The process of netting can be used in various areas of cash management. In its most basic term it is usually a way of offsetting cash amounts in a way that results in benefits for the corporate, such as reduced transaction costs. However, the scale of the benefit can differ significantly depending upon the type of netting that the corporate is involved with. Many forms of netting cover areas of the banking relationships that the corporate holds, while perhaps the most beneficial form of netting focuses on inter-company transactions.
Payables and receivables
Netting accounts payable (AP) and receivable (AR) could be considered the most basic form of netting. A corporate has obligations to a bank, where it may have a derivative instrument, loan or deposit, and is expecting an immediate payment back from an investment with that bank. At the same time, the corporate may have a foreign exchange (FX) contract with the same bank through purchasing some foreign currency, and needs to pay the bank for that foreign currency. Here the corporate can potentially net these two sums off. This means that rather than waiting to receive its investment back and then paying the FX cost back to the bank, an agreement with the bank can allow the corporate to merely settle the net amount.
This is usually done by arrangement with the bank, to make sure that it is expecting either a net settlement or payment, based on the size of the flows either way. Typically there will be a master agreement in place between the two parties that establishes the right to net.
While this process is technically quite simple, there are many challenges. If the corporate has a $2 billion loan coming back, for example, and also has a sizeable settlement to pay to the bank (such as a large FX deal), the bank may be somewhat wary to net those two off. It is important to ensure that the settlement is done in a timely fashion so that neither party is exposed to daylight exposure, which is an intraday exposure when an account is in an overdraft position at any time during the business day.
Balance netting with relationship banks is sometimes referred to as pooling. For example, the corporate may have a balance in euros in France, an overdraft in Italy and a credit balance in the UK. By arrangement with the relationship bank, it is possible to pool the balance of all of these accounts and then net them off. The corporate ends up with a netted cash position, or a netted pool of accounts, in a particular geographic area. Through the arrangement, the corporate would pay or accrue interest on these accounts, on a netted basis, based on the balance.
Most companies in Europe engage in some element of balance netting. One popular practice is to pool euro accounts, where permissible. These can be offset to ensure that the corporate does not have to physically sweep cash into certain concentration accounts. Using the earlier scenario of accounts in France, Italy and the UK, rather than actually physically shifting all cash to one central account to be balanced out, banks can offer corporates the right to net out and have a pool structure. This can save a lot of money on payments that shift cash around different geographies.
Corporates often have the right to offset FX settlement amounts. In one simple example, if the corporate has bought Canadian dollars from Bank A and has sold Canadian dollars to Bank B, these can often be netted off. The corporate may have an agreement where it can net off cross-bank settlement flows, leaving the treasurer to pay only the net to the bank they owe. If Bank B is paying the corporate €100m for Canadian dollars and at the same time the corporate owes €120m to Bank A, then Bank A would receive €100m from Bank B, leaving the corporate to pay €20m to Bank A.
This tactic avoids multiple flows of large currency amounts. The corporate can net them all off and allow the banks to settle between themselves based on the obligations they have to those banks.
FX netting is becoming more common, particularly around continuous linked settlement (CLS). The whole point of CLS is to avoid daylight exposure, by netting exposures out.
Multilateral netting is perhaps the most interesting form of netting available to corporates. It is a form of netting that is usually done on an inter-company basis where subsidiaries have inter-company payables and receivables. For example, Subsidiary A may buy some elements of the production from Subsidiary B. Subsidiary B may itself be buying some elements that it needs from Subsidiary C, and so on. These inter-company payables and receivables are typically settled on a monthly basis.
Multilateral netting allows the treasurer to set up a process where all subsidiaries go into a central repository and log all of their payables and/or receivables. Every subsidiary that is expecting to receive something from another subsidiary goes into the netting session and puts in the amount they are expecting to receive, the currency and which subsidiary it is from. The same is true for subsidiaries that go in to the netting session to declare what they are expecting to pay.
If an organisation has many inter-company settlements, a netting solution will allow it to enter all of these into a central location and then net them out. In a simple example, Subsidiary A needs to buy $10m to pay to Subsidiary B. Subsidiary B needs to buy Canadian dollars and use its US dollars to pay Subsidiary C. In a netting centre, the company can net the two off and the US dollar amount can disappear. It may be left with a euro/Canadian dollar exposure, for example. The end result is that the corporate does not have hundreds of payments in foreign currencies happening between subsidiaries. Instead, there is a limited number of transactions that central treasury has to undertake in foreign currency.
Multilateral netting allows the treasurer to set up a process where all subsidiaries go into a central repository and log all of their payables and/or receivables.
In this case, if Subsidiary A were to pay Subsidiary B without a netting solution, it would have to go to the bank to request the $10m, while its base currency may be euros. In effect, they are doing an FX transaction. Unlike central treasury, subsidiaries are rarely experts in FX and will typically get both a poor rate from the bank and a poor spread on that rate. If a corporate buys and sells foreign currency it will pay a buy/sell spread. For example, if Company A is buying sterling from the US, they may find it at around 1.50. If conversely Company A is selling, it may be around 1.52 for a small FX deal. That spread of $0.02 for every transaction carried out can soon mount up across an organisation.
