Reviewed by Oct 05, 2020| Updated on
Netting involves setting off of the value of multiple positions or payables between two or more parties. It ascertains the party who owed obligation in a multi-party agreement. Netting is a broad concept that has several more specific uses, also in the financial markets.
Netting refers to a method of risk reduction in financial contracts by connecting or aggregating multiple financial obligations to arrive at the amount of net obligation. Netting is adopted to decrease the settlement, credit, and other financial risks between two or more participants.
Netting is usually used in trading, where a stock trader can offset a position in one scrip or currency with another position. The objective of netting is to offset losses in one position with profits in another. For instance, if an investor has gone short on 35 shares of a security and taken a long position on 100 shares of the same security, the net position is long on 65 shares.
Netting is also applied when a company files for insolvency and bankruptcy. The parties' net the balances owed to each other. It is also called a set-off clause or set-off law.
A company carrying out business with a defaulting company may offset any liability they owe the defaulting company with the receivable due from them. The balance represents the total amount owed by them or to them, which can be utilised during the insolvency proceedings.
In other cases, companies use netting to simplify third-party invoices. It ultimately reduces multiple invoices into a single one. For instance, several divisions in a big transport company purchase paper from a particular supplier, and likewise, the supplier also uses the same transport company to make sales.
By netting the amount owed by the party with each other, a single invoice can be created for the company that has the balance outstanding. This method can also be adopted while transferring funds between two subsidiaries.
Netting helps in saving more time and money by reducing the number of transactions per month that needs billing. It cuts down the transactions just to a single payment. It also limits the number of foreign exchange transactions as the number of fund flows decreases for banks.
The four types of netting are listed below:
(1) Close-Out Netting
Close-out netting occurs after default. In other words, when a party fails to make repayments, transactions between the parties are netted for a single amount payable by only one party.
(2) Settlement Netting
Settlement netting consolidates the amount due among parties and offsets the cash flows into a single payment. The party only exchanges the net difference in the total amounts with the net owed obligation.
(3) Netting by Novation
Novation netting refers to the cancellation of offsetting swaps. It replaces them with new obligations on calculating the net amount, where two companies have obligations to each other on the settlement date.
(4) Multilateral Netting
Multilateral netting refers to a form of netting involving more than two parties. A clearinghouse or central exchange often mediates in a multilateral netting event. It can also happen inside a company with multiple subsidiaries.