NETTING

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.
A netting agreement is a contract whereby each
party agrees to set off amounts it owes against
amounts owed to it.
Netting agreements can be either bilateral, ie
between two parties, or multilateral, involving
several parties.

TYPES OF NETTING
1. Bilateral Netting
On a payment date, each party will aggregate the
amounts of a currency to be delivered by it, and
only the difference in the aggregate amounts will
be delivered by the party with the larger
aggregate obligation.
2. Multilateral Netting
Multilateral Netting involves netting among more
than two parties, using a clearing-house or
central exchange.

Example of Bilateral Netting

Three bilateral netting agreements are in

force, one between each pair of
counterparties. If Party C defaulted, the
replacement cost for Party A would be 3.
For Party B, there would be no
replacement cost because Party C owes it
no net obligation

Multilateral netting

$20
A < ------------------------- C
$100
>B
Multilateral netting arrangements involve settlement between more
than two persons. In the following simple example of a multilateral
netting agreement, A owes B $100, B owes C $20, C owes B $30
and A $20.
Without a netting agreement, A owes $100, B owes $20
and C owes a total of $50. The total amount owed is $170.
Using a multilateral netting agreement, A owes $80, B owes nothing
and C owes $30. The total exposures have been reduced to $110.

Example: No Netting

Without netting, a defaulting counterparty

can "cherry pick" obligations, demanding
payments on obligations owed it while
defaulting on its own obligations. If Party C
defaults in this example, Parties A and B
will still have to perform on their respective
obligations of values 3 and 4.

Multilateral Netting
If Party C were to default, the total
replacement costwhich would be shared
by Party A and Party Bwould be 2. The
manner in which that replacement cost
would be allocated between Party A and
Party B would depend on the specific
provisions of the multilateral netting
arrangement.

 BENEFITS OF NETTING
Netting allows parties to reduce their exposures and
consequently reduce their risk.
This allows capital to be used more efficiently. Netting is
widely used in financial markets, around the world, as a
means of lowering the risks to which banks and other
large institutions are exposed.
Reduction of credit risk
Reduction of settlement risk
Reduction of liquidity risk
Reduction of systemic risk

 In 1990, the Bank for International

Settlements issued minimum standards
for the design and operation of netting
schemes. (They are now known as the
Lamfalussy standards after the chairman
of the Committee that wrote the report, Mr
Alexandre Lamfalussy.) The six standards
are:

 Well founded legal basis under all relevant jurisdictions

Participants have clear understand of system on each of
the risks affected by the netting process
System should have clearly defined procedures of
management of credit and liquidity risks that specify the
responsibilities of the system and the participants
System capable of timely completing of daily settlements
even if the participant with the largest position fails
System should have objective and disclosed criteria for
admission that permit fair and open access
System must ensure operational reliability of systems
and availability of back-up facilities

Matched Pair Novation Netting

Netting only occurs if the two transactions involve the

same pair of currencies.

Example: Matched Pair Novation Netting

Deal 1: Buy JPY / Sell USD
Deal 2: Buy USD / Sell EUR
Deal 3: Buy EUR / Sell JPY
No two deals involve the same currency pair, and
therefore no netting under matched pair novation
netting.

 Example: Matched Pair Novation Netting

Deal 1: Sell 145 USD / Buy 100 GBP
Deal 2: Buy 147 USD / Sell 100 GBP
Here there is a matched pair: USD/GBP
After Netting: 2 USD

Two forms of netting are widely

employed in derivatives markets:
1. Payment netting reduces settlement risk: If counterparties are to
exchange multiple cash flows during a given day, they can agree to
net those cash flows to one payment per currency. Not only does
such payment netting reduce settlement risk, it also streamlines
processing.
2. Closeout netting reduces pre-settlement risk: If counterparties
have multiple offsetting obligations to one anotherfor example,
multiple interest rate swaps or foreign exchange forward contracts
they can agree to net those obligations. In the event that a
counterparty defaults, or some other termination event occurs, the
outstanding contracts are all terminated. They are marked to market
and settled with a net payment. This technique eliminates "cherry
picking" whereby a defaulting counterparty fails to make payment on
its obligations, but is legally entitled to collect on the obligations
owed to it.

 What is netting by novation?

What is Close out netting?

 Netting by novation, means that an existing

obligation is discharged by replacing it with a
new obligation. When two parties agree to
obligation netting, they are legally bound to net
amounts from two or more trades due in the
same currency for settlement on the same day.
Under an obligation netting agreement for
foreign exchange transactions, counterparties
are required to settle on due date all of the
trades included under the agreement by either
making or receiving a single payment in each of
the relevant currencies. This reduces the
amount at risk by lowering the number and size
of payments that would otherwise be needed to
settle the underlying transactions on a trade-bytrade basis

 Close-out netting is an arrangement to settle all

contracted but not yet due liabilities to and
claims on an institution by one single payment,
immediately upon the occurrence of one of a list
of defined events, such as the appointment of a
liquidator to that institution. If such an event
does not happen, then each trade is settled
individually on due date unless the
counterparties also have a supplementary
obligation netting agreement. Close-out netting
does not, by itself, reduce routine foreign
exchange settlement exposures.