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Two options for financial transaction settlement—differing in both speed and style—here, we’ll look at how both Net Settlement and Gross Settlement work in action.
How Net Settlement Works
Net settlement works by utilizing a clearing house to process and settle the daily transactions between banks. During the business day, banks collect data on transactions before sending that data on toa Federal Reserve Bank for settlement.
Let’s look at net settlement in the context of a set of daily transactions between USA Bank and XYZ Bank. During the normal business day, both banks collect and record all of the transactions initiated by their customers.
At the end of the business day, when it comes time to settle all of the transactions, USA Bank and XYZ Bank send all of their daily aggregate transaction data to a Federal Reserve Bank, which then processes, clears, and settles all of the transactions between the two financial institutions.
If, for example, USA Bank owes XYZ Bank $3,000,000 and XYZ Bank owes USA Bank $2,000,000, instead of having two multi-million dollar transactions between the two banks the Federal Reserve Bank can instead move $1,000,000 from USA Bank to XYZ Bank to settle the difference in transaction amounts between the two financial institutions.
Net settlement helps banks to better manage their liquidity and be confident that they have enough cash on hand to cover ATM and in-person banking transactions.
How Gross Settlement Works
Gross Settlement (also called Real-Time Gross Settlement) refers to a system that sends funds and settles transactions instantaneously. Gross settlement is a continuous process of settling transactions individually and as they occur, rather than being processed in a batch. Because of their instant nature, transactions that are settled via gross settlement are irrevocable and can not be reversed.
RTGS systems are managed on a nation-wide level by a given nation’s central bank, and transactions are limited to those who bank within that central bank’s country. While some RTGS systems may be available 24 hours a day year-round, each system and its operating hours are different.
Generally better-suited for larger transaction amounts where funds need to be moved as quickly and as securely as possible, gross settlement can minimize the potential for fraud because of the speedy settlement time.
Net Settlement vs. Gross Settlement
Both forms of settling financial transactions, there are a few key differences to remember when comparing net settlement and gross settlement.
- Net settlement deals with aggregate transaction data, usually processed and settled at the end of a day (or at the end of another pre-specified time period). Gross settlement deals with individual transaction data in real-time, meaning transactions process and settle instantly.
- Net settlement utilizes batching, while gross settlement does not.
- Gross settlement transactions are irreversible, due to their real-time nature.
- Gross settlement transactions are generally better-suited for large dollar-amount transactions that need to move and settle quickly.
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