Interbank settlement, moving value between banks

Interbank settlement is the movement of value between banks that makes the payment final. In a real time gross settlement system, each payment settles individually in central bank money as soon as it is processed, and the debtor bank central bank account is debited while the creditor bank central bank account is credited. In a deferred net settlement system, payments are netted during the day and settled in one or more batches, so that only the net amount moves between banks. Both models achieve settlement, but they have different liquidity needs and different risk profiles. Real time settlement needs more liquidity but removes settlement risk, while net settlement saves liquidity but creates a window where a bank failure could affect unsettled payments. Settlement is usually invisible to the end customer, but it determines whether the creditor agent can safely credit the beneficiary. If settlement has not yet occurred, the creditor agent may still credit the beneficiary intraday, taking on credit risk against the debtor bank, or it may wait until settlement is confirmed. The choice depends on the system rules, the relationship between the banks, and the amount involved. In cross border payments, settlement may involve multiple currencies and multiple central banks, and the timing can be affected by time zones and by the operating hours of each settlement system. What can go wrong at settlement includes a bank having insufficient liquidity to settle, a settlement system outage, or a payment that is settled for the wrong amount due to a processing error. A liquidity shortfall can cause a queue of payments to wait, and in a stressed market it can cascade to other banks. Analysts must understand the settlement model for each system they work with, the liquidity requirements, and the contingency arrangements. Requirements should state the expected settlement time, the finality point, and the action to be taken if settlement fails or is delayed, because those are the moments when treasury and operations teams need clear guidance. Take a simple example. During one day, Bank A sends 100 payments to Bank B worth 10 million dollars in total, and Bank B sends 80 payments to Bank A worth 8 million dollars. Under net settlement, only the 2 million dollar difference moves between the banks at the end of the day, instead of 18 million dollars moving in both directions. Under real time gross settlement, each of the 180 payments settles on its own in central bank money as it is processed, so the full 18 million dollars moves, but no bank waits for the end of the day. The same payments, two very different liquidity needs. Worked example with real numbers: Bank A sends EUR 80 million and receives EUR 75 million through a retail clearing system on Monday, so its net debit is EUR 5 million. At the 15:00 cut-off the system nets the positions, and at 16:00 the net EUR 5 million is settled through T2, so Bank A reserve account falls by EUR 5 million, and the settlement is final in central bank money. The gross flows were EUR 155 million, but the settlement was only EUR 5 million, which is the liquidity saving from netting, and the saving is why clearing systems exist. The choice between net and gross settlement is therefore a liquidity choice, and treasury must fund the net debit before the cut-off. Failure and recovery: a participant that cannot fund its net debit at the cut-off puts the whole cycle at risk, and the system applies its default procedure, which may exclude the participant, unwind the cycle, or share the loss among the survivors, under the Bank for International Settlements Principles for Financial Market Infrastructures. A settlement account that does not agree with the central bank statement, by EUR 100,000, is a break, and the investigation starts with the clearing file, not with the customer accounts, because the difference is in the interbank leg. Each failure is a system failure, not a customer failure, and the customer must be told the payment is delayed, with a new value date. For a business analyst, product owner or subject matter expert, the test is to state, for every payment product, the settlement model, net or gross, the clearing system, the cut-off, the settlement timing, the settlement account, and the default procedure if a participant cannot fund. The ISO 20022 pacs.009 financial institution credit transfer moves the settlement amount between banks, and the camt.053 statement proves it arrived, so the requirement must name both, and must state how the net amount is calculated and who calculates it. A requirement that says the payment settles, without naming the model, the system and the default procedure, will be challenged by treasury and risk at the first review, because settlement is where the bank money moves.