged between two or more parties. It can be used to determine which party is owed remuneration in a multiparty agreement. Netting is a general concept that has a number of more specific uses, specifically in financial markets.
How Netting Works
Netting used in trading, where an investor can offset a position in one security or currency with another position either in the same security or another one. The goal in netting is to offset losses in one position with gains in another. For example, if an investor is short 40 shares of a security and long 100 shares of the same security, he is net long 60 shares.
Also, when a company files for bankruptcy, parties tend to net the balances owed to each other. This is also called a set-off clause or set-off law. That is, a company doing business with a defaulting company will offset any money they owe the defaulting company with money that’s owed them. The remainder represents the total amount owed by them or to them, which can be used in bankruptcy proceedings.
Companies can also use netting to simplify third-party invoices, ultimately reducing multiple invoices into a single one. For example, several divisions in a large transport corporation purchase paper supplies from a single supplier, but the paper supplier also uses the same transport company to ship its products to others. By netting how much each party owes the other, a single invoice can be created for the company that has the outstanding bill. This technique can also be used when transferring funds between subsidiaries.
Netting saves a great deal of time by eliminating the need to process multiple transactions, reducing the number of transactions down to one.
Types of Netting
Here are the top four ways netting is used:
Close-out netting happens after default, where transactions between two parties are netting to arrive at a single amount for one party to pay the other.
Netting by Novation
Novation netting cancels offsetting swaps and replaces them with new obligations.
Also known as payment netting, settlement netting aggregates the amount due among parties and nets the cash flows into one payment.
Multilateral netting is netting that involves more than two parties. In this case, a clearinghouse or central exchange is often used.
- Netting offsets the value of multiple positions or payments due to be exchanged between two or more parties.
- Netting is used in a number of settings and instances—securities or currency trading, bankruptcy, and inter-company transactions, among others.
- Netting can involve more than two parties, called multilateral netting, and generally involves a central exchange or clearing house.
Benefits of Netting
Netting saves companies a great deal of time and costs by eliminating the need to process a large number of transactions per month and reducing the transactions necessary down to one payment. For banks transferring across borders, it limits the number of foreign exchange transactions as the number of flows decreases.
With netting in foreign exchange, companies or banks can consolidate the number of currencies and foreign exchange deals intro larger trades, reaping the benefits of improved pricing. When companies have more organized time frames and predictability in settlements, they can more accurately forecast their cash flows.
Example of Netting
Netting is very common in the swap markets. For example, assume two parties enter into a swap agreement on a particular security. At the end of the swap period, Investor A is due to receive $100,000 from Investor B. At the same time, Investor B is due to receive $25,000 from Investor A. Instead of Investor B giving Investor A $100,000 and Investor A giving Investor B $25,000, the payments would be netted. Investor A would give Investor B $0, while Investor B would give Investor A $75,000.
This netting process occurs on a wide variety of swaps, but there is one type of swap where netting does not occur. With currency swaps, since the notional amounts are in different currencies, the notional amounts are exchanged in their respective currencies, and all payments due are exchanged in full between two parties; no netting occurs.