What does netting mean in finance and how does it actually work?
Netting in finance is the offsetting of several payments against each other. The aim is to reduce the number of transactions. The procedure is used to simplify payments both by groups that include several subsidiaries and by non-affiliated companies. Find out here exactly how netting works, what types there are and what advantages it offers.
Netting in finance is used to offset outstanding payments or transactions against each other so that only one payment or transaction needs to be made instead of several. For example, if both party A and party B have debts to each other in different amounts, they are netted against each other, leaving only one remaining debt for either party.
Netting is intended to reduce the effort involved in making reciprocal payments. This saves costs for the transactions and time for all parties involved. It can also help maintain corporate liquidity by requiring a lower final amount to be paid.
Netting is also often used when a company has filed for insolvency. It is then checked what debts the company has and what debts other parties have with the company. These are all offset against each other so that in the end the creditors can be paid from the remaining liquid assets.
There are four different types of netting.
If one party can no longer pay its interest payments (e.g. for a loan), a payment default occurs. With close-out netting, the outstanding amounts of the two parties are then offset against each other.
This creates a single amount that must be paid by the party in debt to the other. The existing contract is terminated because the debtor has breached his obligation to pay, and the full balance must be paid.
Settlement netting is also called payment netting. In this case, the due payment amounts that two parties owe each other are combined into a single payment. However, the previous contracts regarding the liabilities remain in place.
The remaining difference must then be paid by the party with the larger total debt to the other party. Both parties must agree to this procedure in a netting agreement. This also specifies at what time the difference must be paid.
Novation netting involves cancelling the liabilities that two parties have to each other and instead calculating a differential amount from these liabilities.
By cancelling the existing contracts, novation netting differs from settlement netting. The difference is then recorded in a new contract as a new liability of the owing party towards the other.
Multilateral netting always involves more than two parties. It is often used in groups that include several companies (even in different countries) and that owe each other payments (e.g. by providing services).
In multilateral netting, payments often come together in a corporate unit that serves as a clearing house. There, the different invoices, payments and currencies are offset against each other and the payments are also made.
To simplify invoicing among themselves, companies can also make use of netting. The invoice amounts owed are offset against each other. Afterwards, only the party that still has to expect the remaining amount from the other party issues an invoice.
For example, several service items can be offset against each other, which considerably reduces the effort involved in invoicing and also simplifies accounting due to fewer invoices.
Netting is also interesting when it comes to transfers in foreign currency. Since the banks always charge extra fees for a transaction, netting can be worthwhile if the parties involved offset their debts against each other in advance in order to turn several transactions into only one.
Company A owes Company B an amount of £100,000 and Company B owes Company A an amount of £70,000. Instead of both companies making a transaction and having these comparatively large amounts drain their liquidity, they use netting. The two amounts are simply offset against each other and a difference is created:
Netting balance = £100,000 - £70,000 = £30,000
Company B does not have to carry out a transaction at all, but receives the remaining amount of £30,000 from Company A. For Company A, netting has the advantage that it has to transfer significantly less money to Company B and can thus preserve its liquidity.