Learn how multinational companies manage intercompanY payment processes involving many currencies.
What is Multilateral Netting? Learn how multinational companies manage intercompany payment processes involving many currencies. November 23, 2020 | Author: Evan Mahoney
Multilateral netting is a treasury management technique used by large companies to manage their intercompany payment processes, usually involving many currencies. Correctly applied, netting can yield significant savings from reduced foreign exchange (FX) trading and improved intercompany or intra-entity settlement efficiency.
A netting system collates batches of cashflows between a defined set of member entities, and offsets them against each other such that just a single cashflow to or from each Participant takes place to settle the net result of all cashflows. Participants can be company branches and subsidiaries. As shown in the images below, all participants have a base currency into which all regular payables and receivables are converted for netting. The netting process takes place on a cycle basis, typically monthly, and is managed by a central entity called the Netting Center.
Although netting systems are occasionally used to net out cashflows in just one currency, it is more usual for a netting system to manage cashflows in several currencies. In a multiple currency netting system, each entity’s cashflows are converted to an equivalent amount in the entity’s base (or functional) currency, so that the entity still has only a single net position to settle in that currency.
BEFORE NETTING Without netting, each entity settles its obligations directly and individually with each counterparty.
AFTER NETTING Using a netting system, each entity pays or receives just a single local currency balance to or from the netting center.
The task of managing the conversions from one currency to another is the function of the netting system: it uses exchange rates supplied by the netting administrator to calculate all conversions, and will generate a list of currency positions - one position per currency - that must be traded in order to purchase and sell the relevant cash positions that will be settled with each entity. Trading takes place at the conclusion of the netting process: using a provisional list of open currency positions, the netting operator will trade each position, either against each other or more often against a selected overall base currency (for example the US Dollar), and then uses the actual traded rates to recalculate the final net position of each Participant.
To settle the net, the netting operator then pays or receives each entity’s net position to or from the entity, and uses the resulting long or short currency balances to offset the FX trades. These cashflows are normally settled using a set of multicurrency accounts, and if all has been correctly calculated, the net currency balances will be zero after everything has settled.
Savings From Netting A netting system is typically used by a multinational company that has many production and sales divisions in a number of countries. Direct billing in many currencies by each entity can lead to excessive foreign exchange trading, in which individual entities may be both buying and selling the same currencies many times over.
The traditional objective of a netting system is to reduce the overall foreign exchange volume traded and thereby cut the amount of foreign exchange spread paid by the company to manage all the currency conversions. Trading netted currency positions centrally should also yield the benefit of better (i.e. lower) FX spreads because a more professional approach to FX trading can be employed. In a typical netting operation, it is common to cut FX volume and spread by up to 70%.
In recent years, businesses have focused more on the benefits in efficiency of the intercompany settlement process that a netting system can offer. Channeling all intercompany invoices through a single hub using data interfaces to and from each entity’s ERP or local accounting system ensures consistency and accuracy in the data, as well as enforcing a standard settlement structure to make sure invoices are settled promptly.
A Simple Process & Comprehensive Solution Netting is essentially a very simple process - just a series of simple conversion calculations that could be managed using a carefully constructed spreadsheet, at least for a small number of entities and currencies. Moreover, the netting results generated by any netting system - whether a spreadsheet, an outsourced service or a commercial netting system - will exactly match, provided the same transaction source and netting rates are used. Indeed, a key step in converting from one system to another is to run the data in parallel for one or two cycles to confirm that the new system operates correctly.
However, most attempts at using a spreadsheet fall apart when anything changes: adding new entities, currencies, importing/exporting data to and from the spreadsheet all will cause the spreadsheet approach to break down, and as any treasury professional will recognize, the spreadsheet is difficult to support if the original creator has moved on. This is where a professional netting application will excel at handling any requirements and interfaces on an ongoing basis.
Extending The Basic Netting Model Probably 50% of all netting operations worldwide use a very simple netting process that can be managed by all netting systems - they input or import their netting transactions, set the provisional netting rates, trade the net positions, update the traded rates, recalculate the net and settle the resulting positions.
But many netting operations are now using the netting system in more ways, often in connection with a central or regional treasury management function. Here are a few examples:
The treasury center may be hedging forecasted cashflows and applying the results of those hedges within the netting either by assigning hedge rates to the individual cashflows being settled through the netting system, or by settling hedges trades – both the external hedge trades and internally-derived hedge trades between the treasury center and individual entities – through the netting.
To avoid the administrative and cost burden of actually moving money to and from entities at the end of the netting cycle to settle their net positions, and to not impact other cash concentration programs treasury is running, many businesses now post those net positions to intercompany loan accounts.
The netting system can be used as a payment factory, channeling entities’ payments to third parties through the netting hub. This can be a very good use of the treasury center’s FX expertise by both offsetting even more of the company’s FX requirements through the netting, and by making those third-party payments at better exchange rates.