The Dynamics of Netting
Eric Cohen, PwC - Bruno Lopes, PwC - 3 Oct 2013
Netting, a liquidity management tool for managing commercial flows, is
typically used by multinationals that generate large volumes of
intercompany invoices in multiple currencies. Multilateral netting, the
process most commonly-used by large organizations, is examined in
detail by this article.
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From the several netting alternatives large multinational companies (MNCs) have at
their disposal to net their internal trade and financial flows, the most commonly-used
by large corporates is multilateral netting. This is a process whereby companies
establish a central entity that becomes a party to all intercompany transactions, thus
eliminating the need for multiple bilateral transaction flows. The participants in this
process are typically internal (subsidiaries), but in some cases can also be external (for
example, third-party suppliers). Specifically, the multilateral payments between
participating entities are consolidated, offset and then reduced to a single transaction
to and from each participating entity via the centralised netting centre.
Few other processes provide the possibility for a treasury department to quickly
obtain such significant savings for the overall organisation. Multilateral netting is
typically a process that provides scalable benefits to those companies that have large
inter-company flows in multiple currencies. As an illustrative example, in a company
with 100 subsidiaries there is the potential to have 9,900 inter-company flows
between subsidiaries. With a netting centre and 100 participating companies in the
netting process, this is reduced to a maximum of 100 flows.
While netting is not a new concept - some large corporates fully implemented their
netting process years ago - many companies have yet to implement a netting
programme. Although the benefits of this process are clear, the main factors
commonly cited by companies as reasons for not implementing a netting programme
Tax and regulatory constraints; for example for many companies it is complex
to determine which flows can be netted across businesses and to address local
country regulatory requirements and restrictions around netting.
Decentralised corporate culture may result in a lack of willingness by
subsidiaries to participate in the multilateral netting process.
The cost and resources required to implement the process and technology
enablers of an effective netting programme.
The benefits
Notwithstanding the challenges noted above, in our experience the benefits of
implementing a multilateral netting programme can be compelling. In addition, some
of the market changes over the last few years (such as the development of internetbased netting solutions and balance netting), has kept multilateral netting as a high
priority in the treasurer’s agenda. In general, the benefits that companies experience
from implementing a multilateral netting process includes:
Reduced bank costs, due to fewer fund transfers, a lower number of foreign
currency accounts required and savings on foreign exchange (FX) spreads,
volumes and commissions.
Reduced operational risk associated with manual and decentralised intercompany settlement processes.
Increase in transparency to settlements, as netting can assist in increasing
visibility to inter-company payments and providing greater predictability in
cash flows.
Increase in process efficiencies, by minimising fund requests and potentially
the number of manual wire transfers.
In practice, the most significant quantifiable benefit is the reduction in number of FX
trades that have to be executed and the ability to hedge this consolidated currency
exposure. For example, instead of each individual subsidiary having to execute
foreign currency exchange transactions to settle its own payables, with a netting
solution each entity would only have one cash flow (payable or receivable) in its own
currency and the foreign currency execution is then typically centralised within the
netting centre.
From a risk management perspective, a growing number of companies have been
centralising their FX exposure at a regional level or global level through a central
entity that invoices the subsidiaries in their local currency. This allows the company
to hedge the residual net position externally at the netting centre versus hedging each
exposure at the entity level. The establishment of a netting centre enables treasury to
potentially establish a hedge contract that will offset the net inter-company exposures
on the same maturity date as the netting cycle settlement.
In addition, as the multilateral netting process evolves, the benefits that MNCs can
obtain by implementing a multilateral netting process can be enhanced by further
integrating multilateral netting and cash management. Specifically, the integration of
the netting centre with an in-house bank (IHB) enables the company to settle the
netting transactions without the physical movement of funds.
