Netting
Netting can apply to one of three areas:
- Netting of cash payments and/or securities delivery to minimise settlement risk
When two large institutions trade actively with one another in a benchmark security, on any particular date there may be many deliveries versus payment (DVP) in both directions. Rather than settle each transaction individually, operational risk is reduced dramatically by calculating and settling the net cash/securities movement. - Netting counterparty credit exposure
The credit exposure is the difference between the value of the collateral and the cash for a repo. The international netting agreement for repos is the PSA/ICMA GMRA. A valid netting agreement allows netting of counterparty positive and negative replacement values, reducing both the counterparty credit exposures and the capital adequacy requirement. - Balance sheet netting
This is the netting of assets and liabilities generated by repos and reverse repos to reduce the size of the balance sheet. Under the International Accounting Standard (IAS), netting of repos is permitted where trades with the same counterparty have the same maturity, settle simultaneously (imply same currency) and are covered by a valid netting agreement.
Netting is a powerful concept and institutions look to maximise netting opportunities wherever possible. However, different jurisdictions have different rules on the subject, particularly when it comes to balance sheet netting. For instance, many jurisdictions look simply at the cash component of a repo trade and ignore the collateral side. This can lead to some institutions potentially netting repo positions in corporate paper rather than government paper. Institutions which are already highly leveraged may thus have an even greater exposure to the market than this degree of leverage implies. In addition, these institutions have already shifted many of their risk assets off the balance sheet via TRS and OTC options, further disguising the true extent of their risk profile.
True netting is only possible if trades have same counterparty, same maturity, same currency, same specific security and clear intention to settle simultaneously. Now the attractiveness of a regular bond auction calendar becomes clear. If special term trades in a particular issue all mature on the same date (eg, the settlement date of the next auction in the US Treasury market or the expiry date of a bond futures contract in Europe), then the opportunities for genuine and legitimate netting increase considerably and allow risk managers to focus resources elsewhere.
