20 763 Electronic Payment Systems Lecture 2 Banking

20 -763 Electronic Payment Systems Lecture 2 Banking Systems and Foreign Exchange

Outline • • • The world banking system Central banks What is a bank deposit? Difference between clearance and settlement Gross v. net settlement How foreign exchange works 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

World Banking System WORLD BANK FOR INTERNATIONAL SETTLEMENTS (PUBLIC POLICY LOANS$200 B) (A BANK FOR 45 CENTRAL BANKS, $130 B) ENSURES LIQUIDITY BASEL, SWITZERLAND INTERNATIONAL MONETARY FUND (BALANCE OF PAYMENTS LENDER $300 B) 182 MEMBER COUNTRIES WASHINGTON, DC PRIVATELY OWNED CENTRAL BANKS MIXED-OWNERSHIP CENTRAL BANKS GOVERNMENT-OWNED CENTRAL BANKS U. S. FEDERAL RESERVE DEUTSCHE BUNDESBANK BELGIUM BANK OF JAPAN HONG KONG HKMA BANQUE DE FRANCE BANK OF ENGLAND PRIVATE BANKS AND CREDIT INSTITUTIONS SOURCE: TRANSACTION. NET 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Central Banks • Legal tender (“real money”) is issued by central banks (and banks operating under their authority) • Non-central banks cannot hold legal tender (except in cash form). Why? (What form would it take? ) • Non-central banks must maintain accounts in the central bank • Banks transfer real money via transactions through the central bank 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Cash Transaction 1. CENTRAL BANK ISSUES FIDUCIARY MONEY (ANTI-FORGERY) + (SERIAL NUMBERS) CENTRAL BANK 2. CENTRAL BANK SELLS CASH TO BUYER’S BANK 7. SELLER’S BANK SENDS CASH TO CENTRAL BANK 6. SELLER’S BANK CREDITS SELLER’S BANK ACCOUNT SELLER’S BANK 5. SELLER DEPOSITS CASH IN SELLER’S BANK ACCOUNT 3. BUYER’S BANK ALLOWS BUYER TO DRAW CASH FROM BUYER’S ACCOUNT BUYER SELLER 4. BUYER PHYSICALLY GIVES CASH TO SELLER 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Movement of Money • World economic product ~$30 T – Time to circulate $30 T ~ 6 days • Money supply (U. S. , March 2002) – M 1 (spendable now) $1182 B (liquid = cash + noninterest deposits + travelers checks) M 1 IS MONEY AVAILABLE FOR PAYMENTS – M 2 (M 1+ time deposits + money market funds) $5. 5 T – M 3 (M 2 + long-term investments) $8. 1 T (M 2 + big deposits: institutional money funds) • Cash $605 B 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

The U. S. Money Supply In billions on May 30, 2002 Currency 605 Non-bank travelers checks 8 Demand deposits 306 Other checkable deposits 263 M 1 Total Savings 2483 Small time deposits <100 K 931 Retail money market funds 948 M 2 Total Large time deposits >100 K 801 Institutional money funds 1185 Bank agreements 365 Eurodollars 218 M 3 Total . 1182 USD. 5544 USD. 8113 USD • . SOURCE: FEDERAL RESERVE 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Function of Banks • Central banks: – Issue fiduciary money (both token and notational) • All other (non-central) banks: – Issue notational scriptural money (bank accounts) • Not fiduciary (“real money”), not token • Non-central banks – Move notational money – Accept deposits (loans from depositors) – Loan deposits to others (borrowers) 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

What is a Bank Account? • Notational representation of a loan to the bank from a depositor • Once the depositor puts money in his account, it becomes the bank’s money, not the depositor’s • When the bank deposits money in the central bank, it becomes fiduciary (real) money • The bank then owes the depositor real money • Effect of deposit: bank ends up with more real money I HAVE $1000 CASH I DEPOSIT $200 IN THE BANK MY ASSETS: $1000 CASH 20 -763 ELECTRONIC PAYMENT SYSTEMS I HAVE $800. BANK OWES ME $200 (MY “ACCOUNT”) MY ASSETS: $800 CASH +$200 OWED BY BANK FALL 2002 BANK DEPOSITS $200 IN CENTRAL BANK HAS $200 MORE MONEY NOW BANK’S ASSETS: +$200 REAL MONEY - $200 DEBT COPYRIGHT © 2002 MICHAEL I. SHAMOS

