What it means
Imagine two companies in the same group that trade with each other. One owes the other $700,000 for goods, and the other owes the first $450,000 for services.
Instead of making two payments totalling $1,150,000, they agree to a single payment of the difference, $250,000. This is bilateral netting, between two parties.
Multilateral netting extends the idea to many parties, typically the subsidiaries of a multinational group. A central treasury collects the amounts that each subsidiary owes and is owed, calculates each company's net position and arranges only the net payments.
The benefits are practical. Fewer payments mean fewer bank charges, and when the payments are in different currencies, netting reduces the amount that has to be converted, which cuts foreign exchange costs and risk.
It also reduces the time spent on reconciling and processing payments. For netting to work, the parties need reliable records and an agreed timetable for settlement.
Typically, the group sets a cut-off date, each subsidiary submits its invoices, and the treasury runs the calculation and sends instructions. Disputed items can delay the process, so many companies use specialist software.
Legal and regulatory points matter as well. Some countries restrict or control netting, and the contract should state clearly that the amounts are being offset.
In financial markets, close-out netting is a related idea that allows the amounts owed under many contracts to be combined into a single claim if one party defaults, which reduces credit risk. Timing and currency choices also need care.
The group usually picks a single netting currency and a fixed set of exchange rates for the cycle, so that every subsidiary converts its balances at the same rate. Agreeing these rules in advance prevents arguments about gains and losses once the figures are in.
In practice
Real-world examples
Example 1
A multinational group has five subsidiaries trading with one another every month. Its treasury centre runs a netting cycle on the last day of the month. Instead of dozens of payments in different currencies, each subsidiary makes or receives one payment. The treasury also gains a clear monthly view of what every company owes the group.
Example 2
A car parts maker both buys steel from a supplier and sells that supplier finished components. They sign a netting agreement under which invoices are offset each month. The supplier and the maker pay only the difference and save on transfer costs. Their accountants also spend less time chasing separate remittances.
Example 3
A trading firm has several contracts with the same bank. If the bank fails, the contract allows the claims to be netted to a single amount. The firm's exposure is therefore limited to the net figure, not the sum of all the positive contracts.
Think of it
Imagine you and a friend take turns buying lunch and coffee for each other all week. Instead of swapping money after every single meal, you tally up the receipts on Friday and the person who spent more simply receives the difference.
Formula
Calculation
Net payment = amount owed by A to B - amount owed by B to A
Suppose Company A owes Company B $700,000 and Company B owes Company A $450,000. Without netting, the two companies make payments totalling 700,000 + 450,000 = $1,150,000. With netting, A pays B the difference of 700,000 - 450,000 = $250,000, and the gross flow is reduced by 1,150,000 - 250,000 = $900,000, which is about 78.3%. If each bank payment costs 0.1% in fees, the fee falls from 1,150,000 x 0.1% = $1,150 to 250,000 x 0.1% = $250.Case study
Seen in the real world
Meridian Foods Group is a fictional multinational created for this illustration. Its six subsidiaries traded with each other in three currencies, producing about 180 payments a month with a combined value of $24,000,000.
The treasury introduced multilateral netting with a single settlement date. After the first cycle, the group needed only 11 payments, with a total value of $5,200,000, a reduction of 78% in the amount moved.
The illustrative outcome was a saving of around $210,000 a year in foreign exchange spreads and bank fees. The group also found that disputed invoices were now identified earlier, because every subsidiary had to submit its figures by the cut-off date. Within a year, the number of long-outstanding intercompany items had fallen by more than half, and the year-end reconciliation took days instead of weeks.
Watch out
Common mistakes
- Assuming netting cancels the underlying debts, when each invoice remains valid and only the settlement is combined.
- Ignoring local rules, which in some countries limit or prohibit netting of intercompany balances.
- Letting disputed invoices hold up the cycle, when they should be set aside and settled separately.
Questions
People also ask
What is the difference between bilateral and multilateral netting?
Bilateral netting offsets amounts between two parties, while multilateral netting offsets amounts among a group, usually through a central treasury.
Does netting reduce foreign exchange risk?
Yes, because fewer and smaller amounts need to be converted, so the group has less currency exposure.
How is it different from notional pooling?
Netting combines the amounts owed under invoices or contracts, while notional pooling combines bank account balances to calculate interest.