Chapter9 - Payment Systems

Chapter 9-Payment Systems
Foundation Certificate in Banking
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Chapter 9 Payment Systems - General

Introduction
The Payment systems include a wide range of instruments that constitute the generally
acceptable means of making payments. It comprises of an institutional/Organizational
framework that manages such payments and operating procedures as well as the
communications network employed to initiate and pass on the payment information
between the parties and to settle payments. Payment system facilitates the exchange of
goods and services between electronic agents, which employ an accepted medium of
exchange.
The aim of any national payment system is to enable the circulation of money in its
economy. An efficient and secure payment system enables economic activities. It provides
the channel necessary for payments and transmission of monetary policy.
The Central Bank of a country intervenes to facilitate the national payment system by
roping in participant banks as part of its money supply & control function.
There are three main areas of public policy that have supported the developments and
reforms in payments system mechanisms:
Protecting the rights of users of payment systems
Enhancing efficiency and competition
Ensuring a safe, secure and sound payments system.
Learning Objective
After reading this chapter you will learn about:
The relevance and importance of payment systems in a nations economy
The payment system mechanisms
The role of the Central Bank in payment systems
Types and categories of payment instruments
Need and importance of payment systems in a nations economy.
How payments are settled and cleared within Banks
Role of Settlement Agent
Basic model of Settlement
What system is followed to clear high volume of payments
What steps are taken to clear the net and deferred payments
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Table of Contents
Chapter 9 Payment Systems - General .................................................................................. 3
9.1
Payment System ................................................................................................... 5
9.2 Central Banks Role in Payment Systems................................................................... 10
9.3
Payment Instruments .......................................................................................... 13
9.4Clearing and Settlement System ................................................................................22
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9.1 Payment System

According to the Indian Payment System Bill 2002,
A payment system means a system that enables payment to be effected between a payer
and a beneficiary and includes clearing, settlement or payment service.
(According to the Committee on Payment and Settlement Systems of the Bank for
International Settlements, Basle)
A set of instruments, procedures and rules for the transfer of funds among system
participants
The definition given by the Bank for International Settlement (BIS) describes the
components that constitute a payment system.
A Set of Instruments
o
There are various modes of making payments like cheque, credit cards,
debit cards, e-Money, Demand Drafts, Banker Cheque, Pay Order, Mail
Transfer, Telegraphic Transfer, Travelers cheque etc.
These modes are known as instruments of a payment system
These instruments direct the bank on how and where the funds are to be
transferred.
Procedures
o
Once the payment instruction is initiated by the payer, the back office
operation of fund transfer starts.
The procedures employed for the fund transfer are known as Clearing and
Settlement procedures in which two or more banks participate to settle the
accounts of the payer and Payee under a Clearing & Settlement Agency
Most of the times, the Central Bank of the country or its authorized
representative bank acts as the clearing & settlement agency.
Rules of Fund Transfer

o
They are the norms or regulations which each party participating in the
payment services/funds transfer should follow.
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Generally, all fund transfer take place electronically through the payment
system network.
The rules specified are the protocols or the message formats used for
various types of fund transfer.
System Participants The following are the various participants in a payment

system:
o
Paying bank The bank where payer has an account and from where the
payment is initiated.
Receiving bank The bank where Payee has an account and receives the
money.
Clearing House A place of book keeping where the accounts of every

bank with the Central Bank are maintained. It performs the functions of
crediting or debiting i.e. increasing or decreasing the respective banks
accounts with the Central Bank.
Central Bank The prime monetary/regulatory authority of the country,

issuer of currency, banker of banks. E.g. in India, Central Bank is RBI.
Figure 1 Participants of a payment system
9.1.1
Necessity of payment systems
Payment systems play an important role in the functioning of the financial system of a
country New Payment systems are required for the following fundamental reasons:
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Protection of Existing assets of the banking system: Banks need to maintain

cordial relationship with their customers, who represent the most important asset
of the bank.
Strengthening of Customer Base: Incorporation of a modern payment system

allows the bank to offer a broader range of services.
Decreasing the Present costs and earning New Income: The only way to achieve
lower costs is to substitute the legacy systems with modern ones. By adopting
modern systems, banks will be able to retain the competitive advantage of their
existing client base. Modification of the payment systems will decrease the
operating costs for banks and also open up new avenues of income.
Some of the key features of payment systems are:
a) Payment Systems as a Revenue Generator The primary source of income for a bank is
the Interest Spread which is actually the difference between the Deposit rate and the
Lending rate. Moreover, the latest advancements in payment systems which eliminate the
need of cash transactions have caused a great increase in financial transactions leading to
increased non-interest revenue.
b) Role of Payment Systems in nations financial stability Payment system play a
central role in the financial stability of a nation. Suppose a bank X on account of an
operational crisis or bankruptcy cannot meet its obligations of paying its debts to another
bank at the settlement time (when banks transfer funds to each other they do not pay
money every time a transaction is made but just pay the offset of their total transactions
with every other bank in the system at the end of the day, generally known as settlement
time). Due to this failure to pay, other banks that were to receive pending payments cannot
get the same which in turn affects their payment obligations. This results in a cascading
systemic failure to make payments and thereby affects the clearing and settlements
process. This results in a traffic-jam like situation where everybody gets stuck, technically
called as Grid-Lock. Due to this cash crunch occurs which threatens the overall stability of
nations financial stability. Hence payment systems and the financial systems of a nation are
closely entwined with each other.
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c) Role of Payment Systems in the economic efficiency of a nation An inefficient

payment system would result in cash settlement delays resulting in a cash crunch scenario
thereby affecting / delaying investments and economic growth.
d) Role of Payment Systems in the implementation of monetary policy- Central Bank of

