How does the settlement of payment work in banks

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Seattle Central College *

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BUS395

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Finance

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Apr 3, 2024

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docx

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Uploaded by CHARLOLLE

How does the settlement of payment work in banks? Here is a generic settlement process example as shown below. It can be applied universally all across for payments. For some intricate payment scenario, the model slightly changes, but the gist of it remains the same. Let’s use the example above, Bob wants to send his friend Jake money. Assuming they are using some real-time mobile solution that sends money across instantly. Both Bob & Jake are using two different banks. So the question usually asked is how is the money instantly transferred across? In Bob's bank? how does the core banking software move money and how is this money, suddenly posted in Jake's bank account, which might be using a different core banking software?

In most cases, a settlement bank is used. The settlement bank will usually settle all the net transactions at the end of the day (at a particular anointed time and will settle the net funds for all the participating member banks). In this example, let us consider three banks:  X-Bank (which is the bank Bob uses)  Y-Bank (which is the bank Jake uses)  Bank Z - which is the settlement bank for all these participating banks using the switch. At a particular time, (let’s take this clock for example), when Bob sends money across to Jake, at 9:40:00 AM, a message is generated on a switch (think of a

switch as a financial router/authority that both the banks agree-to/listen-to). This message (and lets not get into the technical details of the message) simply says, in a secure, irrevocable manner that: " Y-Bank, please pay Jake US$ 100, as I have already taken US$ 100 from Bob, from his X-Bank ". Remember, nothing more than a message is sent across. No money actually moves. Just an "instruction" (or message). Here is where the magic that seemed so confusing, actually happens - how does the money move? The short answer is - its doesn't move (yet!) X-Bank will deduct money from Bob's account (US$ 100) and credit this money in its own bank Settlement Account. Think of this settlement account as an SWITCH IOU Account, or a safekeeping account. Y-Bank will take money from its own Settlement Account or Switch IOU Account, and credit the money to Jake's account. The assumption here was, that when both these banks decided to do business with the switch and each other, they decided they would need a Settlement Account and this account will be funded by the bank's own money, which would be used to fund the transfers, pending the actual net settlement of funds. In simple words, we will loan the money to whomsoever needs it immediately, because I have already been assured by the switch that the money is available, and you will settle with me later on.

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If you assume that both X-Bank and Y-Bank started the day with US$ 1,000 in their settlement accounts, then this is how the ledger would reflect as the transaction was done: Before Transaction: X-Bank Settlement Account: US$ 1,000.00 Bob's Bank Account: US$ 100.00 Y-Bank Settlement Account: US$ 1,000.00 Jake's Bank Account: US$ 0.00 (Let’s assume Bob has US$ 100 only and Jake has zero money, at the start of the transaction). After the transaction is done, this is how the accounts will look like: X-Bank Settlement Account: US$ 1,100.00 Bob's Bank Account: US$ 0.00 Y-Bank Settlement Account: US$ 900.00 Jake's Bank Account: US$ 100.00 During the day, a lot many transactions can happen, back and forth for different accounts between each participating member bank. As a switch operator or payment system operator, they too will have a Settlement Bank to use. Participating banks appoint a time when they will do net settlements (transfers In/Out) with the Settlement Bank of the Switch Operator. This is usually done during banking hours for RTGS type of a transfer.

So, the final ledger of accounts would looks something like this: Before Transaction: X-Bank Settlement Account: US$ 1,000.00 Bob's Bank Account: US$ 100.00 Y-Bank Settlement Account: US$ 1,000.00 Jake's Bank Account: US$ 0.00 Bank-Z: Settlement Account for X-Bank: US$ 0.00 Bank-Z: Settlement Account for Y-Bank: US$ 0.00 After the transaction is done, this is how the accounts will look like: X-Bank Settlement Account: US$ 1,100.00 Bob's Bank Account: US$ 0.00 Y-Bank Settlement Account: US$ 900.00 Jake's Bank Account: US$ 100.00 Bank-Z: Settlement Account for X-Bank: US$ 0.00 Bank-Z: Settlement Account for Y-Bank: US$ 0.00 and the end of the batch process day, this is how the ledges would look like (expanding it to show how the transfer are made) X-Bank Settlement Account: US$ 1,000.00 Bob's Bank Account: US$ 0.00

Y-Bank Settlement Account: US$ 900.00 Jake's Bank Account: US$ 100.00 Bank-Z: Settlement Account for X-Bank: US$ 100.00 Bank-Z: Settlement Account for Y-Bank: US$ 0.00 and transfer to the final Bank (Y-Bank): X-Bank Settlement Account: US$ 1,000.00 Bob's Bank Account: US$ 0.00 Y-Bank Settlement Account: US$ 900.00 Jake's Bank Account: US$ 100.00 Bank-Z: Settlement Account for X-Bank: US$ 0.00 Bank-Z: Settlement Account for Y-Bank: US$ 100.00 Final transfer to Y-Bank X-Bank Settlement Account: US$ 1,000.00 Bob's Bank Account: US$ 0.00 Y-Bank Settlement Account: US$ 1000.00 Jake's Bank Account: US$ 100.00 Bank-Z: Settlement Account for X-Bank: US$ 0.00 Bank-Z: Settlement Account for Y-Bank: US$ 0.00 Now you will notice... X-Bank's Settlement Account and Y-Bank's Settlement Account have both been topped up back to their initial investment of US$ 1,000 Bob's Bank Account is US$ 0.00 Jake's Bank Account is US$ 100.00 and the Settlement accounts at Bank-Z for X-Bank and Y-Bank are US$ 0.00 each as all has been settled.

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