Deferred Settlement

An in-depth look at the Deferred Settlement Model and its Risks

Deferred Net Settlement (DNS) is a settlement process that allows for the accumulation of transactions over a certain period of time before they are settled. During this period, the transactions are stored and sorted by the payment processor, which calculates the net amount owed by each financial institution involved in the transactions.

In a typical deferred settlement model institutional settlement always happens after the receiving customer accounts have been credited (i.e after end-user settlement).

Transactions are settled through a settlement agent after they are cleared by the switch, most often on a multilateral netting basis according to a regular schedule.

In most cases, though not necessarily always, the operator of the switch manages operations. One of these core operations in a deferred net settlement model is maintaining the net positions of all participants in the scheme to be affected on the Settlement Accounts held by participants at the Settlement Agent.

Figure (1) - Illustration of 4 transactions between 3 Participants in a Scheme and their Net Settlement Position

At pre-determined intervals and at an exact cut-off, the above constantly calculated net positions are shared with the settlement agent for them to affect the net positions on the single treasury account or settlement account that all FSPs hold with the settlement agent.

Figure (2) - How is Settlement or Transaction Finality achieved in DNS Systems

Advantages of the Deferred Net Settlement Model

DNS is often used in payment systems where large volumes of transactions are processed over a period of time, such as in the case of credit card processing. By deferring settlement, financial institutions are able to reduce the number of individual transactions that need to be settled, which can help to reduce transaction fees and processing costs.

By deferring settlement, financial institutions are able to reduce the number of individual transactions that need to be settled, which can help to reduce transaction fees and processing costs.

Some of the scenarios where DNS may be the preferred settlement method include:

• Credit card processing: DNS is commonly used in credit card processing systems, where there are numerous transactions that occur over the course of a day, week, or month. By deferring settlement, financial institutions can reduce the number of individual transactions that need to be settled, which can help to lower transaction fees and processing costs.

• Large-value transactions: DNS can be particularly useful for settling large-value transactions. By deferring settlement, financial institutions can ensure that they have adequate funds available to settle these transactions, which may require significant financial resources.

• Settlement across multiple time zones: In payment systems that involve financial institutions in different time zones, DNS can help to ensure that all transactions are settled in a timely and efficient manner. By deferring settlement, financial institutions can ensure that they have enough time to reconcile their accounts and transfer funds between accounts located in different time zones.

• Payment systems with limited liquidity: DNS can also be useful in payment systems where there is limited liquidity. By deferring settlement, financial institutions can avoid the need to transfer funds between accounts multiple times, which can help to reduce the risk of insufficient funds and improve overall liquidity.

Disadvantages in the Deferred Net Settlement Model

While it has its advantages, the DNS model does have some disadvantages to it as well. Most notably, a typical DNS system without additional safeguards introduces three types of risk in the Payment System.

It is because of these risks that regulators and schemes make stringent membership criteria for participants of deferred net settlement systems since there are no usually real-time checks during transaction clearing, direct membership cannot be offered to non-bank or unregulated entities. This is one of the pivotal reasons for movements towards instant payment systems, because of their more advanced risk management capabilities, it is possible to extend the scope of a scheme's direct membership to non-banking DFSPs.

Removing Risk from a Deferred Net Settlement System

To manage these risks, participants, including the settlement bank, often rely on bank regulation (e.g., “safety and soundness” oversight) to ensure that settlement risks are either covered or exist at an acceptable level.

More elaborate liquidity risk management capabilities exist for high-value settlement systems but are generally not applied to retail payment systems. These include measures such as collateral, dynamic calculation of multilateral positions for each transaction etcetera. These are more usually found in next-generation Instant Payment Systems.