World-wide Derivatives market is huge and fast moving with different players changing their positions or taking new positions frequently. For many cases, some derivative positions offset other positions and there should be an effective way to reduce overall liability or counterparty risk for these derivatives transactions.
Hence Netting is used to offset what one party owes to a defaulted counterparty against what they themselves are owed to the same party.
For Example, Investor A owes Investor B USD 20,000 while Investor B owes Investor A USD 15,000. Instead of the complete transactions at the end or when any of them defaults, payment is netted which means Investor A owes Investor B only USD 5,000.
⦁ Investor A to give Investor B USD 20,000
⦁ Investor B to give Investor A USD 15,000
⦁ Investor A to give Investor B USD 5,000
⦁ Investor B to give Investor A USD 0
Through netting mechanism, the position exposure has been reduced to USD 5,000 only which also reduces overall credit risk. There are two types of Netting