What does Bitcoin mean in terms of clearing and settlement for the global banking industry?

Many comments have been devoted to Bitcoin’s contribution in simplifying the legacy clearing and settlement system; but surprisingly, most of these articles lack a fundamental explanation to the mechanism of global payment system and the roles of central banks in global payment system. This article tries to bridge that knowledge gap and provide a simplistic description of the global payment systems.

The description provided in this article is based on the original blog by Richard Gendal Brown. We present a simplified explanation of the original blog entry for a quick review of the clearing and settlement processes.

Fundamentals

First of all, let’s start with college economics 101: Customer A’s deposit in Bank A is the bank’s liability. If customer A transferred her deposit $10 to customer B then Bank A has to move $10 from its liability side to asset side. It’s very simple and easy. But, what if customer B has his account in Bank B? Then Bank A has to hold an account with Bank B, and the transaction goes like following: 1) Bank A will first reduce customer A’s balance and 2) then add the $10 to Bank B’s account with Bank A. 3) Bank A will send a message to confirm credit into Bank B’s account and tell Bank B to increase customer B’s balance by $10. 4) Eventually, customer B will actually receive the $10 from customer A.

It doesn’t sound very complicated yet, however there are problems involved. First of all, if Bank A and Bank B do not have a direct relationship with each other, customer A and B cannot transfer money to each other’s account or need to route it through a third (or fourth or fifth) bank, until the transaction can be completed. Secondly, there are also counterparty risks, i.e. if one bank goes bust during the transaction the other bank will not be paid the corresponding money.

What about SWIFT and other faster payment methods, like ACH?

The SWIFT (Society for Worldwide Interbank Financial Telecommunication) network exists to allow banks to securely exchange electronic messages with each other. The movement of funds is done by debiting and crediting several accounts at each institution and relies on banks maintaining accounts with each other (either directly or through intermediary banks). The SWIFT message is merely the instruction. The much worse hidden problem is the liquidity problem. Recall the case in our example above and think about how much money Bank A would need to have tied up at all its correspondent banks every day if the system above is used. It would be an epic one if Bank A is a major bank.

What if we kept track of all transaction during the day and only settled the balance?

What about Automated Clearing House (ACH) system? ACH is a system, used in the United States of America, where messages (or files) are sent to a central “clearing” system which keeps track of all the payments, and then, on some schedule, calculates the net amount owed by each bank to each other. They then settle amongst themselves (perhaps by transferring money to/from the accounts they hold with each other). This dramatically cuts down the cost and liquidity demands, but it also introduces a potentially worse problem: the loss of settlement finality. E.g. you might issue your payment instruction in the morning but the receiving bank doesn’t receive the (net) funds until later.

In the European context, Single Euro Payments Area (SEPA) is the payment system similar to ACH in the USA. SEPA enables pan-European payments within the 28 European Union member states and four European Free Trade Association (EFTA) member countries. The key motive behind SEPA is to improve the efficiency of cross-border payments and turn the fragmented national markets for Euro payments into a single domestic one.

Is there any possible solution to achieve both settlement finality and zero counterparty risk?

We need the system that was outlined in our example above and add something to make it useable in practice. This is where the central bank steps in and such system is called Real Time Gross Settlement (RTGS). Imagine if the major banks hold accounts with central banks then they can move money between themselves simply by instructing the central bank to debit one account and credit the other. Such a system allows real-time movements of funds between accounts held by banks at their respective central bank. Thanks to central banks’ credibility, the counterparty risks would also be eliminated even for cross border transactions.

What changes could Bitcoin bring to this system?

Bitcoin network most closely resembles a Real-Time Gross Settlement system. Today, most retail transactions are not performed over the RTGS. For example, person-to-person electronic payments in the UK go over the Faster Payments System (FPS), which settles net several times per day, not instantly. Why is this? This is primarily because FPS is (almost) free, whereas Clearing House Automated Payment System (CHAPS) payments (UK’s RTGS) cost about £25. Most consumers probably would use an RTGS if it was just as convenient and just as cheap. Will the Bitcoin payment network end up resembling a traditional RTGS, only handling high-value transfers? Or will advances in the core network (block size limits, micropayment channels, etc.) occur quickly enough to keep up with increasing transaction volumes in order to allow it to remain an affordable system both for large- and low-value payments? The answers are not sure. Bitcoin will change the world but it is altogether less convincing that we’ll end up in a world where every transaction is “cleared” over the Block Chain.

Source:
Richard Gendal Brown
http://gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/

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