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Settlement Processes

Settlement can be defined as the process of transferring of funds through a central agency, from payer to payee, through participation of their respective banks or custodians of funds. The two key elements for payment processing are payment order or message requesting the transfer of funds to the payee and the actual transfer of funds between the payer's bank and the payee's bank. Settlement systems can be classified based on (i) time - designated-time (or deferred) settlement systems and real-time (or continuous) settlement systems and (ii) amount - gross settlement and net settlement. India has multiple payments and settlement systems, for both gross and net settlement systems.

Participants in PSS are exposed to two risks that need to be addressed, viz., credit risk and liquidity risk. Credit risk, which may occur due to default of a counterparty, is the risk that a counterparty will not meet an obligation when due. Liquidity risk is when a counterparty will fail to settle an obligation for full value when due, but will do so at some unspecified time thereafter. Both credit and liquidity risks together constitute settlement risk.

Gross Settlement

A gross settlement system is one in which the settlement or funds transfer occurs individually as and when each payment transaction is processed in the system. Each transaction is settled on a one-to-one basis without bundling or netting with any other transaction. In some countries, there are systems in which the final settlement of transfers occurs at the end of the processing day without netting the credit and debit positions on a transaction-by-transaction basis. Such systems are called end-of-day gross settlement systems. In the RTGS systems, usually operated by a country's central bank as it is seen as a critical infrastructure for a country's economy, the inter-member payments settle on a 'real' time and a 'gross' basis in the books of the central bank.

Since RTGS does not have a settlement lag, it eliminates settlement risk. The liquidity risks in RTGS are managed through IDL extended to members by RBI against fully collateralised Indian government securities held by the members in their IDL-SGL account. IDL is extended free of interest. IDL has to be reversed by the end of the day and failure to do so is subject to penal interest on outstanding balances.

Net Settlement

In a net settlement system, many transactions are accumulated and offset against each other, with only the net differential being transferred between members. A participating member's net settlement position, debit or credit, as the case may be, is calculated, on either a bilateral or a multilateral basis, as the sum of the value of all the transfers it has received up to a particular point in time minus the sum of the value of all the transfers it has sent. Multilateral net settlement makes it easier for members to manage their liquidity.

A few clearing institutions send net transfer information to settlement institutions several times a day in batches for processing which are called MNSB files. NEFT settlement works on net-settlement in batches, with 48 batches of settlement over a span of 24 hours, the first and last batches taking place at 0030 hours and midnight, respectively.

Deferred Settlement

In NEFT, the beneficiary customer receives the funds only after final settlement takes place between members. However, in a few systems like UPI and IMPS, while funds are credited to the beneficiary customer immediately, the inter-bank settlement is done later according to a pre-defined settlement cycle which at present takes place four times a day. This is called Deferred Settlement and in the case of IMPS and UPI, the settlement.

In IMPS, a transaction is received at NPCI for routing to beneficiary bank / PPI only after the remitting bank has debited the remitting customer's account. Therefore, the risk of a remittance being made with the remitting customer not having adequate funds is addressed. The transaction is credited to beneficiary account on message being received by destination bank. From the members' perspective, MNSB files are generated by NPCI based on these messages which are also received by NPCI as the settlement agency. Final interbank settlement by debiting the sending bank and crediting the beneficiary bank takes place on a net basis.

Settlement Guarantee Mechanism

Deferred Net Settlement (DNS) systems may expose participants to credit and liquidity risks for the period during which settlement is deferred. Settlement finality is only achieved at the end of designated settlement cycles in DNS systems and thus if there is no settlement guarantee, either by the system or its participants, there is no certainty that the payments will be settled until that point in time. If a participant fails to meet its payment obligation when due, some or all processed payments could be unwound, thereby exposing participants to liquidity risk and possibly credit risk.

To mitigate these risks, the settlement agency operates a Settlement Guarantee Fund (SGF). The SGF provides a cushion for any residual risk and operates like a self-insurance mechanism wherein members themselves contribute to the fund. In the event of a member failing to meet its settlement obligation, on the settlement date and thereafter, then the fund is utilised to the extent required for successful completion of the settlement. The remaining participating member banks will make contribution towards sharing of loss in accordance with the defined loss sharing mechanism put in place. This eliminates counter-party and settlement risks as the settlement takes place on time irrespective of default by isolated members.

Unwinding

In a scenario where supervisory action undertaken on a participating member bank by imposing restrictions on a member bank indicates that a fraudulent / erroneous transaction was undertaken that needs to be reversed, the member positions or specific transaction may need to be removed from the settlement file of the payment system by unwinding the position in the system. This unwinding of payment transactions from the settlement file is essential for risk mitigation to eliminate settlement risk. However, unwinding is undertaken sparingly, only in case of exigencies, with the aim to ensure safety and security of payment systems.

Source : RBI



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