Netting is a general financial concept that has multiple specific uses. In general, netting means to allow a negative value and a positive value to set-off and entirely or partially cancel one another out. Businesses use the netting of cash flows is reducing credit exposure to the counterparties.
Netting is commonly employed in the derivatives market. Derivatives are financial instruments that include Swap Rates, forwards, futures and options. The name ‘derivative’ refers to the notion that somehow the agreement will derive value at one or more future points based on observable prices such as indexes and interest rates. There are two types of derivative exchanges: over-the-counter and exchanged-based. Common over-the-counter derivative contracts include: Interest Rate Swap, currency swaps, and Credit Default Swaps and common exchange-based are futures, calls and put.
Common Types of Netting in Derivative Markets
Two forms of netting are commonly associated with the derivative market:
Closeout netting reduces pre-settlement risk, the risk that counterparty will default prior to the derivative instruments maturity date. Counterparties that have multiple offsetting obligations to each other, such as multiple interest rate swaps or forward contracts then they can net those obligations. Therefore, if counterparty does default then all outstanding contracts are terminated. They are then marked to market settled with a net payment.
Payment netting is used to reduce settlement risk. Settlement risk is the credit risk that arises on the date the contract is suppose to settle or the date when both parties of the contract make good on their end. Therefore, settlement risk is greater than other type risk because there is exposure to the entire value of the counterparty’s obligation.
Payment netting occurs when counterparties are due to exchange multiple cash flows on a given date, they agree to net those cash flows to one payment per currency subsequently reducing settlement risk and making processing more direct.
Bilateral and Multilateral Netting
With bilateral netting there are two counterparties that agree to net with each other. They sign a contract that specifies the type of netting that will be performed and what existing and future contracts that will be affected. This is most common in the other-the-counter Derivatives Market.
Multilateral netting occurs between more than two counterparties. It is often managed through membership organisations such as an exchange. The advantage to multilateral netting is that it reduces credit exposure rather than mutualizing credit risk such as in bilateral netting because credit exposure is spread among all participants and therefore there is less incentive to doubt the credit worthiness of the other counterparties.
Netting can effectively reduce credit exposures and reduce operational cost and that is why it has become a common practice between trading in exchanges, forwards and options. Netting is not just fancy financial jargon in the derivatives sphere but has practical application to everyday finance.