11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown

gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 1/12
Richard Gendal Brown
Thoughts on the future of finance

POSTED BY
RICHARD BROWN
POSTED ON
NOVEMBER 24, 2013
POSTED UNDER
UNCATEGORIZED
COMMENTS
11 COMMENTS
A simple explanation of how money moves
around the banking system
Twitter went mad last week because somebody had transferred almost $150m in a single Bitcoin
transaction. This tweet was typical:
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 2/12
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.
CoinDesk
@coindesk
Follow
CoinDesk @coindesk
16 RETWEETS 10 FAVORITES
There was much comment about how expensive or difficult this would have been in the regular
banking 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 a
supplier 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, lets 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 dont really have a deposit. There isnt a pot of money sitting
somewhere with your name on it. Instead, you have lent that money to the bank. They owe it to you. It
becomes one of their liabilities. Thats why we say our accounts are in credit: we have extended credit to
the bank. Similarly, if you are overdrawn and owe money to the bank, that becomes your liability
and their asset. To understand what is going on when money moves around, its important to realise
that every account balance can be seen in these two ways.
Paying somebody with an account at the same
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 3/12
bank
Lets start with the easy example. Imagine youre 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 to
do, they debit the funds from your account and credit 10 to your friends account. Its all done
electronically on Barclays core banking system and its all rather simple: no money enters or leaves the
bank; its just an update to their accounting system. They owe you 10 less and owe Bob 10 more. It
all balances out and its all done inside the bank: we can say that the transaction is settled on the
books 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 youre a Euro customer of Deutsche Bank or a
Dollar customer of Citi, etc)
(http://gendal.files.wordpress.com/2013/11/single-bank-
settlement.png)
But what happens if you need to pay somebody at
a different bank?
This is where it get more interesting. Imagine you need to pay Charlie, who banks with HSBC. Now
we have a problem: its easy for Barclays to reduce your balance by 10 but how do they persuade
HSBC to increase Charlies balance by 10? Why would HSBC be interested in agreeing to owe Charlie
more money than they did before? Theyre 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 cant be Alice: Alice doesnt 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
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 4/12
Heres what you could do:
Barclays could reduce Alices balance by 10
Barclays could then add 10 to the account HSBC holds with Barclays
Barclays 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 Charlies balance by 10
HSBC would receive the message and, safe in the knowledge they had an extra 10 on deposit with
Barclays, could increase Charlies 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 correspondent
banking. 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 banking
arrangement 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
dont, you either cant 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. (Some
commentators 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 HSBCs perspective. As a result of this
payment, their exposure to Barclays has just increased. In our example, it is only by 10. But
imagine it was 150m and the correspondent wasnt 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 HSBCs account, Barclays could ask
HSBC 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
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 5/12
interconnectedness inherent in this model is a very real problem.
Well 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 think
it'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 so
complicated? Cant you just say SWIFT and be
done with it?
It is common when discussing payment systems to have somebody wave their hands, shout SWIFT
and believe theyve settled the debate. To me, this just highlights that they probably dont know what
theyre talking about
The SWIFT
(http://en.wikipedia.org/wiki/Society_for_Worldwide_Interbank_Financial_Telecommunication) netwo
rk 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 is
MT103 (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 imagine
an 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 its critically important
to realise what is going on under the covers: the SWIFT message is merely the instruction: the
movement 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 ones hands and shouting SWIFT serves to mask this complexity and so impedes
understanding.
OK I get it. But what about ACH and EURO1
and Faster Payments and BACS and CHAPS and
FedWire and Target2 and and and????
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 6/12
Slow down.. Lets recap first.
Weve shown that transferring money between two account holders at the same bank is trivial.
Weve 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.
Weve also discussed how electronic messaging networks like SWIFT can be used to manage the flow of
information 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 well tackle first are liquidity and cost
We need to address the liquidity and cost
problem
First, we need to acknowledge that SWIFT is not cheap. If Barclays had to send a SWIFT message to
HSBC every time you wanted to pay 10 to Charlie, you would soon notice some hefty charges on
your statement. But, worse, theres a much bigger problem: liquidity.
Think about how much money Barclays would need to have tied up at all its correspondent banks
every day if the system I outlined above were used in practice. They would need to maintain sizeable
balances 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 to
work.
But theres a really nice insight we can make: on balance, its probably just as likely that a Barclays
customer will be sending money to an HSBC customer as it is that an HSBC customer will be sending
money 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 deposit
at 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 creation
of deferred net settlement systems. In the UK, BACS is such a system and equivalents exist all over
the 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
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 7/12
some schedule, calculates the net amount owed by each bank to each other. They then settle amongst
themselves (perhaps by transferring money to/from the accounts they hold with each other) or by
using 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)
Its worth noting that we can also describe the credit card schemes and even PayPal as Deferred Net
Settlement systems: they are all characterised by a process of internal aggregation of transactions, with
only the net amounts being settled between the major banks.
