Electronic Payment Systems 20 -763 Lecture 2 Banking

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

Lecture Outline • • • World banking system Central banks Money supply measures What

World Banking System WORLD BANK UNITED NATIONS AGENCY (DEVELOPMENT LENDER) 184 MEMBERS ASSETS: $230 B WASHINGTON, DC BANK FOR INTERNATIONAL SETTLEMENTS (A BANK FOR 45 CENTRAL BANKS, $130 B) BASEL, SWITZERLAND INTERNATIONAL MONETARY FUND (PUBLIC POLICY 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 SWISS NATIONAL BANK S. AFRICAN RESERVE BANK BELGIUM BANK OF JAPAN HONG KONG HKMA BANQUE DE FRANCE BANK OF ENGLAND PEOPLE’S BANK OF CHINA CENTRAL BANK OF INDIA PRIVATE BANKS AND CREDIT INSTITUTIONS SOURCE: TRANSACTION. NET ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Central Banks • Legal tender (“real money”) is issued by central banks (and banks operating under their authority) – U. S. : Federal Reserve Bank • Non-central banks cannot hold legal tender (except in cash form). Why? (What form would it take? ) • How do banks pay each other? – Through accounts in the central bank (directly or indirectly) ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Payment System Layers VALUE TRANSFERRED FROM BANK TO BANK ON BOOKS OF CENTRAL BANK Securities Financial markets CENTRAL BANK FINAL SETTLEMENT INTERBANK SYSTEMS Transportation/Exchanges CLEARING Risk/Credit Management Head Office BANK B Head Office BANK A BANKS Branch A 1 3 2 2 Branch A 2 3 2 1 Client A 2 3 Branch B 1 Branch B 2 SETTLEMENT BETWEEN BRANCHES AND CUSTOMERS’ ACCOUNTS Client B 1 Client B 2 SOURCE: WORLD BANK

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 ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Money Supply • Money supply (US, November 2003, in USD) – M 0 (currency = coins & notes) 661 B – M 1 (spendable now) 1281 B (liquid = M 0 + noninterest deposits + travelers checks) M 1 IS MONEY AVAILABLE FOR PAYMENTS – M 2 (M 1+ time deposits + bank CDs) 6. 07 T – M 3 (M 2 + large time deposits + institutional money funds) 8. 86 T ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

The U. S. Money Supply In billion USD Nov. 30, 2003 Currency 661 Non-bank travelers cheques 7 Demand deposits 306 Other checkable deposits 307 M 1 Total Savings 3155 Small time deposits <100 K 810 Retail money market funds 825 M 2 Total Large time deposits >100 K 876 Institutional money funds 1129 Bank agreements 502 Eurodollars 282 M 3 Total • . ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 (2/3 outside the U. S. ) . 1281 USD. 6071 USD. 8860 USD SOURCE: FEDERAL RESERVE COPYRIGHT © 2004 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) ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 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 MY ASSETS: $1000 CASH I HAVE $800. BANK OWES ME $200 (MY “ACCOUNT”) I DEPOSIT $200 IN THE BANK MY ASSETS: $800 CASH +$200 OWED BY BANK ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 BANK DEPOSITS $200 IN CENTRAL BANK HAS $200 MORE MONEY NOW BANK’S ASSETS: +$200 REAL MONEY - $200 DEBT COPYRIGHT © 2004 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 – If the reserve ratio is 25%, then for a $1000 deposit, the bank can lend out $3000 ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 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 ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 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 HKD, USD and EUR. • A foreign exchange transaction requires two settlements, one in each currency • Therefore, two countries’ central banks (or settlement systems) are involved (except in HK) ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Foreign Exchange Example • Buyer in the US wants to pay an invoice in GBP from Seller in the UK • Buyer needs GBP. Where does he get them? Where does he put them? This is done through banks. • Bank B (buyer) in the U. S. buys 1 million GBP for 1. 78 million USD from Bank S (seller) in the UK • Bank B must have an account denominated in GBP somewhere, probably at Bank C in the UK • Bank S must have an account denominated in USD somewhere, probably at Bank T in the US ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 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. 78 MILLION USD TO BANK T CENTRAL BANKS SELLER S NOW HAS 1. 78 MILLION USD IN BANK T ELECTRONIC PAYMENT SYSTEMS 20 -763 SETTLEMENT TWO: BANK S TRANSFERS 1 MILLION GBP TO BANK C BUYER B NOW HAS 1 MILLION GBP IN BANK C SPRING 2004 COPYRIGHT © 2004 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 or is owed? • Settlement – Actual payment, often involving a central bank • Foreign exchange requires two settlements – Exchange HKD (HK dollars) to JPY (Japanese ¥) requires settlement in both 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 9 D 14 10 49 31 A 31 B 16 “A HAS $49; B HAS $16; A OWES B $31” 44 E 17 15 B “A OWES B $31” F 7 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 ELECTRONIC PAYMENT SYSTEMS 20 -763 31 SPRING 2004 COPYRIGHT © 2004 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 ELECTRONIC PAYMENT SYSTEMS 20 -763 • 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 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A 23 16 (-46) 7 8 F C 9 (+52) D 14 44 E 17 15 10 31 G 55 12 H (-85) (+68) (+15) 13 96 I (-95) ELECTRONIC PAYMENT SYSTEMS 20 -763 (+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 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A 23 16 (-46) 7 8 E 17 (-46) F (+52) D 31 G (+68) (+90) E G (+90) 55 12 H (-85) (+68) 15 10 14 44 A C 9 D (+15) (-23) (+15) F C (+52) B 13 H 96 (-85) I I 46 (-95) 23 85 (-95) 95 NET CREDITOR CLEARING HOUSE NET DEBTOR ELECTRONIC PAYMENT SYSTEMS 20 -763 +249 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Net Settlement (+24) B 31 (-23) A 23 16 (-46) 7 8 E 17 F (-46) (+52) D 31 G (+68) (+90) E G (+90) 55 12 H (-85) (+68) 15 10 14 44 A C 9 D (+15) (-23) (+15) F C (+52) B 13 96 H (-85) I I (-95) 52 NET CREDITOR 24 68 CLEARING HOUSE NET DEBTOR ELECTRONIC PAYMENT SYSTEMS 20 -763 15 90 +249 -249 = 0 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Net v. Gross Settlement • Net settlement requires “clearing” – Determining the net amounts owed or owing • Need a separate clearing house • Introduces delay (for clearing) • Reduces 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

