What is Settlement?

Settlement is transferring funds through a central agency (a settlement agent), from payer to payee, through their respective banks.

A country’s economic activity depends on consumers and businesses being able to make and receive easy, quick, and secure payments between one another. Payment systems have evolved over time to comprise cheques, direct debits, electronic payments, card payments – all with their own rules, membership, clearing cycle, clearing processes and settlement processes.

Settlement agents regulate and oversee these complex and vital processes by facilitating low-risk exchange of funds between members of the various payment systems.

Most countries have a central bank or monetary authority which acts as trusted settlement agent. For example, the Bank of England has acted as settlement agent for the UK’s payment systems since the 19th century.

What is a payment system?

A payment system is a platform with a set of rules and common procedures that support the transfer of funds.

Most payment systems are managed by independent operators and supported by providers of the hardware, software, and communications network on which it runs. Some retail banks have direct access to each payment system to provide payment services to their customers.

Why is a settlement agent necessary?

Because not all bank accounts are held at the same bank, when an individual or business makes a payment to a business or individual at a different bank, the sender’s (payer’s) bank owes the recipient’s (payee’s) bank the value of the money. For a short time, this creates a level of risk that the sending bank may not honour the transfer if it fails before it completes the transfer to the recipient’s bank. This is where a settlement agent acts as an intermediary for the final settlement of funds between banks.

Banks, and other financial institutions, hold accounts with the settlement agent that are used to settle transactions by moving money between them. Because the settlement agent is usually a central bank or monetary authority and is backed by the government, it helps promote monetary stability.

The settlement agent acts like a bank to the banks. It may have much wider responsibilities regarding financial stability of the banking system, such as ‘lender of last resort’ in times of severe economic and financial turbulence.

As money is being transferred both ways between banks, usually only a net amount is transferred, with the payment instruction debiting the payer’s account and crediting the payee’s account.

If Bank A is sending €100,000,000 to Bank B in payment instructions, and Bank B is sending €120,000,000 to bank A, only €20,000,00 is moved from Bank B to Bank A, supported by details of the transactions that make up the payment instructions. This provides stability to the financial system as huge amounts of money isn’t being transferred.