20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
20-763 Electronic Payment Systems
Lecture 2
Banking Systems and Foreign Exchange
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
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
PRIVATELY OWNEDCENTRAL BANKS
U.S. FEDERAL RESERVEDEUTSCHE BUNDESBANK
MIXED-OWNERSHIPCENTRAL BANKS
BELGIUMBANK OF JAPAN
HONG KONG HKMA
GOVERNMENT-OWNEDCENTRAL BANKSBANQUE DE FRANCEBANK OF ENGLAND
BANK FORINTERNATIONAL SETTLEMENTS
(A BANK FOR 45 CENTRAL BANKS, $130B)ENSURES LIQUIDITY
BASEL, SWITZERLAND
WORLD BANK(PUBLIC POLICY LOANS$200B)
INTERNATIONAL MONETARY FUND(BALANCE OF PAYMENTS LENDER $300B)
182 MEMBER COUNTRIESWASHINGTON, DC
SOURCE: TRANSACTION.NET
PRIVATE BANKS ANDCREDIT INSTITUTIONS
PRIVATE BANKS ANDCREDIT INSTITUTIONS
PRIVATE BANKS ANDCREDIT INSTITUTIONS
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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
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Cash Transaction
1. CENTRAL BANK ISSUES FIDUCIARY MONEY (ANTI-FORGERY) + (SERIAL NUMBERS)
2. CENTRAL BANK SELLS CASH TO BUYER’S BANK
3. BUYER’S BANK ALLOWS BUYER TO DRAW CASH FROM BUYER’S ACCOUNT
4. BUYER PHYSICALLY GIVES CASH TO SELLER
5. SELLER DEPOSITS CASH IN SELLER’S BANK ACCOUNT
6. SELLER’S BANK CREDITS SELLER’S BANK ACCOUNT
7. SELLER’S BANK SENDS CASH TO CENTRAL BANK
CENTRALBANK
BUYER’SBANK
SELLER’SBANK
BUYER SELLER
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FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Movement of Money
• World economic product ~$30T– Time to circulate $30T ~ 6 days
• Money supply (U.S., March 2002)– M1 (spendable now) $1182B (liquid = cash + non-
interest deposits + travelers checks)M1 IS MONEY AVAILABLE FOR PAYMENTS
– M2 (M1+ time deposits + money market funds) $5.5T
– M3 (M2 + long-term investments) $8.1T (M2 + big deposits: institutional money funds)
• Cash $605B
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FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
The U.S. Money Supply
Currency 605Non-bank travelers checks 8Demand deposits 306Other checkable deposits 263 .
M1 Total 1182 USDSavings 2483Small time deposits <100K 931 .Retail money market funds 948
M2 Total 5544 USDLarge time deposits >100K 801 .Institutional money funds 1185Bank agreements 365Eurodollars 218
M3 Total 8113 USD
• .
In billions onMay 30, 2002
SOURCE: FEDERAL RESERVE
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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 its 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$1000CASH
I DEPOSIT$200 IN THE
BANK
I HAVE $800.BANK OWESME $200 (MY“ACCOUNT”)
BANK DEPOSITS $200IN CENTRAL BANK
BANK HAS$200 MORE
MONEY NOW
MY ASSETS: $800 CASH +$200 OWED BY BANK
BANK’S ASSETS: +$200 REAL MONEY - $200 DEBT
MY ASSETS: $1000 CASH
20-763 ELECTRONIC PAYMENT SYSTEMS
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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
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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) JPY (Japan yen)– GBP (Great Britain pound) CHF (Swiss franc)– HKD (Hong Kong dollar) 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
BANK B (US)WANTS TO BUY1 MILLION GBP
FOR USD
BANK S (UK)WILLING TO SELL
1 MILLION GBPFOR USD
BANK T (US)
BANK SUSD ACCOUNT BANK C (UK)
BANK BGBP ACCOUNT
US FEDERALRESERVE BANK
BANK B USD ACCOUNT
BANK T USD ACCOUNT
THE BANKOF ENGLAND
BANK S GBP ACCOUNT
BANK C GBP ACCOUNT
SETTLEMENT ONE: BANK B PAYS 1.56 MILLION USD TO BANK T
SELLER S NOW HAS 1.56 MILLION USD IN BANK T
SETTLEMENT TWO: BANK S TRANSFERS 1 MILLION GBP TO BANK C
BUYER B NOW HAS 1 MILLION GBP IN BANK C
US BANKS
UK BANKS
(NOSTRO ACCOUNT)
(NOSTRO ACCOUNT)
CENTRALBANKS
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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
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
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 batchedExample: 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.
