Netting

Netting is one of the most effective ways of reducing settlement risk in FX trades. Payment (or settlement) netting is defined as an arrangement between two or more counterparties to net all payments in a single currency owed between them on a given value date.

Regulatory authorities encourage netting arrangements because they reduce the amount of payments that have to be made.The lower the number of payments, the lower the probability that there will be a default. In addition, because netting reduces the number of payments, both the opportunity for human error and the charges levied per payment are reduced.

Ideally, the process of payment netting should be supported by a legal agreement. This can take the form of a brief document that only supports netting, or it can be a settlement netting provision that is included in a master agreement.

Calculating netted amounts correctly is important to ensure accurate settlement monies. Market participants should automate the actual netting calculation, if possible, so that errors introduced by manual calculations are reduced. Counterparties should confirm the net payment amount with each other at a predetermined cut-off time prior to settlement.


Types of Netting

Netting of payments between counterparties take place through different methods.

• Bilateral netting
• Multilateral netting
• Netting by novation
• Close-out netting

Bilateral Netting

The netting of payments between two counterparties is known as bilateral settlement netting. 

Example
Invest Bank is due to make five payments to Finance Bank for a total of GBP 100 million. However, Finance Bank is due to make three payments to Invest Bank for a total of GBP 95 million.

If the two banks use bilateral settlement netting then they need not make eight separate payments totaling GBP 195 million. Instead, Invest Bank can simply make one payment to Finance Bank for GBP 5 million.

The one drawback with bilateral netting is that although it reduces the number of payments a bank has to make, the actual reduction is often rather small in practice. The reason for this is that a bank may not have reciprocal deals with all the banks that it deals with. In such situations, bilateral netting cannot bring the maximum benefit of netting.

Multilateral Netting



Netting by Novation
Payment netting reduces the number of settlement payments flowing between counterparties and therefore reduces settlement risk. However, it does not reduce credit risk as the contracts giving rise to the obligations being netted remain in effect, and both counterparties remain legally obliged to settle for the gross amount of their obligations.

Netting by novation is the process whereby a number of contracts are canceled and replaced by one single contract. This new contract is legally binding and aggregates and nets all of the payment obligations of the previous contracts.

Novation netting, unlike payment netting, refers not only to the payments due under transactions, but also to the transactions themselves – it is arranged not at settlement but when a contract is entered into, and it has the effect of lowering counterparty credit risk.


Close-Out Netting
In addition to payment netting, master agreements may also provide for close-out netting. This is an agreement to settle all contracted claims and obligations by one single payment, upon the occurrence of default by one party (or if some other termination event occurs).

Close-out netting differs from netting by novation in that the latter is accomplished prior to a default or bankruptcy occurring (when the transaction takes place), whereas the former type of agreement occurs in the event of default (that is, a contract is signed but only retrieved in the event of default).