Electronic Payment Systems
20-763
Lecture 2
Banking Systems
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Outline
• What banks do
• Their role in money movement
• Foreign exchange
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
World Banking System
PRIVATE BANKS AND
CREDIT INSTITUTIONS
PRIVATE BANKS AND
CREDIT INSTITUTIONS
PRIVATE BANKS AND
CREDIT INSTITUTIONS
PRIVATELY OWNED
CENTRAL BANKS
MIXED-OWNERSHIP
CENTRAL BANKS
GOVERNMENT-OWNED
CENTRAL BANKS
U.S. FEDERAL RESERVE
DEUTSCHE BUNDESBANK
BELGIUM
BANK OF JAPAN
BANQUE DE FRANCE
BANK OF ENGLAND
BANK FOR
INTERNATIONAL SETTLEMENTS
INTERNATIONAL MONETARY FUND
(PUBLIC POLICY LENDER $300B)
182 MEMBER COUNTRIES
WASHINGTON, DC
(A BANK FOR 45 CENTRAL BANKS, $130B)
BASEL, SWITZERLAND
SOURCE: TRANSACTION.NET
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Central Banks
• Legal tender (“real money”) is issued by authorized
central banks
– Government-owned
– Privately owned
– Joint private-government
• Other banks cannot hold legal tender (except in cash
form). Why? (Consider what form it would be in.)
• Other banks must maintain accounts in the central
bank
• Banks transfer real money via transactions through
the central bank
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Movement of Money
• World economic product ~$30T
– Time to circulate $30T ~ 6 days
• Money supply (U.S., July 31, 2001)
– M1 (spendable now; money for payments) $1.1T (liquid =
cash + non-interest deposits + travelers checks)
– M2 (M1+ short-term investments < $100K) $5.3T (M1 + time
deposits + money market funds)
– M3 (M2 + long-term investments) $7.7T (M2 + big deposits:
institutional money funds)
• Cash (U.S, July 31, 2001) $554B
– 0.1% counterfeit (in the U.S., only 0.03% is counterfeit)
– Over 70% held outside the U.S. (but counted in M1 because
it can be spent in the U.S.)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
The U.S. Money Supply
In billions on
July 31, 2001
Currency
554
Non-bank travelers checks
9
Demand deposits
313
Other checkable deposits
260
M1 Total
Savings
2087
Small time deposits <100K 1116
Retail money market funds 984
M2 Total
Large time deposits >100K
812
Institutional money funds
986
Bank agreements
379
Eurodollars
197
M3 Total
• .
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
.
1136
.
5323
.
7697
SOURCE: FEDERAL RESERVE
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Function of Banks
• Central banks:
– Issue fiduciary money (both token and notational)
• All other (non-central) banks:
– Issue notational scriptural money (bank accounts)
• Not fiduciary (“real money”), not token
• Non-central banks
– Move notational money
– Accept deposits (loans from depositors)
– Loan deposits to others (borrowers)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
What is a Bank Account?
• Notational representation of a loan to the bank from a
depositor
• Once the depositor puts money in his account, it
becomes the bank’s money, not the depositor’s
• When the bank deposits its money in the central
bank, it becomes fiduciary (real) money
• The bank then owes the depositor real money
• Effect of deposit: bank ends up with more real money
I DEPOSIT
$200 IN THE
BANK
I HAVE
$1000
MY ASSETS:
$1000 CASH
I HAVE $800.
BANK OWES
ME $200 (MY
“ACCOUNT”)
BANK DEPOSITS $200
IN CENTRAL BANK
MY ASSETS:
$800 CASH
+$200 OWED BY BANK
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
BANK HAS
$200 MORE
MONEY NOW
BANK’S ASSETS:
+$200 REAL MONEY
- $200 DEBT
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Benefit of a Bank Deposit
• Bank can
– loan the money (more than was deposited!)
