Bilateral Netting

Bilateral netting is an arrangement between two counterparties under which the amounts they owe each other are offset, leaving a single net obligation in each currency or asset. Instead of each side paying the other in full for every trade or payment, only the difference changes hands. Banks use it for foreign exchange, money market and derivatives trading; companies use it for intercompany and supplier relationships; and it is the simplest building block of every larger netting system.

Bilateral netting reduces the number of transfers, the liquidity needed to settle them, and, when it is legally binding, the exposure each party has to the other. It is distinct from multilateral netting, where many parties net against a central point, and from advisory netting, where a net figure is calculated but the gross obligations survive. Its risk benefit depends on a written agreement that courts will enforce, especially if one party becomes insolvent.

Two neighbours borrow from each other all month: tools, a lawnmower, cash for a pizza. At the end of the month, instead of returning every item and every coin separately, they add it all up and one of them pays the other the difference.

If they write down and sign that the difference is the only thing either of them owes, they are also protected. If one of them moves away in a hurry or runs into money trouble, the other only has to worry about the single net amount, not every item lent during the month.

The two parties first agree which obligations are covered, for example all spot and forward FX trades settling on the same value date in the same currency. As trades are booked, each side records what it must pay and receive. On the settlement date the amounts are added and offset, and only the net figure in each currency is paid. Confirmations or a matching service make sure both sides agree on the trades before the net figure is calculated.

A simple example shows the effect. Bank A owes Bank B 100 million euros from a series of trades, and Bank B owes Bank A 80 million euros from others, all for the same value date. With bilateral netting, Bank A pays 20 million euros and the obligations are discharged. Without it, 180 million euros would move between the two banks.

Bilateral netting comes in several legal strengths:

• Payment or settlement netting. The parties agree to settle amounts due on the same day in the same currency on a net basis. This reduces liquidity needs but may not survive insolvency on its own.
• Netting by novation. Each new trade is automatically merged with existing ones for the same value date and currency, and the old obligations are legally replaced by one running net amount.
• Close-out netting. If one party defaults, all covered contracts are terminated, valued and reduced to a single sum payable one way. Master agreements such as the ISDA Master Agreement for OTC derivatives rely on this.

Banks typically combine these in master agreements and obtain legal opinions confirming that the netting will be upheld in each counterparty's home jurisdiction. Bank capital rules only let banks measure counterparty risk on a net basis where such enforceability is established.

The main benefits are fewer payments, lower funding needs and smaller credit exposures. For FX trading in particular, bilateral netting cuts the gross amounts exposed to settlement risk, the danger that one side pays and the other does not.

Its limits are equally clear. Netting only between pairs leaves each bank with many separate net positions, one per counterparty, each needing its own payment and its own risk management. It also does nothing about the remaining net amount: if a counterparty fails after receiving its money but before paying its net leg, the loss is still real. These limits led to multilateral systems and to payment versus payment settlement through CLS, which combines multilateral netting of funding with simultaneous settlement of both legs.

Bilateral netting often sits inside larger arrangements. Some deferred net settlement systems use bilateral limits between pairs of participants as part of their risk controls. In correspondent banking, two banks that hold accounts with each other may settle the net of their mutual flows periodically, often through their nostro accounts. In real-time gross settlement systems, liquidity-saving mechanisms can offset queued payments between two banks so that only the difference needs to be funded at that moment, which is a form of bilateral offsetting carried out by the system.

Central banks and the Committee on Payments and Market Infrastructures have encouraged legally robust netting since the 1989 Angell Report and the 1990 Lamfalussy Report, which examined netting schemes in the G10. Supervisors continue to check that banks relying on netting for capital or risk purposes have current legal opinions and track any changes in insolvency law.

• International Swaps and Derivatives Association (ISDA)
• Committee on Payments and Market Infrastructures (CPMI)