Clearing and Settlement Systems

Clearing is all of the steps involved in transferring funds ownership from one party to another except for
the final step, which is settlement. Settlement involves the finalization of a payment, so that a new party
takes possession of transferred funds. The treasurer should be aware of these processes in order to
understand the timing of payment transfers.

CHARACTERISTICS OF CLEARING AND SETTLEMENT SYSTEMS

In clearing and settlement systems, the banks of the payer and beneficiary exchange information
regarding monetary transfers; the result of this exchange is payments between the banks.

OVERVIEW OF THE CLEARING AND SETTLEMENT PROCESS

The general concept of clearing and settlement is for the banks of the paying party (the payer) and the
receiving party (the beneficiary) to exchange information regarding monetary transfers, resulting in the
transfer of funds between the two banks. The banks, in turn, debit the account of the payer and credit
the account of the beneficiary. Given the massive volume of such transactions, formal clearing and
settlement systems have been installed to streamline the process.

Clearing and settlement systems are generally organized around individual countries or economic
regions. Banks located within these areas can have an account with the local clearing and settlement
institution; settlement takes place between the accounts of the banks held at the clearing institution.
Banks located outside of these areas do not have such an account, and so must use a local bank as a
correspondent bank that handles payment instructions on their behalf.

Settlement Types

Payments can be on a gross basis, where each bank pays the total amount owed. Payments handled
through a gross settlement system are more likely to have a requirement for immediate execution,
where payment instructions are processed separately for each individual transaction. The cost of gross
settlement transactions is high, so individual transactions running through these systems tend to involve
larger amounts of funds or be very time sensitive.

Payments can also be on a net basis, where a large number of transactions are accumulated and offset
against each other, with only the net differential being transferred between banks. Payments handled
through a net settlement system usually wait until the end of the day, when all transactions between
the banks are summarized and offset against each other by a clearing institution; the clearing institution
then sends the net transfer information to the settlement institution, which executes the transfer of
funds between banks. The clearing institution normally completes its daily summarization process and
transmits net transfer information to the settlement institution after the cutoff time of the settlement
institution. This means that the transfer of funds to the account of the beneficiary bank will be delayed
by one business day. A few clearing institutions compile net transfer information to settlement
institutions not only before their cutoff times, but several times per day, which allows for settlement
speeds like those of gross settlement systems. The cost of net settlement transactions is low, so lower-
value transactions are usually settled through these systems.
Banks prefer to use net settlement systems because payments processed through them require greatly
reduced funds transfers (and therefore considerably less liquidity) than gross settlement systems.

Transaction Types

Each clearing and settlement system is primarily designed to handle a certain type of transaction. One
such type is the high-value payment, which must be executed immediately. Because of the time
constraint, high-value payments cannot wait for end-of-day netting, and so are settled on a gross basis,
with an immediate cash transfer between banks. Another payment type is the low-value payment,
which does not require immediate execution and tends to be for smaller amounts. Because of the
reduced need for immediate execution, these payments are handled through a net settlement system.

FEDWIRE

The Fedwire system is a gross settlement system that is operated by the U.S. Federal Reserve and
processes large-value items with same-day, real-time settlement. Nearly all U.S. banks and the agencies
of foreign banks participate in the Fedwire system. If a bank is sending funds through the Fedwire
system on behalf of a client company, then the deadline for initiating such transfers is 6 P.M. eastern
time. The fee for a Fedwire payment is relatively inexpensive.

The process flow for a Fedwire payment is for a paying company to transmit payment instructions to its
bank, which debits the paying company’s account and forwards the payment instructions on to the
Federal Reserve (Fed). The Fed then debits the paying bank’s account at the Fed and credits the account
of the beneficiary bank at the Fed. Finally, the beneficiary’s bank credits the account of the beneficiary.
The process flow for a Fedwire payment is shown in Exhibit 11.1.

