Net settlement

A net settlement is a payment system used for inter-bank transactions. It is the process by which banks calculate the collective total of all transactions up until designated times within each day.[1][2][3]

In an inter-bank payment system using net settlement, debits and credits are recorded and only the difference between the debits and the credits (the net position) is actually paid between the parties.[4] In most payment systems this netting will take place on the clearing house books between the designated settlement times with final settlement of the net positions occurring occurs when funds are debited or credited on its reserve account at a central bank, in the US at a Federal Reserve Bank.

For example, if two parties (A and B) are exchanging transactions bilaterally in a net settlement scheme,[5] and A pays B ¤200 and B pays A ¤150, the net obligation to be settled is ¤50 from A to B. The rest is effectively 'canceled out'.[6]

Multilateral net settlement[7] occurs when there are three or more parties involved. In this example, A pays B ¤200, B pays C ¤150, and C pays A ¤175. The net obligations in the multilateral model are for A and C to each pay ¤25 into the settlement 'pot', and for B to receive ¤50.[8]

Net settlement is used because it reduces the amount of money that has to be held in the settlement medium compared to gross settlement, which requires immediate payment of each individual transaction. It also reduces inter-bank risks.[9] Net settlement is a multilateral transaction, usually with the central bank for the currency being used.[10] All transactions included in a multilateral net settlement cycle are settled in one movement of funds representing the overall net position.[11] Examples of net settlement systems are CHIPS in the US, CHAPS in the UK, and BOJ-NET (until 2000)[12] in Japan.[13]

Net settlement can introduce its own particular risks. If the application of transactions to the netting is not legally binding, in the event of the insolvency of a participant, the other participants may end up legally owing their gross obligations to the failed participant, and not be due any settlement from the failed participant in return.[14] Furthermore, if one of the participants in a net settlement system is unable to settle its obligations at the end of the settlement cycle, it prevents the settlement from completing for all parties: this may require unwinding all the transactions that have been placed into that settlement cycle.[15]

A special form of net settlement is used in the settlement of securities obligations, known as delivery versus payment.

References
  1. Horii & Summers, p. 76
  2. "Net Settlement". Investopedia.
  3. Committee on Payment and Settlement Systems (March 2003). "A glossary of terms used in payments and settlement systems" (PDF). Bank for International Settlements. p. 34. net settlement: the settlement of a number of obligations or transfers between or among counterparties on a net basis
  4. Committee on Payment and Settlement Systems (March 2003). "A glossary of terms used in payments and settlement systems" (PDF). Bank for International Settlements. p. 34. net settlement system: a system in which transfer orders are settled on a net basis
  5. Committee on Payment and Settlement Systems (March 2003). "A glossary of terms used in payments and settlement systems" (PDF). Bank for International Settlements. p. 9. bilateral net settlement system: a settlement system in which participants’ bilateral net settlement positions are settled between every bilateral combination of participants.
  6. Summers (1994) p37
  7. Committee on Payment and Settlement Systems (March 2003). "A glossary of terms used in payments and settlement systems" (PDF). Bank for International Settlements. p. 33. multilateral net settlement system: a settlement system in which each settling participant settles (typically by means of a single payment or receipt) the multilateral net settlement position which results from the transfers made and received by it, for its own account and on behalf of its customers or non-settling participants for which it is acting.
  8. Summers (1994) p38
  9. Van den Bergh, p. 36
  10. Sato and Humphrey p1
  11. Sato & Humphrey, p. 6
  12. Imakubo and Soejima, p. 152
  13. Humphrey, p. 74
  14. Summers p 99
  15. Summers (1994) p.101

Bibliography
  • David B. Humphrey, Payment Systems: Principles, Practice, and Improvements, World Bank Publications, 1995 ISBN 0821331116.
  • Kei Imakubo: Yutaka Soejima, "The microstructure of Japan’s interbank money market: simulating contagion of intraday flow of funds using BOJ-NET payment data", Monetary and Economic Studies, November 2010.
  • Akinari Horii, Bruce J. Summers, "Large-value transfer systems", ch. 6 in, Bruce J. Summers (ed), The Payment System: Design, Management, and Supervision, International Monetary Fund, 1994 ISBN 1557753865.
  • Setsuya Sato, David B. Humphrey, Transforming Payment Systems: Meeting the Needs of Emerging Market Economies, World Bank Publications, 1995 ISBN 0821333550.
  • Bruce J. Summers (ed) The Payment Systems: Design, Management and Supervision 1994
  • Paul Van den Bergh, "Operational and financial structure fo the payment system", ch. 3 in, Bruce J. Summers (ed), The Payment System: Design, Management, and Supervision, International Monetary Fund, 1994 ISBN 1557753865.
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