There are circumstances where a company has subsidiaries in multiple countries that actively trade with each other. If so, they should have accounts receivable and payable with each other, which could give rise to a flurry of foreign exchange transactions in multiple currencies that could trigger any number of hedging activities. It may be possible to reduce the amount of hedging activity through payment netting, where the corporate parent offsets all accounts receivable and payable against each other to determine the net amount of foreign exchange transactions that actually require hedges.
A centralized netting function may be used, which means that each subsidiary either receives a single payment from the netting center, or makes a single payment to the netting center. Netting results in the following benefits:
- Foreign exchange exposure is no longer tracked at the subsidiary level
- The total amount of foreign exchange purchased and sold declines, which reduces the amount of foreign exchange commissions paid out
- The total amount of cash in transit (and therefore not available for investment) between subsidiaries declines
Intracompany netting will still result in some payments between subsidiaries located in different countries. Since each subsidiary may be operating its own cash concentration system, this means that cash must be physically shifted from one cash pool to another, which is inefficient. Where possible, the treasury staff should consider creating cash pools that span international boundaries, so there is no need for cross-border transfers between cash pools. The result is essentially free cash transfers within the company.
The same concept can be applied to payables and receivables with outside entities, though a considerable amount of information sharing is needed to make the concept work. In some industries where there is a high level of trade between companies, industry-wide netting programs have been established that routinely offset a large proportion of the payables and receivables within the industry. The net result is that all offsetting obligations are reduced to a single payment per currency per value date between counterparties.
A related concept is close-out netting, where counterparties having forward contracts with each other can agree to net the obligations, rather than engaging in a large number of individual contract settlements. Before engaging in close-out netting, discuss the concept with corporate counsel. A case has been made in some jurisdictions that close-out netting runs counter to the interests of other creditors in the event of a bankruptcy by one of the counterparties.
The only downside of netting is that the accounting departments of the participating companies must sort out how their various transactions are settled. This requires a procedure for splitting a group of netted transactions into individual payments and receipts in the cash receipts and accounts payable modules of their accounting systems. This can require a considerable amount of manual labor.