a nation holds the magic stick to control the total liquidity or the cash in the market. This
magic stick is known as short-term interest rate i.e. the rate of interest at which banks can
lend and borrow money from each other in money markets (also known as Inter-bank
borrowing). If the large value payment systems of a nation are not efficient then Central
Bank cannot control the demand and supply of funds. Moreover, due to delays in the large
value payment systems the banks might not be able to settle their accounts with each other
in a days time. Therefore payment systems have a very important role to play in the
implementation of the monetary policy of Central Bank.
e) Payment systems customer support function Now payment systems have become
full fledged customer support and service providing systems. They not only transfer money
which is their basic function but also help customers to transfer funds from one account to
another electronically. They provide security-handling services to corporate and
institutional customers such as pension funds, mutual funds and endowments.
9.1.2
Goal of Payment Systems
Anyone can make payments to whomsoever one likes, whenever one likes, in whatever type of
currency one likes, at the cost of a few cents per transaction. There are no settlement delays or
mountains of paperwork and value is received instantaneously. There are no distinctions in
costs or delays between a domestic and a foreign currency transaction. Interest is computed
real-time rather than on a "settlement day", a relic from the ancient times, when accounting
was done manually. Finally, privacy and security are guaranteed.
(RBI Vision Statement for Payment Systems, 2001)
The RBI Vision statement encompasses the following tenets for an efficient payment
system. They are referred to as Triple S+E by RBI. This acronym stands for Safety,
Security, Soundness and Efficiency.
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Safety - This addresses the need of the payment system being secure so that it can
handle system risks. There are many forms of risks which may hamper the
credibility of the payment system. They are primarily:
o
Credit Risk associated with the risk of inability to fulfill a financial

obligation. For example, if a borrowing bank is unable to settle its account
with the lending bank within the specified period of settlement or gets
bankrupt, then this is the Fulfillment or Credit risk faced by the Lender.
Liquidity Risk This risk is about the probability that if the party within the
system will be able to meet its financial obligations within settlement time
or not. Though it may have sufficient funds afterwards to pay but not at the
time of settlement. (Here we should know that in credit risk the party does
not meet its financial obligations at all whereas, in liquidity risk the party
does not meet its financial obligations within the time period of settlement.)
Operating Risk This is the risk of malfunction of support systems which

could result in an incomplete payment or the risk that the system operator
or core infrastructure provider to the system is operationally unable to
process.
Systemic Risk Risk arising out of a failure to pay, leading to a cascading

effect of other parties being similarly affected. The situation of Grid-Lock is
when every partys financial obligation is affected by the some other partys
failure to pay.
Legal Risk- This is the risk of not having appropriate legal framework and
procedures to protect the interests of the system participants and hence
adversely affecting the situations of credit and liquidity risks.
Business Risk: refers to the risk the payment system or any of its
components e.g. any of its infrastructure providers cannot be maintained as
a going concern in face of adverse financial shocks which may disrupt its
capacity to deliver processing services.
Security- Confidence and integrity levels for paper-based payment systems are
inculcated after years of continuous efforts. This goal talks about the development
of confidence and integrity for the todays non-cash and paperless payment
systems. For this the security objectives and policies must be established while
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designing the system and reviewed periodically, also the system should be subject
to regular security risk analysis.
Soundness- Due to high volume and frequency of transactions it is essential to

automate the clearing and settlement procedures. Therefore, the underlying
communication backbone and IT infrastructure must work soundly in order to avoid
any systemic disruptions.
Efficiency Being efficient means doing a task in an optimal time at optimal costs.
Hence it is a goal to make payment systems delay-free and free from all the
transactional costs involved.
9.2 Central Banks Role in Payment Systems

The Central Bank of a country is the ultimate provider of liquidity in the system and is also
termed as lender of last resort. In national interest Central Bank has the responsibility of
maintaining both monetary and financial stability. As we read in previous sections that
payment systems are the mode by which Central Bank can achieve its ultimate goal.
9.2.1 Central Bank as an operator of the payment systems
Payment systems for large value payments (LVPs) amongst the banks, payment and
settlement systems for the settlement of securities and forex are often critical to the
system, these are termed as Systemically Important Payment Systems (SIPS). Due to their
criticality of operation, SIPS are owned and operated by the Central Bank of the country.
Credit and Liquidity risks are reduced to miniscule levels if Central Banks money is used
rather than the commercial bank money (i.e. money held in the accounts of private
commercial banks). The Central Bank performs the role of a Central Counter Party (CCP)
and thereby mitigates settlement risk that is inherent in any payment system.
Following are some advantages of using Central Bank money in the settlement process:
Security Because there is no credit risk on the Central Bank.
Availability It is readily available to all participants in payment system.
Efficiency -Since it is secure and can easily be used as a means of payment.
Neutrality- Central Banks do not discriminate between participants while lending

money or settling accounts.
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Finality Central Bank money can be used directly as a means of payment.
9.2.2 Central Bank as an overseer
This role of Central Bank has far-reaching consequences. Central Bank acts as a guardian of
the interests of all the participating members of the system as well as the common public. A
Central Bank must work towards the elimination of settlement risks from the system.
Moreover, it is Central Banks task to regulate and make sure that the international
standards of payment systems are followed while implementation and operations.
9.2.3 Central Bank as the provider of the payment services
All the hardware, software, communication network setup required for the automation of
the whole payment system is provided by Central Bank. The INFINET and the NFS
infrastructure are owned and provided by the RBI to facilitate the Payment systems (both
NEFT and RTGS) in India.
The Central Bank should clearly define its payment system objectives and should publicly
disclose its role and major policies with respect to important payment systems. E.g. the
objective and role of the Reserve bank in the systematically important payment systems is
published and available in public domain. The Central Bank, in promoting the payment
system safety and efficiency must cooperate with other Central Banks and with relevant
foreign or domestic authorities. E.g. at the international level RBI has been in touch with
various multilateral institutions like World Bank, IMF etc.
9.2.4 Core principles of a Systematically Important Payment System (SIPS)
Numerous international initiatives are taken to keep the financial stability in the payments
systems scenario by strengthening financial infrastructure. The Committee on Payment and
Settlement Systems (CPSS) which comprises of the Central Banks of the G10 nations is
contributing to this process through its work on developing core principles for systemically
important payment systems.
A task force was made by CPSS on Payment System Principles and Practices in May 1998 to
consider what principles should govern the design and operation of payment systems in all
countries. The objective of the Task Force was to develop an international consensus on
such principles. In developing universal principles, it consulted groups of Central Banks in
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Africa, the Americas, Asia, the Pacific Rim and Europe. In January 2001 the Bank for
International Settlements (BIS) (established in 1930 for fostering cooperation of Central
Banks and international monetary policy makers) published a draft of the Core Principles for
comment from the wider financial community.
The Core Principles are expressed deliberately in a general way to help ensure that they can
be useful in all countries and that they will be durable. They do not represent a blueprint for
the design or operation of any individual system, but suggest the key characteristics that all
systemically important payment systems should satisfy. Hence following are the core
principles published by the BIS in January 2001 which the nations should follow to develop
their payment systems. By March 2004, India with the help of RBI has made all the SIPS
compliant with the Core Principles. Further, inter-banks clearings at Mumbai and Chennai
were achieved by the end of 2007.
Legal Basis: The system should have a well-founded legal basis under all relevant
jurisdictions.
Rules & Procedures: The systems rules and procedures should enable participants
to have a clear understanding of the systems impact on each of the financial risks
they incur through participation in it.
Risk Management Procedures: The system should have clearly defined procedures
for the management of credit risks and liquidity risks, which specify the respective
responsibilities of the system operator and the participants and which provide
appropriate incentives to manage and contain those risks.
Final Settlement Process: The system should provide prompt final settlement on
the day of value, preferably during the day and at a minimum at the end of the day.
Multilateral Netting: A system in which multilateral netting (i.e. offsetting of

payables, receivables among number of parties to a transaction, with each of them
making payments for net obligations to others or receiving net payments due from
others) takes place should, at a minimum, be capable of ensuring the timely
completion of daily settlements in the event of an inability to settle by the
participant with the largest single settlement obligation.
Claim on Assets: Assets used for settlement should preferably be a claim on the
Central Bank; where other assets are used, they should carry little or no credit risk.
Security and operational Reliability: The system should ensure a high degree of
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security and operational reliability and should have contingency arrangements for
timely completion of daily processing. This principle addresses operational risk.
Efficient Payment Means: The system should provide a means of making

payments which is practical for its users and efficient for the economy.
Fair & Open Access: The system should have objective and publicly disclosed
criteria for participation, which permit fair and open access.
Transparency & Accountability: The systems governance arrangements should be

effective, accountable and transparent.
9.3 Payment Instruments

All payments essentially require a transfer or exchange of money between two parties:
Payer and a Payee. The way or the mode in which this transfer is made is determined by the
instrument of payment used and the channel through which the parties choose to make the
payment.
The transactions thus can be categorized into:
Cash transactions
Non-cash transactions.
9.3.1 Credit based instrument
When a credit-based instrument is used (for example, a payment order), the Sender gives
the instruction directly to his own bank for onward transmission to the Receivers bank. So,
as can be seen from Fig 2 for a credit-based transfer, instruction and funds move in the
same direction.
Figure 9.2 Credit Based Payment
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9.3.2 Debit based instrument
When a debit-based instrument is used (such as a cheque), the Sender first of all gives the
instruction to the Receiver himself, and the Receiver then passes the instruction to his bank,
which will in turn pass it to the Senders bank. So, as can be seen from Fig 3, for a debitbased transfer instruction, funds move in opposite directions.
Figure 9.3 Debit Based Payment
9.3.3 Categories of payment Instruments
Payment Instruments can be broadly categorized into following categories
Paper based payment instruments

o
Cash
Negotiable instruments
Card based instruments
Electronic funds transfer debit transfer and credit transfer.
Cash
Money is a standardized unit of exchange. The practical form of money is currency or
cash. Currency varies across countries whereas money remains the same. For example, in
India, the currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD). Cash or
Currency has been the predominantly used medium of payment across the globe until the
advent of cards. Cash is being increasingly replaced by Plastic Money or cards as they are
usually referred to.
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The modern day currency was originally preceded by drafts and bills, which were the two
ancient forms of paper money. Paper money came into being to make up for coin
shortages.
Negotiable Instruments
Exchange of goods and services is the basis of every business activity. All these transactions
require flow of cash either immediately or after a certain time. In modern business, large
numbers of transactions involving huge sums of money take place everyday. It is
inconvenient as well as risky for either party to make and receive payments in cash. Hence,
it is a common practice for businessmen to make use of certain documents as means of
making payment. Some of these documents are called negotiable instruments.
A negotiable Instrument is a Transferable document, which is an integral part of business
mechanism and is transferable by delivery or by endorsement and delivery.
In India, Negotiable Instruments are governed by the Negotiable Instrument Act 1881.
Cheques, Bills of Exchange, Promissory Notes, Demand Drafts are some examples of it.
These instruments can be easily converted into cash; hence they are used for business
transaction purposes.
To understand why these instruments are called negotiable instruments we will look at
some common examples:
Example 1: Suppose Ram, a book publisher has sold books to Govind for Rupees 10,000/on three months credit. To be sure that Govind will pay the money after three months, Ram
may write an order addressed to Govind that he is to pay after three months, for value of
goods received by him, Rs.10,000/- to Ram or anyone holding the order and presenting it
before him (Govind) for payment. This written document has to be signed by Govind to
show his acceptance of the order. Now, Ram can hold the document with him for three
months and on the due date can collect the money from Govind.
He can also use it for meeting different business transactions. For instance, after a month, if
required, he can borrow money from Hari for a period of two months and pass on this
document to Hari. He has to write on the back of the document an instruction to Govind to
pay money to Hari, and sign it.
Now Hari becomes the owner of this document and he can claim money from Govind on the
due date. Hari, if required, can further pass on the document to Arun after instructing and
signing on the back of the document.
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This passing on process, also known as endorsement in banking parlance, may continue
further till the final payment is made.
Example 2: Ramesh issues a cheque worth Rs. 5,000/ - in favor of Shankar, then Shankar
can claim Rs. 5,000/- from the bank, or he can transfer it to Vishnu to meet any business
obligation, like paying back a loan that he might have taken from Vishnu. Once he does it,
Vishnu gets a right to Rs. 5,000/- and he can transfer it to Ganesh, if required. Such transfers
through endorsements may continue till the payment is finally made to somebody, also
known as the holder in due course, in banking parlance.
In the above examples, we find that there are certain documents used for payment in
business transactions and are transferred freely from one person to another. Such
documents are called Negotiable Instruments. Thus, we can say negotiable instrument is a
transferable or endorsable document, where negotiable means transferable or endorsable
and instrument means document.
Types of Negotiable Instruments

