Introduction to

Payments system

Waquar Ahmad
Domestic and International Payments

A domestic payment is an electronic funds transfer that is carried out in the

• same country or the same monetary zone
• transfer is in the currency of the country
• share the same market infrastructures
• clearing and settlement systems that support the currency of that country
• under the supervision of the central bank of that country.

A cross border payment involves at least two countries or monetary zones. The
currency can be:
• the one of the Sending party
• or the one of the receiving party
• or any other currency

What about SEPA Payments?

SEPA payments are transfers in

• Euro between accounts located in the SEPA Area

• The SEPA Area is a monetary zone with currently 36 countries
• countries share the same market infrastructures that support Euro and
• are under the supervision of the European Central Bank.

So, is SEPA domestic or international payment ???

4 strategies to understand a cross border payment

Strategy #1 - The open loop model & CSM

Strategy #2 - Correspondent Banking & account relationships between banks

located in different currency zones

Strategy #3 – Swift network & standards

Strategy #4 – 4 corner model & SEPA messages

Strategy #1 The open loop model

Payments systems in all countries in the world operate essentially on open loop
models because they are by far the most widespread models and the ones that can
be used to study any payment instrument.
In an open loop system, end parties can send funds to one another without
having direct relationship to the same bank. All end parties are in a way
connected to each other through the payments system and the intermediary
banks.

The payment instructions and information are sent from an end party to its bank
or PSP, then from that bank to another bank through the payments system and
finally the receiving bank delivers the payments to its end party customer.

You may wonder what is inside the payments system. How is it made up?

Anatomy of Payments system

Anatomy of a payments system

Composed of many interbank systems and a central bank system(s) in the middle.
All the interbank systems are connected to the Central Bank system. The Banks
are connected to one or many interbank systems and but always to the central
bank system.

Interbank systems allow banks to exchange payments instructions (without

immediate transfer of funds) and clear them according to a defined frequency, in
general daily. But this can happen many times during the day. The transfer of
funds called settlement is carried out only after the (multilateral) clearing.

Banks may also exchange payments with immediate transfer of funds. In this case,
they will go through the central bank system(s) also called Real-time
Gross Settlement System.

This brings us to two topics that are fundamental in payments:

Clearing and settlement
Clearing and settlement mechanisms

It plays a major role in the interbank exchanges of payments. They can be

considered as the cornerstone of payments systems in a monetary zone.

Although generally mentioned together, Clearing and Settlement are two

completely different things.

What is Clearing?

The Bank for International Settlements (BIS) defines the term clearing as the
process of transmitting, reconciling, confirming transactions prior
to settlement, including the netting of transactions and the establishment of
final positions for settlement.
Bilateral clearing – With & without netting

Imagine that the two participants(A & B)have to originate credit transfers. If A
owe B € 10 millions and B owe A € 6 millions, then there are two options to
resolve their debts with credit transfers:

€ 4 million is the final position after the netting. The final position is made by
neutralizing the reciprocal commitments between them. That is the offsetting
of obligations.
Bilateral Clearing continues..

In the first option, two credit transfers are made. In the second option, only
one transfer is made. And it is possible to make only one transfer because we
first do the netting of amounts. Therefore we can save one transaction. If we
consider a netting process with a very high number of participants, we
immediately see that clearing contributes to significantly reduce the number of
transfers needed to settle a set of transactions.

Now if we transpose this example to two financial institutions, the number of

transactions they exchange among each other may amount to hundreds of
thousands or even to millions every day. The clearing allows them not to make
a transfer each time a transaction is sent from one bank to another. They can
decide at the end of each day for instance to do the netting and then the party
which owns money to the other will make a single transfer.
Multilateral clearing

A high number of financial institutions are involved but the principle is the
same as for bilateral clearing. All the participant banks will exchange
payments among each other up to a certain time. Then the netting will
happen after which the final position will be calculated for each of the bank.

Multilateral clearing without a clearing house

To understand how effective multilateral clearing is, imagine a bank that is

directly connected to several other banks and there is no clearing system in
between.

