When it comes to liquidity management, netting is a process that all corporate treasurers will encounter. Given that the rewards can be plenty – reduced foreign exchange exposure and improved intercompany settlement efficiency, for instance – it is pertinent to reacquaint ourselves with the process, as well as exploring the nuances surrounding the process in Asia Pacific.

Intragroup invoicing is widely used by multinational corporates (MNCs), especially where a high degree of trading between subsidiaries exists. When a corporate has a number of different subsidiaries in various countries, there is the potential for a large number of cross-border intercompany payments to be generated each month. If each participant was to produce direct bills, this could lead to excessive foreign exchange (FX) trading where individual subsidiaries may be buying and selling the same currencies repeatedly. This can result in high costs in terms of banking fees, float, FX spreads and administration. Netting is one tactic used to control and lower these costs.

The driving force

As the name suggests, netting allows payments between business units to be made on a net, rather than a gross, basis. Netting entails collating numerous cash flows between a defined set of entities (known as netting participants) and offsetting them against each other. The result: only a single cash flow to or from each participant or the netting centre needs to take place on a periodic basis in order to settle the net of all cash flows. Most netting schemes are only open to companies with the same parent but, in some cases, it may be possible to also allow a corporate to net its third party payments from a non-group company. Common forms of netting include:

Bilateral netting.

With bilateral netting, each subsidiary nets its payments with each of the other subsidiaries over an agreed timeframe. At the end of this agreement, the subsidiary participant in deficit within each pair makes a single payment to its counterparty. This single payment agreement removes the risks of a large number of daily payments being made and received between the various subsidiaries. No netting centre is involved and payments still need to be made via the external banking system where fees will be charged.

Chart 1: Bilateral netting

BU: business unit
Source: Treasury Today Best Practice Handbook European Cash Management 2014

Multilateral netting.

Multilateral netting is a many-to-many scenario where multiple parties may net off their transactions. A single netting centre acts as the counterparty to all of the subsidiaries in the group. In a multilateral netting arrangement, the business units retain their local accounts but each participant needs to hold an account with the netting centre and, if they are a net receiver, the netting centre will credit their local account. If they are to make a payment, they will send the funds to the netting centre. No payments are made within the system except to or from the netting centre.

Chart 2: Multilateral netting

BU: business unit
Source: Treasury Today Best Practice Handbook European Cash Management 2014

Single currency (domestic) netting.

Netting is at its simplest when it takes place in a single currency. Single currency netting is open to all business units for their payments in a single currency. This will create a benefit of reducing the volume of payments in the organisation.

Multi-currency netting.

Multi-currency netting offers additional benefits for organisations that make many foreign currency payments. With this process, all the business units in the netting system send their payment instructions to the netting centre, regardless of the currency they originate in. The netting centre will translate any foreign currency payments into the netting currency. At the end of the netting cycle, the netting centre will make payments to or receive payments from the participants. These payments will be made through the external banking system and will usually be denominated in the operating currencies of the participants.

The netting cycle

The precise operation of a netting cycle varies depending on the entities involved (whether payments to non-group members are included, for example) and the type of software used to manage it. However, the basics of all multilateral cycles are similar and include the following steps:

1. Data to netting centre.

   Participants in the netting system must forward the details of all invoices and payment requests to the netting centre. This is usually completed electronically and by direct entry into a netting system (increasingly so). A cut-off date for submissions will be in place for each cycle.

2. Reconciliation of data.

   All invoices and payments requests are processed by the netting centre’s software and when the netting process is run (normally once a month), someone will investigate discrepancies between what people are offering to pay and what the counterparty is expecting to pay. In some systems, subsidiaries may be able to query data input by other entities within the group to fix the problem without further input from other teams.

3. Information from netting centre.

   The netting centre can provide a variety of information to the subsidiaries. This will include the netted balance of each subsidiary’s account at the netting centre, usually available in the subsidiary’s operating currency. Some software allows the subsidiaries to access their balances via a web browser. The netting centre will also provide data that can be input into the subsidiaries’ general ledgers.