– invest the money
– move the money, e.g. make payments
– buy foreign currency with the money
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Payment Orders (Checks)
DATE
MAKER (DRAWER)
CHECK
NUMBER
PAYEE
AMOUNT
CURRENCY
DRAWEE
BANK
DRAWEE BANK
NUMBER
ACCOUNT NUMBER
THIS CHECK IS AN ORDER TO MELLON BANK TO
PAY $100 TO PAYEE OR HIS TRANSFEREE FROM
THE CARNEGIE MELLON UNIVERSITY ACCOUNT
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
AUTHORIZED
SIGNATURE OF
MAKER’S AGENT
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Checks
•
•
•
•
U.S. -- 63 billion checks per year, average $1100
80% of noncash payments made by check
“On-Us” (payor and payee in same bank -- 30%)
Interbank (payor and payee in different banks) -requires settlement
– Direct presentment (“direct sends”)
– Correspondent banks
– Clearing house associations (150)
– Federal Reserve system (15 billion checks/year,
27%)
• Complex laws re bank liability in check processing
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Check Processing
“On-Us”
Check
Deposit
Ticket
Encode
Sort/Balance
Check
Deposit
Ticket
BANK A’S
DEPOSITS
Clearing
House
Check
Cash
Letter
“Clearing
House”
OTHER BANKS
Check
Cash
Letter
“Direct
Sends”
BANK B
SOURCE: PNCBANK
Clearing Payment Orders (Check)
CUSTOMER CMU
OF MELLON BANK
1. CMU SENDS CHECK TO SHAMOS
“PAY SHAMOS $100”
9. MELLON SENDS
CHECK BACK TO CMU
MELLON BANK
7. MELLON
DEDUCTS $100
FROM CMU
ACCOUNT
2. SHAMOS DEPOSITS
CHECK AT CITI
8. CLEARING HOUSE
SENDS CHECK TO
MELLON
CUSTOMER A
CUSTOMER CMU -100
...
CUSTOMER Y
CUSTOMER Z
CITIBANK
4. CITI SENDS CHECK
TO CLEARING HOUSE
CUSTOMER A
CUSTOMER B
...
SHAMOS
CUSTOMER Z
CLEARING HOUSE
(FEDERAL RESERVE)
6. CLEARING
HOUSE SENDS
MELLON
DEBIT INFO
CUSTOMER SHAMOS
OF CITIBANK
MELLON
BANK A
...
BANK Z
CITIBANK
-100
3. CITIBANK CREDITS
SHAMOS WITH $100
+100
5. CLEARING HOUSE ADDS $100 TO CITI,
SUBTRACTS $100 FROM MELLON
20-763 ELECTRONIC PAYMENT SYSTEMS
+100
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Settling Payment Orders (Checks)
1. AT END OF DAY, EACH
BANK HAS A NET POSITIVE
OR NEGATIVE CLEARING
HOUSE BALANCE
6. CLEARING HOUSE PAYS
MELLON $34,299,321
MELLON BANK
CUSTOMER A -15085
CUSTOMER CMU +3167
...
CUSTOMER Y +728103
CUSTOMER Z +35529
5. CLEARING HOUSE ADVISES
MELLON IT WILL
RECEIVE $34,299,321
2. BANKS WITH NEGATIVE
BALANCES MUST PAY;
THOSE WITH POSITIVE
BALANCES RECEIVE
MONEY
REAL-TIME GROSS
SETTLEMENT SYSTEM
(FEDWIRE)
MELLON
+34,299,321
BANK A
...
BANK Z
CITIBANK
-107,071,775
CLEARING
+107,071,775
HOUSE
4. CITI PAYS THE CLEARING
HOUSE THROUGH RTGS
CITIBANK
CLEARING HOUSE
(FEDERAL RESERVE)
MELLON
BANK A
...
BANK Z
CITIBANK
20-763 ELECTRONIC PAYMENT SYSTEMS
+34,299,321
+2786
CUSTOMER A
CUSTOMER B -988713
...
