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The Difference Between Settlement and Clearing and Why it Matters to Banks

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Sam AaronsCTO

For banks in the US and around the world, settlement and clearing systems are an important component of modern payment operations. Within minutes, banks can send and receive wire transfers through secure interbank payment networks, which clear and settle numerous daily transactions.

Every day, payments in different currencies pass through interbank clearing networks before settling in each currency’s interbank settlement network, typically run by their central bank. In the US, the Federal Reserve Board operates Fedwire Funds Services, or Fedwire, which processes transactions in USD. In addition to being a real-time gross settlement system, Fedwire, and other currencies’ settlement networks, are considered clearing systems. While this may suggest that “settlement” and “clearing” are interchangeable terms, they are two different processes. This distinction has important implications for banks’ payment operations.

What Is Clearing?

When an individual or business initiates a wire transfer, clearing begins the fund delivery process. First, the sender’s bank submits payment instructions to an interbank clearing network. These include each currency’s interbank settlement network along with systems dedicated to clearing. The Clearing House Interbank Payments Systems, known as CHIPS, is privately operated by The Clearing House (TCH). CHIPS allows transactions to be netted so they are not processed in real-time. If payments are not time-sensitive, CHIPS is a less expensive option than Fedwire, which processes gross settlements in real time.

One commonly misunderstood system, the Society for Worldwide Interbank Financial Telecommunication (SWIFT), is neither a settlement network nor a clearing network. Instead, SWIFT is a messaging system which sends global payment orders to be processed by a clearing or settlement system.

With information about the wire’s amount, recipient’s account number, and bank routing number, clearing networks pass the payment instructions from the sender’s bank to the recipient’s. Then the recipient’s bank deposits the wire amount into the recipient’s account using reserve funds. When the sending bank withdraws the corresponding amount from the sender’s account, clearing is completed.

What Is Settlement?

Banks can begin the settlement phase either immediately after clearing has taken place or later on. Most payment systems, CHIPS included, send a final settlement wire at the end of the business day to initiate this process.

Unlike clearing, only a settlement network can facilitate settlement. If a clearing system like CHIPS has been handling the transaction, CHIPS will send the wire information to a settlement network to settle. For transactions in USD, this means Fedwire. If both participant banks have an account with the same Federal Reserve Bank, Fedwire has direct access to their account balances. When the banks settle their accounts, Fedwire removes the wire transfer amount from the sending bank’s Federal Reserve balance and adds it to the recipient bank’s. The recipient’s bank is notified of the credit, and, when funds have been transferred, the wire is completed.

What Are the Differences Between Settlement and Clearing?

One primary way in which clearing and settlement differ is that clearing determines the commitments of the funds and settlement is how banks do a final true-up with each other.

Settlement involves exchanging funds between the two banks, while clearing can end without any interbank money movement. In the clearing process, funds move between the recipient’s or sender’s bank account and their bank’s reserves. Because central banks run interbank settlement networks, settlement systems can facilitate money movement between banks, debiting the sender’s account and crediting the receiver’s account at the central bank directly.

Another difference between the two processes is timing. Though wire transfers facilitate the intraday transfer of funds, clearing and settlement do not occur with the same urgency. The clearing process takes place very quickly, typically within minutes. However, because the wire recipient can already access the delivered funds by the end of the clearing stage, the timing of settlement is more flexible. Banks can settle their accounts and exchange the wire amount either immediately after clearing or later on.

By understanding the differences between these processes, banks can make smart, informed decisions about liquidity management on behalf of their customers. For example, if a business is sending a time-sensitive payment via wire, opting for Fedwire over CHIPS makes sense as Fedwire settles payments in real time. If payment speed isn’t an issue, then CHIPS, which is less expensive than Fedwire, is the more financially prudent choice.

Moving Forward

For accurate monitoring of payment rails, banks understand the nuances of terms like clearing and settlement to ensure precise accounts. For businesses working with banks, what’s most useful about noting the difference between these terms is that using the proper terminology can help clear up communication when talking about payments.

If you're interested in consolidating payment management, Modern Treasury’s API offers a seamless platform for tracking payments. See how you could run more accurate payment operations by signing up for a sandbox, or reaching out to one of our payments advisors.

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