Financial derivatives—netting
Financial derivatives—netting

The following Banking & Finance practice note provides comprehensive and up to date legal information covering:

  • Financial derivatives—netting
  • Netting
  • Why do parties net?
  • How netting differs from set-off
  • Types of netting in derivatives
  • Payment netting (also known as settlement netting)
  • Close-out netting (also known as termination netting)
  • Enforceability of close-out netting provisions
  • Enforceability in different jurisdictions
  • Netting opinions
  • More...

Netting

Netting is a contractual arrangement between two parties. Essentially, it means that the parties have agreed that, when they transact with each other, they will not have individual cross-claims against each other. Instead, at any time there will be just one amount owed by the party whose notional cross-claim is worth less than its counterparty's cross-claim.

Netting is extremely important in the context of derivatives. For example, under a swap two parties agree to exchange payment streams. Each party to the swap makes regular payments to the other. The payments made under the swap by one party are calculated on a different basis to the payments made by the other party. For example, under the most common type of interest rate swap (known as a fixed to floating interest rate swap):

  1. one party makes regular payments by reference to a floating rate of interest, eg LIBOR, and

  2. the other party makes regular payments based on a fixed rate of interest

Depending on fluctuations in interest rates, either party could be in-the-money or out-of-the-money at any one time.

In summary, a party is said to be in-the-money if the net present value (NPV) of all future cash flows payable to it under the swap is greater than the NPV of all future cash flows payable to the other party under the swap.

A party is said to be out-of-the-money

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