Recently, one of our readers asked us this question from How does a central bank ?set? interest rates?:
It would be great if you could post another article on this subject as I?d love to understand it better. Some examples might help and a definition of ?exchange settlement funds?.
Today, we will explain what exchange settlement funds (ESF) are.
Everyday, in the hustle and bustle of commerce and economic activity, a lot of cash gets transferred between banks. For example, your boss may pay your salary by transferring cash from his bank account to your bank account. Or a business may pay its supplier by doing an electronic funds transfer.
As you may have been aware already, fund transfer from one bank account to another (especially if the accounts reside in different banks) take at least one business day to take effect. Why is this so? As this article from the RBA, The Role of Exchange Settlement Accounts explained,
Historically, payments systems settled on a “deferred net” basis. Most low-value systems still do and will probably do so for the foreseeable future; the costs of settling a large number of low-value payments in real time cannot be justified by the reduction in risk.
With deferred net settlement, institutions offering payments services to their customers exchange instructions with other payment system participants throughout the day. After the close of the business day, they calculate their net obligations to each other. Most commonly, participants agree to calculate their multilateral net obligations “to the system”. In this case, the total payments made by and to each participant from all other participants are calculated and offset. The resulting multilateral net settlement obligations are “to the system”, not to an individual bank.
Let’s suppose we have 4 banks- A, B, C and D- in the financial system. At the end of each day, the net obligations to the ‘system’ will look like this:
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So, the next question is, how does the bank settle their obligations with each other? Well, one way will be for each of the bankers (A, B, C and D) to sit in a round table and put/take physical cash on/from the table. For example, in this case, Banks A, C and D will put physical cash on the table while Bank B will collect them.
But surely, this is extremely inconvenient right? In economies where there are billions of dollars worth of transactions per day, moving physical cash around is extremely risky (e.g. robberies, hijacks), troublesome and impractical. A better system is required. That system is called the Exchange Settlement Accounts. How does it work?
You see, in addition to holding physical cash, banks (in addition to governments) have an account with the central bank where they ‘deposit’ their cash. It’s very similar to the way individuals hold their cash physically and in the form of bank deposits. For banks, this is called the exchange settlement funds (ESF). So, instead of settling their net obligations physically, they do so at the ESF level, which is nothing more than just flicking some book-keeping numbers on their account balances at the central bank’s books.
Just one note: As we said before in What is money?,
The next broader measure of money is the monetary base, which is (1) physical notes and coins held by the ?private sector? (which is anything that is not of the government), (2) banks? deposit at the RBA and (3) what the RBA owes to the ?private non-bank sector.? The central bank (RBA) is the bank of the government and banks. Therefore, your bank will have an account at the RBA where it keeps its money, which is the previously mentioned (2).
Therefore, funds at the ESF are part of the monetary base.
Tags: banks, central banks, Exchange Settlement Account, Exchange Settlement Funds, RBA
