Payment netting reduces settlement risk: If counterparties are to exchange multiple cash flows during a given day, they can agree to net those cash flows to one payment per currency. Not only does such payment netting reduce settlement risk, it also streamlines processing.
Closeout netting reduces pre-settlement risk: If counterparties have multiple offsetting obligations to one another—for example, multiple interest rate swaps or foreign exchange forward contracts—they can agree to net those obligations. In the event that a counterparty defaults, or some other termination event occurs, the outstanding contracts are all terminated. They are marked to market and settled with a net payment. This technique eliminates "cherry picking" whereby a defaulting counterparty fails to make payment on its obligations, but is legally entitled to collect on the obligations owed to it.
With bilateral netting, two counterparties agree to net with one another. They sign a master agreement specifying the types of netting to be performed as well as the existing and future contracts which will be affected. Bilateral netting is common in the OTC derivatives markets.
Multilateral netting occurs between multiple counterparties. Typically, it is facilitated through a membership organization such as an exchange. Multilateral netting has the advantage that it reduces credit exposure even more than does bilateral netting. It has the disadvantage that it tends to "mutualize" credit risk. Because credit exposure to each counterparty is spread across all participants, there is less incentive for each participant to scrutinize the credit worthiness of each other counterparty.
Let's consider an example. Exhibit 1 illustrates non-netting commitments between three counterparties. To keep the example general, "commitments" could be cash flows to occur in a single day, or they might represent the market value of outstanding contracts.
Finally, Exhibit 3 illustrates identical commitments under multilateral netting. Here, if Party C were to default, the total replacement cost—which would be shared by Party A and Party B—would be 2. The manner in which that replacement cost would be allocated between Party A and Party B would depend on the specific provisions of the multilateral netting arrangement.
While netting can be an effective means of reducing credit exposures, it can raise legal issues. Many jurisdictions do not recognize the enforceability of closeout bilateral netting agreements, arguing that such agreements undermine the interests of third-party creditors. Responsible legal counsel should be consulted before entering into any netting arrangement.