There are 3 types of payment instruments defined by the Negotiable Instruments Act 1881
Promissory Notes
Bills of Exchange
Cheques.
Promissory Note - Section 4 of the Negotiable Instruments Act, 1881 defines a Promissory
Note as an instrument in writing (not being a bank Note or a currency Note) containing an
unconditional undertaking, signed by the maker, to pay a certain sum of money only to or
to the order of a certain person or to the bearer of the instrument.
For example Bank Notes.
Let us take an example to understand better - Suppose Sanjeev takes a loan of Rupees five
thousand from your friend Ramesh. Sanjeev can make a document stating that he will pay
the money to Ramesh or the bearer on demand. Or he can mention in the document that he
would like to pay the amount after three months. This document, once signed by Sanjeev,
duly stamped and handed over to Ramesh, becomes a negotiable instrument. Now Ramesh
can personally present it before Sanjeev for payment or give this document to some other
person to collect money on his behalf. He can endorse it in somebody elses name who in
turn can endorse it further till the final payment is made by Sanjeev to whosoever presents
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it before Sanjeev. This type of a document is called a Promissory Note because a promise is
made by the Payee to pay a particular sum after a particular time to the payer.
Parties to a Promissory Note:

There are primarily two parties to a Promissory Note. They are
The Maker or Drawer the person who makes the Note and promises to pay the
amount stated therein. In the above specimen, Sanjeev is the maker or drawer.
The Payee the person to whom the amount is payable. In the above specimen it is
Ramesh.
In course of transfer of a Promissory Note by Payee and others, the parties involved may be:
Endorser The person who endorses the Note in favor of another person. In the Above
specimen if Ramesh endorses it in favour of Ranjan and Ranjan also endorses it in favour of
Puneet, then Ramesh and Ranjan both are endorsers.
Endorsee The person in whose favor the Note is negotiated by endorsement. In the above
example, it is Ranjan and then Puneet.
Characteristics of a Promissory Note: Following are the main features
A Promissory Note must be in writing, duly signed by its maker and properly
stamped as per Indian Stamp Act.
It must contain an undertaking or promise to pay. Mere acknowledgement of

indebtedness is not enough. For example, if some one writes I owe Rs. 5000/- to
Satya Ramesh, it is not a Promissory Note.
The promise to pay must not be conditional. For example, if it is written I promise
to pay Suresh Rs 5,000/- after my sisters marriage, is not a Promissory Note.
It must contain a promise to pay money only. For example, if some one writes I
promise to give Suresh a Maruti car then it is not a Promissory Note.
The parties to a Promissory Note, i.e. the maker and the Payee must be certain.
A Promissory Note may be payable on demand or after a certain date. For example,
if it is written three months after date I promise to pay Satinder or order a sum of
rupees Five Thousand only then it is a Promissory Note.
The sum payable mentioned must be certain or capable of being made certain. It
means that the sum payable may be in figures or may be such that it can be
calculated.
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Bill of Exchange
Section 5 of the Negotiable Instruments Act, 1881 defines a Bill of Exchange as an
instrument in writing containing an unconditional order, signed by the maker, directing a
certain person to pay a certain sum of money only to or to the order of a certain person, or
to the bearer of the instrument.
Let us look at the following example for the better understanding:

Suppose Rajiv has given a loan of Rupees Ten Thousand to Sameer, which Sameer has to
return. Now, Rajiv, in turn has borrowed Rupees Ten Thousand from Tarun. In this case,
Rajiv can make a document directing Sameer to make payment up to Rupees Ten Thousand
to Tarun on demand or after expiry of a specified period. This document is called a Bill of
Exchange, which can be transferred to some other persons name by Tarun. Following is a
specimen of the Bill of Exchange.
Parties involved in a Bill of Exchange

There are three parties involved in a Bill of Exchange. They are
Drawer The person who makes the order for making payment. In the above example,
Rajiv is the drawer.
Drawee The person to whom the order to pay is made. He is generally a debtor of the
drawer. It is Sameer in this case.
Payee The person to whom the payment is to be made. In this case it is Tarun. The drawer
can also draw a bill in his own name thereby he himself becomes the Payee. Here the words
in the bill would be Pay to us or order. In a bill where a time period is mentioned, just like the
above specimen, is called a Time Bill. But a bill may be made payable on demand also. This
is called a Demand Bill.
A bill must be in writing, duly signed by its drawer, accepted by its drawee and
properly stamped as per Indian Stamp Act.
It must contain an order to pay. Words like please pay Rs 5,000/- on demand and
oblige are not used.
The order must be unconditional.
The order must be to pay money and money alone.
The sum payable mentioned must be certain or capable of being made certain.
The parties to a bill must be certain.
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Cheques
The Negotiable Instruments Act, 1881 defines a cheque as a Bill of Exchange drawn on a
specified banker and not expressed to be payable otherwise than on demand. Actually, a
cheque is a debit based instrument in the form of written order by the account holder of the
bank directing his banker to pay on demand, the specified amount, to or to the order of the
person named therein or to the bearer.
Features of a cheque
A cheque must be in writing and duly signed by the drawer.
It contains an unconditional order.
It is issued on a specified bank only.
The amount specified is always certain and must be clearly mentioned both in
figures and words.
The Payee is always certain.
It is always payable on demand.
The cheque must bear a date otherwise it is invalid and shall not be honored by the
bank.
Types of Cheques
Broadly cheques can be categorized on the basis of ownership or on the basis of timing of
issue.
On the basis of ownership cheque has following four sub-categories.
Open cheque: A cheque is called Open when it is possible to get cash over the
counter at the bank. The holder of an open cheque can do the following:
Receive its payment over the counter at the bank,
Deposit the cheque in his own account
Pass it to some one else by signing on the back of a cheque.
Crossed cheque: Since open cheque is subject to risk of theft, it is dangerous to

issue such cheques. This risk can be avoided by issuing another type of cheque
called crossed cheque. The payment of such cheque is not made over the counter at
the bank. It is only credited to the bank account of the Payee. A cheque can be
crossed by drawing two transverse parallel lines across the cheque, with or without
the writing Account Payee or Not Negotiable.
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Bearer cheque: A cheque which is payable to any person who presents it for
payment at the bank counter is called Bearer cheque. A bearer cheque can be
transferred by mere delivery and requires no endorsement.
Order cheque: An order cheque is one which is payable to a particular person. In

such a cheque the word bearer may be cut out or cancelled and the word order
may be written. The Payee can transfer an order cheque to someone else by signing
his or her name on the back of it.
On the basis of time of Issue, cheques can be classified into: .
Ante-dated cheques- Cheque in which the drawer mentions the date earlier to the
date of presenting it for payment. For example, a cheque issued on 20th May 2003
may bear a date 5th May 2003.
Stale Cheque- A cheque which is issued today must be presented at bank for
payment within a stipulated period. In India the stipulated period is 6 months. After
expiry of that period, no payment will be made and it is then termed as a stale
cheque.
Post-dated Cheque- Cheque on which drawer mentions a date which is

