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20-763 Electronic Payment Systems

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. World Banking System. WORLD BANK

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20-763 Electronic Payment Systems

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  1. 20-763 Electronic Payment Systems Lecture 2 Banking Systems and Foreign Exchange

  2. 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

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

  4. 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

  5. CENTRAL BANK BUYER’S BANK SELLER’S BANK BUYER SELLER 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 7. SELLER’S BANK SENDS CASH TO CENTRAL BANK 6. SELLER’S BANK CREDITS SELLER’S BANK ACCOUNT 5. SELLER DEPOSITS CASH IN SELLER’S BANK ACCOUNT 4. BUYER PHYSICALLY GIVES CASH TO SELLER

  6. 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

  7. The U.S. Money Supply In billions on May 30, 2002 Currency605 Non-bank travelers checks8 Demand deposits306 Other checkable deposits 263. M1 Total 1182 USD Savings 2483 Small time deposits <100K 931. Retail money market funds 948 M2 Total5544 USD Large time deposits >100K 801. Institutional money funds1185 Bank agreements365 Eurodollars218 M3 Total8113 USD • . SOURCE: FEDERAL RESERVE

  8. 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)

  9. 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 $800. BANK OWES ME $200 (MY “ACCOUNT”) BANK HAS $200 MORE MONEY NOW I DEPOSIT $200 IN THE BANK I HAVE $1000 CASH BANK DEPOSITS $200 IN CENTRAL BANK MY ASSETS: $1000 CASH BANK’S ASSETS: +$200 REAL MONEY - $200 DEBT MY ASSETS: $800 CASH +$200 OWED BY BANK

  10. 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

  11. 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

  12. 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

  13. 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

  14. BANK T (US) BANK S USD ACCOUNT BANK C (UK) BANK B GBP ACCOUNT US FEDERAL RESERVE BANK THE BANK OF ENGLAND BANK B USD ACCOUNT BANK S GBP ACCOUNT BANK T USD ACCOUNT BANK C GBP ACCOUNT Foreign Exchange Example US BANKS (NOSTRO ACCOUNT) BANK S (UK) WILLING TO SELL 1 MILLION GBP FOR USD BANK B (US) WANTS TO BUY 1 MILLION GBP FOR USD (NOSTRO ACCOUNT) UK BANKS CENTRAL BANKS 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

  15. 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

  16. 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.

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

  18. G A B C D H E F I Gross Settlement • 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 23 31 16 8 7 15 9 10 14 44 31 17 55 12 96 13

  19. G A B C D H E F I Net Settlement (+24) • 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 23 31 (+15) (-23) 16 8 7 (-46) 15 9 (+52) 10 14 44 (+68) (+90) 31 17 55 12 96 (-85) 13 (-95)

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

  21. (+24) B 23 31 (+15) (-23) 16 A F 8 7 (-46) C 15 9 (+52) 10 14 D 44 (+68) (+90) 31 E G 17 55 12 H 96 (-85) 13 I (-95) NET CREDITOR NET DEBTOR Net Settlement (+24) B (+15) (-23) A F (-46) C (+52) D (+68) (+90) E G H (-85) I (-95) 24 68 52 15 90 CLEARING HOUSE +249-249 = 0

  22. 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

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

  24. 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

  25. Q A &

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