-9-

Under a centralized settlement operation, all banks maintain a clearing account with one bank. The settlement bank processes the settlement transactions between the originator and the receiver on its books. In the 10 bank example using centralized settlement, ten accounts rather than 45 would be requireclW and less money would be required for settlement because liquidity would be less fragmented. Centralized settlement has operational and liquidity advantages over distributed settlement. However, if the single settlement agent is a commercial bank, centralized settlement will increase the systemic risk of bank failure over a distributed system.

In most developed countries, the nation's central bank serves as the primary settlement agent for payment transactions. The central bank provides the operational and liquidity advantages of centralized settlement. Because the central bank cannot fail (unless the government fails), no systemic risk is inherent in central bank clearing balances. In most countries, banks and other financial institutions are required to hold balances with the central bank for monetary policy, liquidity, safety and soundness. Using these balances for settlement allows them to perform double duty, and minimizes the financial resources tied up in payment processing.

Central bank settlement can take place in one of two forms. Gross settlement happens when each item is settled separately. Net settlement happens when exchanged values are netted between participants and the residual balance is settled in the central bank's books. For example, assume three banks exchange payment and each has a single $100 debit against the other two banks. In a gross settlement, each bank would make four settlement entries - two $100 debits and two $100 credits or 12 entries in total. A net settlement would calculate each bank's single net position with the settlement agent and post a single entry (in this case zero) for each participant. This is also known as multilateral netting, an arrangement between three or more parties in which each member makes payments to a clearinghouse for the net payments due to the other members and receives the net amounts due from the other members from the clearinghouse. Multilateral netting has significant cost advantages over gross or even bilateral netting, but contains greater legal uncertainty in the case of failure of one of the settling participants.

Receiver processing. The receiving bank performs several tasks to complete the payment transaction. The bank must post the item to the receiving customer's bank account (credit to account for a credit item; debit to account for a debit item). The bank may have a requirement to notify the customer of the payment by phone, mail or regular periodic statement. The payment instrument (e.g. check) may accompany this notification. The receiver may have requirements to verify the item's authenticity (signature verification) before posting, verify the availability of funds (for a debit item) and archive the payment transaction record for reconciliation and error resolution.

The receiver may be the bank branch where the receiving customer has an account, any branch of that bank, or the bank's central or regional processing center. The receiver's physical location often depends upon automation within the bank and the presentment rules within the country.

Clearing and settlement must be organized cooperatively within the nation's banking industry, striking a difficult balance between cooperation and competition. Banks compete for customers based upon how they differentiate their originator and receiver processing. Payment instumments clearing and settlement standards and rules must be developed in concert. The embryonic state of development of private financial intermediaries in most transitional socialist economies argue strongly for the central bank to take a leadership role in payment system design and development. In more advanced market ' _C_ **_(r,_** _n) = lO!I,fl) (1lflJ10= ! = 10._