How Interbank Settlements Work

Article by GlobalMacroForex

An interbank payment system has two separate components.  The first is the communication between the banks and second is the actual transfer of the funds.

For the communication part, most banks use SWIFT.

For the actual transfer of funds, the choices are Fedwire or CHIPS.

A bank would first contact the other one using SWIFT and then actually send the money though CHIPS or Fedwire.

SWIFT

SWIFT (which stands for which stands for Society for Worldwide Interbank Financial Telecommunications) is a nonprofit member-owned cooperative association of 9,000+ banks worldwide.  Basically SWIFT is a messaging system that allows a network of banks to communicate with each other about financial transactions in a secure and standardized format.  Imagine a “text messaging service” for trillions of dollars of secure information. While SWIFT lets banks communicate, there needs to be an actual clearing of the transaction.

Fedwire

Fedwire is run by the Federal Reserve and allows for the clearing of transactions sent through SWIFT.  Banks that are part of the Federal Reserve system have to keep reserves at the Fed.  Through Fedwire, banks can send each other money by having the Fed transfer funds on their behalf from one reserve account to the other.  Fedwire is a real-time gross settlement system, meaning a bank gets the funds immediately and it’s paid in full.  This is in contrast to CHIPS in which payments are netted.

CHIPS

While Fedwire is run by the government and SWIFT is a non-profit, CHIPS is a private for-profit international clearing house based out of New York City.  CHIPS settles transactions at the end of each business day by netting the payments.  This means it operates at a cheaper cost than Fedwire, but it works slower since parties have to wait until the end of the day to receive their funds.

When to use which?

Both systems use SWIFT to communicate.  Most banks prefer to use CHIPS since it’s cheaper, but when money is loaned overnight it’s done through the Fed.  This is where the Fed Funds Rate comes from.  But when it’s not a loan but just a transfer of funds for its customers, banks prefer to use CHIPS because it’s cheaper and they still get to use the funds for the rest of the business day.

China’s New System

When Russia annexed Crimea, the United States froze Russian access to CHIPS and SWIFT.  This had disastrous and destructive effects to the Russian economy, essentially freezing up their financial plumbing.  According to author Eswar Prasad, China was influenced by these US sanctions into developing its own financial clearing system, independent of the United States. 

China developed China Cross Border International Payment System, or CIPS.  This system facilitates offshore RMB clearing and directly challenges the dominance of CHIPS.   However China still currently uses SWIFT (the American communications system).  Eventually though, the Chinese could replace SWIFT with its own network.