subsequent to the date on which it is presented, is called post-dated cheque. For
example, if a cheque presented on 8th May 2003 bears a date of 25th May 2003, it is
a post-dated cheque. The bank will make payment only on or after 25th May 2003
upto a period (six months) after which the cheque becomes stale.
Credit Transfers
Credit transfers (or giro payments as they are frequently called) are the traditional means of
non-cash payment in a number of European countries.
They can be in paper or electronic form and can be used for both non-recurring and
recurring (e.g. weekly, monthly, quarterly) payments; they are not, however, suitable for
point-of-sale transactions.
A particular advantage of credit transfers is that the receiving customer does not have to
worry about the credit-worthiness of the payer since, by definition, a credit transfer cannot
be sent without the approval of the paying customers bank, and without the paying
customers account having first been debited. (So, as with a pre-paid cheque or bankers
draft, certainty of payment for the receiving customer is at the expense of the paying
customer in terms of immediate debiting of his account.)
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Customers who need to make recurring payments (for example payment of household
mortgages, insurance premiums etc.) can enter into a standing order arrangement with their
bank, which then contracts to carry out the necessary credit transfers on a regular specified
date, to a specified customer and for a specified amount.
Corporate customers can similarly arrange for regular payments to be made (e.g. wages and
salaries) under a direct credit arrangement.
Customers needing to make (or receive) time-critical and/or high-value payments may use
an electronic credit transfer. Not only does it provide greater certainty of payment for the
receiving customer but it may also provide him with funds on the same day that the payer
initiated the transfer.
Indeed, in terms of the total value of payments, rather than the number of transactions, the
dominance of the electronic credit transfer is readily apparent.
Direct debits
A Direct Debit is an instrument specifically developed to facilitate recurring customer
payments, and like a standing order, is well-suited to automation. It is gaining increasing
importance in a number of countries. Direct Debit payments are reauthorized by the paying
customer, who gives permission for his bank to debit his account upon receipt of
instructions initiated by the receiving customer (e.g. a utility company, or insurance
company).
Cheques are popular from the payers point of view because of the delay between the
drawing of the cheque and the debiting of the payers bank account. Indeed, this feature
can be deliberately used by enterprises to improve their management of cash flow.
However, as with all debit-based instruments, there is the potential problem of the
creditworthiness of the drawer of the cheque (the person making the payment): what
guarantee does the receiving customer have that the cheque which he has received will
represent good value i.e. that the payer has funds in his bank account to back the cheque.
Card based Payment Instruments

It is a term collectively used to refer to different cards used by a cardholder for payment,
and includes credit card, debit card, charge card or any other card issued by financial
intuition like banks and which help cardholder to make payment for service, product or to
obtain cash.
Page 21 of 40
The basic choice here is between credit cards and debit cards. A credit card indicates that
the holder has been granted a line of credit by the card-issuing bank, enabling the holder to
make purchases up to a prearranged ceiling limit. Credit thus granted can be settled in full
by the end of a specified period; or can be settled in part, with the balance taken as
extended credit on which interest is charged.
Travel and entertainment cards (charge cards) operate on a similar principle, except that
the card holder is not given the opportunity to have a period of extended credit, the full
amount of the outstanding debt having to be settled at the end of the specified period.
A Debit Card enables the holder to have his expenditure directly charged to his bank
account. It does not offer a period of free credit to the holder after he has made a purchase;
but it is seen by many as a more convenient alternative to writing a cheque for a point-ofsale purchase.
Nowadays, Debit Cards are the primary means to carry money in pockets, it is very useful in
terms as it can also be used as an ATM card to carry out bank withdrawals. Thus they are
both convenient and time saving. Both Debit and Credit card systems may incorporate
authorization procedures, whereby merchants at the point-of-sale obtain the approval
(increasingly by on-line electronic means) of the Card Issuer to accept the transaction.
A third kind of payment card that is now being developed is the Pre-Paid Card. This is a
card incorporating a computer chip/integrated circuit on which value is loaded, either
from the card-holders bank account or in return for cash. Value is then removed from the
card as purchases are made, using special point-of-sale terminals.
Single-purpose, non-reusable prepaid cards have been in existence for a number of years,
for use in telephone kiosks and car parks for example.
The new generation of cards will be multipurpose, and rechargeable.
Payment cards may also incorporate non-payment functions. Specifically, they may be used
as a cheque guarantee card (as discussed above), or as an ATM/cash dispenser card.
9.4Clearing and Settlement System

9.4.1 Introduction
Clearing process is used to denote all the activities that take place from the time a
transaction is initiated till the time it gets settled. Clearing is essential because the trade
takes place at a speed much faster than the cycle time for finishing the underlying
transaction. Clearing makes transactions easier and smoother Settlement of a payment
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transaction is deemed to have taken place on finalization and posting of accounting entries
(both debit and credit).
Clearing & Settlement Definition
CLEARING: It is the process of transmitting, reconciling and in some cases confirming

payment orders or security transfer prior to settlement.
SETTLEMENT: It refers to the act of transferring good and final funds between two
parties.
Types of Settlements
Designated-time Net Settlement (DNS): Under this type of settlement, running balances
are calculated on a bilateral or multilateral basis for each participant in comparison with the
other participants and only net amounts are settled at pre-specified times during the day.
Real Time Gross settlement (RTGS): Settlement of funds occurs on a transaction by

transaction basis continuously in real time without netting debits against credits.
Bilateral Correspondent Arrangement A basic model of settlement
Here we shall start with a basic model of payment settlements through a correspondent
Bank. After having gone through this model carefully reader would appreciate the basic
concept of what exactly settlement means.
Figure 9.4 Bilateral payment arrangements
Assumptions made for this model are:

