A gentle introduction to interbank payment systems

How do banks pay each other?  In most countries, when banks want to transfer money to each other, perhaps upon instruction from a customer, they don’t put bundles of banknotes in vans, they pay each other digitally.  How does this work?

This post is intended as a primer about payment systems and explains correspondent banking, nostros, real time gross settlement (RTGS) systems and deferred net settlement (DNS) systems.  It supports other posts where I discuss decentralisation of these systems using distributed ledgers.

 

Interbank payments: The problem

Annie who banks at Bank A wants to transfer $10 to Clarabel who banks at Bank C.

problem_with_digital_payments

What do the customers see?  We see that Annie’s account goes down by $10, and Clarabel’s account goes up by $10.

The problem.  But if that’s all that happened, can you see the problem from the banks’ perspective?  Remember that your “account balance” with a bank is how much the bank owes you – it’s how much you can attempt to withdraw from a cash machine.  The more you have in your account, the more the bank owes you.

So, after this transfer:

  • Bank A now owes Annie less money! It’s really happy 🙂
  • Bank C is not happy at all – it now owes $10 more to Clarabel 😦

Essentially Bank A is better off and Bank C is worse off.  So this payment instruction must be balanced by a bank to bank transfer: Bank A needs to pay Bank C $10 to balance out the customer account movements.

Settling up.  So how do banks pay each other?  Banks don’t tend to put banknotes in vans and dispatch them to other banks.  How does it work digitally?  There are two main ways:

  • Correspondent bank accounts
  • Central bank payment systems

 

Correspondent bank accounts

If Bank A opened an account with Bank C, it could instruct Bank C to transfer the $10 from its account to Clarabel’s account:

correspondent_bank_accounts_nostros

In this way, neither bank is better or worse off:

  • Bank A owes Annie $10 less 🙂 but has $10 less in its account with Bank C 😦
  • Bank C owes Clarabel $10 more 😦 but owes Bank A $10 less 🙂

So that’s all neatly squared off.

Initial funding.  How might Bank A fund its account at Bank C in the first place?  Perhaps the banks opened accounts with each other at the same time, funded with the same amounts: Bank A opens an account at Bank C, and Bank C opens an account at Bank A, and they both agree “Let’s start off by owing each other $100,000.”.  Or Bank A could sell an asset to Bank C “Here’s a bond, please pay me by crediting my account”.

Correspondent banking.  This is called correspondent banking – Bank A calls Bank C its correspondent bank, and calls its account there it’s “nostro” account.  (Nostro is Latin for “our”, so using the word nostro is basically a pretentious way of saying “our account”.  If you felt like it, you could refer to your bank accounts as your nostros, but you would lose your friends.)

Pain point.  However, if you were a bank, maintaining accounts at every single other bank that your customers might want to transfer money to would be quite a pain, and expensive (they have to have money sitting there doing nothing, in anticipation of payment instructions, and as we all know, current accounts pay very low interest).  And risky!  What if the other bank went bankrupt?  You’d lose your money.

There is another way…

 

Central bank payment systems

One bank to bank them all.  So there is a more efficient way.  If all banks held a bank account with a super bank, they wouldn’t need to hold accounts with each other any more, they would just need to maintain that account at the super bank, and instruct the super bank to make payments from it, to any of the other banks with an account there.

Central banks.  This is one of the roles of a central bank, and we call this system a settlement system – perhaps a Real Time Gross Settlement (RTGS) system if the -10/+10 adjustments were made during the day, or a Deferred Net Settlement (DNS) system if the payments were queued up for a period of time and then net adjustments were made, perhaps every hour, or perhaps at the end of every day.

How does Annie pay Clarabel if both banks are on a RTGS?

RTGS

Clearing.  So the final settlement where the banks pay each other and everyone is happy, is done at the central bank.  You’d say that the central bank clears the transaction because there is no further action needed.  (NB Just to confuse everyone, the word clearing in payments means something different to the word clearing in securities trading).

  • If both customers bank with the same bank, then that bank clears the transaction.
  • If there is a correspondent banking relationship, then the receiving bank clears the transaction.
  • If there is a central bank system – a RTGS or DNS, then the central bank clears the transaction.
  • Basically, whoever does the -10/+10 adjustment to their ledger is the clearer.

The accounts that each bank holds with the central bank for this purpose is sometimes called their clearing account.  (In reality banks hold multiple accounts at the central bank, for different purposes).

This is much more efficient than maintaining lots of nostros.  However, it only works within one country and in one currency.  So most advanced countries will have a centrally cleared RTGS or DNS system for clearing interbank payments within that country for the domestic currency.

Banks who participate in the RTGS and have accounts with the central bank are known as “clearing banks” for that currency and they have a higher status than non-clearing banks – because the non-clearing banks need to use clearing banks to participate in the RTGS/DNS.

 

International payments

International currency accounts.  In fact, correspondent banking is how banks can give customers accounts in non-domestic currencies where they don’t have a banking licence.  For example, a Singapore bank may not have a banking licence in the UK, and so it will maintain a GBP denominated nostro with a big bank in the UK, and it would use that as a mega-account for all its customers’ GBP currency.

non_domestic_currency_accounts

A Singapore bank customer might log in to her account and see that she has £200, but the £200 is actually sitting in a UK bank account under the name of the Singapore bank, mixed up with all the other Singapore Bank customers’ GBP.

For international payments (of one currency – ie not foreign exchange!), we rely on correspondent banks rather than RTGS because it’s unlikely that both banks will be on the same RTGS.

For example if a Thai banking customer wants to pay GBP to a Singapore banking customer, this will be cleared somewhere in the UK, either by the Bank of England, or, if by chance they use the same correspondent bank, by that correspondent bank:

non_domestic_payments

And that’s the happy scenario!  Sometimes smaller banks or banks in poorer countries might not be able to establish banking relationships with big foreign banks, as I have written about.  Then the small banks need to open accounts with larger local banks and use their facilities…  So payments take longer and fees accumulate.

There’s more to this than what I have described, but that is the gist of it.  I hope it has been helpful!  For more, please head over to Richard Brown’s excellent primer on how money moves around the banking system.

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