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Gross settlement

What Is Gross Settlement?

Gross settlement refers to a method of processing financial transactions where each payment or security transfer is settled individually and in its entirety, without being netted against other transactions. This approach ensures that once a transaction is processed, the transfer of funds or assets is final and irrevocable. Gross settlement is a fundamental concept within financial market infrastructure and a key characteristic of modern payment systems, particularly those designed for large-value payments.

The primary objective of gross settlement is to minimize settlement risk by ensuring the immediate finality of individual transactions. This contrasts with other settlement methods where multiple transactions are batched and then settled on a net basis at a later time, potentially exposing participants to greater risks.

History and Origin

The evolution of gross settlement systems is closely tied to the global financial system's need for greater safety and efficiency in processing high-value payments. Prior to the widespread adoption of modern gross settlement, many interbank transactions were processed through deferred net settlement systems, which accumulated significant credit risk among participating financial institutions. If a bank failed before final settlement, a cascade of defaults could occur, posing a substantial systemic risk to the entire financial system.

To mitigate these risks, central banks and international financial organizations championed the development of systems that offer immediate and final settlement. The first system possessing the attributes of a real-time gross settlement (RTGS) system was the US Fedwire system, launched in 1970. Other countries, such as the United Kingdom and France, independently developed their own RTGS-type systems in 1984, known as CHAPS and SAGITTAIRE, respectively. The 1990s saw international finance organizations emphasize the importance of large-value funds transfer systems, leading to more widespread adoption of RTGS systems globally to reduce risk in high-value electronic payment settlement.

Key Takeaways

  • Gross settlement involves the individual, full, and immediate settlement of each financial transaction.
  • It significantly reduces settlement risk and associated credit risk within payment systems.
  • Transactions settled via gross settlement are final and irrevocable once processed.
  • Real-time gross settlement (RTGS) systems are the most common manifestation of gross settlement in modern finance.
  • While offering high security, gross settlement systems typically require higher levels of liquidity from participants compared to netting systems.

Interpreting Gross Settlement

Interpreting gross settlement involves understanding its implications for financial stability and the flow of money in an economy. In a gross settlement environment, each transaction is processed independently, meaning that the full value of a payment must be available in the payer's account at the time of settlement. This "gross" processing provides absolute finality and minimizes the risk that a payment might fail due to insufficient funds later in the day, or due to the insolvency of a counterparty.

The transparency and certainty provided by gross settlement systems allow financial institutions to have an accurate, real-time view of their liquidity positions. This real-time understanding is critical for effective cash management and for ensuring that banks can meet their obligations without delay. For regulators and central bank authorities, the widespread use of gross settlement in critical financial market infrastructure reduces systemic vulnerabilities by isolating potential failures and preventing them from cascading across the system.

Hypothetical Example

Consider two commercial banks, Bank A and Bank B, both participants in an RTGS system.

Scenario:
Bank A needs to send $10,000,000 to Bank B for a corporate client's large-value payment. Separately, Bank B needs to send $3,000,000 to Bank A for a different client.

Gross Settlement Process:

  1. Bank A Initiates Payment: Bank A initiates the $10,000,000 payment to Bank B through the RTGS system.
  2. Funds Verification: The system verifies that Bank A has sufficient funds (e.g., in its account at the central bank) to cover the full $10,000,000.
  3. Immediate Settlement: If funds are available, $10,000,000 is immediately debited from Bank A's account and credited to Bank B's account. This transaction is final and irrevocable.
  4. Bank B Initiates Payment: After the first transaction settles, Bank B then initiates its $3,000,000 payment to Bank A.
  5. Funds Verification: The system verifies Bank B has $3,000,000.
  6. Immediate Settlement: $3,000,000 is debited from Bank B's account and credited to Bank A's account. This is also final and irrevocable.

In this example, two distinct interbank transfers occur, each settled for its full value independently. There is no netting of the $10,000,000 payment against the $3,000,000 payment; each is processed in "gross" terms, providing certainty and finality for both banks involved.

Practical Applications

Gross settlement is predominantly used in critical payment systems that handle large-value or time-sensitive transactions, serving as the backbone for various financial market operations.

