I’m more concerned about the return of my money than with the return on my money.
Will Rogers (1879–1935)
Derivatives markets are fast-moving, with participants regularly changing their positions and where a large number of transactions may partially offset (hedge) one another. If a derivatives counterparty defaults, then it is possible that a given institution may have hundreds or even thousands of separate derivatives transactions with that counterparty. For OTC transactions that are not exchange-traded or centrally cleared, this is potentially a major issue.
The need for netting is illustrated in Figure 5.1. Suppose parties A and B trade bilaterally and have two transactions with one another, each with its own set of cashflows. Without netting, this situation is potentially over-complex for two reasons: