💸 What are Payment Systems? 💸

Good morning. Today we continue our series on market infrastructures, the rails of global finance, with a look at what payment systems are. Each Wednesday we will share an article about the global custody industry and its complex and highly regulated landscape. Each Friday we share a roundup of key industry news and insights.

The Payment System Ecosystem

You swipe your card at a coffee shop. A series of messages quickly move between the terminal, the merchant’s payment processor, the card network, and the bank that issued your card. In milliseconds, the funds are confirmed as available and your skim oat milk mocca-chocca frappe is “paid for”. But is it?

Behind the scenes, unless using some types of direct bank to bank payment methods, the coffee shop will have to wait a day or two to get paid, perhaps even more depending on what it has agreed with whoever sold them the payment terminal you swiped or tapped your card on.

The retail payment process is complicated enough, but we’re not going to be talking about how you pay for your coffee today. Instead, we’re going to explore the institutional payment system. This is how governments earn and spend, how central banks interact with commercial banks, how hedge funds borrow in the repo market, and how market infrastructures like clearinghouses receive and pay central bank money as full and final settlement of liabilities.

One of the Principles of Financial Markets Infrastructures is that market infrastructures should control the credit and liquidity risk of using bank money by conducting settlement for transactions in central bank money. This is because a commercial bank might collapse, yet for the purposes of designing market infrastructure, the central bank can always ensure full and final settlement as it is sovereign backed i.e. your government stands behind everything happening in that system at the end of the day.

So the payment systems we care about are the central bank controlled and operated systems where regulated firms become participants and move central bank money back and forth all day to enable the world to move. They are all built on SWIFT messaging - not APIs or stablecoins or central bank digital currencies (yet).

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What is Real Time Gross Settlement (RTGS)?

RTGS is when payments are settled in real-time on a gross basis. Bank A pays $1 million to Bank B and then Bank C pays $1 million to Bank A. If the payment passes the system checks, it goes through, and that is full and final settlement. This means that only banks or highly regulated firms can get access to an RTGS system.

Participants have to make sure that there are always enough funds in their account to account for the gross amount of any transaction they will do on any given business day. This means that a high amount of liquidity is required to fund activity inside an RTGS system.

An example of an RTGS system is Fedwire, operated by the US Federal Reserve.

What is Deferred Net Settlement (DNS)

DNS is when payments are added up and netted throughout the day, with a single net amount being paid or received at the end of the day or whenever the payment system has a settlement batch. This approach requires much less liquidity from the participants, but introduces different credit risks and liquidity risks that have to be managed by both the payment system and participants themselves.

An example of a deferred net settlement payment system is CHIPS which is operated by The Clearing House and processes trillions of dollars worth of payments daily.

What is Settlement Finality?

Settlement finality is a key concept in payments systems. It’s the idea that once a payment has been processed, it is irrevocable and can’t be wound back. This matters because market infrastructures need to have clear rules and procedures for what happens if a participant collapses. There are a number of other legal issues that must be clearly set out and aligned to global standards when it comes to how transactions are netted, how cross-border complexities might be resolved, and the legal enforceability of settlement as full and final.

What else do I need to know about Payment Systems?

There are many risks faced by payment systems. The Principles of Financial Markets Infrastructures are a global rulebook that aims to ensure each country sets up the laws governing its market infrastructures properly so that systemic risks are managed and the overall payment systems are efficient and clear for all participants.

There are also many technology challenges. The global custody world is a long way from using anything like a stablecoin for settlement of securities trades or FX trades. The world of payment systems is about SWIFT messages and interacting primarily with RTGS payment systems or using correspondent banks in other countries to enable multi-currency activity for their clients.

This article is a brief introduction to payment systems, but hopefully gives a flavor of how complex the world of market infrastructures as the rails of global finance can be. It isn’t yet feasible for a developer at a hedge fund to simply download an API swagger and start making RTGS or DNS payments.

A lot of the rules and complexity come from very real losses and scandals that have occurred in the past. Over time though, the efficiency and reliability of these payment systems is good enough that trillions of dollars in value is processed through them every day, mostly without fanfare or anyone knowing how it all works under the hood.

Key Takeaways

• Real-Time Gross Settlement (RTGS) systems handle immediate, irrevocable payments between banks and regulated institutions, requiring significant liquidity but providing instant finality.

• Deferred Net Settlement (DNS) systems like CHIPS offer a more liquidity-efficient alternative by batching and netting payments throughout the day, though this introduces additional credit and liquidity risks that must be carefully managed by both the system and its participants.

• Settlement finality is a crucial concept in payment infrastructures, ensuring that processed payments are irrevocable - this principle is particularly important for market stability and helps establish clear procedures in case a participant fails or becomes insolvent.

• Central bank money is preferred for settlement in market infrastructures because it eliminates counterparty risk - unlike commercial bank money, central bank settlements are backed by sovereign governments, providing the highest level of security and reliability.

• Payment systems are built on complex legal and technological frameworks developed in response to historical financial incidents, processing trillions of dollars daily through established protocols like SWIFT messaging rather than newer technologies like stablecoins.

• While retail payments might appear instant to consumers, the actual settlement process often takes several days and involves multiple intermediaries, highlighting the distinction between payment initiation and final settlement.

• Global payment systems must adhere to the Principles of Financial Markets Infrastructures, a comprehensive set of standards ensuring that systemic risks are properly managed and operations remain efficient across jurisdictions.

What’s next?

Next week we will continue our market infrastructure series by looking at Central Securities Depositories. Understanding how all these building blocks work together is an important part of understanding how the value chain of the global custody industry operates. Let us know if you have a particular topic you’d like to learn more about.