Just Imagine!!!
Multilateral clearing without a clearing house continues…

In the following figure, a system with five participant banks has been considered.
To reach all the other banks, each bank has to establish a point-to-point
connection with each of them. This results in a fully connected network topology
which is extremely impractical for large networks.
Multilateral clearing without a clearing house continues…

In the configuration, many bilateral clearings have to be performed. As a matter of

fact, the topology yields many drawbacks:

1. Each bank in the system has to take care of the netting of positions itself. It has
to do that for each of the bank it is connected to, which is quite cumbersome
and the complexity will obviously increase for the netting.

2. Every time a new bank joins “the market”, it has to set up a connection with all
the other banks if it wants to reach them directly. That will become also more
and more difficult with the growing number of banks.

3. How to make sure that the other banks will really pay after the clearing
process?

Is there any solution ??

Clearing house – The solution

These problems are solved by introducing a third party, the Clearing House,

which implements the clearing mechanism.

1. A bank has to establish only one connection to the CSM to reach all Banks
connected to the CSM (Clearing and Settlement Mechanisms)

2. A bank does not have to implement the clearing with each counterparty

since the Clearing House takes care of it.

3. And the CSM as a hub can better manage the risk associated to the
availability of funds than each bank by itself.
Multilateral clearing with a clearing house

Below you see a picture with four participant banks which are connected to a
clearing house and the clearing house is connected to the central bank.
Multilateral clearing with a clearing house continues…

The central bank comes into play because as overseer of the banking system in
the economy, it implements the settlement mechanism that banks uses
to transfer funds among themselves. This is a crucial point to keep in mind: in
almost all economies, banks do not exchange funds directly among themselves.
They have to do it through the central bank.

The clearing system computes the final position of all the participant banks

one or several times a day.

Each participant bank considers the clearing system as a single counterparty.

When a bank receives a credit transaction, it considers that the clearing
system owes it money regardless of the bank that issued the operation. If it is a
debit transaction, it considers that it owes money to the clearing
system regardless of the bank that issued the operation.

Netting done, Now, settlement !!!!

Settlement

It is the funds transfer that is carried out by one party to fulfill his obligations

towards the counterparty in a financial operation. It 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 funds transfer

occurs individually after each payment transaction is processed in the system.
Banks generally use this type of system to exchange urgent or large amounts
transfers and 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.
An RTGS system is a critical infrastructure for a country’s economy since it
connects all the (participating) banks and facilitates fast transfer of funds among
them. RTGS systems are usually operated by the central bank of a country or
monetary zone. 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.

• Transactions are exchanged among participants without transfers of funds

• Then the multilateral netting happens among all the participants and the
multilateral net settlement positions are calculated at specific time(s).
Net settlement position Participant position
+Ve Credit
-Ve Debit

To reduce 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.

Several multilateral clearing systems may exist in a country or region, but there is
only one RTGS which is operated by the central bank.
After the multilateral clearing - net settlement

Note: Sum of all Bank’s final positions is zero. The debit of one party is
always the credit of another and vice versa. So, the total amount must be
zero.
In the USA, RTGS is Fedwire. CHIPs, Checking, ACH and Cards Systems are
multilateral clearing systems for which settlement takes place in Fedwire.

Multilateral Used for

Clearing
systems
ACH high value
funds transfer
CHIPS retail
payments or low
value payments
The Eurozone countries have one RTGS : TARGET 2. However, in each Eurozone
country, many multilateral systems are available.

Multilateral Used for

Clearing
systems
EBA high value
EURO1/STEP1 funds transfer

EBA STEP2 retail mass

payments 
CORE retail
payments or low
value payments
France belongs to a monetary zone, the Euro zone. EBA systems, CORE and
TARGET2 are all denominated in Euro

If a Bank in France wants to send or receive USD or JPY, it is not possible

through these systems.

How then do French banks send and receive funds in different currencies?

This brings us to the strategy number 2

• Principles of Correspondent Banking and
• Account relationships between banks located in different currency
zones.

Stay tuned for the answers ……