In this article
Settlement in payments is the step in which funds are actually transferred and the obligation between payer and payee, or between their banks, is discharged. Everything before it is a message, a promise or a calculation; settlement is the moment the debt stops existing because the money has moved. The glossary of the Committee on Payments and Market Infrastructures at the Bank for International Settlements defines settlement as "the discharge of an obligation in accordance with the terms of the underlying contract".
A payment that shows as approved, sent or received on a screen may not be settled. A payment that is settled between two banks may not yet be in the payee's account. A payment that is in the payee's account may still be reversible.
Cleared, settled, available and final are four different states. Rules and timetables differ from one country and one system to the next, and the article says which one each rule belongs to. It is general information, not legal advice.
Illustrative worked example detailed in the section on gross and net settlement; the amounts are invented for the calculation.
What does settlement mean in a payment?
Settlement in a payment means that the asset agreed as payment has been transferred and the payer no longer owes the amount. The word describes a legal result, the discharge of an obligation, and not a technical event such as a message being delivered or a balance being displayed.
Take an invoice of $40,000. The buyer owes the seller $40,000 from the day the invoice falls due. When the buyer clicks "pay" in a banking portal, nothing has been discharged: an instruction has been given to a bank. When the buyer's bank sends a message to the seller's bank, still nothing has been discharged between the two banks: one of them now knows it will owe the other. The obligation between the banks is discharged only when value passes from one to the other in an asset both accept, usually a balance at a central bank or at a bank where both hold accounts.
Two layers of obligation are therefore at work in almost every non-cash payment. The first sits between the payer and the payee. The second sits between the institutions that serve them. The settlement that payment systems talk about is the second one, and the first follows from it under the contract and the law that apply.
The same glossary defines the settlement asset as the asset used for the discharge of obligations under the rules, regulations or customary practice of a system. That is why the question "has it settled?" always has a second half: settled in what, and between whom.
What are the three stages of a payment: initiation, clearing and settlement?
A payment passes through three stages: initiation or authorisation, where the payment is requested and approved; clearing, where the instructions are transmitted, reconciled and often netted; and settlement, where the funds are transferred. Only the third stage discharges anything.
The BIS glossary describes clearing as the process of transmitting, reconciling and, in some cases, confirming transactions prior to settlement, potentially including the netting of transactions and the establishment of final positions for settlement. Clearing produces a number: who owes whom, and how much. Settlement pays that number.
The table follows them on two common instruments.
| Stage | What happens | Card payment | Bank transfer |
|---|---|---|---|
| Initiation or authorisation | The payment is requested and approved | The merchant's terminal asks the card issuer to approve the amount; the issuer answers in seconds | The payer instructs the bank; the bank checks the balance and the instruction |
| Clearing | Instructions are exchanged, matched and totalled | The network sorts transactions between acquiring and issuing banks and computes each bank's position | The instruction goes to the system operator, alone or in a batch, and positions are computed where the system nets |
| Settlement | Funds move between institutions | Banks pay or receive their net position, typically daily | Accounts of the two banks are debited and credited, at once or at a fixed time |
A fourth event sits outside the table: the payee's own bank or processor crediting the payee's account, which can happen before, at or after settlement.
How does a card payment settle?
A card payment settles between banks after the sale, on a net basis, and usually a day or more after the cardholder saw "approved". The approval at the terminal is an authorisation, a promise by the issuer that the amount is covered; it moves no money.
The report on United States payment systems in the Red Book series published by the BIS committee in 2012 describes two processing models. In a single-message system, authorisation and clearing happen in one step, typically when a PIN is entered at the terminal. In a dual-message system, authorisation is completed first and clearing is completed in a separate second step, when the merchant's batch of the day's transactions is submitted. The second model is why a hotel or a fuel station can authorise one amount and clear another.
On settlement, the same report states that card networks settle on a net basis with the acquiring and issuing banks daily, typically with a one- or two-day lag between payment initiation and settlement, and that the banks may settle directly with each other, through regional settlement banks or through the Federal Reserve.
Three consequences follow for a business that accepts cards. The amount settled is the amount cleared, not the amount authorised. The settlement described in the report is between banks; when the merchant is funded is a matter for the contract between the merchant and its acquirer or processor. And settlement between banks does not close the cardholder's right to dispute the charge under the card scheme's rules, so a card payment can be settled and still be reversed later through a separate process.
How does a bank transfer settle?
A bank transfer settles in one of two ways: individually and at once through a real-time gross settlement system, or in a batch at a fixed time through a clearing system that settles afterwards. Which one applies depends on the rail the bank chose for the instruction, and it decides whether the payee's bank holds final funds within minutes or the next day.
A wire sent over Fedwire is the standard example of the first kind in the United States. The Federal Reserve describes the Fedwire Funds Service as a real-time gross settlement system in which a participant instructs a Federal Reserve Bank to debit funds from its own account and credit the account of another participant, and states that these transfers are immediate, final and irrevocable once processed.
