2.1 Understanding the Clearing Process

Clearing is the process of transmitting, reconciling, and confirming payment instructions prior to settlement. It involves :

  • Transmission: Sending payment instructions from originator to recipient

  • Reconciliation: Matching payment instructions between counterparties

  • Calculation: Determining net obligations of participants

The Four Stages of Payment Processing

  1. Authorization: The payer’s PSP verifies that funds are available and the transaction is legitimate

  2. Clearing: Instructions are transmitted and reconciled

  3. Settlement: Funds are transferred between PSPs

  4. Reporting: Participants are notified of completed transactions

2.2 Settlement Models

The different settlement methods involve a trade-off between different risks .

Real-Time Gross Settlement (RTGS)

In an RTGS system, each payment is settled individually on a gross basis—meaning funds are transferred immediately and irrevocably on a transaction-by-transaction basis .

Characteristics:

  • Immediate and final settlement

  • No credit risk between participants

  • More liquidity-intensive (requires funding for each transaction)

  • Typically used for wholesale payments

  • Central bank-operated

Examples: Fedwire (US), TARGET2 (Europe), RTGS systems in over 176 countries

Deferred Net Settlement (DNS)

In DNS systems, payments are accumulated and netted over a period, with settlement occurring periodically (e.g., end-of-day) .

Characteristics:

  • Less liquidity required (incoming and outgoing payments offset)

  • Settlement risk during the deferral period

  • Risk of default cascade if one participant fails

  • Typically used for retail payments

Examples: Traditional ACH systems, check clearing systems

Hybrid Models

Some systems combine features of RTGS and DNS. CHIPS (US) uses a “hybrid” settlement model that continuously matches and nets payments while maintaining real-time settlement capabilities .

2.3 Settlement Risk

Settlement risk is the risk that settlement will not take place as expected .

Types of Settlement Risk

  • Credit Risk: Risk that the payer or the payer’s PSP defaults prior to final settlement

  • Liquidity Risk: Risk that the payer cannot settle the payment when it falls due, resulting in a delay in receiving funds

  • Systemic Risk: Risk that the failure of one participant triggers a cascade of failures

Mitigation Strategies

  • Collateral Requirements: Participants must pledge assets

  • Margin Requirements: Initial and variation margin (particularly for CCPs)

  • Position Limits: Caps on net positions

  • Netting Arrangements: Bilateral or multilateral netting to reduce exposure

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