There exist only two Banks in the whole system of Banking
Both of these Banks hold an account in the name of each other in their accounting
system, i.e. the Bank A has an account of Bank B in their books and vice-versa.
Page 23 of 40
Example: Payer A has to pay a sum of Rupees 10,000 to the Payee B. Both have their
accounts with Banks A and B respectively.
Now the Payer gives the payment instruction of money transfer, for example typical wire
transfer to Bank A. Both Banks have Nostro-Vostro (mutual) accounts of each other in their
books of accounts. Let us assume that in As accounting books Bank Bs account has 10,
00,000 rupees and Bs books have Bank As account with 12, 00,000 rupees. On generation
of the payment instruction of 10,000 rupees by the Payer to payee, one of the following two
procedures can be followed by both Banks to transfer the funds.
Bank A increases (credits) the account balance of Bank B by 10,000 rupees making it
10,10,000 and passes the information to Bank B so the Bank B in-lieu decreases (debits) its
own Bank balance and credits the account of the payee held in their Bank by the same
money.
Or
Bank A simply passes the information to the Bank B where in turn Bank B decreases the
balance of As account by 10,000 rupees making it 11, 90,000 rupees and increases the
balance of payees account by 10,000 rupees.
Figure 9.5 Generic Payment Flow process using a Clearing House

Page 24 of 40
In a transaction process the creation, validation and transmission of payment is

administered. It involves the following steps:
ID verification of the involved parties
The validation of the payment instrument
Verification and check over the ability to pay
Authorization of the transfer of funds by the Payer and the Payers financial
institution
Communication of the transaction settlement and clearance proceedings between

the parties
Processing of the transaction.

Role of Settlement Agents
To eliminate the difficulty in settlement, a Settlement Agent is included in the process,

which works for the process of settling each Banks account with respect to others
depending upon the transactions they make with each other.
Figure 9.6 Role of Settlement Agent
The Settlement Agent is the third party which can be another financial institution
performing the task of holding each Banks account with them and making the adjustments
in each others accounts depending upon the transactions they have made with each other.
Generally Central Bank of the country acts as the Settlement Agent.
For example in India, RBI acts as a Settlement Agent and every other Bank like ICICI, PNB,
HDFC, SBI etc hold an account with RBI and all the payments amongst them are accounted
for at RBI.
Page 25 of 40
So for example: a person/firm having an account in PNB who needs to pay Rs. 20,000 to
another person/firm having an account in HDFC Bank, can pay the amount through an
instrument which is transferred between them and then processed by the RBI in each of the
Banks account, so the changes in the accounts are done by the respective Banks, but the
money transfer between the Banks is taken care of by the RBI.
Correspondent Bank as Settlement agent
In the basic model our assumptions were very simple and far from the reality of actual
world. The financial space has numerous Banks; it obviously becomes very difficult for each
of the Bank to maintain a mutual account with every other Bank.
Consider the difficulty if we have N Banks, N being a very large number, then every Bank
has to have N-1 accounts of other Banks with them. Suppose every Bank has equal number
of customers M, which will obviously be a large number also. Let x, y be a subset of M and z
be a subset of N-1, then the total number of transactions every day held by each Bank are
xyz. In the worst case this number can be M*M*(N-1) which would be a big headache for
Banks.
Figure 9.7 Payment Settlements through Correspondent Bank
As the whole process is described algorithmically above, the correspondent Bank is acting
as the Settlement Agent for both Banks. Both Banks keep account with Bank C which in
turn debits or credits their accounts depending upon the flow of funds amongst them.
Page 26 of 40
Gross Settlement & Net Settlement
In this section, we will focus on frequency of the settlement processes in a day i.e. when the
settlement should be done.
Participating Banks, can settle their payment balances with the other Banks either at the
end of every day (deffered) or they can settle it after every payment made or received (real
time). Depending upon the frequency of the settlement of the payments, at the end of day
or payment by payment basis there are two methods to settle payments:
Gross settlement and
Net settlement.
Net Settlement Mechanism
In the net settlement mechanism, the total number of a particular Banks out-payment are
offset against the total number of Banks in-payments i.e. as soon as the payment is made
or received by a Bank no actual transfer of funds takes place between the settling authority
(assume Central Bank) and the Bank. Instead the entries are made only into the account of
the Bank with RBI. At the end of day, i.e. at the settlement time, the final transfer of funds
takes place which is equivalent to the net position of the Bank.
Example: Retail payments like cheque transactions, credit card and debit card transactions
etc.
The process of Net Settlement can be divided into two steps, either of which may form the
basis for producing the entries for posting to settlement accounts:
Bilateral Settlement - Let us take an example of Banking systems comprising of four
banks. In this system, every Bank deals with every other Bank bilaterally i.e. payments are
offset between each pair of Banks individually
Figure 9.8 Bilateral Settlement

Page 27 of 40
The diagram above shows the day long actual flow of instructions in between every pair of
Bank. Lets take a look at the flow of funds in a tabular form.
Table 9.1 Bilateral Payments
From/To
A
B
C
D
A
70
0
10
B
90
50
30
C
40
0
60
D
80
0
20
-
In Table 1, the values in the row denote the payments to be made by the Bank to the other
Banks in the columns. The values in the column denote the payments to be received by the
Bank in the column from other Banks.
The following diagram shows how the net payment positions are calculated bilaterally for
each Bank. Here Clearing House comes into the picture. The Clearing House calculates net
obligation of each Bank by considering all the payments to be made to other Banks
individually and total payments to be received from other Banks.
In other words, bilateral netting involves the offsetting of the bilateral claims and
obligations between each pair of Banks. In the four-Bank example this means that each
Bank will have three separate bilateral positions with respect to the other members of the
system - positions that can be either a net pay or a net receive, or a zero net obligation
(though this last possibility is not included in the example).
Thus in the next diagram, Bank A is a net Payer to the three other Banks; while Bank D is a
net receiver from A, but a net Payer to B and C. These bilateral net positions may be used
instead of the gross figures for the Inter-Bank settlement.
Figure 9.9 Bilateral Net Settlements
Page 28 of 40
We will show you how such a settlement takes place by calculating the net positions of Bank
A with every other Bank:
Between Banks A&B 90 -70 = 20 (Net Payable)
Between Banks A&C 40 0 = 40 (Net Payable)
Between Banks A& D 80 10 = 70 (Net Payable)
For an m*m matrix the general formula to get the bilateral net positions will be
A(i , j) A( j , i) ; where i j
Multilateral Net Settlement When bilateral net positions are calculated, then in the
second step each Bank in the system settles its overall net position with respect to all the
other members of the system. There will only be one settlement account entry for each
Bank.
Figure 9.10 Multilateral Net Settlements
Under multilateral net settlement, Bank A is a net Payer; Banks B and C are net receivers,
while Bank D has a zero net position. This whole process can be presented in tabular form in
a settlement matrix. This shows all the gross payments between pairs of Banks and how
the ultimate multilateral net positions are derived.
As discussed, Payment systems with multilateral net settlement usually operate through a
clearing house, a central location through which the payment instructions pass and which is
responsible for calculating the multilateral net positions of the member Banks and passing
them on to the Central Bank for posting to the members settlement accounts.
Page 29 of 40
This leads to the question of the timing of settlement. A netting operation requires the
collection of details of in and out-payments submitted over a specified time period - often a
whole business day, although it may involve shorter, more frequent periods. There is thus a
delay between the initial submission of the payment instruction and the settlement across
the accounts at the Central Bank. Indeed, it may be the case that payment instructions pass
through the clearing house and on to the receiving Banks before settlement takes place.
This has important implications for the risks in payment systems.
In below table, settlement matrix of all the net positions of Banks are calculated as below.
For 1st Bank
X(1,j) - X(i,1)
For 2nd Bank
X(2,j) - X(i,2)
: For Mth Bank
X(M,j) - X(i,M)
All those payments systems where volume of transactions is greater than the value of
transactions per day use Net Settlement systems. For example retail payment systems that
deal with settlement of credit card payments or cheque payments employ Net Settlement
systems to settle their payments.
Table 9.2 Settlements
Bank sending
payment
A
B
C
D
Sum of claims
Sum of
obligations
Multilateral Net
Positions
A
70
0
10
80
210
-130
Bank Receiving payment

