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My last two post was on netting , lot of people asked me to provide some more insight view for netting, so this post is meant to walk through ,the concept to someone not very familiar with accounting in real world...so here to go..(adopted)
When trading partners agree to offset their positions or obligations, they are netting. By doing so, they reduce a large number of individual positions or obligations to a smaller number of positions or obligations, and it is on this netted position that the two trading partners settle their outstanding obligations. Besides reducing transaction costs and communication expenses, netting is important because it reduces credit and liquidity risks, and ultimately systemic risk. For a non accounting personal risk can be best understood as :the risk of a trading partner not fulfilling his obligations in full on due date or at any time thereafter is a risk that affects all aspects of business.
Definition of Netting
In this method of reducing credit, settlement and other risks of financial contracts by aggregating (combining) two or more obligations to achieve a reduced net obligation.
Netting rules a basic part of master agreements.
Netting rules define precisely the netting of positions or claims between counter parties.
Benefits of Netting
Netting potentially address four major risk in financial area, there are
- Reduction of credit risk
- Reduction of settlement risk
- Reduction of liquidity risk
- Reduction of systemic risk
Types of Netting
- Payment Netting
- Novation Netting
- Close-Out Netting
- Multilateral Netting
Also called â€œSettlement Nettingâ€ or Also called "Position or Accounting Netting".
On a payment date, each party will aggregate the amounts of a currency to be delivered by it, and only the difference in the aggregate amounts will be delivered by the party with the larger aggregate obligation.
This can be best understood as:
Daily settlement or offsetting of several, due claims in the same currency
Reduction of transaction costs, settlement risk and liquidity risk.
No impact on credit risk.
Types of Payment Netting Agreements
- Master Agreement with a Payment Netting Clause
- Stand-Alone Payment Netting Agreement
- Informal, â€œad hocâ€ agreement
If the parties enter into a transaction which gives rise to an obligation for the same value date and in the same currency as an existing obligation, then the two obligations are cancelled and simultaneously replaced with a new obligation for the net amount.
Settlement of not yet due claims in the same currency and the same maturity.
Reduction of limit usage and credit risk.
Two Types of Novation Netting:
- Matched Pair Novation Netting
- â€œComprehensiveâ€ Novation Netting
Matched Pair Novation Netting
Netting only occurs if the two transactions involve the same pair of currencies.
Example1: Matched Pair Novation Netting
Deal 1: Buy JPY / Sell USD
Deal 2: Buy USD / Sell EUR
Deal 3: Buy EUR / Sell JPY
No two deals involve the same currency pair, and therefore no netting under matched pair novation netting.
Example 2: Matched Pair Novation Netting
Example 3: Comprehensive Novation Netting
A Payment Netting vs Novation Netting
- Payment Netting reduces settlement risk, but does achieve netting for balance sheet or regulatory capital purposes because the transactions remain in gross.
- Contrast with Novation Netting, which achieves true netting through the cancellation of offsetting transactions and their replacement with a new, net transaction.
Effective upon a default:
- Existing transactions are terminated
- Termination values are calculated
- Termination values are netted to arrive at a single net amount
- Recourse to credit support, if any
- Settlement/offsetting of not yet due claims in different currencies in case of a default event or an early termination event of the contractual relationship.
- All outstanding gross obligations or payments are replaced by a single obligation or payment
Bilateral Netting is between two parties.
Multilateral Netting involves netting among more than two parties, using a clearing-house or central exchange.
When it come to party , it may be two party interacting with third party. Th two party may be your other entity in the same instance, which do business internally, what we called Intercompany.
Multilateral netting is a settlement mechanism used by companies to pay for goods and services purchased from affiliated companies. The netting process consolidates
intercompany transactions and calculates settlement requirements internally instead of using external payment systems. Netting is typically used by companies with a number of affiliates in different countries. By netting, these companies reduce bank fees, currency conversion costs, bank balances and improve operating efficiency.
Will take this in some more details in another post.
Requirement Mapping with Existing Oracle EBS Product
Still these two processes are not fully enabled in Oracle EBS suite. Though first type of netting somehow mapped as Contra Charging in post 11i10 releases where as in R12 this functionality can be mapped as part of AP/AR netting, a new feature of R12.
Here is summarize list of the different types of netting and there corresponding netting.
Feel Free to comment or share any information.:)