Counterparty risk: It refers to default by a counterparty which is on the borrowing side of a financial transaction.
Credit Netting gains significance in case of large financial institutions that have positions in several financial transactions. Individual credit checking for all transactions in that case, would be extremely costly, cumbersome and time consuming. Hence, credit netting is the accepted practice in case of transactions of financial institutions.
Credit netting essentially involves bundling together of all transactions instead of checking of individual small transactions.
Netting in case of OTC instruments is done by the Central Counterparty.
Let us illustrate netting through an example
Let there be 2 entities A and B. Let A be involved in a short futures contract with B for INR 1 lac. Also let A be involved in a long futures contract with B for INR 1 lac. Hence, the net exposure of party A would be 0 after netting.