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Richard Gendal Brown

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A simple explanation of how money movesaround the banking system

Twitter went mad last week because somebody had transferred almost $150m in a single Bitcointransaction. This tweet was typical:

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194,993 BTC transaction worth $147m sparks mystery and

speculation coinde.sk/18eil43

1:11 AM - 23 Nov 2013

Retweeted by Jon Matonis

194,993 BTC transaction worth $147m sparks

mystery and speculation

By jon southurst @southtopia

Bitcoin internet hangouts were buzzing today after noticing

someone had shifted 194,993 BTC (over $147 million on

CoinDesk's BPI) in one transaction.

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There was much comment about how expensive or difficult this would have been in the regularbanking system – and this could well be true. But it also highlighted another point: in my expecience,almost nobody actually understands how payment systems work. That is: if you “wire” funds to asupplier or “make a payment” to a friend, how does the money get from your account to theirs?

In this article, I hope to change this situation by giving a very simple, but hopefully not oversimplified,

survey of the landscape.

First, let’s establish some common ground

Perhaps the most important thing we need to realise about bank deposits is that they are liabilities.When you pay money into a bank, you don’t really have a deposit. There isn’t a pot of money sittingsomewhere with your name on it. Instead, you have lent that money to the bank. They owe it to you. Itbecomes one of their liabilities. That’s why we say our accounts are in credit: we have extended credit tothe bank. Similarly, if you are overdrawn and owe money to the bank, that becomes your liabilityand their asset. To understand what is going on when money moves around, it’s important to realisethat every account balance can be seen in these two ways.

Paying somebody with an account at the same

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bank

Let’s start with the easy example. Imagine you’re Alice and you bank with, say, Barclays. You owe£10 to a friend, Bob, who also uses Barclays. Paying Bob is easy: you tell the bank what you want todo, they debit the funds from your account and credit £10 to your friend’s account. It’s all doneelectronically on Barclays’ core banking system and it’s all rather simple: no money enters or leaves thebank; it’s just an update to their accounting system. They owe you £10 less and owe Bob £10 more. Itall balances out and it’s all done inside the bank: we can say that the transaction is “settled” on thebooks of your bank. We can represent this graphically below: the only parties involved are you, Bob

and Barclays. (The same analysis, of course, works if you’re a Euro customer of Deutsche Bank or aDollar customer of Citi, etc)

(http://gendal.files.wordpress.com/2013/11/single-bank-

settlement.png)

But what happens if you need to pay somebody ata different bank?

This is where it get more interesting. Imagine you need to pay Charlie, who banks with HSBC. Nowwe have a problem: it’s easy for Barclays to reduce your balance by £10 but how do they persuade

HSBC to increase Charlie’s balance by £10? Why would HSBC be interested in agreeing to owe Charliemore money than they did before? They’re not a charity! The answer, of course, is that if we want

HSBC to owe Charlie a little more, they need to owe somebody else a little less.

Who should this “somebody else” be? It can’t be Alice: Alice doesn’t have a relationship with HSBC,remember. By a process of elimination, the only other party around is Barclays. And here is the first “a

ha” moment… what if HSBC held a bank account with Barclays and Barclays held a bank account with

HSBC? They could hold balances with each other and adjust them to make everything work out…

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Here’s what you could do:

Barclays could reduce Alice’s balance by £10

Barclays could then add £10 to the account HSBC holds with BarclaysBarclays could then send a message to HSBC telling them that they had increased their balance by

£10 and would like them, in turn, to increase Charlie’s balance by £10HSBC would receive the message and, safe in the knowledge they had an extra £10 on deposit with

Barclays, could increase Charlie’s balance.

It all balances out for Alice and Charlie… Alice has £10 less and Charlie has £10 more.

And it all balances out for Barclays and HSBC. Previously, Barclays owed £10 to Alice, now it owes

£10 to HSBC. Previously, HSBC was flat, now it owes £10 to Charlie and is owed £10 by Barclays.

This model of payment processing (and its more complicated forms) is known as correspondentbanking. Graphically, it might look like the diagram below. This builds on the previous diagram and

adds the second commercial bank and highlights that the existence of a correspondent bankingarrangement allows them to facilitate payments between their respective customers.

