Netting

Netting is the process of offsetting obligations that two or more parties owe each other, so that only the net difference is actually paid or delivered. Instead of every individual payment moving in full, the parties, or a system acting for them, add up what each owes and is owed and settle one net amount. Netting reduces the number and value of payments, the liquidity each participant needs, and, when legally effective, the credit exposure between them.

Netting is used in interbank payment systems, securities and derivatives clearing, foreign exchange settlement, corporate treasury and informal value transfer systems.

Bilateral netting

Two parties offset their mutual obligations. If Bank A owes Bank B 100 million and Bank B owes Bank A 70 million over the course of a day, a single payment of 30 million from A to B settles both.

Multilateral netting

Three or more participants net their obligations through a central system or agent. Each participant ends up with a single net position against the system as a whole: either a net amount to pay or a net amount to receive. Multilateral netting is the basis of many retail clearing systems and of deferred net settlement (DNS), in which net positions are settled at set times, often across accounts at the central bank. A central counterparty (CCP) also performs multilateral netting by becoming buyer to every seller and seller to every buyer.

Payment netting, novation netting and close-out netting

Payment netting, sometimes called settlement netting, combines amounts due on the same day in the same currency. Netting by novation replaces offsetting contracts with a single new net contract. Close-out netting applies when a counterparty defaults: all outstanding transactions under a master agreement are terminated, valued and combined into one net amount owed. Close-out netting is a cornerstone of over-the-counter derivatives documentation, and its enforceability in insolvency is supported by specific legislation in many countries.

Three banks exchange payments during a day. Bank A owes B 50 and C 30. Bank B owes A 20 and C 40. Bank C owes A 60 and B 10. In gross terms, 210 would move. On a multilateral net basis, A receives 80 and pays 80, for a net position of zero; B receives 60 and pays 60, also zero; and C receives 70 and pays 70, also zero. In this case no money needs to move at all, although in practice net positions are rarely perfectly balanced.

In a real-time gross settlement (RTGS) system, each payment settles individually and immediately, giving early payment finality but requiring much more liquidity. Netting systems economize on liquidity but create exposures during the period before settlement: if a participant with a large net debit position fails, the system may have to unwind its payments or call on other participants, a form of settlement risk.

The 1990 Lamfalussy Report, prepared under the Bank for International Settlements, set minimum standards for netting schemes, including a sound legal basis and the ability of the system to complete settlement if the participant with the largest net debit position fails. These ideas were later carried into international standards for payment and settlement systems developed by what is now the Committee on Payments and Market Infrastructures (CPMI). Many modern systems are hybrids. The US CHIPS system, for example, combines prefunded balances with continuous bilateral and multilateral offsetting to release payments with final settlement.

Continuous Linked Settlement (CLS) settles each foreign exchange trade gross on a payment versus payment (PvP) basis, but members fund only their net positions in each currency, which reduces the liquidity required by a very large factor. Banks also net FX trades bilaterally under master agreements.

Multinational companies use intercompany netting centers to offset invoices between subsidiaries in different countries, converting and paying only the net amount in each currency. This cuts bank fees and FX costs and can serve as a natural hedge. Informal systems work similarly: hawala operators often settle accumulated imbalances between themselves periodically rather than moving money for each transfer. Where netting crosses borders, some countries restrict it under foreign exchange rules, requiring gross reporting or approval.