Monetary Mechanics of Payments
Learn about the underlying principles of payments
As we move forward on our quest to grasp the fundamentals of payments, in this article, we will describe the monetary mechanics of payments, the transfer of monetary value from one party to another, and provide an overview of the key components needed to design a basic payment system. In an upcoming post, we will design a basic bilateral settlement mechanism using the information presented here.
Bank deposits are liabilities, not personal pots of money. When you deposit money into a bank, you are essentially lending it to the bank, making it one of their liabilities. Therefore, your account balance is considered in credit since you have extended credit to the bank. Conversely, if you are overdrawn and owe money to the bank, that becomes your liability and their asset. It's crucial to understand that each account balance can be viewed from these two perspectives to grasp the dynamics of money movement.
Let's dive into a straightforward scenario of a monetary movement. Picture yourself as Emma, a customer of BNP Paribas. You have a debt of 15€ to your friend, David, who is also a BNP Paribas customer. Settling this payment is a breeze: you communicate your intent to the bank and they deduct the funds from your account and credit 15€ to David's account. This entire process takes place within BNP Paribas' banking system as an internal transfer. No physical money enters or exits the bank; it's simply an adjustment within their books. BNP Paribas now owes you 15€ less and owes David 15€ more. This internal balancing act signifies that the transaction is "settled" within the records of your bank. In the visual representation below, the key players involved are Emma, David, and BNP Paribas.
As you can see from the example above, monetary value can be transferred through adjustments in bank records or bookings. What if the two parties are not customers of the same bank? The transfer of monetary value between parties who are not customers of the same bank requires an intermediary, typically a clearinghouse or correspondent banking relationship between the two banks. We will explore the correspondent banking relationship now.
Imagine that Emma wants to pay her rent of 1,000€ to her landlord Sebastian who banks with Société Générale. If we want to make this payment, BNP Paribas and Société Générale will need to establish a correspondent banking relationship and set up a settlement mechanism. This will enable BNP Paribas to transfer the 1,000€ from Emma's account to Sebastian's account. If we want Société Générale to owe Sebastian a little more (1,000€), they need to owe somebody else a little less, here is where the Nostro/Vostro accounts come into play and this is the sequence of logical steps that will make it work:
BNP Paribas debits Emma's account by 1,000€
BNP Paribas credits Société Générale's Vostro account (from BNP perspective) with 1,000€.
BNP Paribas sends a message to Société Générale informing them they have increased their balance by 1,000€ and would like Société Générale to credit Sebastian's account accordingly.
Upon receiving the message, Société Générale would confidently acknowledge that they possess an additional 1,000€ securely deposited with BNP Paribas, allowing them to augment Sebastian's account balance with the corresponding amount.
It all balances out for Emma and Sebastian, Emma has 1,000€ less and Sebastian has 1,000€ more. And it all balances out for BNP Paribas and Société Générale. Previously, BNP Paribas owed 1,000€ to Emma, now it owes 1,000€ to Société Générale. Société Générale now owes 1,000€ to Sebastian and is owed 1,000€ by BNP Paribas. You can also see depicted in the diagram the case Sebastian returns the rent payment to Emma.
A note before we continue, Nostro and Vostro accounts are terms that refer to an account held by one bank on behalf of another bank.It all depends on the perspective of the bank holding the account. When referring to an account of ours held at another bank we will call it a Nostro account, while if we refer to an account of another bank held by us, we will call it a Vostro account.
Another element you will notice in the diagram is the introduction of mirror accounts. A mirror account, also known as contra account, is a separate account that mirrors the balance and transactions of another account. It serves as a complementary account to track the opposite side of transactions occurring in the Nostro account. Mirror accounts are commonly used in double-entry bookkeeping systems to maintain accurate and balanced records. For every debit entry in one account, there is a corresponding credit entry in its mirror account, and vice versa. This ensures that the accounting equation remains in balance, with total debits equaling total credits. By using mirror accounts, banks can maintain accurate records of transactions and facilitate easier analysis and reconciliation of accounts.
In certain regions, it is common for banks to adopt the bilateral agreement format when integrating payments from national public institutions. This format facilitates seamless coordination between the banking sector and public entities.
Bilateral agreements come with inherent drawbacks. If banks lack a direct relationship, payments become more costly and complex as they need to be routed through third or fourth banks to establish a path from A to B. To mitigate these challenges, banks commonly opt to participate in Automated Clearing Houses (ACH).
Additionally, there is a significant risk factor to consider. Let's examine the situation from SG’s standpoint. With Emma's payment, their level of exposure to BNP has suddenly escalated. In our given example, the increase is merely 1,000€. However, imagine a scenario where the payment amount is 100€ million, and the correspondent bank is not BNP but a smaller, potentially riskier institution. If that bank were to face insolvency, Société Générale would find itself confronted with a substantial problem.
Stay tuned for our next post where we delve deeper into the exciting world of payment systems and explore how this model can evolve into a sophisticated multi-lateral netting system. This evolution not only addresses the downsides of the current model, such as high costs and liquidity issues, but also offers new opportunities for increased efficiency and streamlined transactions. So don't miss out on this insightful exploration!.