The banking system, a giant settlement infrastructure

A few weeks ago I noticed a tweet from one of the most interesting accounts I follow on Twitter, that of Holger Zschaepitz

As I didn’t fully understand the impact of the fact highlighted in the tweet, I decided to research more into Target2 balances and generally on how the banking system works, ultimately as a giant settlement system.

This post is the product of my investigation and aims to give a clear explanation of the journey an interbank payment goes through in its lifecycle.

Central banks as a settlement infrastructure

Even though today we see banks as huge organisations, diversified into a number of business lines and products, one of the original and key functions of a bank is to enable fluid payments between agents (companies and people).

This somewhat low-profile function actually shapes a lot of the bank’s activities and behaviours.

Let’s use a simple example of domestic payments: a customer A  who wants to pay a firm B in the same country.

During the day the National Central Bank will simply log the payments flow and facilitate the exchange of money (Intraday credit). At the end of the day, Bank A and Bank B will have a net position with the NCB. Assuming, for simplicity, that there was only one payment that day, A will have a liability with the NCB (A owes money to the NCB) and B will have a claim (NCB owes money to the Bank B). At that point A will have to settle its liability, either paying directly with its reserves or borrowing money in the money market (Settlement of credit).

The following day the game starts again, in the same way.

The type of settlement previously described is net and not in real time:

  • Net: transactions are aggregated over a certain time window and only the net value is settled
  • Not in real time: the settlement is done once a day, not as soon as the transaction happens

Real Time Gross Settlement (RTGS)

Over the last decades a new type of settlement infrastructure has become the standard in banking: Real Time Gross Settlement.

This new system essentially settles transactions immediately and at a gross level: every transaction is settled on a one-by-one basis as it reaches the platform, so there is no end-of-day net to settle.

Some famous examples of RTGS are Fedwire in the US, CHAPS in the UK and, the object of my investigation, Target2 in the Eurozone.

Trans-European Automated Real-time Gross Settlement Express Transfer System (or Target2) is a payment system that enables the speedy and final settlement of national and cross-border payments in central bank money. 

An average of around 350,000 payments with a value of about € 1.7 trillion is processed using Target2 each working day. In one year, TARGET2 settles about 90 million payments with a value of about € 430 trillion.

What is a Target 2 balance?

Going back to the tweet, I couldn’t really understand why a real time settlement scheme has balances: if any agent always settles real time its claims, why is the concept of balance even present?

The devil is always in the details and, even though Target2 is a European centralized RTGS, legally speaking, it is made up of multiple component systems operated by the national central banks (NCBs) and the European Central Bank (ECB). And the real time settlement is widely applied to the agents of the system but not to anybody, in particular NCBs don’t really settle their liabilities and claims with the ECB.

Let’s use another concrete example: let’s say an Italian customer wants to pay a firm in Germany.

In this system every agent settles real time except for the National Central Bank claims and liabilities that stay unsettled: those unsettled claims and liabilities are called Target2 Balances.

Therefore, Target2 balances are cumulated cross-border transactions, executed through the Target2 system and facilitated by the ECB, that provided liquidity to the National Central Banks to make those transactions happen, but not settled yet.

This is the latest update of the Target balances:

The reason behind this huge imbalance between core and periphery of the Eurozone is a very long and complex discussion that would easily end up in politics so outside the remit to my investigation. 

Wrapping up

Finally, this analysis really revealed how central is the payment function to the banking system and how the omni-present principles of elasticity and disciplines are ingrained at every level of the payment infrastructure. Interestingly, in my opinion this is something that applies to any type of monetary system, including that of cryptocurrency, as I discussed in my previous post on Bitcoin and the hierarchy of prices.


Resources

Settlement systems:

Target 2 imbalances: