Chapter Seven

Netting

NETTING HAS BECOME A WAY of life for many large corporations around the world. Conceptually, it appears to be a simple enough task for the planning and execution teams. However, most finance professionals who have been through a netting implementation would vouch for the discipline, process, and complete end-to-end understanding and coordination required to ensure that the project adds value to the smooth day-to-day operations of the organisation.

INTRODUCTION AND CONCEPTS

Netting of payments, commonly referred to as netting, is the periodic net settlement of specific outstanding payments between different entities or units. This is different from gross settlement, whereby each payment is made individually. Netting simply reduces the total set of payments to a smaller set of payments, where the net amounts are paid or received, thereby greatly lowering the transactional workload and foreign exchange conversions, potentially saving significant costs for the organisation.

Figure 7.1 shows a sample netting structure wherein payments from entities across the globe can be simplified into a single set of payments from a single location, the netting centre.

FIGURE 7.1 Sample Netting Structure

Types of Payments That Can Be Included in Netting

Different payments can be included in the netting process. These are:

• Trade (supplies, sales, logistics)
• Intercompany funding
• Debt servicing (interest payments and principal repayments)
• Investments
• Hedging or risk management contracts (internal or external)
• Service, advisory, or professional payments
• Management fees
• Royalty or license payments
• Third-party payments
• Dividends
• Surplus or contingency cash requirements

Some of the payments that usually are not included in the netting cycle are:

• Payroll (salaries, etc.)
• Tax payments
• Statutory payments
• Where payments have to be grossed up (cannot be netted off or clubbed) for regulatory or exchange control reasons

Different Types of Netting

Netting can be categorised across different themes. For example, netting across different parties can be:

• Unilateral, for different entities of the same company
• Multilateral, for different legal entities including third parties across countries

Netting across different currencies can be:

• Single currency
• Multiple currency

Figure 7.2 shows a simple single-currency netting payment. Netting is a periodic process and can happen across various frequencies (also called a netting cycle), including even daily settlements if the transaction volumes and urgencies so warrant. The payments can be variable, and in some cases there may be no payments from either party or even from both parties in a netting cycle.

FIGURE 7.2 Single-Currency Netting

In the example, Entity R needs to make a payment of USD 300,000 to Entity S. Entity S needs to make a payment of USD 450,000 to Entity R. A net payment comprises of a single payment of USD 150,000 (the difference between USD 450,000 and USD 300,000) from Entity S to Entity R. This activity would typically reduce the number of transactions by half and hence potentially save on resources and direct transaction cost.

Figure 7.3 continues the same theme with one additional complexity: What if both entities were euro based and hence had to convert currencies every time they had to make payments in USD?

FIGURE 7.3 Netting with Foreign Exchange Conversion

In this case, without netting, there might have been two separate conversions and total purchase of USD 750,000 from euros (EUR). The netting reduces the foreign exchange (FX) purchased to only USD 150,000, thereby creating more process and cost efficiency.

Similarly, there could be cases where there are conversions on opposite sides; for example, one entity could be buying EUR and selling USD, while another entity could be selling EUR and buying USD. Netting reduces the need to have transactions on both sides, and the net resultant purchase of foreign exchange reduces not only the number of transactions but also the net purchase or sale of any currency. Later in the chapter, we cover an example on determining the benefits of netting.

Netting also can be characterised by line item:

• At an individual line item level, where line-by-line payments are considered
• At an invoice level, where payments are netted at an invoice level

In addition, netting can be characterised by payables or receivables. The premise of the netting process is to consider either:

• All payments to be made by all entities in the netting process, or
• All receivables due to all entities in the netting process.

Since the sum of payables across all entities is equal to the sum of receivables across the same entities, either approach must be used, but not both, since using both will result in duplication: A payable of one entity is the receivable of another, and the sum of payables less receivables is zero—it is a zero-sum game.

Example of a Simple Netting Process

Figure 7.4 depicts a sample scenario of payments across regions. In this scenario, there are a total of 14 payments across regions daily with average volumes or throughputs across currencies as depicted. There are multiple currency conversions, sometimes across opposite currencies. For example, Europe operations would have to purchase Japanese yen (JPY) and sell EUR to remit JPY to Asia. Conversely, Asia would have to buy EUR and sell JPY to remit EUR to Europe. A netting process based from a netting centre (see Figure 7.5) could dramatically reduce the scope of FX conversions by creating efficiency through essential conversions only.

FIGURE 7.4 Payments Across Regions (Pre-Netting)

FIGURE 7.5 Netting Centre Reduces the Payments to One Only

If the FX rate for the day (assuming mid-rates for convenience) was EUR USD at 1.3000 and USD JPY at 80.00, the regions would have had to pay and receive FX (all in USD) as shown in Table 7.1.