Benefit of a Bank Deposit • Bank can – loan the money (more than was deposited!) – invest the money – move the money, e. g. make payments – buy foreign currency with the money • Reserve ratio – Fraction of deposits the bank must keep in the central bank (HK minimum 25%, 40% in practice) – With a reserve ratio of 25%, for a $1000 deposit, the bank can lend out $3000 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Foreign Exchange • • Currency = token fiduciary money of a central bank Every bank account is denominated in one currency Most banks allow accounts in only one currency All currencies have three-letter ISO currency codes: – USD (U. S. dollar) – GBP (Great Britain pound) – HKD (Hong Kong dollar) JPY (Japan yen) CHF (Swiss franc) EUR (Euro) • Usually, the first two letters indicate the country; third letter is the first letter of the currency name • Foreign exchange is a barter transaction – To buy GBP for USD, buyer has to find someone with GBP who wants USD 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Foreign Exchange • Every bank must have an account at the central bank (or with another bank that has a central account) • The account is (usually) denominated in that country’s currency and is used to settle obligations in that currency – [Hong Kong is an exception. It has systems for transacting in both HKD and USD. ] • A foreign exchange transaction requires two settlements, one in each currency • Therefore, two countries’ central banks are involved 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Foreign Exchange Example • Bank B (buyer) is in the U. S. • Bank S (seller) is in the UK • B wants to buy 1 million GBP for 1. 56 million USD from S • B must have an account denominated in GBP somewhere, probably at Bank C in the UK. Why? • S must have an account denominated in USD somewhere, probably at Bank T in the US. Why? • Generally, 4 banks are involved in a foreign exchange 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Foreign Exchange Example US BANK B (US) WANTS TO BUY 1 MILLION GBP FOR USD BANK T (US) (NOSTRO ACCOUNT) BANK S USD ACCOUNT BANK C (UK) BANK B GBP ACCOUNT (NOSTRO ACCOUNT) BANK S (UK) WILLING TO SELL 1 MILLION GBP FOR USD UK BANKS US FEDERAL RESERVE BANK THE BANK OF ENGLAND BANK B USD ACCOUNT BANK S GBP ACCOUNT BANK T USD ACCOUNT BANK C GBP ACCOUNT SETTLEMENT ONE: BANK B PAYS 1. 56 MILLION USD TO BANK T CENTRAL BANKS SELLER S NOW HAS 1. 56 MILLION USD IN BANK T 20 -763 ELECTRONIC PAYMENT SYSTEMS SETTLEMENT TWO: BANK S TRANSFERS 1 MILLION GBP TO BANK C BUYER B NOW HAS 1 MILLION GBP IN BANK C FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Clearance v. Settlement • Messaging – Transmission of payment orders • Clearance – Determining the net effect of multiple payment orders – How much does each party owe? How much is it owed? • Settlement – Actual payment in fiduciary (real) money, often involving a central bank • Foreign exchange requires two settlements – Exchange HKD (HK$) to JPY (Japanese ¥) requires settlement in HKD and JPY

Gross v. Net Settlement Systems • Gross settlement system: every transaction is processed separately (usually immediately) Example: cash purchase, large-value bank transfers • Problem: transaction overhead, network load • Net settlement system: transactions are batched Example: credit cards – Merchant is paid once per day, not for each sale – Customer is billed once per month • Problem: delay. Time is the enemy of money.

