Paul Van den Bergh1
This chapter describes the operational and financial structure of a modern payment system. It provides a general structure of the payment system that builds onto the payment system hierarchy explained in Chapter 2, focuses on the interbank payment system, which lies at the heart of the payment process, and uses a simple numerical example to explain the key concepts of gross and net settlement.
General Structure of the Payment System
The payment system consists of the set of arrangements for discharging obligations assumed by economic actors whenever they acquire real or financial resources. In nonbarter economies, such obligations are discharged by transferring the title of ownership of a set of assets that, by virtue of their wide acceptability, are known as “money.” Historically, money assets have taken the form of commodities (for example, gold or silver) or various types of IOU (I owe you) issued by government entities, financial firms, or private persons, which, in principle, could be redeemed in commodity money. In practice in modern financial systems, the set of money assets is more narrow, consisting of claims on the government (coin), the central bank (bank notes or bank reserves), or other depository institutions (bank deposits). These types of assets represent pure “fiat money,” which means that they are not convertible into gold or other commodities. Fiat money is acceptable as a medium of exchange when the public has confidence in this form of money.
Included in the payment system are the mechanisms by which “fiat money” is transferred among economic actors when they settle their own payment obligations or when they act as intermediaries for third parties by providing payment services. These mechanisms include the institutions providing payment services, the various instruments used to convey payment instructions, the means of transferring those instructions (including communications channels), and the contractual relationships between the parties concerned.
Chart 1 illustrates the relationships and linkages between the major participants in the payment system. It is based on the payment system hierarchy and account relationships described in Chapter 2. The major payment system participants include nonbanks, commercial banks, clearinghouses, and the central bank. Funds transferred include (1) liabilities of the central bank held by the nonbank public (bank notes); (2) commercial bank deposits held with the central bank (commercial banks’ reserve balances); (3) liabilities of banks vis-à-vis the nonbank public (bank deposits); and (4) liabilities of banks to other banks (correspondent bank deposits). Linkages to counterparties overseas and overseas banks are also shown to illustrate international commercial banking connections.
Payment System Participants, Message Flows, and Funds Transferred
Payment System Participants, Message Flows, and Funds Transferred
Payment System Participants, Message Flows, and Funds Transferred
The most traditional and direct means of transferring funds between nonbanks is through the use of cash (bank notes). When cash is used to discharge an obligation, for instance, to buy a newspaper at a kiosk, payment is made directly and immediately for each individual transaction: in other words, settlement is gross and takes place in “real time.” In contrast, the transfer of ownership of deposit money in banks must take place by book-entry on the accounts of the issuing institutions, that is, the central bank or commercial banks. In this case, an economic actor instructs a bank to transfer funds from its account (“the payor”) to the account of another economic actor (“the payee”). A lag usually occurs between the time the payment instruction is issued and the time the actual book-entry transfer of deposits takes place, signifying settlement of the payment. When the payor and payee hold accounts with different banks, the execution of a payment order requires the payor’s bank to transfer funds to the payee’s bank, giving rise to an interbank transfer. Thus, payments involving deposit money give rise to a chain of instructions and book-entries. A single payment can consist of a number of related transfers of funds.
Interbank funds transfers are transfers of funds in which the banks are in the role of payor and payee. Such transfers originate either when banks send payments to one another in response to payments between their customers or when they discharge obligations they have incurred with one another, for example, in money market transactions. Three main methods are used for these transfers. The first method consists of the crediting and debiting of interbank payments to nostro and vostro accounts held bilaterally between banks. In this case, the banks will agree to adjust any large imbalances that may accumulate on their accounts through periodic transfers to or from another institution (cover payments), or an interbank loan. The second method involves crediting and debiting accounts held with a third party correspondent bank. The third method involves debiting and crediting accounts that the banks hold at the central bank, which is a specialized banker’s bank.
Every single underlying transaction, involving either the customer of a bank or transactions made by banks for their own account, can be carried out by making a corresponding interbank funds transfer. In this case, interbank settlement is on a gross basis. Alternatively, individual payment obligations can be made subject to mutual offset in a netting arrangement, with settlement of net obligations occurring at the end of a designated settlement period. In the case of netting, individual payment instructions are processed and book-entry records are updated to reflect the underlying payment transactions. The interbank exchange of funds to settle all the underlying transactions, however, is on a net basis.
Funds transfers may take the form of credit or debit transfers. In a credit transfer (also called a giro instruction in some cases), the payor instructs the bank to transfer his funds to the payee. In contrast, in a debit transfer (for example, using a check), the payment is initiated by the payee, who instructs the bank to transfer the payor’s funds, usually after prior authorization by the payor.2 With regard to the technology used to make payment instructions, funds transfers can be classified in terms of the form taken by the instructions and the advices of delivery (paper or paperless) and, in electronic payments, by the transmission channels used (telephone, telex, or computer-to-computer telecommunications).
