NETTING

What is netting?
 A method of reducing credit, settlement and other risks of financial contracts by
aggregating (combining) two or more obligations to achieve a reduced net obligation.

 Netting offsets receivables against payments due, to reduce net payments and save
transaction costs.

 Example include-
1. Netting system used by clearing houses.
2. Treasury department uses netting for cash management.
3. Telecom uses netting to settle international call charges.
4. Netting is also used in derivative markets such as swaps contract.

How different types of netting works?

1. Bilateral Netting

 A bilateral netting agreement enables two counterparties in a financial contract to offset

claims against each other to determine a single net payment obligation that is due to the
other, meaning that the payables and receivables are netted off.

Let’s take an example

Trade No Shares Qty Price Turnover Buyer CM Seller CM

1 Infosys 500 650 325000 Zerodha ICICI
2 TCS 250 1800 450000 ICICI Zerodha

Without Netting-

INR 325,000
Zerodha ICICI
INR 450,000

With Netting-

Zerodha ICICI
INR 125,000
2. Multilateral Netting

A Multilateral Netting is similar to bilateral netting with only difference is that bilateral
involves two parties and multilateral involves more than two parties.

Let’s take an example

Trade No Shares Qty Price Turnover Buyer CM Seller CM

1 Infosys 500 650 325000 Zerodha ICICI
2 HCL 750 500 375000 HDFC ICICI
3 TCS 250 1800 450000 ICICI Zerodha
4 Infosys 600 600 360000 HDFC Zerodha
5 HCL 1000 450 450000 ICICI HDFC
6 TCS 300 1700 510000 Zerodha HDFC

Without Netting-

INR 325,000
Zerodha ICICI
INR 450,000

INR 510,000 INR 450,000

INR 360,000 INR 375,000

HDFC

With Netting-

Zerodha ICICI

INR 25,000 INR 200,000

HDFC
3. Close-Out Netting (ISDA Research Notes 2010)

 Close-out netting refers to a process involving termination of obligations under a contract

with a defaulting party and subsequent combining of positive and negative replacement
values into a single net payable or receivable.

 After a default, existing transactions are terminated and the values of each are calculated
to distill a single amount for one party to pay the other.

Let’s take an example

With Close-Out Netting-

INR 100,000
Non-defaulting
Party Defaulting Party
INR 80,000

Net Payment INR 20,000

Without Close-Out Netting-

INR 100,000
Non-defaulting
Party Defaulting Party
Recovery <= INR 80,000

 If close-out netting is enforceable, the non-defaulting party is obligated to pay the

net difference of INR 20,000 to the defaulting party. Had the net amount favored
the non-defaulting party, the non-defaulting party would become a general
creditor to the defaulting party for the net obligation

 But if close-out netting were not enforceable, the non-defaulting party would be
obligated immediately to pay INR 100,000 to the defaulting party but then wait,
possibly months or years, for whatever fraction of the INR 80,000 gross amount it
recovers in bankruptcy.
 4. Netting by novation-

 The legal obligations of the parties to make required payments under one or more
series of related transactions are canceled and a new obligation to make only
the net payments is created.

 Netting by novation can be of bilateral or multilateral.

Why use Netting?

 Netting reduces the number of transaction, average size and cost of payments
(transactions costs)

 Netting allows parties to reduce their exposures and consequently reduce their
risk. Since only the net obligation is exchange, it allows capital to be used more
efficiently and leads to reduction in

1. Credit Risk
2. Settlement Risk
3. Liquidity Risk
4. Systemic Risk
5. Cost of capital

Author – Keval Shah

(CA, FRM 2 Candidate)