In general terms, netting refers to the practice of consolidating two different settlements in order to create a single value.
How does netting work?
For instance, if Company A owes $50,000 to Company B and Company B owes $40,000 to Company A, they can set a netting value of $10,000 (that Company A owes to Company B).
Foreign currency netting, also known as cash pooling is a common form of netting. Multinationals with subsidiaries in other countries might need to conduct frequent foreign exchange transactions between subsidiaries and the parent company.
In some cases, these companies can use a netting centre, which holds accounts in a reserve currency, while the subsidiaries hold accounts in their local currencies.
To put it simply, this structure allows the firm to reduce payments from and between subsidiaries, as each subsidiary will receive payments from the netting centre, and make single payments back to the netting centre.
There are three advantages to reducing the volume of foreign payments:
1. Less money in transit means more money available for investment.
2. Fewer foreign currency payments mean reduced transaction risk.
3. A reduction in the commission paid on foreign exchange transactions.