Clearing and Settlement Low value payments Large value payments National Clearing Centres Real Time Gross Settlement System RTGS Settlement accounts Electronic End of day Cards Net balances Securities Balances Central Bank Electronic transactions Net systems interfaces Queuing mechanism Exchange interface CB Interfaces Liquidity G/L Monitoring Real Time Commercial Bank Interface HQ commercial banks Regional offices Regional clearing paper Local clearing Local offices paper Commercial banks ATM, POS, PHONE, INTERNET, E-COMMERCE Clients SOURCE: WORLD BANK Clients

Payment Orders (Checks) CHECK NUMBER DATE MAKER (DRAWER) PAYEE AMOUNT CURRENCY DRAWEE BANK NUMBER ACCOUNT NUMBER THIS CHECK IS AN ORDER TO MELLON BANK TO PAY $100 TO PAYEE OR HIS TRANSFEREE FROM THE CARNEGIE MELLON UNIVERSITY ACCOUNT ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 AUTHORIZED SIGNATURE OF MAKER’S AGENT COPYRIGHT © 2004 MICHAEL I. SHAMOS

Check Processing “On-Us” Check Deposit Ticket Encode Sort/Balance Check Deposit Ticket BANK A’S DEPOSITS Clearing House “Clearing House” OTHER BANKS THE UNIVERSITY OF HONG KONG Check Cash Letter “Direct Sends” BANK BJANUARY 2004 SOURCE: PNCBANK COPYRIGHT © 2004 MICHAEL I. SHAMOS

U. S. Cheque Clearing 26 billion checks transported ~40 billion checks transported 2. 1 billion checks returned SOURCE: CELENT ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Clearing Payment Orders (Check) CUSTOMER CMU OF MELLON BANK 1. CMU SENDS CHECK TO SHAMOS “PAY SHAMOS $100” 9. MELLON SENDS CHECK BACK TO CMU MELLON BANK 2. SHAMOS DEPOSITS CHECK AT CITI 8. CLEARING HOUSE SENDS CHECK TO MELLON CUSTOMER A CUSTOMER CMU -100. . . CUSTOMER Y CUSTOMER Z 7. MELLON DEDUCTS $100 FROM CMU ACCOUNT CUSTOMER SHAMOS OF CITIBANK 4. CITI SENDS CHECK TO CLEARING HOUSE CUSTOMER A CUSTOMER B. . . SHAMOS CUSTOMER Z CLEARING HOUSE (FEDERAL RESERVE) 6. CLEARING HOUSE SENDS MELLON DEBIT INFO MELLON BANK A. . . BANK Z CITIBANK -100 +100 3. CITIBANK CREDITS SHAMOS WITH $100 +100 5. CLEARING HOUSE ADDS $100 TO CITI, SUBTRACTS $100 FROM MELLON ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Settling Payment Orders (Checks) 1. AT END OF DAY, EACH BANK HAS A NET POSITIVE OR NEGATIVE CLEARING HOUSE BALANCE 6. CLEARING HOUSE PAYS MELLON $34, 299, 321 MELLON BANK CUSTOMER A -15085 CUSTOMER CMU +3167. . . CUSTOMER Y +728103 CUSTOMER Z +35529 5. CLEARING HOUSE ADVISES MELLON IT WILL RECEIVE $34, 299, 321 ELECTRONIC PAYMENT SYSTEMS 20 -763 REAL-TIME GROSS SETTLEMENT SYSTEM (FEDWIRE) +34, 299, 321 MELLON BANK A. . . BANK Z CITIBANK -107, 071, 775 CLEARING +107, 071, 775 HOUSE CLEARING HOUSE (FEDERAL RESERVE) MELLON BANK A. . . BANK Z CITIBANK +34, 299, 321 2. BANKS WITH NEGATIVE BALANCES MUST PAY; THOSE WITH POSITIVE BALANCES RECEIVE MONEY 4. CITI PAYS THE CLEARING HOUSE THROUGH RTGS CITIBANK +2786 CUSTOMER A CUSTOMER B -988713. . . +100 SHAMOS CUSTOMER Z -31872 3. CLEARING HOUSE INFORMS CITI IT MUST PAY $107, 071, 775 -107, 071, 775 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Checks • • U. S. -- 63 billion checks per year, average $1100 80% of noncash payments made by check “On-Us” (payor and payee in same bank -- 30%) Interbank (payor and payee in different banks) -requires settlement – Direct presentment (“direct sends”) – Correspondent banks – Clearing house associations (150) – Federal Reserve system (15 billion checks/year, 27%) • Complex laws re bank liability in check processing ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS

Major Ideas • • • Central banks play a central role in money movement Payment requires M 1 Foreign exchange requires two settlements Gross v. net settlement Check processing is cumbersome: requires clearing and settlement. ELECTRONIC PAYMENT SYSTEMS 20 -763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOS