Payment and Settlement Systems in Trading

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Category: General

Written by Lia Freedman

Just as each nation has its own national currency, so also does each nation have its own payment and settlement system— that is, its own set of institutions and legally acceptable arrangements for making payments and executing financial transactions within that country, using its national currency.

“Payment” is the transmission of an instruction to transfer value that results from a transaction in the economy, and “settlement” is the final and unconditional transfer of the value specified in a payment instruction.

Thus, if a customer pays a department store bill by check, “payment” occurs when the check is placed in the hands of the department store, and “settlement” occurs when the check clears and the department store’s bank account is credited. If the customer pays the bill with cash, payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction, they are agreeing on the terms of a currency exchange and committing the resources of their respective institutions to that agreement. But the execution of that exchange—the settlement—does not take place until later.

Executing a foreign exchange transaction requires two transfers of money value, in opposite directions, since it involves the exchange of one national currency for another.

Execution of the transaction engages the payment and settlement systems of both nations, and those systems play a key role in the operations of the foreign exchange market.

Payment systems have evolved and grown more sophisticated over time. At present, various forms of payment are legally acceptable in the United States—payments can be made, for example, by cash, check, automated clearinghouse (a mechanism developed as a substitute for certain forms of paper payments), and electronic funds transfer (for large value transfers between banks).

Each of these accepted forms of payment has its own settlement techniques and arrangements. By number of transactions, most payments in the United States are still made with cash (currency and coin) or checks.

However, the electronic funds transfer systems, which account for less than 0.1 percent of the number of all payments transactions in the United States, account for more than 80 percent of the value of payments. Thus, electronic funds transfer systems represent a key and indispensable component of the payment and settlement systems. It is the electronic funds transfer systems that execute the inter-bank transfers between dealers in the foreign exchange market.

The two electronic funds transfer systems operating in the United States are CHIPS (Clearing House Interbank Payments System), a privately owned system run by the New York Clearing House, and Fedwire, a system run by the Federal Reserve.

Other countries also have large-value interbank funds transfer systems, similar to Fedwire and CHIPS in the United States. In the United Kingdom, the pound sterling leg of a foreign exchange transaction is likely to be settled through CHAPS—the Clearing House Association Payments  System, an RTGS system whose member banks settle with each other through their accounts at the Bank of England.

In Germany, the Deutsche mark leg of a transaction is settled through EAF—an electronic payments system where settlements are made through accounts at Germany’s central bank, the Deutsche Bundesbank.

A new payment system, named Target, has been designed to link RTGS systems within the European Community, to enable participants to handle transactions in the euro upon its introduction on January 1, 1999.

Globally, more than 80 percent of global foreign exchange transactions have a dollar leg.  Thus, the amount of daily dollar settlements is huge, one trillion dollars per day or more. The settlement of foreign exchange transactions accounts for the bulk of total dollar payments processed through CHIPS each day.

The matter of settlement practices is of particular importance to the forex market because of “settlement risk,” the risk that one party to a foreign exchange transaction will pay out the currency it is selling but not receive the currency it is buying. Because of time zone differences and delays caused by the banks’ own internal procedures and corresponding banking arrangements, a substantial amount of time can pass between a payment and the time the counter-payment is received—and a substantial credit risk can arise.