Slipping through the net
Netting makes bankers' eyes glaze over. But close-out netting can make them money. By Christopher Stoakes.
If bank A and bank B enter into a criss-cross of foreign exchange or derivatives transactions, it makes sense for them to agree to tot up what each owes the other and for the balance - the net amount, rather than the gross - to be paid over by one to the other. This is payment netting. It reduces the delivery exposure to each party by substituting net for gross amounts. It cuts transaction costs by reducing payment flows and cross-currency conversions.
But the reason why bankers are keen on netting is because a variation, called close-out netting, has recently been recognized as effective for capital adequacy requirements and US accounting rules. This means that bankers can report their risk net rather than gross, thereby reducing the capital attributable to each transaction. The bank's cost of capital is reduced and it can take on more business.
The only decision then is what form of master agreement to enter into with counterparties. One is the International Foreign Exchange Master Agreement (Ifema) which is sponsored by the British Bankers' Association (BBA). The other is the Isda (International Swaps and Derivatives Association) model. Ifema is generally regarded as the simpler and therefore better document, but it covers only foreign exchange (FX) transactions.