Settlement netting
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Settlement netting
/ˈsɛtᵊlmənt/ /ˈnɛtɪŋ/ (n.)
AKA payment netting: a practical operational step that parties take to minimize daily payment flows between them by agreeing to net down opposing payment flows due in the same currency on the same day under different transactions.
It is popular in master trading arrangements where parties have lots of outstanding transactions with lots of payments flowing between them each day.
In the context of an ISDA Master Agreement it is the ability, vouchsaved in Section 2(c), to off-set cashflows due between parties to the agreement on the same day in the same currency but in respect of different Transactions. Say, in each case due today:
Under Transaction 1, I owe you a final payment of £1,000,000.
Under Transaction 2 you owe me a coupon payment of £1,000,000.
If our operations teams are co-ordinated, we can agree between us to off-set these payments so that no payment actually flows: the payments are deemed to be discharged.
This seems sensible, practical and obvious when stated in the abstract. In practice things are a lot more complicated. Between two counterparties there may be thousands of payments under thousands of transactions in dozens of different asset classes between multiple different offices, desks and operational teams flying back and forth each day. Just the brain damage to work out what should be netted against what, and how we’ll agree the settlement each day, is way higher than the practical risk of just making all the payments gross. So in practical fact, Section 2(a) settlement neeting is a lot more limited than abstract simplified logic would suggest.
A practical right, not a legal one
Settlement netting therefore isn’t really, a legal right so much as an operational convenience. If both parties withold the same payment, it works. If one forgets to withhold the payment, then this does not validate the other party’s action in withholding the payment: it must either return the overpayment or just get on and make the original payment — both are, in law, exactly the same action — there is no risk of losing a legal right because a settlement netting arrangement failed.
It’s like clapping: you can’t do it one-handed.
It is a sort of set-off, but by agreement
Settlement netting is a kind of set-off, only it is one carried out by agreement. Usually, we think of set-off as being a rather hostile action that one carries out as a last resort and in desperation because you don’t trust your counterparty to make a payment it owes you. Settlement netting is not like that. It is a mutual operational convenience between chums.
It is not the same as close-out netting
Settlement netting should not be, but routinely is, confused with the much more drastic close-out netting — even less chummy that plain set-off — whereby a counterparty terminates with extreme prejudice all outstanding transactions between the two parties, reduces each of them to single immediate payables, and calculates a single net close-out amount.
This only happens in highly unhappy circumstances. The chief credit officer’s hair will be on fire, Morgan Stanley will be in flames and the world will be losing its head and blaming it on you.
This is not settlement netting.
See also
- Section 2(a) of the ISDA Master Agreement
- Close-out netting
- Set-off