The Principle Of Settlement

The Principle Of Settlement

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1 Opening : The Principle of Settlement
Hello everyone, my name is Yoshi. Today, I would like to present on the topic “The Principle of Settlement” .

Say, 30 years ago, during the good old days, every process is manual, tangible, and visible in banking. At the end of each day, bank officers are getting together physically at a clearing house where we can find small bank counters, calculating net amounts, issuing bank checks each other, and settle at MAS account. It was very easy to share the same picture. But, how can we share the same picture when things become invisible, hiding behind a computer screen? One good example. Some might think swift is a settlement system. This is not correct. Swift is more like a “telephone”, even used by shipping companies through banks. This is an analogy, say, I have an offshore account, and use my mobile only for telephone banking to send money from offshore to a local bank. Can we say mobile is a settlement system? The answer is No.

2 Agenda:
There are three items as shown on the slide. The most important item is the second one. “understand the trade off”. Once we understand the trade off, we can design a settlement scheme based on boundary conditions given to us. And we can assess a settlement system in a country. For example, check. If postal cost is very expensive and not reliable, is it check efficient? No, right? It becomes very expensive with check settlement. Therefore, actually there is always prerequisite for us to design a settlement system in a country.

3 What is Settlement:
Settlement is a process to resolve the relationship of “I Owe You”, “You Owe Me” with finality. With finality, there is no unwind of transactions. Once finality is granted, banks are never to be obliged to unwind transactions. This is very important for financial institutions, as unwinding transactions can be very complicated process, and can be extremely costly to unwind a very old transaction. Finality is the one of the most important thing to be maintained in a financial center. If there is no credibility to the Finality in the financial center, banks will go away.


4 How to Settle (1)? :
First, payment. Payment consists of the two, cash payment and non-cash payment. And non – cash payment consists of debit transfer and credit transfer. Cash payment is ideal in a way finality is granted on the spot. That means, if you received 10 dollars for a change one day, you cannot go back and say “Hey, you should have given me 100 dollars, instead of 10 dollars for the change”. This is because no way you can prove the shop keeper gave you a wrong amount. And there is no record tracking with cash, unlike account transfer, how much the shop keeper paid out for the particular transaction.

What I do not cover with this presentation is, DVP, PVP. Delivery versus payment and payment versus payment. Usually, transactions are two ways. When you pay in exchange for something. With PVP, underlying transaction is Forex. We have to receive foreign currency equivalent in exchange for local currency equivalent simultaneously. This requirement makes settlement process more complex, such as pre-matching so on. However, as long as our scope is loan and deposit business today, transaction is one way. So I do not touch DVP, PVP.

The next is Delivery. When a company purchases a company, which called acquisition, the company can settle by delivering shares.

The last one, others. There are many ways to fulfill our financial obligation associated with a transaction. In the end, with OTC, over the counter transaction, it is up to a counterparty whether he or she accepts. Usually, when we purchase a good, we pay cash. But if you are very famous, you might be able to buy a small thing for your autograph. If you were Michael Jackson, you might be able to purchase, even a car for your autograph. I heard a famous calligrapher settled a bill at a restaurant by his calligraphy, just writing “life is great” or something on the spot. This also depends on a society. Some societies might allow you to escape from your financial obligation when you become a monk. And sorry to say this, committing suicide is also common way, so please do not try.

The important thing to understand here is, payment is not equal to settlement, but a small portion of it.

5 How to Settle (2):
There are two types in non cash payment, debit transfer and credit transfer. The former can be check payment, the latter can be giro payment. The difference is the direction of the instruction flow against payment. If payees’ bank are receiving payment as well as instruction, it is credit transfer. If payees’ bank are receiving payment and sending instruction, it is debit transfer. With debit transfer, a payee’s bank is sending debit instruction to payer’s bank. So that there is possibility the debit instruction fails due to balance shortage. With credit transfer, payer’s bank debits an account in it own bank first, then send a credit instruction to payee’s bank. Since debit instruction may fail, that is why we do not use it for real time, or critical settlement systems.

