e-Finance Trends: Electronic era and real-time gross settlement system

We have seen an initiative by Qatar Central bank towards electronic clearing of cheques without need for physical instrument.

Today, with developments of various C2B, B2B, B2G, C2G models that are emerging, the models can only be efficient when backed by equally efficient payment systems. If two entities can conduct their business in a matter of minutes but face a lag due to delay in payment systems, the efficiency is not realised.

The success of B2B, G2G, B2G models would require a robust end-to-end payment system. What does this require? We need robust payment gateways and we need a global network of RTGS systems, connected to multiple payment systems.

What is RTGS (real-time gross settlement)? How it is different from clearing or even ATM-based settlements? The concept and need for RTGS requires some explanation. The key terminologies in RTGS are 'real time' and 'gross settlement'. Real time indicates that the payment will be straight through processing from one end to another end.

This means if a customer of bank A transfers funds to a customer of bank B, the fund will be withdrawn from his account and made available to the beneficiary account instantly. This real-time transfer is operational even today in electronic payment systems meant for retail customers such as ATM network.

The key differentiation is in the second part of the terminology, i.e. 'gross settlement'. This works different from traditional 'net settlement' followed by ATM and POS switch systems, clearing systems or even the advanced electronic version of clearing systems.

In ATM switch or clearing systems, technology has made fund movement between two ends on real-time basis possible, but corresponding settlement between two banks remains on netting basis. In netting principle, transactions keep taking place during the day with banks honouring the fund request based on some agreed mechanism.

At some cut off point, the net difference between two banks is calculated and settled via their clearing house accounts on netting basis.

Netting system is more convenient for small value transactions for various reasons. The settlement risk is far more acceptable to banks as they do not feel worried about parting with funds and wait for a day or two to receive the fund. There is some sort of a collaborative effort to share channel resources.

Bank statements received from central banks are not crowded with small transactions, and banks can organise different sections internally to manage associated operational work for payments and receipts thro-ugh different modes.

In RTGS system, payment instructions between the banks are settled individually and continuously. In other words, banks commit to make funds available to their customer, only if the other bank has provided funds. There is no waiting period for receiving the fund. The advantage of RTGS is not only in making large value payments faster but, more importantly, in eliminating settlement risks.

Traditional settlement exposes banks to substantial inter-bank systemic risk where one bank may fail to meet its payment obligations. RTGS system completely eliminates this risk. A very well known and often quoted example of settlement risk is the failure of a German bank, Bankhaus Herstatt, in 1974.

Some of the counter parties had irrevocably paid on forex deals assuming they would receive corresponding dollar payments later. When the banking licence was withdrawn in Germany at close of banking hours at 3:30 pm, New York banking was open due to the five hours' time difference.

The New York correspondent bank suspended all outgoing payment obligations, which exposed the counter parties to settlement risk. Such risk has come to be known as Herstatt risk.

Do you remember inter-branch settlement transactions in earlier decades? Whenever a transaction resulted in touching the accounts of two different branches, we used to have inter-branch settlements which grew in volumes with one branch customer being serviced by another branch. There was a separate department controlling it.

Slowly, such entries reduced with computers automatically generating them and, today, it does not need a separate controlling department in most of the banks around. Conceptually, RTGS is the same, generating inter-bank settlement entries automatically in central banks.

What does it involve technology wise? Can technology help in reducing such systemic and settlement risk? The answer is yes.

Implementation of RTGS at country level and expanding its reach as much as possible would address this problem. While there could be various forms of implementation, the most practical has to start from central banks of respective countries, that should further link themselves to create a regional RTGS and go beyond that.

At country level, the central banks should introduce an STP system whereby each bank links its core systems via a payment gateway to the core system of the central bank. In other words, functionally, RTGS system will have some additional components as compared with existing ATM switch.

It needs to have interface with their core system for online settlement in central bank accounts, thereby creating an end-to-end STP environment on real-time basis.

The ability to move funds freely, combined with any business model, will totally revolutionise e-commerce. Countries in the region are in different stages of implementation of RTGS. There are more interesting developments taking place in various payment systems which we will discuss in coming weeks.

The author is General Manager of Doha Bank.