Netting: Definition, How It Works, Types, Benefits, and Example

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, including in the financial markets.

How Netting Works

Netting is a method of reducing risks in financial contracts by combining or aggregating multiple financial obligations to arrive at a net obligation amount. Netting is used to reduce settlement, credit, and other financial risks between two or more parties. 

Netting is often used in trading, where an investor can offset a position in one security or currency with another position either in the same security or a different one. The goal of 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, the position is net long 60 shares.

Netting is also used when a company files for bankruptcy whereby the parties tend to net the balances owed to each other. This is also called a set-off clause or set-off law. In other words, a company doing business with a defaulting company may 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.

Types of Netting

Here are the top four ways netting is used:

Close-Out Netting

Close-out netting happens after default, which is when a party fails to make principal and interest payments. Transactions between the two parties are netted to arrive at a single amount for one party to pay the other. In close-out netting, the existing contracts are terminated, and an aggregate terminal value is calculated and paid as one lump sum.

Settlement Netting

Also known as payment netting, settlement netting aggregates the amount due among parties and nets the cash flows into one payment. In other words, only the net difference in the aggregate amounts is delivered or exchanged by the party with the net owed obligation. Typically, a payment netting agreement must be in place before the settlement date. Otherwise, each of the individual payments would be due to and from all parties involved.

Netting by Novation

Novation netting cancels offsetting swaps and replaces them with new obligations. In other words, if two companies have obligations due to each other on the same value date (or settlement date), the net amount is calculated. However, instead of simply sending the net difference to the party owed, novation netting cancels the contracts and books a new one for the net or aggregate amount. The new aggregate contract under novation netting makes it distinctly different from payment netting, which does not book a new contract; instead, the net aggregate amount is exchanged.

Multilateral Netting

Multilateral netting is netting that involves more than two parties. In this case, a clearinghouse or central exchange is often used. Multilateral netting can also occur within one company with multiple subsidiaries. If the subs owe payments to each other for various amounts, they can each send their payments to a central corporate entity or netting center. The main office would net the invoices and the various currencies from the subsidiaries and make the net payment to the parties that are owed. Multilateral netting involves pooling the funds from two or more parties so that a more simplified invoicing and payment process can be achieved.

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 whereby they both owe money to each other. At the end of the swap period, the following is due:

• Investor A is due to receive $100,000 from Investor B
• Investor B is due to receive $25,000 from Investor A
• Instead of Investor B paying 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.