A batch transfer is the second kind. In the ACH network, the Federal Reserve explains, depository institutions send each other batches of electronic credit and debit transfers, and the operators settle them by crediting and debiting the institutions' settlement accounts. The 2012 Red Book report adds two details that matter for finality. For credit transfers processed by the Federal Reserve, settlement is final when the transactions are posted to the receiving institutions' accounts on the settlement date. For debit transfers, the credit given to the institution that collected the payment is not final at settlement; it becomes final on the banking day after settlement.
A cross-border transfer adds one more layer. The message that travels between banks through a network such as SWIFT is an instruction, not a movement of funds. Settlement happens on the books of correspondent banks, where one bank holds an account with another, or in the payment system of the currency concerned.
What is the difference between gross and net settlement?
Gross settlement pays every instruction individually for its full value; net settlement first offsets what participants owe each other and pays only the difference. The BIS glossary defines netting as the offsetting of obligations between or among participants, thereby reducing the number and value of payments or deliveries needed to settle a set of transactions.
A worked example shows the size of the effect. Three banks, called A, B and C here, exchange thirteen customer payments in one day. The amounts are illustrative.
| Direction | Payments | Value |
|---|---|---|
| A to B | 3 | $800,000 |
| A to C | 2 | $500,000 |
| B to A | 2 | $650,000 |
| B to C | 2 | $600,000 |
| C to A | 2 | $600,000 |
| C to B | 2 | $450,000 |
| Total | 13 | $3,600,000 |
Under gross settlement, all thirteen payments are settled one by one and $3,600,000 moves between the banks' settlement accounts.
Under bilateral netting, each pair of banks offsets the two directions between them. A sent B $800,000 and received $650,000 from B, so A owes B $150,000. C sent A $600,000 and received $500,000, so C owes A $100,000. B sent C $600,000 and received $450,000, so B owes C $150,000. Three transfers settle the day, for $400,000 in total.
Under multilateral netting, each bank is given a single position against all the others. A sent $1,300,000 and received $1,250,000: it owes $50,000. B sent $1,250,000 and received $1,250,000: its position is zero, and it pays and receives nothing. C sent $1,050,000 and received $1,100,000: it is owed $50,000. The three positions sum to zero, as they must, and one transfer of $50,000 settles everything.
Worked example computed from the table of thirteen payments above. The customers' accounts are credited and debited for the full $3,600,000 in every case; only the movement between banks changes.
Multilateral netting cut the value moved between banks by 98.6%, from $3,600,000 to $50,000. That is the reason netting exists: each bank needs far less cash on hand to get through the day. The saving has a price. Until the net amount is paid, none of the thirteen payments has settled between the banks. If bank A cannot pay its $50,000 at the end of the day, the question is not about $50,000 but about what happens to the $1,300,000 of payments it sent and the $1,250,000 it was due to receive. Netting systems answer that question in their rules, with collateral, loss-sharing arrangements or limits on positions, and the law has to support the answer.
Real-time or deferred: when does settlement happen?
Settlement happens either continuously, as each payment is processed, or at fixed times after a period of accumulation. The first design is called real-time gross settlement and the second deferred net settlement, and the choice between them is a trade between liquidity and exposure.
The BIS glossary defines real-time gross settlement as the real-time settlement of payments, transfer instructions or other obligations individually on a transaction-by-transaction basis, and deferred net settlement as a net settlement mechanism which settles on a net basis at the end of a predefined settlement cycle.
| Criterion | Real-time gross settlement | Deferred net settlement |
|---|---|---|
| Unit settled | Each payment, full value | Each participant's net position |
| Moment of settlement | As the payment is processed | At set times, often end of day |
| Liquidity a bank needs | High: the full amount of every outgoing payment | Low: the net amount only |
| Exposure between banks before settlement | None once processed | Builds up through the cycle |
| Typical use | Large and urgent payments | High volumes of smaller payments |
Central banks run real-time gross systems for large-value payments because the sums are too big to leave unsettled for a day, and retail systems use netting because settling millions of small payments one by one in central bank money would tie up liquidity for little benefit. Hybrid designs exist as well. The 2012 Red Book report describes the main private-sector large-value system in the United States as a real-time final settlement system that continuously matches, nets and settles payment messages, with payment orders finally settled at the time of release from its central queue.
"Real-time" describes when the system settles. It does not promise that the sender's bank releases the instruction at once, or that the receiving bank credits the customer immediately; both sit outside the system.
What is the settlement asset: central bank money, commercial bank money or a token?
The settlement asset is the thing that changes hands to discharge the obligation, and its quality decides how safe the settlement is. In practice it is one of three: a balance at a central bank, a balance at a commercial bank, or a token on a ledger.