4. End of netting cycle.

   All transactions (credits and debits) will be netted to a single amount for each subsidiary in its chosen operating currency, initiating payments either to its own bank or to the in-house bank, as appropriate. Subsidiaries with negative balances at the netting centre will have to make the payment to the centre. FX rates for all disbursements are typically set by the netting centre (and therefore do not include the spreads likely to be included by banks).

There are numerous types of payments that are typically included in the netting process, such as: trade, intercompany funding, debt servicing, investments, hedging or risk management contracts (internal or external), advisory or professional payments, management fees, royalty or licence payments, third-party payments, dividends and surplus or contingency cash requirements. On the other hand, payroll, tax and statutory payments are not usually included.

Associated costs

Implementing a new process will naturally incur certain costs which should be evaluated by the treasurer. These include: accounting and legal issues which can differ in complexity dependent on the location of the subsidiaries; implementations costs, if netting is run in-house, the group treasury will have to set aside management time to implement and train employees on the new system; software purchasing and licensing costs either incurred through an additional function of an existing system or the purchase of dedicated netting software and potential outsourcing costs. Any taxation on inter-company payments and central bank reporting requirements must also be considered, but are not solely linked to the netting process. Netting could actually help inter-company taxation.

In some cases, outsourcing the management of the netting system can work out cheaper, whilst also freeing up the treasurer’s time to focus on other issues. Multilateral netting is one of the core products offered by treasury services providers. If the treasurer does decide to outsource the netting system, it is important to remember that approximately 20% of the workload still stays in-house – processes such as confirming and sending payments. It is often the responsibility of the treasurer to weigh outsourcing up against managing netting systems in-house by implementing a TMS or buying a stand-alone solution that can be integrated into their existing IT set-up.

Depending on the requirements of the treasurer, these two operational options can also overlap. For example, while the corporate manages certain aspects of the netting process, a banking partner could manage the FX settlement process. What’s important to remember, however, is that the quality of inputs influences netting systems and their timeliness. It is therefore imperative to keep a keen eye on the accuracy of the numbers and report large variances or adjustments on a regular basis.

Current state of play

While the adoption of netting amongst the corporate community is far from across the board, it is a process that has been slowly developing. Netting is a simple yet effective proposition where the benefits are clear, particularly for MNCs that have a high volume of intercompany invoicing and cross-border, cross-currency transactions. Individual business units will not need to operate overdrafts or maintain idle balances to meet their short-term payment requirements. Moreover, subsidiaries can transact solely in their own operating currencies and FX exposure is no longer tracked at the subsidiary level. The netting cycle means treasurers know the specific date that they are exposed to FX risk, allowing them to hedge efficiently and effectively as it reduces timing gaps in their hedging programme.

Netting is a simple yet effective proposition where the benefits are clear, particularly for MNCs that have a high volume of intercompany invoicing and cross-border, cross-currency transactions.

In addition, each subsidiary in the netting centre knows when it is going to get paid for any intercompany invoices it has issued. This brings visibility and stability to the timing of cash flows within the organisation, as well as improved forecasting. However, there remains a few variables that need to be tackled, particularly the regulatory hurdle in some jurisdictions – Thailand, for instance, allows netting but only with restrictions in place. In Indonesia permission from the central bank is required and the Philippines places notably heavy restrictions on the process. This means that benefits are being missed as some corporates, typically smaller local companies, are still doing things ‘the old way’.

As a general rule, currency restrictions largely determine netting regulations. Countries with exchange controls on their local currency usually have netting restrictions too. In Thailand, Vietnam and Indonesia, for instance, corporates cannot net in local currencies, they have to be converted to US dollars or euros to be remitted. Although these issues are not insurmountable and other countries in the region – Hong Kong, Singapore, Australia, New Zealand and Japan, for instance – allow netting, restrictions will be a factor for not including some countries in the netting system.