B
C
90
40
0
50
30
60
170
100
70
100
100
D
80
0
20
100
100
Sum of
obligations
210
70
70
1000
450
450
30
Role of Clearing House in Net Settlements
We saw that a lot of calculation is needed to come up with the final net payable or
receivable position of each participant. Question arises that who carry out these
calculations on behalf of banks? It is the Clearing House which determines all participants
net funds payable or receivable positions before passing on the result to the Central Bank.
It is important to bear in mind that it is not the Clearing House (that holds the accounts of
every participating Bank) that carries out the settlement process. This is done by the Central
Page 30 of 40
Bank; while the Clearing House merely passes the information to the Bank that how much is
to be settled by which Bank (Clearing settlement details).
Figure 9.11 Role of Clearing House
Facts to be noted here are:
Payment system clearing houses can take a variety of forms
They may be owned and operated by the Central Bank itself, or by the commercial
banks, or by a combination of the two
They may be designed to handle either paper or electronic/automated payment

instructions, or both. With electronic payments, the Clearing House may process
them in batches, or in real-time as each instruction arrives
The latter alternative enables the Clearing House to monitor Banks net positions on
a continuous basis - important if there is a structure of limits in place
They may be organized to either serve the whole country, or on a regional basis
within the country
The latter may be useful in countries with poor communications and transport
infrastructure, or where cities are geographically dispersed at faraway locations
over large distance
In such cases, the settlement accounts of the Banks in the regional/local Clearing
House may be held at the local branch of the Central Bank. Clearing houses may be
owned and operated by Central Bank.
Figure 9.12 below explains the process of net settlement taking the perspective of both the
customer and the Banker.
Page 31 of 40
Figure 9.12 Payment Settlements in Net Settlement System

Real Time Gross Settlement (RTGS)
With gross settlement, each payment instruction is passed from the Paying Bank to the
Central Bank and is individually settled across the accounts of the Paying and Receiving
Banks. Thus, there will be a debit and credit entry for each and every payment instruction
settled. The meaning of real time and gross settlement is explained below:
Gross Settlement is an alternative method of settlement whereby all the payment

instructions are settled on transaction-by-transaction basis without bunching with any
other transaction in real time.
Real-Time is a method all the payments are settled continuously rather than periodically
as is done in the Net Settlement system. In real time payment transaction is not subjected
to any waiting period. The transactions are settled as soon as they are processed.
Thus, RTGS may be defined as a funds transfer mechanism where transfer of funds takes
place from one Bank to another on a real time and gross basis. This is the fastest money
transfer system through the Banking channel. An RTGS system provides continuous finality
to the intra-day payments. As soon as the Payer Bank generates a Payment Instruction it
gets settled, i.e. funds are transferred from the Payer Banks account with the Central Bank
into the Payee Banks account, then and there without any delay.
RTGS is unsuitable for Retail payments because their recurrence is very high and using
continuous settlement mechanisms for them will eventually lead to the severe congestion
problems in the system.
Page 32 of 40
RTGS systems are used for high valued payments
In India the minimum amount to be remitted through RTGS is Rs1 Lakh
There is no upper ceiling for RTGS transactions
High value payments include mainly inter-bank transactions, which comprise:

o
Money market transactions: when Banks take intra day loan to settle their
accounts with RBI from various financial institutions like Industrial
Development Bank of India (IDBI), Industrial Finance Corporation of India
(IFCI) etc
Foreign Exchange Settlement: When Banks deal in foreign exchange

transactions
Cash transactions in Securities Trading: When Banks make or receive cash

payments in-lieu of trading of huge volumes of securities (i.e. Govt. bonds,
Shares, Debentures etc.)
Due to these high value transactions in financial markets sometimes the total turnover for a
RTGS system can be equal to 50 times the total GDP of the economy.
Many developed nations and all G10 countries have employed RTGS systems for their
settlement of high value payments.
In the field of Large Value Payment Systems (LVPS) RBI has implemented Real Time Gross
Settlement System (RTGS) in India.
Other countries also have their own RTGS systems like:
FedWire in US
CHAPS in UK
RITS in Australia
BOJNET in Japan
SIC in Switzerland
FA in Netherlands
EILZV in Germany
RIX in Sweden
ELLIPS in Belgium
BISS in Italy.
International Acceptance of RTGS
Payments in RTGS systems are typically credit transactions, i.e. payments are initiated by
the Remitter (debtor). Payments in RTGS systems are settled via the participants' accounts
Page 33 of 40
with the settlement Bank by simultaneous debiting of the Remitter's account and crediting
of the Recipients account, after which a payment is considered to be final.
In most RTGS systems, the settlement Bank is the national Central Bank, which also owns
the system.
Figure 9.13 below explains the process of settling down the payments via RTGS mechanism.
Figure 9.13 Payment Settlements through RTGS System
All the RTGS transactions are done electronically. A payment message using SWIFT
standards and SWIFT network, (where SWIFT denotes-Society for Worldwide Inter-Bank
Financial Telecommunication) is generated by the Payee Bank (i.e. these messages are
specific electronic formats of data transfer wherein every message contains a header in
which it is specified that what type of transaction is it, BIC (Bank Identifier Code) of the
Bank which generated it and the BIC of the Bank which is going to receive it).
The payment message generated is then routed to the Receiver Bank through the RTGS
system installed at the Central Bank. RTGS system follows the star-topology with Central
Bank acting as a hub.
Objectives of RTGS:
To widen and strengthen the customer base
To improve liquidity management of participating Banks
To reduce settlement risk due to payment default
To reduce the transaction costs and to explore revenues for generating addition
income for Banks
To increase the speed of transfer