  1. Wholesale Payments: The most prominent application is in wholesale payment systems, such as Real-time Gross Settlement (RTGS) systems operated by central banks. Examples include the Fedwire Funds Service in the United States, CHAPS in the UK, TARGET2 (soon to be replaced by TARGET Services with a modern RTGS component) in the Eurozone, and Japan's BOJ-NET. These systems facilitate high-value interbank transfers, corporate payments, and money market transactions. The Eurosystem's TARGET Instant Payment Settlement (TIPS) service, launched in 2018, extends the benefits of real-time gross settlement to instant payments, ensuring final and irrevocable settlement around the clock.5
  2. Securities Settlement: Gross settlement is crucial in securities settlement systems, where the delivery of securities and the corresponding payment are typically settled on a gross, delivery-versus-payment (DvP) basis. This ensures that the transfer of securities only occurs if the payment is simultaneously made, eliminating principal risk. Central securities depository systems often utilize gross settlement for this purpose.
  3. Foreign Exchange Settlements: In foreign exchange markets, large interbank FX transactions are often settled on a gross basis through specialized systems designed to mitigate settlement risk, especially during cross-border transactions involving different currencies.

The Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) jointly issued the Principles for Financial Market Infrastructures (PFMI) in 2012, setting international standards for various financial infrastructures, including payment systems and securities settlement systems, often emphasizing the importance of gross settlement for risk reduction.3, 4

Limitations and Criticisms

While gross settlement offers significant advantages in terms of risk reduction, it also presents certain limitations and criticisms, primarily related to liquidity requirements.

  • High Liquidity Needs: A major drawback of pure gross settlement systems is their demand for substantial liquidity. Since each transaction requires the full amount of funds to be available and settled individually, participants must hold considerable reserves or access to intraday credit from the central bank to ensure continuous processing of payments throughout the day. This can impose an opportunity cost on banks, as these funds could otherwise be used for lending or investment.
  • Liquidity Management Complexity: Managing liquidity effectively in a gross settlement system can be complex for banks, requiring sophisticated liquidity management tools and strategies to optimize their reserve holdings and intraday borrowing.
  • Potential for Gridlock: In systems where payments are strictly gross and sequential, a large outgoing payment from one participant could deplete its liquidity, causing subsequent payments from that participant to be delayed. If these delayed payments are prerequisites for incoming funds to other participants, it can create a "gridlock" where many transactions are held up waiting for liquidity to free up. To address this, modern RTGS systems often incorporate "liquidity-saving mechanisms" (LSMs) which attempt to optimize the timing of payments to reduce overall liquidity needs without reintroducing settlement risk.1, 2 These mechanisms might involve intelligent queuing or offsetting payments where possible, while still ensuring gross settlement finality.

Gross Settlement vs. Net Settlement

The primary distinction between gross settlement and net settlement lies in how transactions are processed and finalized.

Gross Settlement:
In gross settlement, each transaction is processed individually and settled immediately upon verification of sufficient funds. The full value of the payment or security transfer is moved from the payer to the payee in real-time, making the transaction final and irrevocable. This method minimizes settlement risk and credit risk because there is no accumulation of outstanding obligations. However, it typically requires participants to hold higher levels of liquidity to ensure the continuous flow of transactions.

Net Settlement:
Net settlement, often associated with deferred net settlement (DNS) systems, involves grouping multiple transactions over a period (e.g., a day) and then offsetting them to calculate a single net debit or credit position for each participant. Only this net amount is then settled, usually at a specific time, such as the end of the day. While this method is more efficient in terms of liquidity usage, as only net positions are settled, it introduces settlement risk and credit risk. If a participant defaults before final settlement, the outstanding gross obligations might not be met, potentially causing losses for other participants. Centralized entities like a clearing house are essential in net settlement systems to manage and guarantee these obligations.

FAQs

What does "gross" mean in financial transactions?

In financial transactions, "gross" means that each transaction is processed and settled for its full, individual amount, without being combined or offset with any other transactions.

Why is gross settlement important for financial stability?

Gross settlement is crucial for financial stability because it eliminates settlement risk and credit risk for individual transactions. By ensuring immediate and final transfers of funds or assets, it prevents the domino effect of failures that could occur in systems with deferred settlement, where a single participant's default could disrupt the entire market.

What is the main disadvantage of gross settlement?

The main disadvantage of gross settlement is its high demand for liquidity. Participants in gross settlement systems, such as Real-time Gross Settlement (RTGS) systems, need to hold significant funds or have access to intraday credit to ensure that every transaction can be settled individually and immediately.

Is gross settlement faster than net settlement?

Yes, gross settlement, especially in Real-time Gross Settlement (RTGS) systems, is generally faster than net settlement because transactions are settled continuously and individually in "real-time" rather than being batched and settled at a later, predefined time.