Netting

One word covering two related practices. In an account, netting means offsetting contracts in the same instrument against each other so that what remains is a single net position. Between two firms, netting means combining what each owes the other into one amount payable one way, instead of settling every obligation separately in both directions.

The account sense is a bookkeeping rule chosen per account. Where it applies, an order in the opposite direction to an existing contract reduces that contract rather than opening a second one beside it, and a larger opposite order closes it and opens the remainder the other way round. The alternative convention, in which both sides sit open together, is called hedging accounting. Neither changes the arithmetic of profit and loss; they change how many rows the arithmetic is spread across, and therefore which opening price each closing fill is matched against.

The market sense is a legal arrangement rather than a display. Payment netting combines payments due on the same day in the same currency into one transfer. Close out netting, which sits in the master agreements that govern dealing between institutions, terminates every transaction between two parties on a default, values each one and combines the results into a single sum owed one way. Its whole purpose is what happens in an insolvency: without it an administrator can demand what is owed and leave the counterparty queuing for what it is owed, so the enforceability of netting in a given jurisdiction is a question firms take formal legal opinions on.

The tripwire is expecting netting to remove risk. It removes obligations that cancel and leaves whatever does not, so the residual carries exactly the market risk it always did. The two senses are also independent of each other: an account set to net its positions is describing how a platform keeps its books, and says nothing about any netting agreement between the firm and the institutions it deals with.