AUTOMATED CLEARING HOUSE (ACH) SYSTEM

The ACH system is the net settlement system used for electronic payments in the United States, and is
used by most banks in the country. The ACH system is used for large-volume, low-value payments, such
as payroll direct deposits, business-to-business payments, dividends, tax payments, and Social Security
payments. The transfer of funds from the payer to the beneficiary can take several days, depending on
the payer’s payment instructions. This system is significantly more complex than the Fedwire system,
since it comprises a network of bank associations and privately owned processing entities. The cost of an
ACH payment is quite low, usually just a few cents per transaction.

The ACH process flow is for a company to submit an electronic file to its bank (also known as the
originating depository financial institution), containing payment information; the bank lets these
submissions accumulate until the end of the day. At that time, it directly pays any of the authorized
items with a book transfer if the recipient has an account with the bank. If not, the bank batches and
forwards the remaining payment authorizations to its designated ACH operator (usually a regional
branch of the Federal Reserve, or the Electronic Payments Network). The ACH operator collects the ACH
submissions from all of the banks in its region and calculates the net settlement amounts that they must
pay to each other. The ACH operator then aggregates the remaining transactions involving banks
outside of its region, subdivides them by ACH region, and transmits them to the ACH operators
responsible for conducting similar processing for their regions. Payments are made to the beneficiary’s
banks (also known as receiving depository financial institutions), which in turn pay the beneficiaries.
Payments between banks associated with different ACH operators are settled on a gross basis. The
process flow for an ACH payment is shown in Exhibit 11.2.

Exhibit 11.1 Fedwire Process Flow

114
Settlement timing is based on the payment date specified by the payer in the ACH file submitted to its
bank. A company can deliver ACH debit instructions that are no earlier than one banking day prior to the
settlement date, while ACH credits can be delivered no earlier than two banking days prior to the
settlement date. If the ACH file is delivered too late to settle on the specified date, then the ACH
operator will use the next business day as the settlement date.

Exhibit 11.2 ACH Process Flow

115

CLEARING HOUSE INTERBANK PAYMENTS SYSTEM (CHIPS)

CHIPS is a net settlement system that is operated by the Clearing House in New York, which in turn is
owned by a group of banks. It settles primarily foreign exchange and Eurodollar trades, with total daily
volume exceeding $1 trillion. CHIPS accumulates payment instructions throughout the day, and then
calculates the net payment to be paid by each bank in the system. The net payment is then made
through the Fedwire system. The CHIPS system is designed for high-value payments, and can also
transmit remittance information along with payment instructions.
The CHIPS process flow is for a payer’s bank to send payment instructions to CHIPS, which calculates net
positions at the end of the day and sends this information to the Fed. The Fed then debits the paying
bank’s account at the Fed, and credits the account of the beneficiary’s bank at the Fed. A separate
instruction from CHIPS to the beneficiary’s bank results in the beneficiary’s bank crediting the account of
the beneficiary.

There is some risk for a bank using CHIPS because it is not being paid until the end of the day but could
make funds available to its customers prior to the end of the day; if a bank owing it money were to fail,
the bank would then have no means of recovering the funds already paid to its customers. Banks control
this risk by imposing intraday credit limits on their transactions with each other.

CHECK CLEARING

A check issued from a payer to a beneficiary can be cleared and settled through one of several routings.
They are:

• Same bank settlement. The bank on which a check is drawn may be the same bank used by the
beneficiary. If so, the bank simply makes a book entry to shift the in-house funds from the account of
the payer to the account of the beneficiary.

• Correspondent bank settlement. A company may receive a check from an entity located outside of its
country. If so, the company ’s bank sends the check to a correspondent bank in the originating country;
clearing and settlement occurs in that country, and then the correspondent bank uses an electronic
transfer to shift the funds back to the beneficiary’s bank.

• Check-clearing institution. Checks are physically processed through the Federal Reserve System. The
process flow is for the beneficiary (check recipient) to send the check to its bank, which in turn sends the
check to the check -clearing institution (CCI), which is frequently the Fed. The CCI aggregates the
information on all checks received and sends a payment instruction to the Fed. The Fed then debits the
account of the payer’s bank at the Fed and credits the account of the beneficiary’s bank at the Fed.
Meanwhile, the CCI has notified the banks of both the payer and beneficiary, who debit the payer’s bank
account and credit the beneficiary’s account, respectively.