Financial systems in modern market economies offer economic actors a variety of ways to make payments. Economic actors can select the instrument that best suits their needs with respect to speed of execution, transaction cost, and the local customs or legal arrangements governing payment obligations. Small-value retail transactions, for instance, can be settled using cash, checks, credit cards, debit cards, or credit transfers, each of which may involve manual operations, telephone, mail, or magnetic media.3 Businesses will most likely present bulk giro instructions or direct debit orders to their banks on magnetic media such as tapes and diskettes, or by the electronic transfer of computer files. For large-value payments in which timing is critical, such as those associated with trading in financial instruments, more sophisticated electronic funds transfer systems will normally be used, although in some countries traditional manual instruments such as checks drawn on commercial banks or on the central bank are still used.
As with domestic payment arrangements, cross-border payments involve a variety of payment intermediaries, instruments, legal forms, and communications channels. An added complexity is that more than one geographical area or political jurisdiction is involved in international payments and, as well, such payments may include multiple currencies. Nonresident banks participate in domestic interbank funds transfer systems either indirectly through correspondent banks or directly through their subsidiaries chartered in the host country in which the payment is to be made, or through their branch offices located in the host country. These subsidiaries or branches may themselves hold accounts with the host country central bank.
In terms of Chart 1, cross-border payment system arrangements entail linkages at the level of nonbanks and banks in different countries, but not at the level of the clearinghouse or the central bank. Accordingly, payments in any particular currency tend to be executed through banks chartered and located in the country of issue or through the subsidiaries or branches of foreign banks located in the country of issue. Economic actors may, in principle, be able to use foreign currency accounts with a bank abroad to make their payments in that country. It is more likely that they will rely on the international payment services offered by their home country banks, which will, in turn, make use of their own branches, subsidiaries, or correspondent banking relationships, to execute cross-border transactions.
The structure of the payment system shown in Chart 1 can be described as an inverted pyramid. This structure is fundamental to the banking and financial systems in modern market economies. It reflects a high degree of specialization and sophistication and highlights the special role of banks in providing payment services. Banks are equipped to play the role of payment intermediaries because they hold the settlement accounts of those engaged in economic activity.
There are good reasons why nonbank economic agents find it useful to accept claims on commercial banks as a settlement medium. These claims are liquid in that they can be transferred almost immediately at par. Moreover, their credit quality is generally easier to monitor compared with that of claims on nonbank institutions. Also, given the crucial role of banks in the financial system, a sophisticated public safety net has been developed to protect the economy from the potential adverse effects of the failure of a particular bank or group of banks. As described in Chapter 11, this safety net includes deposit insurance schemes, banking supervision, and central bank liquidity support facilities.
Banks also play a key role as payment intermediaries because they can provide credit services in addition to pure payment services. By offering such credit services to their clients (and to one another), payment obligations can be discharged even though the payor may not have the funds immediately available when the payment is due. In essence, banks provide the liquidity to allow the payment process to run smoothly. The importance of the link between money transfer services and liquidity facilities is clearly seen in the capital markets, where many nonbank participants rely heavily on bank credit facilities during the day and overnight to effect the time-critical payments related to the settlement of securities transactions.
The inverted pyramid structure also emphasizes the central bank’s crucial role in the payment system and more generally in the banking system. Since central bank reserves are intrinsically default free, banks normally prefer to settle their interbank payment obligations through the transfer of such claims. Even if these reserves do not bear interest, banks will always want to hold a minimum amount of reserves with the central bank to meet their interbank settlement needs. Given the general acceptability of deposits held with the central bank for interbank funds transfers and because the central bank is a monopoly provider of this type of money, the central bank is able to set the conditions under which it will make these reserves available to the banking system, thereby providing it with a key tool to conduct monetary policy. It also allows the central bank to play a stabilizing role in the interbank money market, such as when the commercial banking system’s demand for bank reserves suddenly rises in periods of financial stress (the so-called lender of last resort function of central banks).
Interbank Funds Transfer Arrangements
As mentioned above, the execution of nonbanks’ payment orders will often entail a chain of payment messages and book-entries by various intermediaries, especially when the counterparties do not hold accounts at the same bank. The characteristics of these chains of messages and funds transfers depend on a variety of factors, including the degree of concentration in the banking system. High concentration reduces the likelihood that customer transfers will involve shifts of deposits between different banks. Banking concentration is determined by the number of banks in a country, the dominance of large institutions as measured by market share, and the geographical areas within which different banks operate.