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Payment Graphs
A
B
C
D
E
F
G
H
I
2331
96
7
31
8
15
16
109
55
44
13
14
17
12
A B31
“A OWES B $31”
A B31
“A HAS $49; B HAS $16;A OWES B $31”
1649
WITH N PARTIES, NUMBER OFPOSSIBLE DEBTS IS N(N-1)/2
10,000 BANKS, 50 MILLION PAYMENTS
A B31
“A HAS $49; B HAS $16;A OWES B $31;
A IS OWED NET $15;B OWES NET $12”
16 (-12)49 (+15)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Gross Settlement
A
B
C
D
E
F
G
H
I
2331
96
7
31
8
15
16
109
55
44
13
14
17
12
• 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
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Net Settlement
A
B
C
D
E
F
G
H
I
2331
96
7
31
8
15
16
109
55
44
13
14
17
12
• 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
(+24)
(+15)
(+90)
(-95)
(-23)
(+52)
(-85)
(-46)
(+68)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Net Settlement
A
B
C
D
E
F
G
H
I
2331
96
7
31
8
15
16
109
55
44
13
14
17
12
(+24)
(+15)
(+90)
(-95)
(-23)
(+52)
(-85)
(-46)
(+68)
NET CREDITOR
NET DEBTOR
A
B
C
D
E
F
G
H
I
(+24)
(+15)
(+90)
(-95)
(-23)
(+52)
(-85)
(-46)
(+68)
CLEARING HOUSE
85
46
95
+249
23
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
Net Settlement
A
B
C
D
E
F
G
H
I
2331
96
7
31
8
15
16
109
55
44
13
14
17
12
(+24)
(+15)
(+90)
(-95)
(-23)
(+52)
(-85)
(-46)
(+68)
NET CREDITOR
NET DEBTOR
A
B
C
D
E
F
G
H
I
(+24)
(+15)
(+90)
(-95)
(-23)
(+52)
(-85)
(-46)
(+68)
CLEARING HOUSE
52
+249-249 = 0
24 68 1590
20-763 ELECTRONIC PAYMENT SYSTEMS
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
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
COPYRIGHT © 2002 MICHAEL I. SHAMOS
U.S. Banking & Payments System
NATIONAL COMMERCIALBANKS (2500)
FEDWIRE
PRINTS CURRENCY
CLEARS USD LEG OFFOREIGN EXCHANGE
FEDERAL RESERVE BOARD
COMPTROLLER OF THE CURRENCY
OFFICE OF THRIFT SUPERVISION
U.S. TREASURYDEPARTMENT
FEDERAL RESERVEBANKS (12)
NY FEDERAL RESERVE
CLEARING HOUSEINTERBANK PAYMENT
SYSTEM (CHIPS)
FEDERAL SAVINGSBANKS
FEDERAL RESERVECLEARING HOUSE
ISSUE MONEY
REGULATESNATIONAL BANKS
REGULATESSAVINGS BANKS
ATM NETWORKS:CIRRUS, HONOR, MAC
CLEAR ATM TRANSACTIONS
FORMULATES MONEY POLICY
CLEAR CHECKS, ACH, CREDIT CARDS
ELECTRONIC PAYMENTS
NETWORK
OTHER
CLEARING HOUSES
VISANET
USES
OWNS
REGULATES
HAS ACCOUNTWITH
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2002
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
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