Netting is a method of reducing various forms of risk in a trade by combining two or more obligations to calculate a "net obligation," or the difference between both obligations, which is paid out instead of the original obligations in the trade.
Types of Netting
There are four types of netting: novation netting, close-out netting, multilateral netting, and payment netting, which is also known as settlement netting.
Each party in a trade aggregates the amount of currency to be delivered according to the terms of the trade. Only the difference in the aggregated amounts are delivered by the party with the larger aggregate obligation.
For example: Firm A owes Firm B $7 million, and Firm B owes Firm A $8 million. Instead of both firms shuffling large amounts of money around, Firm B simply delivers Firm A the difference between their respective obligations - $1 million in this case - and both firms call it even.
While this type of netting reduces settlement risk, both transactions remain in their gross forms for balance sheet and regulatory purposes.
Novation netting is when two parties have obligations, a preferred currency, and a value date set, but then cancel their obligations and replace it with a new one for the net amount of the original trade. In other words, if Firm A and Firm B could engage in payment/settlement netting by having Firm B pay Firm A the $1 million difference between their obligations, they may engage in netting in similar fashion by simply canceling their original deal and entering into a simpler one in which only Firm B need pay, and only the $1 million difference, instead of both sides paying their original obligations.
Close-out netting is a type of netting that happens in the event of a default. Close-out netting happens after the total value of an organization's overdue payment to another organization is calculated, minus the obligations of the creditor to the debtor.
Multilateral netting involves netting between more than two parties, using a clearinghouse or central exchange. Netting between two parties is called "Bilateral" netting.