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 the financial markets.
BREAKING DOWN Netting
When a company files for bankruptcy, parties that do business with the defaulting company offset any money owed to the defaulting company with any money owed by the defaulting company. The remainder represents the total amount owed to the defaulting company or money owed by it, and 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 is also used in trading. 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 gains in one position with losses in another. For example, if an investor is long 100 shares of security and short 40 shares of the same security, he is net long 60 shares.
Netting Example in the Financial Markets
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.
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.