Bitesize Payments
Payments are one of things that we do every day - they just happen, really they are just like magic!!!! But we don't wake up and think today I want to make a payment - we just want to pay a bill or buy a coffee but payments make them happen.
Paradoxically we both know more about them than we think and yet at the same time very little about what they are and how they work.
I have spent a lot of time in our industry doing education and training sessions on Payments and I kinda thought it would be useful to record it. So, here we go.... In Bitesize Payments I try and explain the History of Payments, how they work and who does what. Also who get paid for what....that might surprise you!
Anyway hopefully in less than 20 mins, week after week you can become a payment experts....... or at the very least someone who can ask the tough questions :-)
Please let me have your feedback, input or question at bitesizepayments@gmail.com
Thanks for listening.......
Bitesize Payments
Real Time Gross Settlement part 1
Today we will be discussing something that underpins every major economy and is of vital importance to the flow of money yet is probably totally unfamiliar to many people - Real-Time Gross Settlement systems, or RTGS for short. I’m joined again by David Godfrey to help me explore this subject,
RTGS, as I said, is possibly something that many people are unfamiliar with, yet, they underpin all electronic payments and is moving enormous amounts of money around the economy, so, what is it!
As this is such a key topic, we are going to split it up in to three parts… here’s part 1.
Buckle up here we go!
Payments Industry Insights
History of Payments
Payment System Explained
Corporate Payments Strategy
Payment Regulations Impact
ISO20022 Standard
Digital Payments Evolution
CBDC Advancements
Cryptocurrency in Payments
Financial Technology Education
Today, we're going to discuss one of the core systems of payments. These systems truly make the money go round. To misquote Liza Minnelli, of course, to do it justice, we're going to have to split it up into three parts. But understanding this is key to understanding payments. So hold on to your hats. Here we go. Welcome, dear listeners, to the latest installment of Bite Size Payments, where we'll look into the history of payments, how they work, and of course, who does what. Today, we'll be discussing something that underpins every major economy and is of vital importance to the flow of money. Yet it's probably totally unfamiliar to most people, real-time gross settlement systems, or RTGS for short. I'm joined today by the wonderful Expert of payments, David Godfrey, very good friend, helped me explore this. Welcome, Dave.
SPEAKER_00:Hi, Paul. Great to be here again.
SPEAKER_01:So let's dig into RTGS. RTGS systems are something, you know, probably a term that you've heard of, but probably are really unfamiliar with how they work. And yet, without understanding them, it's very difficult to understand truly how payments work and how they move money around the world. And they do move an enormous amount of money around all the economies of the world. So what are they and how do they work? The basic concepts of RTGS are quite simple. So let's start there. And then we can get into some of the interesting details about why these systems were created and why they are indeed so vital. Obviously, the name tells us quite a bit about what these systems do. These terms probably sound familiar, real-time, gross and settlement. But when you put them all together, what's it really mean?
SPEAKER_00:Yeah, so RTGS systems are typically provided by the central banks in a given economy. So if we were talking about the UK, that would obviously be the Bank of England. the Federal Reserve in the US, the European Central Bank in the EU, and we could go through any country and we could identify the central bank and there would be an associated RTGS system probably that they provide. The central banks provide those systems to allow the financial institutions, that's the banks in each economy, to move money quickly and securely between accounts that those banks hold at the central bank.
SPEAKER_01:Well, that sounds simple enough. But why do banks need to move money between accounts at the central bank? In order to explain that, I guess we need to talk about some of the other things, some of the other banking topics that are very relevant to our discussion today. First, settlement. What do we mean by settlement? In the world of payments, actually, the term settlement gets used a lot and sometimes in subtly different ways. So Dave, let's try and explain this. Can you give me a simple example?
