Domestic Payment Schemes in the UK – Part 2

Domestic Payment Schemes in the UK – By Pradyumna Acharya

Can we achieve both Settlement Finality and Zero Counterparty Risk? 

This is where the final piece of the jigsaw fits in. None of the approaches we’ve outlined so far are acceptable for situations when you need to be sure the payment will be made quickly and can’t be reversed, even if the sending bank subsequently goes bust. If only the banks could all hold accounts with a bank that cannot itself go bust… some sort of bank that sat in the middle of the system. We could give it a name. We could call it The Central Bank! 

And this thought process motivates the idea of a Real-Time Gross Settlement system. 

If the major banks in a country all hold accounts with the Central Bank, then they can move money between themselves simply by instructing the Central Bank to debit one account and credit the other. And that’s what CHAPS, FedWire, and Target 2 exist to do, for the Pound, Dollar, and Euro, respectively. They are systems that allow real-time movements of funds between accounts held by banks at their respective central banks. 

Real-Time – happens instantly, Gross – no netting (otherwise it couldn’t be instant), Settlement – with finality, no reversals 

Despite their clear upsides, RTGS schemes (CHAPS) does come with some downsides: 

The system is quite expensive. Depending on the bank, a CHAPS payment can cost anywhere from £5 to £25 per payment. So, it’s not suggestible for retail customers to use CHAPS to make low-value transactions. In our example, if Alice uses CHAPS to transfer £100 to Carl, she will incur a £5 – £10 fees, which is 5 – 10% of the transactional amount. 

The system works near real-time when it works. However, it only works when the Central Bank (Bank of England), who operate RTGS (CHAPS), are working. In other words, outside working hours, during weekends and bank holidays, RTGS (CHAPS) is sleeping and your money won’t move. 

Hence, that’s why other payment schemes exist, such as Faster Payments, brings the best of both worlds to the game: Banks like the fact that they don’t have to worry about the other party setting, so let’s stick to trusting Central Bank (Bank of England) to handle settlements. Each transaction to the Bank of England (CHAPS) is expensive, so let’s try minimizing talking to the Central bank (Bank of England), even if we have millions of transfers going through. 

The solution is to have Faster Payments handle individual transactions between banks and their customers while netting out the total amounts every now and then and asking the Bank of England to settle the differences in bulk. 

How would it look like for Alice and Carl? 

Alice, as always, sends an instruction to BARCLAYS to send £100 to Carl 

BARCLAYS now sends the instruction to Faster Payments who immediately forwards it to HSBC. 

HSBC in turn credits Carl’s account with £100, ending the clearing process successfully. 

Let’s understand the settlement process now. 

Let’s assume there are 2 more transactions between Barclays and HSBC in the current Batch. 

Transaction 2: Dolly, who holds an account with Barclays, transfers £50 to Edward, who banks with HSBC. 

Transaction 3: Freddie, who holds an account with HSBC, transfers £70 to Gill, who banks with Barclays. 

In all three transactions, the final beneficiary receives the funds almost instantly, but Barclays and HSBC settle the aggregate amount later at the end of the batch period. 

But let’s try to understand how these 2 banks settle the money between themselves. So, if we aggregate the 3 transactions in the current Batch. 

Let’s revisit the three transactions and see how the aggregate is calculated. 

Transaction 1: Barclays owes £100 to the Bank of England. Bank of England owes £100 to HSBC. 

Transaction 2: Barclays owes £50 to the Bank of England. Bank of England owes £50 to HSBC. 

Aggregate of Transactions 1 and 2: Barclays owes £100 + £50 = £150 to Bank of England. Bank of England owes £100 + £50 = £150 to HSBC. 

Transaction 3: Bank of England owes £70 to Barclays. HSBC owes £70 to the Bank of England. 

The aggregate of Transactions 1, 2, and 3 (Settlement): Barclays owes £150 – £70 = £80 to Bank of England. Bank of England owes £150 – £70 = £80 to HSBC. 

Therefore, the settlement between Barclays and HSBC for 3 transactions in the current Batch happens as follows. Barclays transfers £80 to its settlement account in Bank of England (OR) Bank of England may debit £80 from the settlement account of Barclays. Also, the Bank of England credits £80 to the settlement account of HSBC. 

In addition to intermediating millions of payments each month, with money moving continuously, several times per day Faster Payments also help the banks with settling the differences to ensure that everyone is always paid up. 

Faster Payments do so by sending an instruction to the Central Bank (Bank of England), indicating which payment institution should be debited and which one should be credited, and by how much. Also, banks are required to commit dedicated collateral in the Central bank (Bank of England) that helps Faster Payments to ensure that each batch of payments can actually settle and that no bank tries to send out more money than they have available on their Central bank (Bank of England) account. This clever system of moving money between banks through a payment scheme means that people get 24/7 instant payments at a low price, sometimes even for free. 


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