But this approach also introduces a potentially worse problem: you have lost settlement finality. You
might issue your payment instruction in the morning but the receiving bank doesnt 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 receiving
customer 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 couldnt in any way be considered final and so the recipient couldnt rely on the
funds 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 weve outlined so far are
really acceptable for situations when you need to be absolutely sure the payment will be made
quickly and cant be reversed, even if the sending bank subsequently goes bust. You really, really need this
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 8/12
assurance, for example, if youre going to build a securities settlement system: nobody is going to
release $150m of bonds or shares if theres a chance the $15om wont settle or could be reversed!
What is needed is a system like the first one we outlined (Alice pays Bob at the same bank) because
its really quick but which works when more than one bank is involved. The multilateral bank-bank
system outlined above sort-of works but gets really tricky when the amounts involved get big and
when theres 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 bank
that 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 money
between themselves simply by instructing the central bank to debit one account and credit the other.
And thats 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 couldnt be instant)
Settlement - with finality; no reversals
This completes our picture:
(http://gendal.files.wordpress.com/2013/11/rtgs.png)
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 9/12
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. There
is no netting, there are (clearly) no correspondent banking relationships and we have settlement, gross,
with finality.
But the interesting thing about todays traditional financial landscape is that most retail transactions
are 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? I
would 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 a
traditional RTGS, only handling high-value transfers? Or will advances in the core network (block size
limits (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 Im
altogether less convinced that well end up in a world where every Bitcoin transaction is cleared over
the 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 money
moves 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/)
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 10/12
I think for day to day transactions (buying groceries and so forth), players like Coinbase will start
alleviating a lot of the pressure on the blockchain. In a similar fashion, they will act as a bank, only
changing the numbers in between accounts.
2.
gendal says:
November 24, 2013 at 20:10
Hi Simon,
Im 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 not
be the best vehicle for micro-payments. Combine those two observations and you end up with your
prediction: 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 system
disagree with this analysis!
Richard
3.
Jaumenuez says:
November 25, 2013 at 08:08
Great post. Bitcoin protocol works well between untsted parties that know what are they up to, non
reverse, etc. In this case, no need for a Central Bank. Most average users, as you say, still need
trusted 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 Bitcoin
scenario, 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 you
answered.
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 that
method or because they really do cost?
Are SWIFT messages signed? In other words if they contain non repudiation then surely they are a
transfer 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 its not relevant here.
Surely this whole thing is just an model to allow us to understand things. Theres still no actual
value moving around, so its not much more true than just saying that youre 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 doesnt have a real value until the sender
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 11/12
gives up their sheep and the recipient receives a goat (or whatever else it is that makes the money
have value to them). I know you answered this by comparing to a gross settlement system rather
than to real value.
5. Pingback: A Simple Explanation of How Money Moves Around The Banking System | Enjoying
The Moment
6.
kassner says:
November 25, 2013 at 09:52
Can 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, its worth watching the videos at
http://www.positivemoney.org
8. Pingback: Linux Mint Czech - Bitcoin, a ako sa pohybuj peniaze v bankovom systme at Linux
Mint CZ&SK
9.
Benjamin says:
November 25, 2013 at 12:30
Great article, its always easier to understand with small examples.
BUT I really didnt like the graphs you did, mostly because the arrows go both ways. In the first
example for instance, the arrow going from Alice to the bank shouldnt go both ways. But its just
my opinion.
10.
gendal says:
November 25, 2013 at 13:14
@Jaumenuez I agree; I think well see a federated model of the sort you describe but, also as you
say, with the option of going direct for those who know how to and want to
@benjamin thanks. Good point re the diagrams; youre right. The arrows are confusing. Sorry!
@sean thanks for the link
@kassner I left FX as an exercise for the reader but youre right the principles can be
extended. e.g. imagine Barclays held a *dollar* account with Citi. That would give Barclays
customers a way of making Dollar payments and so on. Indeed, this cross-border example is what
most 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 for
FX, if you like. This motivated the creation of the CLS Bank.
11.
11/25/13 A simple explanation of how money moves around the banking system | Richard Gendal Brown
gendal.wordpress.com/2013/11/24/a-simple-explanation-of-how-money-moves-around-the-banking-system/ 12/12
gendal says:
November 25, 2013 at 13:17
@Sam:
* CHAPS fair point. Theyre charged at about 25. They probably cost a lot less.
* SWIFT messages not sure if theyre cryptographically signed but the key thing that SWIFT
offers that the internet does not is security at the end points and within the network. i.e. if you
receive a SWIFT message purporting to be from Barclays, you can be pretty sure it *is* from
Barclays!
* Bitcoin is interesting because it doesnt really fit the liability model. My holding of Bitcoins are
nobody elses liability. This makes them quite unlike any major currency today and far more like
gold or a commodity.
Blog at WordPress.com. | The Zoren Theme.
Follow
Follow Richard Gendal Brown
Powered by WordPress.com