Payment Graphs B 31 23 16 A 8 C D 14 31 A 31 B 16 “A HAS $49; B HAS $16; A OWES B $31” 44 E 17 49 15 10 B “A OWES B $31” F 7 9 31 A G 55 12 H 13 96 49 (+15) A I 16 (-12) B “A HAS $49; B HAS $16; A OWES B $31; A IS OWED NET $15; B OWES NET $12” WITH N PARTIES, NUMBER OF POSSIBLE DEBTS IS N(N-1)/2 10, 000 BANKS, 50 MILLION PAYMENTS 20 -763 ELECTRONIC PAYMENT SYSTEMS 31 FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Gross Settlement B 31 23 16 A 8 F 7 C 9 D 14 44 E 17 15 10 31 G 55 12 H 13 96 I 20 -763 ELECTRONIC PAYMENT SYSTEMS • Each debt is settled individually • # of payments = # of debts • Here, 16 payments required • Collection is a problem (failure to pay) • RTGS = “real-time gross settlement, ” immediate payment FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A 23 (+15) 16 (-46) 7 8 F C 9 (+52) D 14 44 E 17 31 G 55 12 H (-85) (+68) 15 10 13 96 I (-95) 20 -763 ELECTRONIC PAYMENT SYSTEMS (+90) • Compute net amount owed or owing for each party • Net debtors make one payment to the “clearing house” • Net creditors receive one payment from the clearing house • # of payments = # of parties • 10, 000 banks = 10, 000 payments, not 50 million FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A B 23 16 (-46) 7 8 E 17 F (+52) D 31 G (+68) (+90) E G (+90) 55 12 H (-85) (+68) 15 10 14 44 (-46) C 9 D A F C (+52) (+15) (-23) (+15) 13 H 96 (-85) I I 46 (-95) 23 85 (-95) 95 NET CREDITOR CLEARING HOUSE NET DEBTOR 20 -763 ELECTRONIC PAYMENT SYSTEMS +249 FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A B 23 16 (-46) 7 8 E 17 (+52) D 31 G (+68) (+90) E G (+90) 55 12 H (-85) (+68) 15 10 14 44 F (-46) C 9 D A F C (+52) (+15) (-23) (+15) 13 H 96 (-85) I I (-95) 52 NET CREDITOR 24 68 CLEARING HOUSE NET DEBTOR 20 -763 ELECTRONIC PAYMENT SYSTEMS 15 90 +249 -249 = 0 FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS

Net v. Gross Settlement • Net settlement requires “clearing” – Determining the net amounts owed or owing • Net settlement requires a separate clearing house • Net settlement introduces delay (for clearing) • Net settlement eliminates counterparty risk • Used for large numbers of small payments, e. g. cheques, credit cards • Gross settlement can be instantaneous (< 1 minute) • Gross settlement involves a large number of payments; used for large transactions, e. g. interbank transfers

U. S. Banking & Payments System FORMULATES MONEY POLICY PRINTS CURRENCY U. S. TREASURY DEPARTMENT FEDERAL RESERVE BOARD REGULATES NATIONAL BANKS COMPTROLLER OF THE CURRENCY OFFICE OF THRIFT SUPERVISION ISSUE MONEY NATIONAL COMMERCIAL BANKS (2500) REGULATES SAVINGS BANKS FEDERAL RESERVE BANKS (12) NY FEDERAL RESERVE FEDERAL SAVINGS BANKS FEDERAL RESERVE CLEARING HOUSE OWNS REGULATES USES HAS ACCOUNT WITH FEDWIRE ELECTRONIC PAYMENTS NETWORK ATM NETWORKS: CIRRUS, HONOR, MAC OTHER CLEARING HOUSES CLEAR ATM TRANSACTIONS VISANET CLEAR CHECKS, ACH, CREDIT CARDS 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 CLEARING HOUSE INTERBANK PAYMENT SYSTEM (CHIPS) CLEARS USD LEG OF FOREIGN EXCHANGE COPYRIGHT © 2002 MICHAEL I. SHAMOS

Major Ideas • • • Key role of central banks Bank account = debt owed by a bank to a depositor Clearance: determining net effect of multiple debts Settlement: actual payment of money One settlement requires 2 banks (usually) Foreign exchange requires 2 settlements, 4 banks 20 -763 ELECTRONIC PAYMENT SYSTEMS FALL 2002 COPYRIGHT © 2002 MICHAEL I. SHAMOS