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Netting

Netting is a process that allows entities to offset total receivables against total payables. The concept has already been discussed in the context of clearing and settlement systems. Each entity either receives or pays a single net amount to the netting center in its local currency. Exhibit 7.3 illustrates the process.

Before netting. Even if each subsidiary does only one trade with each of the others, there are a total of 12 transactions. Each subsidiary sells in its own currency, so there are four entities managing foreign exchange exposure and paying foreign exchange commissions on the total amount of the gross payables. The full value of the funds in transit results in a loss of availability of two to five days.

After netting. Each subsidiary is involved in a single transaction in its own currency, either to receive from or pay to the netting center the net amount due. The transactions have been reduced to four, which represents a 67 percent offset ratio. Only one entity, the netting center, is involved in purchasing foreign exchange.

The most significant quantitative benefits result from the saving of foreign exchange commissions and the elimination of all collection float. Other benefits include reduction in treasury duplication, as the netting center can now act as the focus for cash flow, exposure, and reconciliation management. Treasury is also in a position to negotiate better exchange rates due to the wholesale amounts now being traded. Initially developed to reduce the costs and exposures of intracompany payables, modern netting systems increasingly accommodate third-party payables, receivables, and FX matching, which offset the foreign currency needs of subsidiaries.

A number of industries that are characterized by commoditized product offerings and large numbers of bilateral payments and receipts among participants have established industrywide netting programs. For example, the International Airlines Transport Association (IATA) operates a netting center between more than 200 airlines for both commercial and cargo flight payments. Another example is the world’s GSM mobile phone operators, which net their incoming receipts and payments through an industry-netting center. These netting systems can produce over 80 percent offset ratios, resulting in significant cost savings to the industry.

Netting systems are relatively easy to establish, requiring only a computer program within a treasury center. However, their success depends on the involvement of all the parties. Many companies are putting such applications on their intranet or the Web for input. This provides direct access to the software, prompt resolution of discrepancies, and faster notification of changes to all participants. Using a Web-based system also puts the cost of netting within the reach of smaller companies. As with pooling, some countries impose restrictions on the use of netting or require prior central bank approval.

Taken From : Essentials of Managing Corporate Cash

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