What is Bilateral Netting?
Bilateral netting is a legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts.The process of consolidating swap agreements between two parties into a single agreement. This means that a bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.As a result, instead of each swap agreement leading to a stream of individual payments by either party, all of the swaps are netted together so that only one net payment is being made to one party based on the flows of the combined swaps.
Bilateral Netting in Forex
A substantial number of international companies are multilayered; that is, they have manufacturing operations in both the parent country and a number of other countries that are often tied in with an additional structure of selling companies.
Bilateral netting arises when two affiliated companies have complementary or reciprocal sales. A number of industries, particularly in the automotive, electronics, and farm equipment fields, have a structure wherein subsidiary A buys components or materials from subsidiary B and assembles them for resale to subsidiary B and incorporation in a final product.
Specialization by country and product also leads to bilateral sales, when one subsidiary buys from another for resale in its local market. Reciprocal invoicing ensues, and if no action is taken, there will be a two-way flow of funds and a double purchase of foreign exchange. Given the two-day value system and the transfer lags, the amount of time during which funds are unavailable to both companies is not negligible.
A major reason for netting is that it adds additional security in the event of a bankruptcy to either party. By netting, in the event of bankruptcy, all of the swaps are executed instead of only the profitable ones for the company going through the bankruptcy. For example, if there was no bilateral netting, the company going into bankruptcy could collect on all in the money swaps while saying they can’t make payment on the out of the money swaps due to the bankruptcy.