(http://gendal.files.wordpress.com/2013/11/correspondent-banking.png)

This works pretty well, but it has some problems:

Most obviously, it only works if the two banks have a direct relationship with each other. If they

don’t, you either can’t make the payment or need to route it through a third (or fourth!) bank until

you can complete a path from A to B. This clearly drives up cost and complexity. (Somecommentators restrict the use of the term “correspondent banking” to this scenario or scenarios that

involve difference currencies but I think it helpful to use the term even for the simpler case)More worryingly, it is also risky. Look at the situation from HSBC’s perspective. As a result of this

payment, their exposure to Barclays has just increased. In our example, it is only by £10. Butimagine it was £150m and the correspondent wasn’t Barclays but was a smaller, perhaps riskier

outfit: HSBC would have a big problem on its hands if that bank went bust. One way round this is

to alter the model slightly: rather than Barclays crediting HSBC’s account, Barclays could askHSBC to debit the account it maintains for Barclays. That way, large inter-bank balances might not

build up. However, there are other issues with that approach and, either way, the

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interconnectedness inherent in this model is a very real problem.

We’ll work through some of these issues in the following sections.

[Note: this isn't *actually* what happens today because the systems below are used instead but I thinkit's helpful to set up the story this way so we can build up an intuition for what's going on]

Hang on… why are you making this socomplicated? Can’t you just say “SWIFT” and bedone with it?

It is common when discussing payment systems to have somebody wave their hands, shout “SWIFT”

and believe they’ve settled the debate. To me, this just highlights that they probably don’t know whatthey’re talking about

The SWIFT

(http://en.wikipedia.org/wiki/Society_for_Worldwide_Interbank_Financial_Telecommunication) network exists to allow banks securely to exchange electronic messages with each other. One of the message

types (http://en.wikipedia.org/wiki/SWIFT_message_types) supported by the SWIFT network isMT103 (http://www.10588.com/pub_web/swift/books/us1m/doc/ajh.htm). The MT103 message enables

one bank to instruct another bank to credit the account of one of their customers, debiting the account

held by the sending institution with the receiving bank to balance everything out. You could imaginean MT103 being used to implement the scenario I discussed in the previous section.

So, the effect of a SWIFT MT103 is to “send” money between the two banks but it’s critically important

to realise what is going on under the covers: the SWIFT message is merely the instruction: themovement of funds is done by debiting and crediting several accounts at each institution and relies on

banks maintaining accounts with each other (either directly or through intermediary banks). Simply

waving one’s hands and shouting “SWIFT” serves to mask this complexity and so impedesunderstanding.

OK… I get it. But what about ACH and EURO1and Faster Payments and BACS and CHAPS andFedWire and Target2 and and and????

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Slow down….. Let’s recap first.

We’ve shown that transferring money between two account holders at the same bank is trivial.

We’ve also shown how you can send money between account holders of different banks through a

really clever trick: arrange for the banks to hold accounts with each other.

We’ve also discussed how electronic messaging networks like SWIFT can be used to manage the flow ofinformation between banks to make sure these transfers occur quickly, reliably and at modest cost.

But we still have further to go… because there are some big problems: counterparty risk, liquidity and

cost.

The two we’ll tackle first are liquidity and cost

We need to address the liquidity and costproblem

First, we need to acknowledge that SWIFT is not cheap. If Barclays had to send a SWIFT message toHSBC every time you wanted to pay £10 to Charlie, you would soon notice some hefty charges on

your statement. But, worse, there’s a much bigger problem: liquidity.

Think about how much money Barclays would need to have tied up at all its correspondent banksevery day if the system I outlined above were used in practice. They would need to maintain sizeablebalances at all the other banks just in case one of their customers wanted to send money to a recipient

at HSBC or Lloyds or Co-op or wherever. This is cash that could be invested or lent or otherwise put towork.

But there’s a really nice insight we can make: on balance, it’s probably just as likely that a Barclayscustomer will be sending money to an HSBC customer as it is that an HSBC customer will be sendingmoney to a Barclays customer on any given day.

So what if we kept track of all the various payments during the day and only settled the balance?

If you adopted this approach, each bank could get away with holding a whole lot less cash on depositat all its correspondents and they could put their money to work more effectively, driving down their

costs and (hopefully) passing on some of it to you. This thought process motivated the creationof deferred net settlement systems. In the UK, BACS is such a system and equivalents exist all overthe world. In these systems, messages are not exchanged over SWIFT. Instead, messages (or files) are

sent to a central “clearing” system (such as BACS), which keeps track of all the payments, and then, on

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some schedule, calculates the net amount owed by each bank to each other. They then settle amongstthemselves (perhaps by transferring money to/from the accounts they hold with each other) or byusing the RTGS system described below.

