Fundamental pillars of the Payment platform

I have been reading different books recently on how payment system works. One of them is SEPA Credit Transfer which was very helpful in understanding basics of the payment engines. I really recommend this book if you want dig deep into the SEPA scheme.

This is my first blog in the Payment field to explain some of the concepts that I learnt. Before digging into the fundamental blocks of payment chain, it’s important to understand the main actors in the payment processing.

1. Originator(Debtor) — originates a credit transfer by giving instructions to her bank
2. Originator bank — after reception of the message from the debtor, makes the necessary checks to ensure the payment request is complete and can be executed.
3. Beneficiary bank — after successful payment execution, the clearing and settlement system inform the beneficiary bank.
4. Beneficiary (Creditor) — the beneficiary bank informs the beneficiary that her account is credited.

Now let’s try and understand the different building blocks of payment processing in a bit more detail.

1. Messaging

The originator initiates a payment by sending messages to their bank. The originator bank then forwards the message to the clearing and settlement systems. Once the payment is settled, the beneficiary bank receives the payment from the clearing and settlement systems which is finally sent to the beneficiary. Messages play an important role in the end to the end payment processing cycle. The participating banks will have to adhere to the respective payment schemes messaging standards.

2. Clearing

It’s the process of transmitting, reconciling and, in some cases, confirming transactions prior to settlement, potentially including the netting of transactions and the establishment of final positions for settlement, according to the definition from the Bank of International Settlements (BIS).

Netting is the key process in the clearing. When two or more participating banks offset the payment obligations between them, thereby reducing the number and value of payments needed to settle a set of transactions is known as netting.

For example, let’s say Person A owes Person B £100. Person B owes Person A £30. There are two ways to resolve the debts between Person A and Person B.

1. Person A makes a transfer of £100 to Person B and Person B makes a transfer of £30 to Person A. This involves two transactions.
2. Person A makes only one transfer of £70 (£100 - £30) to Person B. £70 is the final amount after netting which is obtained by offsetting of obligations.

There are two types of clearing. Bilateral clearing, where only two participants are involved in the netting process and multilateral clearing, where there are many banks and financial institutions are involved. In case of multilateral clearing, the netting will happen after which the final obligation will be calculated for each of the participating banks. Clearing saves a lot of cost by avoiding the payment execution of a huge number of transactions by carrying out netting process.

Clearing House

All the participating banks should establish connection with the clearing house which then takes care of the netting of obligations between each of its connected banks. So the banks don’t have to do the clearing and the clearing house takes care of them.

The clearing system computes the obligations between all the banks several times a day. It also manages the risk associated with the availability of funds.

Note that the money doesn’t transferred during the clearing process. The clearing house is connected to the Central Bank which implements the settlement of funds.

3. Settlement

An act between two or more parties for the discharge of monetary obligations, according to the definition from the Bank of International Settlements (BIS). In simple terms — it’s the process of moving funds between participating banks.

After the clearing, the banks that have a positive position will get funds from the Central bank and banks that have a negative position will have to fulfil their obligations by transferring funds to the Central Bank. To achieve this, all the participating banks will hold funded accounts with the Central bank and the payments are made via these accounts.

There are two types of settlements

1. Gross settlement /Real Time Gross Settlement (RTGS)— is a system in which the fund transfer occurs individually after each payment transaction is processed in the system. This system is used to exchange urgent and large amount of transfers. If the funds are available the payment is executed or settlement instantly.
2. Net settlement — is a system in which the transactions are exchanged among participants without transfer of funds. The transfer of funds happens only during a settlement cycle. There are many settlement cycles throughout the day. If a transaction has to be settled at a specific time, then the transaction must be sent by the bank before the cut-off time for that settlement cycle.

If this is helpful, please let me know in the comments. I will be writing more blogs related to my learnings in the payment domain.