Netting

Netting is a method of settling pending transactions by offsetting them against each other in favor of one. For example, one party requires another to pay a net balance amount after deducting the values of what they owed to each other. The process speeds up and simplifies monetary settlements.

• Netting definition describes a process of consolidating the financial obligations between two or more parties to find out the net amount payable for the final settlement between them.
• It helps in lowering the chances of a default. At the same time, it tries to provide enough liquidity for a business to function smoothly.
• The practice is significant in many ways, depending on the context. In foreign exchange, payables and receivables within the same currency are offset against each other. Other common examples include trades, third-party trades, insolvency proceedings, etc.
• The settlement, multilateral/bilateral, novation, and close-off are common types of netting.

Netting in finance appears to be of great help to those who owe a large amount of money to the other party. However, when the parties involved reach a settlement, the payable amount decreases significantly. It, thus, lightens the burden of the payer who had to pay a hefty amount earlier.

People often use this concept in their day-to-day lives when the balance of the amount owed favors a single one. Usually, the one who owes the higher amount has to pay the remaining balance.

It is a concept extensively popular in financial markets, especially currency and security trading. As is a fact, financial markets are full of risks. But using this strategy, investors can offset a stake in one trading instrument with another in the same or different tradable asset. In doing so, they can balance losses with gains while trading assets of their choosing.

Some common types are listed below -

#1 - Payment Netting

Through this method, the amount due between two or more parties is consolidated to determine the remaining value, which remains unpaid. The parties involved pay or receive the net difference, i.e., the final outstanding amount to settle the deal. It cuts down the transaction cost as well as helps with liquidity issues.

#2 - Novation Netting

Here, the existing contract between the parties is nullified. In the place of the old agreement, a new transaction is issued containing the net payable amount. As such, this kind provides a more holistic way of handling the transactions.  

#3 - Multilateral Netting

As the name suggests, it involves settling the financial obligation among multiple parties. In this method, a central exchange or unit acts as a liaison between the parties involved to ensure proper regulation of transactions. Companies with multiple subsidiaries prefer this method to settle payment disputes and ensure the smooth running of the business.

#4 - Close-Out Netting

It is the method of closing a deal after a default occurs. When a party fails to repay the other party, a single amount is derived, paid by only one party that is liable to do so.

X owed $3,000 to Y while Y was supposed to pay X $5,000. The date of settlement that they mutually decided on was the same. They opted not to complicate things by separating the payments as they were due to repay each other on the same day.

Instead, they used the method of netting and consolidated the entire amount. X owed Y only $3000, which was lesser than the $5000 X was due to receive from Y. X asked Y to settle the $3000 debt with the $5000 and pay the remaining balance. The final payable amount as obtained was $2,000, which Y had to pay X to settle the deal.

• Parties to a netting agreement frequently dread the danger of default that could occur if one fails to meet its payment obligations. However, consolidating the dues reduces the burden on each party, requiring them to pay a simpler amount.
• Inter-banking transactions would never resolve on time if each transaction had to be settled independently. As such, the process helps in speeding up and simplifying the process. It eases transactions between businesses by consolidating and reducing multiple payments into one.
• If traders have a loss on one position but a profit on another, the procedure allows them to leverage the profit to pay the loss.
• It provides a cushion against currency fluctuations involving foreign exchange.

This has been a guide to Netting and its Meaning. Here we discuss how it works along with its types (payment, novation, multilateral & close-out), examples and benefits. You may learn more about financing from the following articles –

• Capital Gain
• Netback
• Cash Settlement