Credit and settlement risk are related types of counterparty risk. Credit risk is the risk that the counterparty will default on the transaction, and settlement risk is the threat that the counterparty may default after payment has been made to them. Netting reduces these risks because neither party makes a payment until the net amount is calculated. See close-out netting below for more on this risk reduction. For example, if Party A owes Party B $100,000 and Party B owes Party A $80,000, the two parties can net the two obligations to one $20,000 ($100,000 - $80,000) payment.
How Netting in Finance Works
Netting is typically done in over-the-counter (OTC) derivative transactions using a master netting agreement. The agreement spells out what type of netting is to be done and how the transaction will work. The most common type of agreement is the ISDA (International Swaps and Derivatives Association) Master Agreement, which also governs the other aspects of OTC derivative transactions. The master agreement will spell out whether the transactions added to the master agreement will have payment and/or close-out netting. The U.S. Generally Accepted Accounting Principles (GAAP) allow companies that use the agreement to report the net amount of derivatives they own on their balance sheets as long as there are determinable amounts, the netting is legally enforceable, and the reporting party intends to net the transaction. This is important because reporting gross amounts could skew the balance sheet of the reporting company. Banks that engage in billions of dollars’ worth of derivative transactions each year could have net positions that are fractions of the gross amounts in the transactions. Reporting the gross amount, without breaking down the inputs in that amount, would make it much more difficult for users of the statement to compare balance-sheet line items.
Types of Netting
There are four main types of netting. Let’s go over each with an example:
Payment/Settlement Netting
Payment or settlement netting is the netting of each payment in a derivative transaction between two parties. Let’s say two companies set up an interest rate swap in which one makes fixed payments each month and the other makes payments based on a variable interest rate. This month, the first company owes the second $55,000 and the second owes the first $48,000. If the two agreed to net the payments each month, there would be one total payment of $7,000 from the first company to the second.
Close-Out Netting
Close-out netting is done if one party defaults on the transaction. Let’s say two banks have several swap arrangements at any one time. On this specific day, Bank A owes Bank B a total of $1,000,000 and Bank B owes Bank A $900,000. If Bank B were to go bankrupt, the totals would net and Bank A would join bankruptcy proceedings in an attempt to recover its $100,000. If there was no netting, Bank A would still be required to pay $900,000 to Bank B and then would have to join bankruptcy proceedings to attempt to recover the full $1,000,000. Netting reduces the risk for Bank A, in this instance, by 90%.
Novation Netting
When two parties use netting by novation, the net settlement amount is not paid but instead pushed forward into a new contract between the two parties. The two parties often have a running total of the net amount due between them.
Multilateral Netting
Netting between two parties is called bilateral netting; netting between more than two parties, like a company and its subsidiaries, is called multilateral netting. Let’s say that the two companies in the first example both have relationships with a third company. Remember that Company 1 owed Company 2 a net total of $7,000. If Company 2 owes Company 3 a net $12,000 and Company 3 owes Company 1 a net $5,000, each company would send its payment to an intermediary and the intermediary would distribute the net amounts.
What It Means for Individual Investors
In the type of trading in which netting is used regularly, OTC derivatives (meaning derivatives that don’t trade on an exchange), are typically structured by the parties on a case-by-case basis, and these types of transactions are usually only done by institutions. One way an individual might encounter netting would be via variable-rate mortgages used by a real estate investor to purchase buildings on the cheap. To hedge against interest rate risk, they set up an interest rate swap through their bank. Each month, the investor and the bank would owe each other a payment and net the amount due.