Another factor affecting the chain of payment instructions may be the existence of different types of banking institutions, such as commercial, savings, or cooperative banks, which provide payment services to their customers and may set up interbank funds transfer systems within their own groups. Intragroup settlement may then occur through correspondent account relationships, often through a central group institution acting as a bankers’ bank for its members.4
Some geographic segmentation in interbank funds transfer arrangements may exist, typically in the form of local or regional clearinghouses. This stems from the potential cost advantages of processing transactions in the area in which they occur. Thus, banks operating on a nationwide basis may clear and settle a large portion of their payments directly through local facilities. Geographic segmentation and local or regional clearing are common where the technology used involves the physical exchange of payment instructions, either on paper or magnetic media.
As suggested above, an important factor influencing the operation of the interbank funds transfer system is the use of information technology. Electronic processing and telecommunications, for example, have enabled the introduction of continuous or real-time gross settlement systems that transfer funds among centralized accounts at the central bank. In many modern financial systems, automation has led to greater specialization in payment systems, such as large- and small-value payments. Today, paper and automated clearinghouses (ACH) generally process the bulk of small-value payments related to commercial and retail transactions. In addition, in almost every country there is now at least one large-value electronic interbank transfer system, providing same-day settlement and finality for interbank and wholesale payments. The role of technology in the payment system is described more fully in Chapter 12.
With respect to the operational characteristics of interbank funds transfer systems, a distinction can also be made between batch and real-time systems. A batch system involves the transmission or processing of a group of funds transfer instructions at a single point in time. Manual clearinghouses operate in batch mode. Automated clearinghouses typically receive and send bulk payment instructions via magnetic media or telecommunications and will process the payments on computers at a particular time during the day.
In a real-time system, the transmission and processing of payment instructions takes place payment-by-payment at the time each payment is initiated. Information pertaining to incoming and outgoing instructions is thus available continuously. Modern telecommunication and computing facilities are required for real-time processing, which although typically used in gross settlement systems, may also be used in net settlement systems.
In cross-border payments, the chain of messages and book-entries involves a complex, multinational network of banks active in their respective domestic payment systems that provide specialized clearing services. Banks involved in executing cross-border payments are linked by a series of communication networks that carry funds transfer instructions through the respective domestic payment systems. The networks may be operated by the post, telegraph, and telecommunications authorities or by banks themselves (proprietary networks), central banks, or other suppliers of telecommunications services. Among the private message carriers, the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which is a specialized cooperative company owned by banks, is the system most widely used to convey cross-border payment instructions.
Gross and Net Settlement
As noted above, the interbank funds transfers relating to payment instructions can be settled individually on a gross basis. To reduce the need to hold large balances in the settlement medium for settlement purposes, especially deposits at the central bank, and to help manage interbank risks associated with settlement, banks rely on netting arrangements.
In netting, banks send information related to individual payments to a single location, the so-called clearinghouse. The banks participating in the clearinghouse agree not to settle for each individual payment immediately through interbank funds transfers, but to let their claims and obligations accumulate over a certain period (called the clearing cycle) and to offset incoming and outgoing payments. Banks then transfer only the value of their net obligation to the clearinghouse at a designated settlement time at the end of the clearing cycle. Settlement typically takes place at the end of the day on the books of a settlement bank, normally the central bank. But it can also take place one or even more business days after the calculation of the net positions. Further, it is possible to settle net obligations through nostro accounts held with a commercial bank.
Charts 2–4 illustrate the different financial effects of gross, bilateral net, and multilateral net settlement, respectively. The examples are simple but the effects of netting that are demonstrated are quite realistic. Chart 2 shows that with gross settlement payment messages are exchanged between each pair of banks, resulting in a relatively large number of communications channels (six in the case of the four banks shown). Banks settle each and every payment individually through funds transfers. In the nine interbank payments exchanged, nine interbank funds transfers are actually made with a total value of 450 units of account. If settlement takes place on reciprocal correspondent accounts, each bank needs to hold an account with each other bank.
Example of Interbank Funds Transfer System with Gross Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 9Value of actual funds transfers made by banks: 450Example of Interbank Funds Transfer System with Gross Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 9Value of actual funds transfers made by banks: 450Example of Interbank Funds Transfer System with Gross Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 9Value of actual funds transfers made by banks: 450
Example of Interbank Funds Transfer System with Multilateral Net Settlement
Number of potential interbank communication channels: 4Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 3Value of actual funds transfers made by banks: 130Example of Interbank Funds Transfer System with Multilateral Net Settlement
Number of potential interbank communication channels: 4Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 3Value of actual funds transfers made by banks: 130Example of Interbank Funds Transfer System with Multilateral Net Settlement
Number of potential interbank communication channels: 4Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 3Value of actual funds transfers made by banks: 130The example of bilateral net settlement in Chart 3 shows that little has changed in terms of the total number of communications channels potentially needed. Since in this case the banks offset their bilateral obligations resulting from the various instructions sent to and received from one another, the total value of actual settlements made is significantly reduced, to 250 units of account. The banking system’s need for settlement balances is thus reduced by almost half.
