Also called rolling netting, netting by novation involves the modification of contracts by agreement of the parties. Therefore, previous claims are deleted and replaced with new claims. Clearing is often used in trading, where an investor can balance a position in one security or currency with another position in the same or another. The purpose of compensation is to offset losses in one position with gains in another. For example, if an investor subscribes for 40 shares of a security and 100 shares of the same security, the position consists of net long shares of 60 shares. In financial markets, at least three main forms of compensation can be distinguished.  Both are widely used for financial market risk management, particularly credit risk. This clearing process takes place with a variety of swaps, but there is one type of swap where clearing does not take place. In currency swaps, notional amounts are exchanged in their respective currencies because notional amounts are expressed in different currencies and all payments due are exchanged in full between two parties. There is no net. Similar methods of close-out netting exist for entering into standardised agreements in market transactions with respect to derivatives and lending of securities such as repo, futures or options.  Netting avoids the valuation of future and contingent liabilities by an insolvency practitioner and prevents insolvency practitioners from deviating from enforceable contractual obligations, as permitted by some jurisdictions such as the United States and the United Kingdom. The reduction of systemic risk induced by a forfeiture system is protected by law. Other systemic challenges to clearing, such as the recognition of Basel II regulatory capital and other insolvency-related issues listed in the Lamfalussy Report, have largely been addressed through lobbying by professional associations for legislative reform.  In England and Wales, the effect of British Eagle International Airlines Ltd v. Compagnie Nationale Air France was largely overridden by Part VII of the Companies Act 1989, which allows set-off in situations relating to money market contracts. As regards the BASEL agreements, the first set of directives, BASEL I, lacked guidelines on compensation. BASEL II has introduced guidelines on compensation. In some jurisdictions (including the United Kingdom), certain types of set-off are automatic in the event of a company`s insolvency. This means that for each party that is both creditor and debtor of the insolvent corporation, the mutual debts are set off against each other, and then either the bankrupt`s creditor can claim the balance of the bankruptcy, or the trustee can demand that the balance be paid, depending on which party owes the most. The main argument This has been criticized as an undeclared security interest that violates the pari passu principle.
The alternative, where a creditor must pay all its debts but receives only a limited portion of the remaining funds that other unsecured creditors receive, carries the risk of bankruptcy and thus systemic market risk.   Nevertheless, there are three main reasons for and justifying compensation. First, the law should preserve autonomy and set-off prior to insolvency, as parties always rely on pre-insolvency obligations. This is a key political point. Second, for reasons of fairness and efficiency, insolvency reduces the costs of negotiation and enforcement both outside and inside insolvency.  Third, risk management, particularly systemic risk, is crucial. The clearing house rules state that the relationship with buyers and sellers is replaced by two relationships between the buyer and the clearing house and the seller and clearing. This results in automatic novation, i.e. all elements are internalized in the current accounts. This can be done in different currencies as long as they are converted during the calculation. The deduction of one amount from another. For example, debtors are generally recorded on the balance sheet after offsetting.
Suppose «A» and «B» enter transaction 1 on Monday, with A agreeing to pay B £1,000,000 on Thursday. On Tuesday, A and B complete deal 2, with B agreeing to pay £400,000 to A on Thursday. The novation netting comes into effect on Tuesday to extinguish the parties` obligations under Transactions 1 and 2 and create in their place a new obligation for A to pay £600,000 to B on Thursday. The new Bank Act also supports the enforceability of netting, as it specifies that where netting has been made, (a) net obligations are not taken into account in bankruptcy or liquidation proceedings; and (b) any net unfulfilled obligations are due. Second, «close-out set-off» can be used when a contract still to be performed is terminated. Unlike debt contracts (where set-off is more appropriate), the obligations of the parties under a contract that has not yet been performed are not acquired assets. A netting clause may, upon termination, require that the mutual obligations of the parties be valued and that the profits and losses arising from the valuation be offset so that a single amount is created to be paid by one party to the other. Under the new Banking Act, net liabilities will not be taken into account in bankruptcy or liquidation proceedings, and clearing operations or financial transfers already paid will not be cancelled. Close-out set-off takes place after default, i.e. when one party fails to pay the principal and interest. Transactions between the two parties are cleared to obtain a single amount that one party pays to the other. With close-out netting, existing contracts are terminated and an aggregate final value is calculated and paid as a lump sum.
For transactions settled in cash, this can be applied bilaterally or multilaterally and to related or unrelated transactions. Obligations are not changed under settlement set-off, which relates only to how the obligations are fulfilled.  Unlike close-out netting, settlement netting is only possible for similar obligations with the same settlement date.