• Electronic check presentment. Either the recipient of a check or its bank can scan a check to create an
electronic image, and then send the image to the CCI. Since no transport of actual checks occurs, the
clearing process can be several days quicker than traditional paper check clearing. The process flow for
an electronic check presentment is shown in Exhibit 11.3.

Exhibit 11.3 Electronic Check Presentment Process Flow

Foreign exchange settlement presents a risk of one party’s defaulting before a transaction has been
completed because settlement takes place through accounts in the correspondent banks in the
countries where the relevant currencies are issued. Because the various national payment systems are
located in different time zones around the world, one side of a foreign exchange transaction will likely
be settled before the other side of the transaction. For example, dollar payments are settled later than
euro payments, which in turn are settled later than yen payments. Thus, someone buying in dollars and
paying in euros will have settled the euro side of the payment before receiving any dollars. If the
counterparty were to fail in the midst of this transaction, the transaction initiator would have paid
dollars but lost the offsetting euros. This risk is called settlement risk.

To avoid this settlement risk while also speeding up the settlement process, a number of major banks
banded together to create the CLS system. The system is operated by CLS Bank International, of which
the founding banks are shareholders. Other banks can submit their foreign exchange transactions
through these member banks. The following currencies can be settled in the CLS system:
Australian dollar

British pound

Canadian dollar

Danish krone

Euro

Hong Kong dollar

Israeli shekel

Japanese yen

Korean won

Mexican peso

New Zealand dollar

Norwegian krone

Singapore dollar

South African rand

Swedish krona

Swiss franc

U.S. dollar

The CLS system has proven to be a popular one, with system settlements averaging more than $2 trillion
per day.

CLS maintains an account with the central bank controlling each of the above currencies. Also, each
member bank of CLS has its own account with CLS, which is subdivided into a sub-account for each
currency. The member banks submit their foreign exchange transactions to CLS, which uses a gross
settlement system to debit the account of a participant in one currency, while at the same time
crediting its account in a different currency. If a member bank has a net debit position in a particular
currency, CLS requires that it have sufficient balances in its other subaccounts (less a small margin to
account for possible fluctuations in exchange rates during the day) to act as collateral for the debit
position. If a member bank ’s debit position exceeds a preset limit, then that bank has to replenish its
subaccount in the currency having the debit position.

The CLS settlement process flow is for member banks to send their foreign exchange transaction
information to CLS during the day, after which CLS creates a schedule of net payments that the member
banks must pay to CLS. CLS then processes both sides of each individual foreign exchange transaction, so
that the account of one member bank is debited, while the account of another member bank is credited.
CLS processes these transactions on a first-in, first-out basis. If, during the processing sequence, a
member bank’s cash position with CLS becomes too low, CLS will shunt aside and postpone its remaining
transactions until additional funds are provided by the member bank.

After CLS has completed this process, it transfers the updated balances of the settlements back to the
accounts that the member banks hold at the central banks in their home countries. Since these
payments are the result of the aggregation of a multitude of smaller transactions, they are on a net
basis. This processing period must be completed during a five-hour period that covers the overlapping
business hours of the participating national settlement systems.

How does CLS impact the corporation? It gives the treasurer exact information about when settlements
will occur in various currencies, which previously had been difficult to predict with precision. With better
foreign exchange settlement information, the treasury staff can now optimize its short-term investment
strategy.

SUMMARY

With the exception of the CLS system, this chapter has described only the clearing and settlement
systems operating within the United States. Similar systems operate in other countries and economic
regions, and also fall into the general categories of high-value, gross settlement systems or low-value,
net settlement systems. Examples of such systems are TARGET2, Euro1, and STEP2 in Europe, BACS and
CHAPS in the United Kingdom, and BOJ-NET and FXYCS in Japan. If a treasurer’s company transacts
significant business in regions outside of the United States, it may be worthwhile to research the process
flows of the clearing and settlement systems used in those regions.