PAYMENT AND SETTLEMENT SYSTEMS

Just as each nation has its own national currency, so also does each nation have its own payment and settlement system— that is, its own set of institutions and legally acceptable arrangements for making payments and executing financial transactions within that country, using its national currency. “Payment” is the transmission of an instruction to transfer value that results from a transaction in the economy, and “settlement” is the final and unconditional transfer of the value specified in a payment instruction.

Thus, if a customer pays a department store bill by check, “payment” occurs when the check is placed in the hands of the department store, and “settlement” occurs when the check clears and the department store’s bank account is credited. If the customer pays the bill with cash, payment and settlement are simultaneous.

When two traders enter a deal and agree to undertake a foreign exchange transaction, they are agreeing on the terms of a currency exchange and committing the resources of their respective
institutions to that agreement. But the execution of that exchange—the settlement—does not take place until later.

Executing a foreign exchange transaction requires two transfers of money value, in opposite directions, since it involves the exchange of one national currency for another.

Execution of the transaction engages the payment and settlement systems of both nations, and those systems play a key role in the operations of the foreign exchange market. Payment systems have evolved and grown more sophisticated over time. At present, various
forms of payment are legally acceptable in the United States—payments can be made, for example, by cash, check, automated clearinghouse (a mechanism developed as a substitute for certain forms of paper payments), and electronic funds transfer (for large value transfers between banks).

Each of these accepted forms of payment has its own settlement techniques and arrangements.