SHAMOS
+100
CUSTOMER Z -31872
3. CLEARING HOUSE INFORMS
CITI IT MUST PAY $107,071,775
-107,071,775
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Electronic Clearing
MAKER (DRAWER)
DATE
PAYEE
CHEQUE
NUMBER
The paper cheque is just
a carrier of information.
AMOUNT
CURRENCY
DRAWEE
BANK
DRAWEE BANK
NUMBER
AUTHORIZED
SIGNATURE OF
MAKER’S AGENT
DRAWER
ACCOUNT
NUMBER
Electronic transmission is
better.
We dematerialize the cheque
(remove the paper).
06130018184310143700000000100000USD061200356425020010130
DRAWEE
BANK
NUMBER
DRAWER
ACCOUNT
NUMBER
CHECK
NUMBER
AMOUNT
CURRENCY
PAYEE
BANK
NUMBER
PAYEE
ACCOUNT
NUMBER
DATE
Only the information is sent to the clearing house
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Foreign Exchange
•
•
•
•
Currency = token fiduciary money of a central bank
Every bank account is denominated in one currency
Most banks allow accounts in only one currency
All currencies have three-letter ISO currency codes:
– USD (U.S. dollar)
– GBP (Great Britain pound)
– HKD (Hong Kong dollar)
JPY (Japan yen)
CHF (Swiss franc)
EUR (Euro)
• Usually, the first two letters indicate the country; third
letter is the first letter of the currency name
• Foreign exchange is a barter transaction
– To buy GBP for USD, buyer has to find someone with GBP
who wants USD
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Foreign Exchange
• Every bank must have an account at the central bank
(or with another bank that has one)
• The account is (usually) denominated in that
country’s currency and is used to settle obligations in
that currency
• A foreign exchange transaction requires two
settlements, one in each currency
• Therefore, two countries’ central banks are involved
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Foreign Exchange Example
• Bank B (buyer) in the U.S. buys 1 million GBP for
1.44 million USD from Bank S (seller) in the UK
• Bank B must have an account denominated in GBP
somewhere, probably at Bank C in the UK
• Bank S must have an account denominated in USD
somewhere, probably at Bank T in the US
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Foreign Exchange Example
US BANKS
BANK B (US)
WANTS TO BUY
1 MILLION GBP
FOR USD
BANK T (US)
BANK S
USD ACCOUNT
(NOSTRO ACCOUNT)
(NOSTRO ACCOUNT)
BANK C (UK)
BANK B
GBP ACCOUNT
BANK S (UK)
WILLING TO SELL
1 MILLION GBP
FOR USD
UK BANKS
US FEDERAL
RESERVE BANK
THE BANK
OF ENGLAND
BANK B USD ACCOUNT
BANK S GBP ACCOUNT
BANK T USD ACCOUNT
BANK C GBP ACCOUNT
SETTLEMENT ONE:
SETTLEMENT TWO:
BANK B TRANSFERS
1.44 MILLION USD TO
BANK T BY FEDWIRE
BANK S TRANSFERS
1 MILLION GBP TO BANK
C BY CHAPS (BOE RTGS)
SELLER S NOW HAS 1.44
MILLION USD IN BANK T
BUYER B NOW HAS 1
MILLION GBP IN BANK C
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
The Euro – A Basket Currency
• Single currency for 11 European countries
• Issued by the European Central Bank (ECB)
• 1 euro (EUR) =
–
–
–
–
–
–
–
–
–
–
–
1.95583 DEM (German deutschmark)
6.55957 FRF (French franc)
1936.27 ITL (Italian lira)
166.386 ESP (Spanish peseta)
2.29371 NLG (Netherlands guilder)
40.3399 BEF (Belgian franc)
13.7603 ATS (Austrian schilling)
200.482 PTE (Portuguese escudo)
5.94573 FIM (Finnish markka)
0.787564 IEP (Irish punt)
40.3399 LUF (Luxembourg franc)
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS
Q&A
20-763 ELECTRONIC PAYMENT SYSTEMS
FALL 2001
COPYRIGHT © 2001 MICHAEL I. SHAMOS