Netting
Netting is the process of combining multiple offsetting financial obligations between two or more parties into a single net obligation, reducing the gross notional amount of transactions that must be settled and lowering both counterparty risk and funding requirements.
Netting is one of the most powerful risk-reduction mechanisms in financial markets. Without netting, every transaction would require full gross settlement — each payment flowing separately in each direction. With netting, only the difference between offsetting obligations changes hands, dramatically reducing the capital and collateral required to support a given level of market activity.
There are several forms of netting. Bilateral netting applies between two specific counterparties: if Bank A owes Bank B $50 million on one transaction and Bank B owes Bank A $35 million on another, bilateral netting reduces this to a single net payment of $15 million from Bank A to Bank B. ISDA Master Agreements contain close-out netting provisions that specify how all outstanding derivatives between two counterparties will be netted upon a default event.
Multilateral netting extends across multiple counterparties, typically facilitated by a central counterparty or clearinghouse. The DTCC's NSCC performs multilateral netting for US equity transactions: instead of settling every individual trade between every pair of counterparties, NSCC calculates each member's net obligation across all trades for the day and settles only that net amount. The DTCC has reported that multilateral netting reduces the daily settlement value of US equity markets by approximately 98%, from trillions in gross trades to tens of billions in net obligations.
Netting significantly reduces systemic risk. In a financial crisis, if gross settlements must be made, a single institution's failure to pay can cascade through the system as sequential settlement failures propagate. With netting, the financial exposure is compressed to the net amount, dramatically reducing the size of any contagion channel.
The legal enforceability of netting agreements is critically important. In the US, the enforceability of netting in bankruptcy is protected under the Bankruptcy Code through safe harbor provisions that exempt qualified financial contracts (derivatives, repos, securities contracts) from the automatic stay that normally prevents creditors from acting against a bankrupt counterparty. This safe harbor enables the rapid close-out and netting of derivatives positions upon a counterparty default, which is essential for market functioning.