Net settlement represents banks’ modern approach to reconciling the day’s transactions at the close of the business day. It’s an updated process essential for the contemporary, electronically-driven financial world.
Since many or most bank transactions are conducted electronically today, this process is no longer simply about counting physical cash. Instead, banks must compute all electronic credits and debits. Once these are tallied, the resulting settlement file is delivered to a central bank, such as a Federal Reserve Bank, which then credits the necessary funds via the interbank settlement system.
Key Highlights
- Throughout the day, banks accumulate credits and debits with other institutions.
- By the end of the day, each bank determines what it owes and what is owed to it by others.
- These finalized figures are then reported to the central bank, facilitating the transfer of funds among all involved banks.
Grasping Net Settlement
The net settlement system permits the accumulation of credits and debits between banks throughout the business day. These totals are only reconciled at the end of the day, with only the net differences requiring actual transfer.
In the context of stock market trading, net settlement plays a critical role. For instance, the National Securities Clearing Corporation (NSCC) employs continuous net settlement to handle security trades executed by member entities during the trading day.
In many ways, a bank’s net settlement process is akin to balancing an individual’s checkbook. When juggling various forms of inflows (cash, checks, direct deposits) and outflows (cash payments, checks, credit card purchases), netting all transactions provides a comprehensive financial picture.
Net settlement significantly aids the management of bank liquidity, ensuring sufficient cash is available for customer demands at branches and ATMs.
Two main types of net settlement systems are used:
- Bilateral settlement systems, where payments between two banks are resolved at the end of the business day, typically through the central bank.
- Multilateral settlement systems, where a bank’s net balance encompasses all system participants, rather than individual banks.
Differentiating Net Settlement from Gross Settlement
Gross settlement shouldn’t be confused with net settlement. Specifically, a real-time gross settlement system (RTGS) entails immediate, on-the-spot interbank fund transfers rather than accumulating them through the day.
For example, the U.K.’s BACS Payment Schemes (formerly Bankers’ Automated Clearing Services) accumulates transactions throughout the day. Post-business, the central bank adjusts institutional accounts by the net exchanged amounts.
Significant interbank transfers utilize real-time gross settlement, demanding immediate and complete clearance organized by the nation’s central bank. This rapid nature of RTGS reduces a bank’s settlement risk, as transactions finalize in real-time, avoiding potential delays inherent in net settlement.
Despite the higher fees associated with real-time gross settlement, its instantaneous handling can provide added security and efficiency in managing large-value interbank funds transfers.
Related Terms: Gross Settlement, Liquidity, Settlement Risk, Real-Time Gross Settlement.
References
- Federal Reserve Banks. “National Settlement Service”.
- Bacs Payment Schemes Limited. “An Introduction to the UK’s Interbank Payment Schemes”, Pages 4-5.
