Clearing and Settlement Mechanisms – Settlement

The Bank of International Settlement (BIS) defines settlement as an act that discharges obligations in respect of funds or securities transfers between two or more parties. Thus settlement is the funds transfer that is carried out by one party to fulfill his obligations towards the counterparty in a financial operation. The settlement must be performed after bilateral or multilateral clearing to actually move the funds. In payments, there are basically two types of settlements: gross settlement and net settlement.

A gross settlement system is a system in which the settlement of funds transfer occurs individually after each payment transaction is processed in the system. Banks generally use this type of system to exchange urgent transfers or large amounts transfers. If the funds are not available, the transfer cannot be executed. However, when the funds are available, the instructions are executed almost instantaneously.  That is why these systems are called RTGS, which stands for Real-Time Gross Settlement System. “Real-time” means that fund transfer happens right away if funds are available. In addition, when a fund transfer is made between two accounts at the central bank, it becomes final and irrevocable immediately after the transfer is made. The risk of default is therefore eliminated.

An RTGS system is a critical infrastructure for a country’s economy since it connects all the (participating) banks and facilitates the fast transfer of funds among them. RTGS systems are usually operated by the central bank of a country or monetary zone. Remember that the central bank plays the function of “Bank of banks” as overseers of the banking system. The following picture illustrates the connections of banks to an RTGS. After the processing of each transfer, accounts of instructing and receiving banks with the central bank are respectively debited and credited.

Things are a bit different in a net settlement system. First, transactions are exchanged among participants without transfers of funds. Then the multilateral netting happens at specific time(s). The obligations are netted among all the participants and the multilateral net settlement positions are calculated. The net settlement position is the sum of the value of all the transfers a participant has received during a certain period of time less the value of the transfers made by that participant to all other participants. If the sum is positive, the participant is in a multilateral net credit position; if the sum is negative, the participant is in a multilateral net debit position.

Some time is needed to compute the net positions, send the information to the banks and proceed to the transfer of funds. This inevitably adds delays in the actual moving of funds. To reduce the delays and improve the liquidity in the overall system, many settlement cycles are carried out during the day after related multilateral clearings. If a participant wants a transaction to be settled at a specific time, it has to send that transaction before the cut-off time for that settlement cycle. The clearing system communicates the cut-off times of settlement cycles to all participants and the information about the settlement times. So each participant is aware that transactions that reach the CSM after the cut-off time for a specific settlement cycle cannot be taken into account. They may be taken into account in the next settlement cycle depending on the CSM rules.

Please refer to the previous article to see a picture of the multilateral clearing system and get more detail about it.

Several multilateral clearing systems may exist in a country or region, but there is only one RTGS which, as mentioned above is operated by the central bank. Those multilateral clearing systems belong to the so-called ancillary systems. In the USA, the RTGS is Fedwire. CHIPs, Checking, ACH and Cards Systems are multilateral clearing systems for which settlement takes place in Fedwire. The Eurozone countries have one RTGS : TARGET 2. However, in each Eurozone country, many multilateral systems are available. You can read the last part of the first article again where different high and low-value payment systems of a few countries are mentioned.

Banks can participate in clearing or settlement systems as direct or indirect participants. What does it mean? And what are the difference between direct and indirect participation? That will be the topic of the next article.

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