This dramatically cuts down on cost and liquidity demands and adds an extra box to our picture:

(http://gendal.files.wordpress.com/2013/11/deferred-net-settlement.png)

It’s worth noting that we can also describe the credit card schemes and even PayPal as Deferred NetSettlement systems: they are all characterised by a process of internal aggregation of transactions, withonly the net amounts being settled between the major banks.

But this approach also introduces a potentially worse problem: you have lost settlement finality. Youmight issue your payment instruction in the morning but the receiving bank doesn’t receive the (net)funds until later. The receiving bank therefore has to wait until they receive the (net) settlement, just in

case the sending bank goes bust in the interim: it would be imprudent to release funds to the receivingcustomer before then. This introduces a delay.

The alternative would be to take the risk but reverse the transaction in the event of a problem – but

then the settlement couldn’t in any way be considered “final” and so the recipient couldn’t rely on thefunds until later in any case.

Can we achieve both Settlement Finality

and Zero Counterparty Risk?

This is where the final piece of the jigsaw fits in. None of the approaches we’ve outlined so far arereally acceptable for situations when you need to be absolutely sure the payment will be madequickly and can’t be reversed, even if the sending bank subsequently goes bust. You really, really need this

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assurance, for example, if you’re going to build a securities settlement system: nobody is going torelease $150m of bonds or shares if there’s a chance the $15om won’t settle or could be reversed!

What is needed is a system like the first one we outlined (Alice pays Bob at the same bank) – becauseit’s really quick – but which works when more than one bank is involved. The multilateral bank-banksystem outlined above sort-of works but gets really tricky when the amounts involved get big and

when there’s the possibility that one or other of them could go bust.

If only the banks could all hold accounts with a bank that cannot itself go bust… some sort of bankthat sat in the middle of the system. We could give it a name. We could call it a central bank!

And this thought process motivates the idea of a Real-Time Gross Settlement system.

If the major banks in a country all hold accounts with the central bank then they can move moneybetween themselves simply by instructing the central bank to debit one account and credit the other. And that’s what CHAPS, FedWire and Target 2 exist to do, for the Pound, Dollar and Euro,respectively. They are systems that allow real-time movements of funds between accounts held by

banks at their respective central bank.

Real Time – happens instantly.Gross – no netting (otherwise it couldn’t be instant)

Settlement - with finality; no reversals

This completes our picture:

(http://gendal.files.wordpress.com/2013/11/rtgs.png)

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I thought this article had something to do with

Bitcoin?

Well done for getting this far. Now we have a question: can we place Bitcoin on this model?

My take is that the Bitcoin network most closely resembles a Real-Time Gross Settlement system. Thereis no netting, there are (clearly) no correspondent banking relationships and we have settlement, gross,

with finality.

But the interesting thing about today’s “traditional” financial landscape is that most retail transactionsare not performed over the RTGS. For example, person-to-person electronic payments in the UK go

over the Faster Payments system, which settles net several times per day, not instantly. Why is this? Iwould argue it is primarily because FPS is (almost) free, whereas CHAPS payments cost about £25. Most consumers probably would use an RTGS if it were just as convenient and just as cheap.

So the unanswered question in my mind is: will the Bitcoin payment network end up resembling atraditional RTGS, only handling high-value transfers? Or will advances in the core network (block sizelimits (http://www.washingtonpost.com/blogs/the-switch/wp/2013/11/12/bitcoin-needs-to-scale-by-a-

factor-of-1000-to-compete-with-visa-heres-how-to-do-it/), micropayment channels(https://en.bitcoin.it/wiki/Contracts#Example_7:_Rapidly-adjusted_.28micro.29payments_to_a_pre-determined_party), etc) occur quickly enough to keep up with increasing transaction volumes in order

to allow it to remain an affordable system both for large- and low-value payments?

My take is that the jury is still out: I am convinced that Bitcoin will change the world(http://gendal.wordpress.com/2013/10/23/on-the-blockchain-nobody-knows-youre-a-fridge/) but I’m

altogether less convinced that we’ll end up in a world where every Bitcoin transaction is “cleared” overthe Blockchain.

[Updated several times on 25 November 2013 to correct minor errors and to add the link to my Finextra

video at the end]

11 thoughts on “A simple explanation of how moneymoves around the banking system”

1. Simon de la Rouviere (@simondlr) says:November 24, 2013 at 19:54

About these ads (http://en.wordpress.com/about-

these-ads/)

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I think for day to day transactions (buying groceries and so forth), players like Coinbase will startalleviating a lot of the pressure on the blockchain. In a similar fashion, they will act as a bank, onlychanging the numbers in between accounts.