TABLE 7.1 Consolidated Netting Position

Consider this example for the receivables for Asia from Europe:

Hence, the receivables from each entity to the other can be plotted as shown in Table 7.1.

For Asia, the receivable amount comes to USD 350mm, and the payable is USD 140mm. The net payable amount to Asia becomes USD 210mm, which is the single payment made from the netting centre. Similarly, the net payment due from Europe is USD 250mm, and the net payment due to the U.S. region is USD 40mm. As can be seen from Figure 7.6, the net sum of receivables and payables is zero.

FIGURE 7.6 Net Sum of Receivables and Payables

Table 7.2 indicates the efficiency or reduction of actual throughput flows as a percentage of the total flows—a good criterion for volume-based cost estimates.

TABLE 7.2 Efficiency of Throughputs of Flows on Account of Netting

Table 7.3 shows the number of transactions required—hence a reduction of effort or resources that can provide an estimate of resource saved because of netting.

TABLE 7.3 Efficiency of Volume of Transactions as Result of Netting

This simple example shows how benefits can be calculated through simplistic means. FX process efficiency and resource saving may be derived from these numbers.

NETTING IMPLEMENTATION

Implementation of netting is a simple yet lengthy process that requires rigour for setup and implementation as well to run on a regular basis. Next we discuss the various alternatives available for implementing a netting solution and cover a basic netting cycle—the process and tasks involved in running netting on a regular basis.

Netting Solution Implementation

The system and operations are two key considerations for deciding how to implement netting. The three solutions generally available are:

The benefits and issues associated with each are elucidated in Table 7.4.

TABLE 7.4 Implementation Alternatives for Netting Solutions

Depending on scales and availability of vendors, the appropriate alternative may be chosen for each organisation.

Netting Cycle

The netting cycle comprises the entire end-to-end process for operationalising netting for the organisation. Figure 7.7 shows a sample netting system with timelines. Timelines may vary from firm to firm depending on the nature of the operations and implementation.

FIGURE 7.7 Sample Netting System with Timelines

The entities are allowed to enter their transactions through direct entry or upload (or verify the transactions if the entire receivables and payables are already on the system). An indicative netting run with sample FX rates is done, and the entities are given a big-picture idea of the monies due to or from them. An opportunity is then provided for the entities to make any changes (large changes—inclusions or omissions—might have to be pre-cleared by the Treasurer for funding purposes). The final netting run and FX deals are then executed. The payment instructions are then made, and settlements are tracked by entities and reported back to the netting centre. If account management is centralised, the netting centre can track this on its own. Reporting is done, and exceptions are reconciled and resolved.

For hybrid or fully outsourced models, the service-level agreement (discussed in detail in Chapter 30) has to be well executed.

Considerations for Implementation

The elements discussed next should be part of a good implementation solution.

Quality (Accuracy and Timeliness) of Inputs

No process is well managed if the inputs into it are not accurate. The same applies for the netting process. Accuracy of inputs from the netting entities is critical, as is timeliness. Regarding accuracy, the entities have a chance to make minor adjustments to achieve 100% accuracy; regarding timeliness—not submitting the estimates or number in time—this area impacts not only their own cash position but also that of the other parties. Hence, it is imperative to keep a tab on the accuracy of these numbers and report large variances or adjustments on a regular basis.

Quality (Accuracy and Timeliness) of Execution

Accuracy and timeliness of the payments execution process is also important, not only to ensure smooth operations from a cash flow perspective but also to maintain the reputation of the company, especially where third parties are involved. Errors and exception history must be tracked, and repetitions must be acted on. This is an area that has a high degree of operational risk and opportunities for losses owing to poor operations and controls. Hence, a high degree of accuracy, monitoring, and control is called for.

Costs

Since costs are a key driver for implementing a netting solution, it is important to assess not only the setup costs but also the implementation costs on an ongoing basis. These costs include costs of operational errors and exception resolution.

Tax

Tax treatment and impact of netting-related flows have to be considered and clear counsel obtained prior to implementation. Certain tax jurisdictions might levy withholding and other taxes on payments, while some payments that need to have taxes charged could be a part of the netting process. Hence, the tax aspects have to be very clearly articulated and documented prior to execution.

Regulations and Exchange Controls

Regulations and exchange controls form a key determinant to the netting process. The different kinds of netting jurisdictions include:

• Gross payments or net payments. Some jurisdictions allow gross-in and gross-out in the foreign currency—that is, they allow all inflows to be clubbed together and outflows to be clubbed together. Fully developed markets without capital controls, such as New York, London, and Singapore, allow net settlement with no specific restrictions.
• Local currency or foreign currency. Some jurisdictions may allow only the local currency payment to be netted, while some may allow only foreign currency payments to be netted.

It is important to get a good regulatory opinion on the applicable type of netting prior to implementation.