Example of Interbank Funds Transfer System with Bilateral Net Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 6Value of actual funds transfers made by banks: 250Example of Interbank Funds Transfer System with Bilateral Net Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 6Value of actual funds transfers made by banks: 250Example of Interbank Funds Transfer System with Bilateral Net Settlement
Number of potential interbank communication channels: 6Number of interbank payment messages exchanged: 9Number of actual interbank funds transfers: 6Value of actual funds transfers made by banks: 250A further reduction in the value of actual settlements is achieved through multilateral netting, as shown in Chart 4. In this case, the number of communications channels is significantly reduced (to four), since each bank needs only to open a communications line with the central clearinghouse. Banks in a multilateral net debit position cover their obligations by transferring settlement funds to an account held with the settlement bank, say, the central bank. The clearinghouse may act as agent for the participants in the netting by monitoring the settlement account and ordering transfers to the banks in a multilateral net credit position, once all net debit obligations are paid. In the example, the total value of funds transferred by the banks is 130, which again represents a saving of close to 50 percent in the settlement medium required compared with bilateral netting. Experience with multilateral netting has shown that the total value of the settlement may be reduced by as much as 90 percent from the case of gross settlement.
Table 1 shows the bookkeeping record of the clearinghouse for the example explained in Charts 2–4. As can be seen, the total sum of the payment obligations of all the banks is equal to the total sum of claims on all the banks (450 units of account). In other words, the sum of all multilateral net debit positions in a netting arrangement is always equal to the sum of all the multilateral net credit positions. This bookkeeping record is used in Chapter 7 to illustrate the problems encountered when one of the participants in a net debit position fails to meet its obligation to pay funds at settlement.
Bookkeeping Record of Multilateral Net Settlement System for Credit Transfers
Bookkeeping Record of Multilateral Net Settlement System for Credit Transfers
| I. Gross Payments Among Banks Before Netting | |||||
|---|---|---|---|---|---|
| Bank sending payment | Bank receiving payment | Sum of obligations | |||
| A | B | C | D | ||
| A | — | 90 | 40 | 80 | 210 |
| B | 70 | — | 0 | 0 | 70 |
| C | 0 | 50 | — | 20 | 70 |
| D | 10 | 30 | 60 | — | 100 |
| Sum of claims | 80 | 170 | 100 | 100 | 450 |
| II. Net Claim (+) or Obligation (–) of Each Bank with Clearinghouse | |||||
| Bank | A | B | C | D | Net net |
| Total | –130 | 100 | 30 | 0 | 0 |
Bookkeeping Record of Multilateral Net Settlement System for Credit Transfers
| I. Gross Payments Among Banks Before Netting | |||||
|---|---|---|---|---|---|
| Bank sending payment | Bank receiving payment | Sum of obligations | |||
| A | B | C | D | ||
| A | — | 90 | 40 | 80 | 210 |
| B | 70 | — | 0 | 0 | 70 |
| C | 0 | 50 | — | 20 | 70 |
| D | 10 | 30 | 60 | — | 100 |
| Sum of claims | 80 | 170 | 100 | 100 | 450 |
| II. Net Claim (+) or Obligation (–) of Each Bank with Clearinghouse | |||||
| Bank | A | B | C | D | Net net |
| Total | –130 | 100 | 30 | 0 | 0 |
Conclusions
A modern payment system is a complex apparatus whose functioning depends on the interaction of operational and financial design features. The operational and financial structure of the payment system is very much a matter of choice, with different designs available to meet the needs of different types of transactions arising in the economy. Regardless of the general design, banks are always at the core of the settlement process because interbank transfers of funds—especially transfers of deposits held with the central bank—provide settlement for underlying payments. Two basic designs are available: gross and net settlement. Netting is an important tool used by banks to increase the efficiency of their settlement operations and to control interbank settlement risk, although the effects of netting on settlement risk need to be defined and controlled fully.
This chapter is based on earlier joint work with C.E.V. Borio of the Bank for International Settlements.
Other terms used to characterize the difference between the two types of payment instructions are “credit push” and “debit pull.”
The services of such central institutions may not only include clearing and settlement services but also the provision of credit facilities, investment services, and the like.