2. gendal says:November 24, 2013 at 20:10Hi Simon,

I’m inclined to agree. I think there are two major forces driving us towards this sort of outcome. 1)the “average” user is likely to trust a reassuring brand more than themselves to manage their

wallet, driving a move to a bank-like “safekeeping” business model and 2) the blockchain may notbe the best vehicle for micro-payments. Combine those two observations and you end up with yourprediction: there is a gap in the market for off-blockchain ‘aggregators’ of smaller transactions.

But I also know that many of the core developers, with infinitely more knowledge of the systemdisagree with this analysis!

Richard

3. Jaumenuez says:

November 25, 2013 at 08:08Great post. Bitcoin protocol works well between untsted parties that know what are they up to, nonreverse, etc. In this case, no need for a Central Bank. Most average users, as you say, still needtrusted relations, so there will always be a trusted layer above Bitcoin for anyone in need for it,

giving some space to the current retail banking model. Banks do have a place in the Bitcoinscenario, same as today, but the difference is that you could still operate without them if you wish.Banks will be just another option.

4. Sam Garforth (@samjgarforth) says:November 25, 2013 at 08:54

Excellent article Richard. I found myself asking a few questions as I read it, most of which youanswered.“CHAPS payments cost about £25″. Do they really, or is that just the price? Do they charge that

much because they want to make money, or because they want to dissuade us from using thatmethod or because they really do cost?Are SWIFT messages signed? In other words if they contain non repudiation then surely they are atransfer of value rather than just the veil that you describe, however your focus is on whether the

sender will go bust rather than deny sending it so it’s not relevant here.Surely this whole thing is just an model to allow us to understand things. There’s still no actualvalue moving around, so it’s not much more true than just saying that you’re moving money. But

of course it is a much more thorough model that allows you to do more things.Surely bitcoin is still just the movement of liabilities. It still doesn’t have a real value until the sender

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gives up their sheep and the recipient receives a goat (or whatever else it is that makes the moneyhave value to them). – I know you answered this by comparing to a gross settlement system ratherthan to real value.

5. Pingback: A Simple Explanation of How Money Moves Around The Banking System | EnjoyingThe Moment

6.

kassner says:November 25, 2013 at 09:52Can I assume that currency exchange works the same way between central banks?

7. Sean Handley says:November 25, 2013 at 10:20

Nice explanation.

Also, for an understanding of modern fractional reserve banking, it’s worth watching the videos athttp://www.positivemoney.org

8. Pingback: Linux Mint Czech - Bitcoin, a ako sa pohybujú peniaze v bankovom systéme at LinuxMint CZ&SK

9. Benjamin says:November 25, 2013 at 12:30Great article, it’s always easier to understand with small examples.

BUT I really didn’t like the graphs you did, mostly because the arrows go both ways. In the firstexample for instance, the arrow going from Alice to the bank shouldn’t go both ways. But it’s justmy opinion.

10. gendal says:November 25, 2013 at 13:14

@Jaumenuez I agree; I think we’ll see a federated model of the sort you describe – but, also as yousay, with the option of going “direct” for those who know how to and want to

@benjamin – thanks. Good point re the diagrams; you’re right. The arrows are confusing. Sorry!

@sean – thanks for the link

@kassner – I left FX as an “exercise for the reader” but you’re right… the principles can beextended. e.g. imagine Barclays held a *dollar* account with Citi. That would give Barclayscustomers a way of making Dollar payments – and so on. Indeed, this cross-border example is whatmost people think of when you say “correspondent banking”. If you follow this line of reasoning,

the counterparty risk problems becomes even greater and you end up with a need for an “RTGS forFX”, if you like. This motivated the creation of the CLS Bank.

11.

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gendal says:November 25, 2013 at 13:17

@Sam:

* CHAPS – fair point. They’re “charged” at about £25. They probably cost a lot less.* SWIFT messages – not sure if they’re cryptographically signed but the key thing that SWIFToffers that the internet does not is security at the end points and within the network. i.e. if youreceive a SWIFT message purporting to be from Barclays, you can be pretty sure it *is* from

Barclays!* Bitcoin is interesting – because it doesn’t really fit the “liability” model. My holding of Bitcoins arenobody else’s liability. This makes them quite unlike any major currency today – and far more likegold or a commodity.

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