Number of Netting Cycles per Month

The number of netting cycles per month depends on the urgency of payments and the volume. Firms use monthly, fortnightly, weekly, and sometimes even daily payment cycles. The system selected and related processes should have the flexibility to include or exclude parties from a cycle and also to have in place an exception process for these changes.

Credit Limits

Credit limits with banks, especially for daylight overdraft and contingency liquidity requirements (for payments not going through owing to exigencies), have to be set up and tested.

Infrastructural Inefficiencies

Disruptions of payments, such as acts of God or sudden public holidays, and contingency situations in the location of the netting centre, the system hosting, or any of the paying entities ought to be factored into contingency plans and thoroughly tested.

Bank Holidays

For different payment entities across regions, bank holidays across locations must be taken into account during the netting cycle. It is also possible to drop a particular location or entity from a specific cycle.

Culture

The organisation’s culture (mentioned earlier in Part One) is an in important determinant in the success of a netting implementation. Senior management buy-in through demonstration of cost savings and increased efficiency and turnarounds is a must prior to implementation, as is the buy-in from all stakeholders. Another aspect for management to decide is to whether to make participation from each entity mandatory or voluntary. I personally believe that uniform processes across the organisation deliver most value, and the same rule and yardstick must be applied across all entities.

Resistance From Existing Banks

A logical resistance from existing banks (remember, the transaction costs and FX costs for the firm are direct revenue for the bank!) can be overcome by distributing other businesses to these banks. A long-term relationship bank can be rewarded by awarding them with the netting mandate. Most global banks nowadays have good and robust netting solutions, and the relationship can be sustained by routing all the flows through them. There remains only one winner among the banks, though, and some banks that do not get the mandate for netting are bound to feel left out of the company’s operations.

Good Telecommunications for File Upload Integrity

File uploads for data inputs, especially for remote locations, is made more efficient through the use of good telecommunications. Poor network quality could result in file integrity issues and either non-upload or erroneous upload of payment data that could have disastrous consequences for the firm. Hence, when the bandwidth or related network speed or quality is suspect, it is better to put in incremental layers of checks and controls to ensure data integrity.

Alignment With Intercompany Payment Terms and Processes

The netting processes should be aligned with the organisation’s intercompany and account policies and practices. It is good practice to have the process vetted by financial control and other applicable functions.

Stage-Wise Implementation With Parallel Test Runs

Stage-wise implementation with parallel test run is a well-recommended practice that can reduce the probability of teething issues once the entire operations go live.

Documentation

Documentation to implement netting can be time-consuming and onerous, covering many aspects. It is important to spend time and effort to complete the one-time documentation exercise in order to reduce chances of complications later on. Agreements, outsourcing and service contracts, process notes, accounting and tax reporting, and clearance and regulatory documentation (one-time and transaction-wise) need to be in place and regularly reviewed.

BENEFITS AND CAVEATS OF A GOOD NETTING SOLUTION

While there are many direct and indirect benefits of a netting solution, these come attached with caveats. There is no certainty of benefit unless some basic factors are addressed and implemented.

Benefits

Some benefits of netting have been mentioned earlier. These are highlighted in detail here.

• Higher profitability driven by lower operational expense
  • Lower transaction cost owing to reduced number of transactions. The vastly reduced transactional effort results directly in fewer resources being utilised for the same. Including the cost of setting up the netting system and process, the overall gains should be achieved in a reasonable time frame.
  • Increased leverage of centralised operations. The scale of payments will fit in easily with centralised shared service centre operations and adds to the scalability and utilisation of centralised resources.
  • Greater control and visibility of operating cash flow. Owing to the discipline that the netting process brings in, including accuracy and timeliness of information and financial information, the visibility of flows improves. The automated and centralised nature of the process also adds a great degree of control on a potentially high-operational risk process.
• Higher profitability driven by lower FX conversion cost
  • Save on bid-offer spreads. When converting across currencies, centralised FX booking for a single currency pair at one location allows for one single conversion per currency and obviates the need to have multiple conversions across sides.
  • Lower volume of FX conversions. The vastly reduced FX transaction volume also lowers cost.
  • Consistency and uniformity of pricing. Centralisation and banking at one location allows for consistency and uniformity of pricing.

Caveats

Netting certainly brings with it some gains, but there are also some caveats to bear in mind.

• In anticipation of netting payments to be made, some entities try to retain more cash than is required. This results in reduced cash visibility and utilisation of cash and also a higher degree of opportunity loss of the cash and volatility of cash. Hence, netting entities must be educated as to the benefits of adequate and optimal cash retention.
• Netting reduces the amount and extent of FX conversion and in most cases does not change the risk profile per se of the group of entities that are part of the netting cycle.

SUMMARY

Netting in many forms has become almost a way of life for companies around the world. In this chapter, we looked at some key aspects and benefits of netting. We also went through the entire netting cycle in detail with an overview of processes and explored different solutions with their related drawbacks and benefits.