What is Net Settlement?
A net settlement is an inter-bank payment settlement system wherein banks collect data on transactions throughout the day and exchange the information with the clearinghouse and the central bank to settle any outstanding amounts.
In a net settlement system, banks keep track of their electronic (and physical) credit and debit transactions throughout the day. At the end of the day, the information is shared with a mediating institution (the clearinghouse), and the net differential is transferred between participating banks.
How Does Net Settlement Work?
Net settlement amounts are cleared and settled by a clearinghouse, which functions as an intermediary between entities engaged in a financial transaction. For example, in Canada, Payments Canada is the clearing and settlement system for inter-bank financial transactions.
Types of Net Settlement Systems
1. Bilateral net settlement system
Bilateral net settlement systems are payment systems in which payments are settled for each bilateral combination of banks. Banks that send out more funds in transfers than they receive (i.e., banks with a positive net settlement balance) are credited with the difference, and banks with a negative net settlement balance pay the difference.
2. Multilateral net settlement system
In a multilateral net settlement system, transfers received by a bank are offset against those sent out – here, “transfers” refer to the sum of all funds received and sent to banks that are part of the settlement system.
If the sum is positive, the bank is said to be in a multilateral net credit position; if the sum of transfers is negative, the bank is said to be in a multilateral net debit position.
3. Deferred net settlement system
They are settlement systems in which payment obligations can be deferred to be paid at a later time, based on the agreement between the parties involved.
Net Settlements vs. Gross Settlements
An alternative payment/settlement system is the Real-Time Gross Settlements System (RTGS), in which each transaction is settled with immediate payments, unlike net settlements, which are summed up and aggregated at the end of the day, before being paid.
Given that net settlements are not paid immediately, the risk of an institution or bank defaulting on their debt is higher in the net settlement system compared to the RTGS system, where default risk is eliminated due to immediate payments.
Why is the Net Settlement System Important?
The net settlement system allows banks to be flexible and gain more freedom in exchanging and transferring funds between each other.
The net settlement system ensures that liquidity is maintained throughout the exchange period (typically a day, but could be deferred), and the outflow of payments occurs only after the clearing institution clears and approves the accounts.
Similarly, it allows banks to collaborate and supports financial institutions in running their daily operations with ease by delegating the responsibility of clearing and settling accounts to a mediating party.
Suppose Banks A and B are part of a bilateral net settlement system. At the end of the day (i.e., the exchange period), the clearinghouse processes the transactions and confirms that Bank A’s net settlement amount is –$600,000, and Bank B’s net settlement amount is $600,000.
It means that at the end of the day, Bank A owes Bank B the full $600,000.
Suppose banks A and B are part of a deferred net settlement system, with a grace deferral period of two months. At the end of the day (i.e., the exchange period), the clearinghouse processes the transactions and confirms that Bank A’s net settlement amount is –$600,000, and Bank B’s net settlement amount is $600,000.
Therefore, Bank A needs to pay $600,000 to Bank B, but the payment is deferred for 60 days due to the deferred net settlement system.
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