SPEAKER_00:Yeah. So, Paul, let's start with the most simple example I can imagine. So let's say that I owe you£5. Obviously, there are loads of ways that I could pay you. But let's, again, keep it simple. We'll start with the most simple option I can think of. So I'll just give you£5 in cash. Obviously, I'm not really going to give you£5 in cash, Paul, but let's pretend we are. So nice and easy, you're£5 better off, I'm£5 worse off. We didn't need to involve any banks or any kind of payment institution. We didn't need to make any electronic payments. There was no third party involved. Before I gave you the£5, I had an obligation to make a payment to you because I owed you£5. And by giving you that£5, I've settled that obligation. So to my mind, that's really what the settlement is about. It's about making good on the obligation to pay someone. And because I gave you that£5 note, you've got the money. And I don't have it anymore. And that concept is really, really important. There is what we call finality. So by that, I mean, you know, you've got the five pounds and there is no way that I can take the five pounds back off you. And unless we started thinking about things like fake five pounds or something like that, you know that the five pounds you've got is good. You can go and spend that. That is your money. Now, let's again look at a slightly different and slightly more complicated example. And again, a little bit old school, but let's imagine now, instead of me giving you a£5 note, I gave you a cheque, if anybody remembers those. Now we've introduced a risk for you, Paul, because I've given you a cheque. So I've said to you, yeah, I'm going to pay you£5. I've given you a cheque, but now you need to pay that cheque into your bank account and you've got to wait for it to clear. So in the UK now, five working days, the cheque has then cleared. So the risk for you, of course, is that I gave you that cheque, but don't actually have£5 in my bank account. Or I gave you the cheque and then after I've given it to you, before it's cleared, I go to the bank and I cancel the cheque. Now, in either case, the problem for you, of course, is you're not going to get paid. You're not going to have your five quid. But you're going to have to wait up to five days to find out you're not getting paid. So now there is no finality there. to our settlement process at the point I paid you, you needed to wait five days to have finality, to have that guarantee that you were actually going to get the funds. So what we did by moving to using a cheque instead of a£5 note was to introduce something called settlement risk. Because there is a risk you're not going to get your£5. Now... In the situation where a transaction, instead of it just being me owing you£5, involves exchanging something of value, so goods, services, in return for a payment, that settlement risk becomes far more serious because it means I might have access to the goods or services that you've given me, but I'm not going to come good on my obligation to pay for them. So that would be really bad for the supplier of the goods or the services. You, in this case, you've given me something. You've incurred costs. You've done some work, something like that. And worse still, we didn't get paid for it.
SPEAKER_01:Yeah, indeed. So settlement risk is a big issue that financial institutions must deal with. And RTGS systems help navigate that risk. So let's try and unpack that a little bit more.
SPEAKER_00:Yeah. And another interesting point that I think is going to be relevant to this discussion is that once we moved to using a cheque instead of a£5 note, we introduced a third party into the process, or actually multiple third parties, because that cheque's useless to you, Paul, unless you can pay it into your bank account. And your bank has to present my cheque to my bank, in order for my bank to transfer five pounds to your bank to settle that obligation. And there's obviously a fairly complex process that sits behind how that cheque settlement occurred. So now the accounting and the flow of money has got more complex. Not only am I settling my obligation to you by giving you five pounds, but five pounds needs to be transferred from my bank to your bank. And again, think about you only trusted the cheque that I gave you. if I just gave you a piece of paper that said I promised to pay Paul£5, that would be pretty worthless. But ultimately, that's what a cheque is. But you trust it because you know that you can involve your bank, who you trust, in order to settle that payment. And ultimately, that same type of concept applies between the banks. When they need to move the£5 from my bank account to your bank account, how can they do that? They need to involve a settlement institution, in order to oversee and give finality to the movement of that money, the settlement of that payment obligation. And in our example, that would be the central bank, the bank of England.
