Payment Netting vs. Close-Out Netting

Payment Netting vs. Close-Out Netting: An Overview

Both payment netting and close-out netting are methods of settlement (finalizing or completing agreements or payments) between two or more parties, used to reduce exposure to risk. They differ primarily in the fact that payment netting is viewed as reducing settlement risk, while close-out netting reduces pre-settlement risk.

Key Takeaways

• Payment netting and close-out netting are settlement methods between two parties in a financial contract.
• Both are methods of netting, which mitigate financial risks by combining multiple obligations into a single amount.
• Payment netting aggregates the amounts due between two parties and nets the difference into one payment, to be paid by whichever party owes it.
• Close-out netting happens when one party defaults: Its positions are terminated, priced, and then netted to arrive at a single amount due.

Payment Netting

When counterparties have a number of obligations to each other, they can agree to offset and net those obligations—a procedure called payment netting. Payment netting is also known as settlement netting. Netting is the consolidation of multiple payments, transactions or positions between two or more parties; the aim is to create a single amount out of all the exchanges to determine which party is due remuneration and in what amount.

It can be used in bankruptcy cases, offsetting money owed to the defaulting company with money owed by the company, and to determine an amount due to creditors. Netting can also be used in trading: Investors offset one position with an opposing one, to balance out losses from one with gains in another.

The utilization of payment netting streamlines processing and reduces settlement risks. This form of netting often happens in currency trading. Let’s say Party ABC and Party XYZ are trading British pounds and at the end of the day, ABC owes XYZ seven pounds and XYZ owes ABC eight pounds. XYZ would simply pay ABC one pound to settle their accounts.

Important

Combining obligations in netting procedures may result in a reduced payout, but it’s considered worthwhile because it streamlines processes and increases the likelihood of payment.

Example of Payment Netting

A practical example of payment netting might involve two companies, Company A and Company B, which frequently trade goods and services. Suppose Company A owes Company B $10 million, and at the same time, Company B owes Company A $7 million. Instead of each party making a separate payment, they agree to a netting arrangement. By offsetting the amounts, only a single payment of $3 million is required—from Company A to Company B.

Payment netting is also widely used in the derivatives market, particularly in swaps and forward contracts. For instance, in a currency swap, two parties agree to exchange a set amount of currency at regular intervals. Let’s say one party owes $500,000 in one currency and the other party owes an equivalent of $480,000 in another. They could agree to a payment netting arrangement that allows them to settle with a single payment of $20,000.

Close-Out Netting

Close-out netting usually happens after some kind of termination event, like a default. The transactions between two parties are tallied up and consolidated to arrive at a single amount for one party to pay the other.

Assume one party in a derivatives transaction can’t make good on its obligations. Any outstanding contracts are terminated at the time of its default, and the final replacement values of its positions are marked to market and combined into a single net payable or receivable. This rolled-up obligation is then settled with a net payment to the counterparty (or by it, should the defaulting party actually come out ahead).

Without close-out netting, the counterparty would have to join the ranks of other creditors to the defaulting company. Reimbursement might take years and result in a smaller amount.

Example of Close-Out Netting

Consider a scenario where a financial institution, Bank X, enters into multiple derivatives contracts with another institution, Bank Y. If Bank Y defaults, Bank X can invoke close-out netting.

This means Bank X will close all outstanding contracts with Bank Y and calculate the net exposure across all agreements. If Bank Y owes Bank X $15 million across various contracts, while Bank X owes Bank Y $5 million, close-out netting allows Bank X to offset these amounts, resulting in a net obligation of $10 million that Bank Y owes Bank X. This process simplifies settlement and prevents Bank X from having to pay the $5 million, which it might not recover in light of Bank Y’s default.

What Is Payment Netting?

Payment netting is the process of consolidating multiple payment obligations between two parties into a single netted amount, rather than settling each transaction individually. This reduces the total number of payments exchanged.

In What Types of Transactions Is Payment Netting Commonly Used?

Payment netting is frequently used in foreign exchange transactions, commodity trades, and regular business transactions between corporations. It’s also common in derivatives markets.

Why Is Close-Out Netting Important in Financial Markets?

Close-out netting allows financial institutions to quickly mitigate their exposure to a defaulting counterparty by canceling and offsetting contracts, ensuring only the net amount is owed. It’s a way for markets to manage default risk by making sure values are exchanged, even with bankrupt companies.

What Role Does the ISDA Master Agreement Play in Close-Out Netting?

The ISDA Master Agreement provides a standardized legal framework for managing counterparty risk in derivatives. It includes terms for close-out netting.

The Bottom Line

Payment netting consolidates multiple payment obligations between two parties into a single netted amount, reducing transaction volume and settlement costs. Close-out netting, on the other hand, is triggered when one party defaults, allowing the non-defaulting party to terminate all outstanding contracts and offset obligations to determine a single net balance owed.