After presenting the bilateral clearing in the previous article, it is now time to move to the next level: the multilateral clearing.
In a multilateral clearing, a high number of financial institutions are involved. But the principle is the same as for bilateral clearing. All the participant banks will exchange payments among each other up to a certain time. Then the netting will happen after which the final position will be calculated for each of the bank. Since many transactions (thousands or even millions) are exchanged between the banks, the clearing allows to spare the execution of a huge number of transfers.
Multilateral clearing without a clearing house
To understand how effective multilateral clearing is, imagine a bank that is directly connected to several other banks and there is no clearing system in between. In the following figure, a system with five participant Banks has been considered. To reach all the other banks, each bank has to establish a point-to-point connection with each of them. This results in a fully connected network topology which is extremely impractical for large networks.
In this configuration, many bilateral clearings have to be performed. As a matter of fact, this topology yields many drawbacks:
- Each bank in the system has to take care of the netting of positions itself. It has to do that for each of the bank it is connected to, which is quite cumbersome. On the drawing, netting is represented for Bank A and C. With several hundreds of Banks, the complexity will obviously increase for the netting.
- Every time a new bank joins “the market”, it has to set up a connection with all the other banks if it wants to reach them directly. That will become also more and more difficult with the growing number of banks.
- How to make sure that the other banks will really pay after the clearing process? Remember that the money is really transferred after the clearing.
Multilateral clearing with a clearing house
These problems are solved by introducing a third party, the Clearing House, which implements the clearing mechanism. To reach all Banks connected to the CSM (Clearing and Settlement Mechanisms), a bank has to establish only one connection to the CSM. It is far much easier to implement and less costly than building links to each bank directly. A Bank does not have to implement the clearing with each counterparty since the Clearing House takes care of it. And the CSM as a hub can better manage the risk associated to the availability of funds than each bank by itself.
Below you see a picture with four participant banks which are connected to a Clearing House. And the clearing House is connected to the central Bank, the overseer of the banking market in a country or a region. Banks are connected through a clearing house. The central bank comes into play because as overseer of the banking system in the economy, it implements the settlement mechanism that banks uses to transfer funds among themselves. This is a crucial point to keep in mind: in almost all economies, banks do not exchange funds directly among themselves. They have to do it through the central bank.
This configuration is like a star network. Participant Banks can be compared to nodes of the network and the clearing system acts like a central network hub or concentrator. In the real world, the number of banks connected to the CSM is much more important. This gives the CSM an even more crucial role. But the principles underlying clearing mechanism remain the same. The clearing system computes the final position of all the participant banks one or several times a day.
One might think wrongly that the clearing system computes the final position between each bank and each other participant bank. A clearing of this type would certainly limit the number of transfers of funds to carry out. But given the number of participant banks, the number of transfers would still be quite high. I have good news for you. The reality is much simpler. Each participant bank considers the clearing system as a single counterparty.
When a bank receives a credit transaction, it considers that the clearing system owes it money regardless of the bank that issued the operation. If it is a debit transaction, it considers that it owes money to the clearing system regardless of the bank that issued the operation. In the other direction, when a bank sends a debit transaction, it considers that it owes money to the clearing system regardless of the receiving bank of the operation. And if it is a credit transaction, then the clearing system owes money to the bank no matter which is the receiving bank of the operation. Therefore the multilateral net position represents the bilateral net position between each participant and the central counterparty.
Each participant bank considers the clearing system as a single counterparty. In case a participant bank would fail to fulfill its obligations, the other banks will not ask that bank to pay. But they will ask the clearing system to pay. That is what it means for the CSM to be the single counterparty toward participant banks. We see, the clearing system does more than just exchanging transactions and computing the final position. It manages the risk related to the potential failure of a bank to fulfill his obligations toward the CSM and the banking community. The bigger the bank, the more important it is to manage the risk. A failure of a very big bank can cause the whole system to collapse (systemic risk). To avoid this, CSMs set up strict procedures related to risk management. But let us go back to the above figure again.
After the multilateral clearing, final positions of Bank A and Bank C are respectively -70 millions € and -80 millions €. It is said in the financial jargon that they are short. Final positions of Bank B and Bank D are respectively +50 millions € and +100 millions €. The banks with negative positions have to fulfill their obligations by transferring the funds to the CSM. The banks with positive positions get funds from the CSM. The process of moving funds is the settlement.
The CSM will debit the accounts of Bank A and C at the central bank and credit its own account. The Banks with a short position (negative final position) must ensure that sufficient amount is available on their accounts. After crediting its account with funds from Banks A and C, the CSM will debit its account and credit accounts of Banks with a long position (positive final position). Take note that the sum of all Banks’ final positions is zero. The debit of one party is always the credit of another and vice versa. So the total amount must be zero. This was a short introduction to the settlement. We will examine it in more detail in the next article.
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