SPEAKER_01:So, if we put this simply, what this means is that each of the banks will hold an account with the Bank of England in the case of here in the UK. And when they need to settle payment obligations that exist between them, they can use the services of the Bank of England to move money between their accounts. And the system that maintains those accounts and provides that ability for the individual banks to pay each other is the RTGS system and payment network, which in the UK example is called CHAPS. So actually, we can almost think of our TGS system as being a little like an instant payment system that we can use between banks. In the same way that when I want to make a payment from my bank account using online banking, it uses real-time payment networks, faster payments in the UK, CHAPS is used by the banks when they want to make a payment between themselves.
SPEAKER_00:Yeah, Paul, that's a really good analogy. I mean, in reality, RTGS systems like CHAPS, they don't only handle payments that financial institutions need to make between themselves, but also other types of payments. And later on, we'll talk about what kind of payments those are and why they're handled by RTGS and how that might change in the future. But yes, fundamentally, we can think of it absolutely like a real-time payment network that banks can use to move money between themselves.
SPEAKER_01:So really, the Bank of England is the bank's bank. That's the way to look at it. Absolutely,
SPEAKER_00:yeah.
SPEAKER_01:So now we understand... that an RTGS system supports settlement of payment obligations using the services of a central bank. That's the settlement bit of real-time gross settlement. But what do the other words mean, Dave?
SPEAKER_00:Yeah, so, well, let's start with real-time. So, again, when we talk about payments, that's a term that gets used a lot increasingly recently, and it's maybe overused. Nobody probably agrees exactly what it means, but typically when we talk about real-time payments, people think of things like faster payments that you just mentioned in the UK or some of the new payment schemes in Europe and the US like TIPS and FedNow and things like that. So something where we can make a credit transfer to move money to somebody else's bank account within a few seconds. Actually, when we're talking about RTGS systems, the term real-time has a slightly different meaning. So yeah, fundamentally, these systems are still quite quick. And again, we'll delve into that later on. But it has, like I say, a slightly different meaning. So remember earlier on, we said that one of the key things with RTGS is settlement finality. And it's really, really important to get that settlement finality. And that banks need to deal with this thing called settlement risk. So an RTGS system is ultimately... performing accounting against the accounts that the central bank holds. Like you said, the central bank, the Bank of England, is the bank's bank. So it holds a ledger of all the accounts for all of the banks, the bank with it. And when Bank A uses the RTGS system to pay Bank B, Bank A's account at the central bank is debited and Bank B's account is credited. Yeah, very, very simple. The real-time bit means that actually that settlement, that movement of funds happens simultaneously as part of that payment process. And that's really what we're talking about when we say real-time. So it says that when the payment transaction is processed... through the real-time gross settlement system, the settlement happens in real-time as the money is moved between the bank's accounts. And that ensures that both of the banks know that when the payment is processed, there is settlement finality, the payment cannot be reversed. That's really important, again, to ensure that that settlement risk that we talked about earlier is mitigated. So the real-time nature of the settlement, the fact that there is settlement finality in real-time as the transaction payment is processed through the RTG Okay, so that
SPEAKER_01:makes sense. But I think, so I get the real time bit, but let's talk about gross. I mean, what does that mean in this context other than horrible or something? What does gross mean here?
SPEAKER_00:Yeah. And again, this is quite an easy one, actually, when you split it out like this. So gross settlement simply means that each payment entered into the RTGS system is settled in full one after another rather than taking a group of payments between banks being netted against each other. So imagine, again... Bank A owes Bank B£10, so Bank A sends£10 to Bank B, and Bank B owes Bank A£5, and it's going to send£5 to Bank A. You could imagine then, okay, well, wouldn't it be more efficient to say, if I owe you£10 and you owe me£5, then Bank A can just send Bank B£5, so we end up with a single payment. And that's called net settlement. And it's used by lots and lots of other payment systems. And maybe in another one of these podcasts, we can talk about that. Or maybe you've already talked about it on some of your others. But it is used a lot because it's very, very efficient. And it reduces the amount of money flowing between banks. And it hence helps the banks minimize the liquidity that they need to have available. And when we say liquidity, we mean money, right? Yeah. So... The example that I just gave you of a bank A owing bank B£10 and bank B owing bank A£5 and henceforth just£5 being paid from bank A to bank B would be called bilateral payments. settlement netting because we're only considering payments between two banks. But most payment systems have lots and lots of participant banks. If we thought about something like Faster Payments in the UK, there's 30 or 40 banks now. So actually what those settlement systems in those payment systems do is they do multinatural net settlement where all of the payments flowing between all of the banks using that payment system are netted off And then ultimately, each bank either needs to make a single payment in settlement or receive a single payment in order to receive the settlement that it's due. That's not what RTGS is, but that concept of this multilateral net settlement is used by a lot of payment systems. RTGS system is completely different. Every single payment is entered into the system as an individual transaction, and it is settled. So if Bank A owes Bank B£10, they pay£10. Bank B then has to send£5 to Bank A. It sends£5. So every transaction is settled on a gross basis, not on a net basis.
SPEAKER_01:Yeah, in fact, I have a very good friend of mine, Andy Rose, who did a similar sort of calculation on a spreadsheet to work out how much we owed each other on skiing trips. And there was, I think, three of us, and it's a similar sort of principle. But I think the thing here is, Yes, it is quite simple. And RTGS systems are used to move funds around financial institutions at a central bank. And each payment process is individual and settles as it's processed.
SPEAKER_00:Yeah, exactly. And because the settlement occurs in the books of the central bank, so in our example of Bank of England, everyone is safe because we all trust the central bank. After all, they're the ones that issue the currency in the first place.
SPEAKER_01:Yeah. And it's hard not to think about this in terms of lumps of gold, which it was at some time in the distant past. But we haven't used gold since, I think it was 1931. But nevertheless, it's still an interesting concept of physically moving things around. It's likely that we won't directly use these systems ourselves, but indirectly, we probably will. Very rarely, maybe even once in a lifetime.
SPEAKER_00:Yeah, because obviously we've talked about some, what probably sounds to some people like some quite complex banking topics, and they probably think, well, these RTGS systems, they're being used by banks to settle payment obligations. Why is that relevant to me? Well, yeah, as you said, once in a lifetime event, certainly most people at at some point in their life will make a payment that goes through an RTGS system. So we'll talk about that and why those payments go through the RTGS system and if they'll continue to do so in the future. And I think the other really interesting topic we can get into is actually how these RTGS systems ultimately take all of the money that we probably touch in any way so any payment that we make or is made to us or an employer makes or our employer receives how all of that money ultimately folds up to flow through the rtgs system it's a really fascinating topic
SPEAKER_01:it really is and least we forget that point is really so important every transaction ultimately goes through this system in whichever country we're talking about but for now Dave let's put a pause in this and come back to part two I do think this is probably one of the least understood areas but probably the one of the most important areas to understand so thanks for taking us through the first part anything else you want to add before we close on this part?
SPEAKER_00:I'm just looking forward to part two, Paul, and we can go into even more interesting detail and hopefully people will find this a really fascinating topic. I think it's absolutely fascinating, like you say, probably not that well understood.
SPEAKER_01:Brilliant. Dave, as ever, thank you so very much, my friend.
UNKNOWN:Thank you.
SPEAKER_01:Well, there you go. That's the end of part one of real-time gross settlement. I hope that we've started to whet your appetite, so to speak, on how real-time gross settlements work. They are really the underpinning of how money gets moved around. We'll go into a bit more detail of how they work and a little bit more of their history to put things into context for you. We'll probably add a third section, which will be, okay, so all these real-time gross settlement systems are working in each country, but how do they join up around the world? So we'll probably do that as a third part. For now, hope you've enjoyed it. If you have enjoyed it, as ever, please tell a friend. It's much more important that you tell people than I do something on LinkedIn. For now. Cheers, see you in part two.