If the corporate has 600 invoices going between subsidiaries and they are all settled by an FX deal that the subsidiary did with the bank, there will be a lot of spread on currency rates and poor rates on the FX deal as the subsidiaries do not have the same banking relationship as central treasury does.
Netting allows the treasurer to go to the subsidiaries and net down this process, resulting in a consolidated netted position. The central treasury then goes to the bank and carries out the translation of that position into the different currencies. The end result means that, in the case of Subsidiary A based in Europe, it will be told what it needs to pay or should receive in euros. Each subsidiary only has one account, which is in their most suitable currency. A Canadian subsidiary may have payables and receivables in euros, Mexican pesos, Norwegian kroner, for example, but this does not matter. It will only receive one single amount in Canadian dollars. Multilateral netting simplifies the entire process down for every subsidiary, in that each will only pay or receive one amount in their base currency. All of the company invoices will be settled on a netted basis by the central treasury group.
One of the main challenges in implementing a multilateral netting programme is that it is an education process for the subsidiaries which group treasury has to lead. People do not like being overburdened with having to present too much information if they do not understand the reason for this. Multilateral netting is one area in treasury where there is a very tangible return on investment (ROI) for implementation. It is simple to calculate the value saved based on the netting down of all of the spreads.
In terms of setting up a netting process, a corporate will typically start by going to its treasury management system (TMS) or enterprise resource planning (ERP) system. If it is a payables netting session, it will export all of the payables that it is expecting for the month. These are then uploaded to a netting solution at a certain date every month. There are typically four dates in a netting session:
– when the payment invoices are input into the netting solution.
– at this point the reconciliation is done. Before this time, each subsidiary will double check that its appropriate payables and receivables correspond with what its partner subsidiaries have claimed. This dispute process happens between the presentment date and the cut-off date.
FX settlement date
– when the central treasury settles the FX on behalf of all of the subsidiaries.
– when the subsidiaries either receive or pay their money.
The first two dates here are the most important in the process. When implementing a multilateral netting process, the treasurer needs to educate the subsidiaries on how to get the inter-company payables and receivables reconciled into the netting centre. By pulling some reports the treasurer can demonstrate exactly what they are expecting to receive from the subsidiary and how the dispute process should function.
Being able to pull out accurate information by a certain date is the main challenge of setting up a multilateral netting process. Without a netting centre, a corporate will typically have standard terms of trade. The company’s payable terms may be six to eight weeks in terms of invoices, but internally the treasurer may decide to go to a four-week settlement, always on a particular date. This gives the treasurer control over the internal settlement process. Rather than being on floating terms, everything goes into the netting session on a monthly basis. A netting centre brings more discipline to this process, and allows the treasury to get a better FX rate, less spread and better risk management around currency exposure.
The benefits of multilateral netting mean it deserves consideration by all corporates. If an organisation does a lot of inter-company business, there is no reason why it should not be doing multilateral netting today. The process itself is all about cash flows. Each subsidiary in the netting centre knows when it is going to get paid for any inter-company invoices it has issued. Subsidiaries may have to pay their invoices earlier, but they know exactly which day they will receive cash on the invoices that they are expecting. This brings stability to the timing of cash flows within the organisation.
The netting off of transaction costs means that instead of having around 800 inter-company transactions between subsidiaries, treasury can reduce this considerably. Now each subsidiary just has one payment or receipt. If it costs $10 to make a payment, and the number of payments can be reduced from 800 down to 60, this is obviously a considerable saving for the organisation.
Another benefit of multilateral netting comes from the concentration of payments and receipts. The central treasury can control this process, meaning it can choose to have one bank to do its FX with. Treasurers can reduce the number of banks that they are exposed to from a settlement perspective. Savings are also available on the FX spread. The greater the number and size of transactions the corporate puts through, the greater the potential for cost savings.
Things are also very much simplified from the subsidiary perspective. They no longer have to decide which currencies they need to buy, instead paying and receiving in a single currency. This offers a potential head count cost reduction for the company, as there is no longer a requirement for staff to understand all payments in different currencies. The added discipline of running a netting centre means that internal payments are all received on time. It also gives the treasurer a good forecast capability over internal receivables, allowing them to know what is coming in and when.
If an organisation does a lot of inter-company business, there is no reason why it should not be doing multilateral netting today. The process itself is all about cash flows. Each subsidiary in the netting centre knows when it is going to get paid for any inter-company invoices it has issued. Subsidiaries may have to pay their invoices earlier, but they know exactly which day they will receive cash.
An ancillary benefit of multilateral netting is found in hedging. When the treasurer is looking for dates to hedge their FX exposures to, if they have a multilateral netting solution they will know that it is typically the 20th of every month that their netting happens, for example. Therefore they know the specific date that they are exposed to. This allows treasury to hedge very efficiently and effectively as it reduces timing gaps in their hedging programme.
There are also benefits in terms of trade. As already mentioned, multilateral netting provides a forecastable and accurate set of cash flows in and out of the business. This means that terms of trade could be considerably shorter, as they are not spread out over a time period. All parties involved in a trade know that an invoice received by a certain date will be settled by the relevant date.
The benefits to the dispute process are similar to this, as the multilateral netting process sets up a system that records disputes within the organisation efficiently and effectively. The netting centre becomes the repository for dispute management. The treasurer can then use that to make sure that AP and AR balance.