One of such innovative developments is the introduction of provisions on netting in financial transactions.

Netting is a mechanism by which amounts payable between contracting parties are consolidated into a single payment from one party to another. As a reconciliation tool in structured finance, netting provides contracting parties, usually in derivative transactions, a means of mitigating credit and settlement risks by aggregating two or more obligations to achieve a reduced net obligation. Mutual payment obligations are aggregated so that the party owing the greater aggregate amount makes a net payment to the party owing the lesser aggregate amount.

There are different forms of netting; however, the forms mainly used in financial transactions are ‘settlement netting’ and ‘close out netting’. Settlement netting provisions are used where contracting parties have mutual payment obligations under an executory contract to reduce the parties’ payment obligations into one payment balance and discharge a single net payment obligation from one party to the other. The objective of settlement netting is to reduce settlement risk by netting off obligations so that the only obligation of the party with outstanding payment obligations is to pay a net balance. Settlement netting is only possible in respect of payments due in the same currency (or delivery of the same commodity) and on the same date.

Close-out netting provisions provide for the termination of all unmatured open executory contracts, valuation of the parties’ respective liabilities, the gains and losses arising from the valuation are then aggregated and set off against each other to produce a single amount payable by one party to the other. The objective is to reduce exposures on open or executory contracts should one party become insolvent before the value date.

Benefits of Netting
One crucial benefit of netting is the reduction or elimination of credit risk. This can be done by reducing an institution’s capital adequacy costs related to funded credit protection exposures by enabling its regulatory capital requirements to be measured against the net rather than gross exposures.

Another benefit is the reduction of liquidity risk. As stated above, a close-out netting provision in an executory contract would typically provide for the termination of the contract before its value or settlement date. This can be used when an event of default occurs, such as the insolvency of one of the parties.

Other benefits are a reduction of settlement risk and a reduction of systemic risk. A robust netting system generally gives rise to a thriving derivatives market.

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