Cash & Liquidity ManagementCash ManagementNetting/PoolingThe Dynamics of Netting

The Dynamics of Netting

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 include:

  • 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

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 internet-based 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
    inter-company 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

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

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
  • 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

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.

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.

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