Direct and Indirect Participants to Clearing and Settlement Systems

Banks can join a clearing system or a settlement system as direct participant (DP) or as indirect participant (IP). After reading this post, you will understand the differences between these two types of participants and why only direct participants settle in CSM. The following figure depicts direct and indirect participants and the relationship they have to the CSM.

Picture of Direct and Indirect participants to a CSM

Direct and Indirect participants to a CSM

Direct participants have a direct link to the CSM. They exchange payment transactions directly with the CSM. Indirect participants do not have a direct link to the CSM. They have a connection to a direct participant which exchanges transactions with the CSM on their behalf. When the CSM receives a credit transfer from indirect participant through the direct participant, it expects the direct participant to pay the money not the indirect participant. And when the CSM sends a credit transfer to the indirect participant through the direct participant, it expects the direct participant to receive the money not the indirect participant.

Funds transfer between direct participant and indirect participant

The funds transfer between DP and CSM always happens through the Settlement System. The direct participant takes money from the indirect participant and gives it to the CSM and receives the money from the CSM and gives it to the indirect participant. Therefore direct and indirect participants must have an account relationship. The indirect participant opens a so-called correspondent account with the direct participant, so that the DP can receive funds and make payments on behalf of the indirect participant. We will come back later to correspondent accounts. So just keep reading the posts and your patience will be rewarded. 🙂

Even if the CSM exchanges transactions only with DPs, it has the information about all indirect participants represented by a DP. The clearing system uses that information to route to the DP the transactions where the receiving bank is the IP. The payment transactions ultimately reach the indirect participant. The money however will be debited or credited by the CSM on the DP account. It is the DP responsibility to collect the funds from or give them to its IP.

Why become an indirect participant to a CSM?

Now why would a bank choose to be an indirect participant? In summary, there are two main reasons for that: cost and speed. First, becoming direct participant and setting up a connection to a CSM imply to carry out important projects. Without a minimal volume of transactions, there is no return on investment. Indirect participants are most of the time smaller banks which use the services of bigger banks to exchange their transactions. Thus they can save the costs for running and maintaining a direct connection to a CSM. But a big bank with multiple subsidiaries in many SEPA countries can choose to have one direct participant and many indirect participants to lower the cost as well. Subsidiaries of that big bank can be of important size. But they remain indirect participant because the Bank Group has decided to have only one direct participant. The other reason is that it is easier and faster to establish a connection to a direct participant than to a CSM. A big American bank which creates a subsidiary in a SEPA country for example, may choose to start as an indirect participant and only builds its own connection to the CSM later.

Since indirect participants use the services of direct participants to access the clearing system, direct participants have the opportunity to get some revenue from their direct connection. But a direct participant must ensure a good level of quality and service to gain indirect participants as customers. There is theoretically no limit to the number of indirect participants that a direct participant can have. This makes the competition even tougher.

To conclude this paragraph, I want to stress the importance of understanding that indirect participants are banks like the others. They have their own customers and channels. They have their own IT systems. And please do not associate indirect participant with small size or direct participant with big size. A small bank can become a direct participant and a big bank can choose to be an indirect participant. Keep in mind that an indirect participant can connect to a CSM only through a direct participant.

Now let’s come back to the four corner model which consists of End parties, Banks and CSMs. The last articles were about clearing and settlement. Now we will consider the end parties. Who and what are these end parties? What are their needs? Read the next articles

For your information, I have published an ebook about SEPA Credit Transfer where direct and indirect participation and other topics like clearing, settlement, accounting, SEPA Payment messages, payment processing value chain, payment engines, … are handled in depth.

Below are the links on amazon (Check if the book is on the amazon site of your own country).

Kindle edition
Paperback edition

You can download the sample for free. Here is the link to download the sample of the SEPA Credit Transfer eBook.

You can watch the presentation and get the ebook on this page.

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3 Responses to Direct and Indirect Participants to Clearing and Settlement Systems

  1. Venu February 7, 2019 at 7:46 am #

    Jean, I have started reading your articles recently. Big kudos for your explanation.

    Just a small query

    1) how is the Liquidity and credit risks managed for the Indirect participants? Does the Direct participants is accountable to manage the risks which might occur from its Indirect participants or CSM?

    Thanks,

    • Jean Paul February 7, 2019 at 8:29 pm #

      Hi Venu, thank you for your appreciation.
      The direct participant is accountable to manage the risk that might occur from its Indirect participants.
      In practice, an Indirect participant opens an account with a direct participant and puts some money on it. Before sending debit transactions on behalf of the IP, the DP will take the money from that account. In case of Not sufficient funds on that account, the DP rejects the transaction. For credit transactions, the DP credits the IP’s account and forwards the transaction. I hope it clarifies.

  2. Venu February 8, 2019 at 3:42 am #

    Yes Jean its clear now. Appreciate your support.

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