Implementation Considerations
The main consideration for implementing a multilateral netting process depends on
the strategy and vision of the company's overall treasury organisation. In situations
where the implementation of multilateral netting is part of an integrated treasury
roadmap for improvement, there is more flexibility on the implementation options
(i.e. technology and linkage with cash management) than in scenarios in which a
company implements this process apart from other cash management initiatives.
Although the basics of a netting centre implementation can be easily grasped, there
are still many organisations that face practical issues during the implementation. In
most cases, these are related to the non-standardisation of the existing underlying
processes and infrastructure, and to the particular aspects of some of the flows.
Factors such as the number of enterprise resource planning (ERP) systems, chart of
accounts, geographic location of entities and degree of corporate centralisation are
important elements that determine the complexity of the implementation.
A key question to consider in developing a netting programme is whether the
company should outsource the multilateral netting to a bank or a third-party provider
or should run the process in-house. In general, it is important to understand the
following trade-offs when making the selection of the infrastructure to assist with the
multilateral netting process:
Ease of deployment: Outsourcing outsourcing the multilateral netting to a
bank or a specialised netting provider typically provides an easier and more
rapid deployment versus leveraging an in-house ERP or treasury management
system (TMS), due to the need in the latter case to configure these systems.
Functionality provided: Although in general all options provide good baseline
service offerings, third-party ERP modules, or TMS solutions are more
flexible and scalable and tailored to the company’s specific requirements - for
example TMS allows users to meet specific requirements including to add a
netting centre margin for the services provided.
Integration with existing systems (e.g. ERP, TMS): While the ERP modules
may offer less robust netting functionality (such as workflow around invoice
disputes and escalation) than their TMS alternatives, the ERP module is
typically easier to integrate with existing inter-company/payment systems.
Cost of implementation and maintenance: Although cost is the hardest
component to compare - given the different functionality across the alternative
solutions - typically as transactions grow companies prefer to internalise the
process to reduce costs and gain flexibility.
Flexibility: third-party ERP modules or TMS solutions provide more
flexibility to accommodate specific company requirements as compared to
implementing a bank solution (such as alternatives for the company to direct
their FX trading to the bank offering the best quote).
In order to manage the implementation resource requirements and risk, it is common
for companies to adopt a phased approach that focuses on rolling-out multilateral
netting - first by country and regions and later at a global level.
This progressive approach can also be applied to the scope of payments within the
netting process. Typically the netting process starts with the inter-company trade
flows; at a later stage, inter-company financial flows and third-party payables and
receivables may be added. In cases where a company has many subsidiaries across
different territories that have accounts payables towards the same third-party, the
inclusion of third-party payables in the netting process is a key enabler to reduce the
number of cross-border transfers. This can be achieved by netting the flows with the
third-party and then having a local entity process the payment (or, if available, the
IHB may use a local account to process the payment) on behalf of the obligor. The
third-party receivables, due to lower predictability around the timing of settlement,
are less commonly included in the netting process.
As the process becomes more mature, companies may also begin to reduce the netting
period; for example running the netting cycle on a weekly basis, rather than monthly.
Running the netting cycle on a more frequent basis can be important in decreasing the
horizon of some outstanding foreign currency exposures - such as intercompany
accounts payable or accounts receivable (AP/AR) - included in the netting cycle.
Finally, for those companies with the most evolved multilateral netting processes,
leading and lagging are two techniques that are applied to leverage the netting centre
to achieve additional liquidity management benefits. Leading and lagging are
techniques employed in accelerating cross-border payments to fund cash-poor
subsidiaries, and to adjusting the timing of payments and receipts to take advantage of
expected currency movements. In practice, these are sophisticated techniques that
enable the company to leverage the netting centre to both enhance overall liquidity
management and optimise its management of foreign currency risk.
As corporate treasurers continue to focus on ways to better manage liquidity and
foreign currency risk, reduce transaction costs and improve controls through
automation of manual processes, multilateral netting should be a focus point for
treasury and finance to further add value to their organisation.