6 Which is the best ?:
Do you have any idea which is the best? The reason why the net-real time box was stroke out is, to net, payment instruction has to be deferred and accumulated. There is no way to be both “Net” and “Real time”.

7 Risk Analysis:
The answer is…it depends. This is the place where trade-off comes in. If you think banks’ operations is very bad. In case there are too many instructions, operations tend to fail more, then netting is required. If most of the settlement instruction is time critical, real time is good. Also it depends who you are. If you are a settlement officer, your concern is the volume of the instructions to process. If you are a regulatory authority, your primary concern is likely systemic risk.

When we design a operational process, we need to think about five risks. Here is a list of the common risks. Liquidity risk, a bank to fail preparing money for payment. Operational risk, such as crediting/debiting a wrong account by mistake. Systemic risk, one failure triggers another automatically, like domino effect. Credit risk, the risk of our counter party going into bankruptcy. I did not list up here, since we do not need to think about the underlying transaction here, yet, market risk is also an important component.

This is a qualitative analysis, not quantitative, so we can always argue, and it is essential to go through plausible cases, rather than abstract concept.

8 Analysis continued:
Cost is also important factor to design a settlement scheme. If economy is very small, the best scheme might be “cash settlement” for all. If you create a real time gross settlement system, this is a relatively big IT project. It requires a certain level of IT skill set.


9 Clearing house:
Netting is done by a clearing house. Clearing is a process to calculate net position based on deferred or accumulated instructions.

There are many types of netting, but let us focus on two, bilateral netting and multilateral netting . Bilateral netting is calculating the netted amount grouped by counterparts. For instance, if bank A receives 30 and 10 from bank B, pay out 51 to bank B, the net position of bank A is minus 11, that is pay out 11 to bank B. Bank A has aggregated the three instructions down to one for bank B.

Multilateral netting is, to see the clearing house as a counterparty, calculating one netted position based on all the instructions. All payments are fused into one, so that all instructions will be affected, when one instruction has got a problem such as paying out to sanctioned client. This is so called “systemic risk” as one failure impacts many. So actually dangerous. One way to avoid this, do not net, especially when amount is big.

10 Systemic risk:
Systemic risk will be created when a bank enters into another transaction without getting finality on the previous transaction. Once the previous transaction is unwind, the bank will have an exposure suddenly. To avoid this, bank should not enter into a transaction without getting finality with previous transaction. Also this becomes a big issue when we talk about a security settlement, If the security which Bank B needs to deliver to Bank C is very scarce, and we fail to obtain it from Bank A, automatically Bank B fails to deliver it to C.

The other case is, netting. Again once we net, transactions are fused into one. And if one underlying transaction fails, all fail automatically.

11 Domestic /International Settlement
Do you have any idea which is Nostro/Vostro account? This is a trick question. The answer is both are in Bank X. When Bank B opens an account in Bank X as a part of corresponding bank agreement, only Bank B has a right to debit and credit the account in Bank X. Bank B is the owner, and call it Nostro account. From Bank X side, Bank X is providing administrative services through the account, yet has no control over, so call it Vostro Account.

Domestic settlement. When bank A sends money to bank B. It has to go through a central bank. This is where finality comes in, as only central bank can grant finality. Also, instruction might be already netted at this stage, so if it fails, all the underlying transactions fail. To make the transactions as smooth as possible, to prevent system risk, the central bank usually gives overdraft if necessary. Also all the banks are connected to the central bank, in Singapore via the interface MEPS, that is the reason why Swift does not come in this picture.

International settlement. The key point of understanding international settlement is, regardless of security or money settlement, securities and money do not go beyond borders. That is why we have to contract a corresponding bank agreement. And instructions are not necessary to be Swift. If the corresponding bank is the same bank but different branches, why we send instructions through Swift private network. We can send instructions through bank’s private network. However, this is very much invisible part, whether using bank’s private network or swift private network. Also theoretically we may use a telephone as I do for offshore banking, if both parties agree. But obviously this is lack of control.

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