Page 34 of 40
To increase the system reliability
To strengthen the payment system and thus the trade and economy.
Fundamental advantages of RTGS:
Most certain way of eliminating inter-Bank settlement risk
Liquidity problem is easily and immediately detected
RTGS system prevents settlement risk arising between commercial Banks in high
value payments systems
Provides recipients of high value payments with assurance that payments are
irrevocable in their hands at the time of receipt.
RTGS Features
Conventionally, a Payment Instruction is expected to be settled as soon as it is received,

which is a feature of a Real Time system. However, there exists a possibility of few
transactions not getting settled immediately.
In such cases, the RTGS system will maintain a payment queue wherein payment
transactions will be held on a FIFO or First In-First Out basis. The participants are also
provided with facilities to view the transactions held in payment queues, cancel
transaction(s) and can change the order of priority.
In order to cater to the confidentiality and security concerns of participants, one can view
only the other participants in queue or ones own pending incoming payment instructions.
We shall take an example to help the reader appreciate this fact better.
Suppose ICICI Bank is a participant of the RTGS system in India and they need to handle
several high value payments due to a large number of transactions. Assuming ICICI Bank
does not have sufficient liquidity at that juncture; they would also be maintaining a
payments queue which will be working on FIFO principle.
The client of the RTGS system installed at their side will maintain such a queue for them.
Outgoing payments will be put in the queue along with a function, which will continuously
check the position of Banks liquidity pool.
Bypass
In RTGS systems participants can select a bypass function that can be used when the first
payment in the liquidity queue cannot be settled due to lack of liquidity.
Page 35 of 40
With bypass, the system will attempt to settle one or more of the subsequent payments,
provided that there is cover in the participant's account. It will then attempt to settle the
first payment at a later point in time.
The bypass function prevents a situation where a large-value payment blocks the
settlement of small payments.
Optimization Routines
A number of RTGS systems use optimization routines to minimize the number and value of
queued payments. One type of optimization routine typically attempts to settle a group of
payments simultaneously. Another type of optimization routine offsets outgoing and
ingoing payments of the same size.
Message Flow Structures in RTGS systems
To initiate a payment, the message is first transferred to the Central Bank from where it
gets routed to the Beneficiary. Such a setup needs to follow some sort of architecture.
There are four topologies of how messages can be transferred between Banks:.
The V-Shaped Structure
To initiate a fund transfer, the sending Bank dispatches a payment message which is routed
through a Central Bank, to a receiving Bank. In this structure, the message with all
necessary information about the payment is passed on to the Central Bank.
For example, all the information about the beneficiary is passed to the Central Bank. After
the Receiving Bank settles the transfers with Central Bank, the said information is passed on
to the Receiving Bank. In this structure, the Central Bank functions as an arbitrator and a
postman. Most of the RTGS systems worldwide use this structure.
Fig.9.14 V Structure of RTGS

Page 36 of 40
The Y-Shaped Structure

Banks using the Swift Network follow an alternative structure, which is a Y shaped
structure.
In this case, the payment message is transmitted by the sending Bank to the central
processor. The central processor filters the information and takes a subset of information
that is necessary for settlement, from the original message and passes this subset to the
Central Bank. The Central Banks processor retains the original message.
On receipt of the subset, the Central Bank verifies whether the sending Bank has sufficient
funds in its account. Then the Central Bank informs the central processor the status of the
transfer as to whether settled or queued or rejected. Once settlement takes place, the full
message containing all the information confirming the settlement is rebuilt by the central
processor and sent to the Receiving Bank.
In this structure, the business information that is exchanged between the Sending and
Receiving Banks is not known to the Settlement Agent viz. the Central Bank.
Figure 9.15 Y Structure of RTGS
Example: Reserve Bank of India has chosen Y-shaped structure to meet strategic objectives
i.e possibility to hive-off the Inter Bank funds transfer processor (IFTP), which strips and
retains the customer related information and forwards the payments and settlements
particulars to RTGS, to an independent industry service provider.
Page 37 of 40
The L- Shaped Structure

It is similar to the Y-shaped structure in every aspect apart from the little difference that
there is a gateway attached to the sending Banks processing system which does the same
task of central processor in the previous structure - that is of taking a subset of core
information and only sending it to Central Bank for settlement.
Example: CHAPS of UK have implemented this structure.
In this structure, the payment message emanating from the Sending Bank is held at a
system gateway, which is attached to the Sending Banks internal processing system. From
the gateway, a subset of the original message is created and sent to the Central Bank. If the
Sending Bank has sufficient funds in its account, the settlement is completed and the
Central Bank confirms this, by way of a message to the Sending Banks gateway. On receipt
of this confirmation message, the original payment message is automatically relayed from
the sending Banks gateway to the Receiving Bank
Figure 9.15 L Structure of RTGS
The T-Shaped Structure

The common feature in the previous three structures was that only after full settlement
takes place the message is passed on to the beneficiary. But in the T structure a copy of the
unsettled payment message is also passed to the Beneficiary Bank.
This may give rise to some complications as the sole purpose of RTGS is to handle various
risks such as credit risks and other settlement risks which is minimized by not informing the
beneficiary until the final settlement. But due to sending of unsettled messages also to the
Page 38 of 40
beneficiary, beneficiary may give credit to its customers in the anticipation of receipt of
funds. Hence this structure is vulnerable to credit risk exposure.
T shaped structure has generally been viewed as incompatible with the basic principles of
RTGS that a funds transfer should be passed on to a Receiving Bank , if and only if, it has
been settled irrevocably and unconditionally by the Central Bank.
Till now none of the G10 nations have adopted this RTGS structure type.
Figure 9.16: T Structure of RTGS
Page 39 of 40
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