Foreign currency netting
/What is Foreign Currency Netting?
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. This can be achieved with a centralized netting function, which means that each subsidiary either receives a single payment from the netting center, or makes a single payment to the netting center.
Advantages of Foreign Currency Netting
There are several advantages to the use of foreign currency netting, which are as follows:
Reduced administration. Foreign exchange exposure is no longer tracked at the subsidiary level. Instead, it is centralized at the level of the corporate parent, which represents a substantial reduction in administrative effort.
Reduced commissions. The total amount of foreign exchange purchased and sold declines, which reduces the amount of foreign exchange commissions paid out, usually by an order of magnitude.
Reduce cash in transit. The total amount of cash in transit (and therefore not available for investment) between subsidiaries declines. This can result in more interest and/or dividend income from investments.
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Additional Netting Concepts
Intra-company 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.
Close-Out Netting
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.
Disadvantages of Foreign Currency Netting
There are some disadvantages associated with foreign currency netting, which are as follows:
Complex implementation. Setting up a netting system requires alignment across multiple subsidiaries, each potentially using different systems, currencies, and accounting practices. This implementation involves substantial time, effort, and expenses, including software, training, and integration with existing systems.
Regulatory barriers. Some countries have strict foreign exchange controls or regulations that limit or prohibit the netting of payments.
Dependence on a centralized system. A centralized netting system may create vulnerabilities if technical issues or disruptions occur, potentially delaying critical payments.
Lack of local control. Subsidiaries may lose visibility into their individual cash flows, leading to potential inefficiencies or misunderstandings about their financial positions.
Does not work for one-way cash flows. Netting is less effective when transactions are predominantly one-sided, such as in cases where one subsidiary primarily acts as a supplier or a customer.
Administrative burden. Ensuring accurate tracking, reconciling discrepancies, and maintaining records for a large volume of transactions across multiple currencies can be time-consuming. It requires dedicated staff and robust systems to manage, monitor, and audit the netting process effectively.
Risk of errors. Errors in data entry, exchange rate calculations, or intercompany invoicing can lead to significant financial and operational disruptions.
Impact on banking relationships. By consolidating payments, the company may reduce transaction volumes with local banks, potentially affecting relationships or negotiated terms. Some banks may impose limits or fees on netting transactions, particularly if they result in lower revenue for the bank.
In summary, while foreign currency netting offers significant cost-saving and efficiency benefits, it requires careful planning and ongoing management to address its disadvantages. Companies must assess their global operations, regulatory environments, and risk appetite before implementing a netting strategy.