The BIS glossary defines central bank money as a liability of a central bank, in the form of deposits held at the central bank, which can be used for settlement purposes, and commercial bank money as a liability of a commercial bank, in the form of deposits held at that bank. The Principles for Financial Market Infrastructures, the international standards issued by the same committee with the International Organization of Securities Commissions, state in Principle 9 that an infrastructure should conduct its money settlements in central bank money where practical and available, and that where commercial bank money is used the resulting credit and liquidity risk should be minimised and strictly controlled.
| Settlement asset | Whose liability | Who can hold it | What the holder relies on |
|---|---|---|---|
| Central bank money | The central bank | Mostly banks and a few other institutions with a central bank account | The central bank |
| Commercial bank money | A commercial bank | Any customer of that bank | That bank's solvency, and deposit protection up to its limits |
| A token representing money | The issuer of the token | Any holder of a compatible address | The issuer and its reserves |
| A native asset of a blockchain | No one | Any holder of an address | The network; the value floats |
The preference in the standards for central bank money is about one risk: the institution on whose books settlement takes place could fail between the moment it is credited and the moment the recipient uses the funds. A central bank does not fail in its own currency. A business rarely gets to choose: its payments settle in commercial bank money at its own bank, on top of an interbank settlement in central bank money that it never sees.
What is settlement finality, and why is it a legal concept?
Settlement finality is the point at which a transfer is irrevocable and unconditional, so that no participant, court or insolvency official can undo it. Finality is a legal concept because technology can record a transfer but only law can say that the record cannot be challenged.
The BIS glossary defines final settlement as the irrevocable and unconditional transfer of an asset or financial instrument, or the discharge of an obligation by the infrastructure or its participants in accordance with the terms of the underlying contract, and adds one sentence that carries the point: final settlement is a legally defined moment. Principle 8 of the Principles for Financial Market Infrastructures asks an infrastructure to provide clear and certain final settlement, at a minimum by the end of the value date, and the notes to Principle 1 call for a clear legal basis regarding when finality occurs.
The risk the law has to remove is insolvency. In some legal systems, a so-called zero-hour rule treats every transaction made by a failed firm on the day of its failure as void from midnight. Applied to a netting system, such a rule would pull one bank's payments out of a day already netted and force every other position to be recalculated.
The European Union answered with Directive 98/26/EC of 19 May 1998 on settlement finality in payment and securities settlement systems. Under Article 3, transfer orders and netting are legally enforceable and binding on third parties even in the event of insolvency proceedings against a participant, provided the orders were entered into the system before the proceedings opened, and the moment of entry is defined by the rules of the system. Under Article 5, a transfer order may not be revoked by a participant or a third party from the moment defined by those rules. Under Article 7, insolvency proceedings have no retroactive effect on a participant's rights and obligations in the system. The protection applies to systems designated under the directive, not to every payment arrangement, and other jurisdictions have their own statutes with the same aim.
Finality in this sense protects the settlement between participants of the system. It does not, on its own terms, settle a commercial dispute between a buyer and a seller, and it does not stop one party from suing the other for the money.
What is settlement risk, and why is it called Herstatt risk?
Settlement risk is the risk that settlement does not take place as expected, and its most severe form is paying your side of an exchange and never receiving the other. The BIS glossary calls that form principal risk: the risk that a counterparty will lose the full value involved in a transaction.
The name comes from one day. According to the BIS Quarterly Review of December 2002, the German authorities closed Bankhaus Herstatt on 26 June 1974 at 15:30 Central European Time. Some of the bank's counterparties had irrevocably paid large amounts of Deutsche marks to it but had not yet received dollars in exchange, because financial markets in the United States had only just opened. The exposure of having paid one currency without receiving the other has been known since as foreign exchange settlement risk, or Herstatt risk.
The cause was a gap in time between two settlements that were meant to be one exchange, each final in its own system and in its own time zone. The remedy the industry built is conditional settlement. Payment versus payment, in the glossary's words, ensures that the final transfer of a payment in one currency occurs if and only if the final transfer of a payment in the other currency takes place. Delivery versus payment does the same for securities against cash. The same BIS article records that a dedicated institution for settling foreign exchange on that principle began operating in September 2002.
Shortening the gap is the other remedy. Securities markets measure it as a settlement cycle: the Securities and Exchange Commission shortened the standard cycle for most broker-dealer transactions in the United States from two business days after the trade date to one, known as T+1, with a compliance date of 28 May 2024.
How does settlement work onchain?
Onchain, the transfer of the token is the settlement: there is no separate instruction, clearing cycle and interbank transfer, because the ledger entry that tells the recipient about the payment is also the entry that moves the asset. The three stages of the table earlier become one transaction, signed by the payer and recorded by the network.
What that removes is the wait between message and money and, with it, the exposure that builds up during a clearing cycle. Each transfer is gross, for its full amount, in the asset itself; no netting is involved and no participant holds a position against another at the end of the day. Finality comes from the network's consensus rules rather than from the rule book of a designated system: Ethereum's documentation describes a transaction as final when it is part of a block that cannot change without a large amount of staked ETH being lost.
What it does not remove matters just as much. The settlement asset is a token, and a token representing dollars is a claim on its issuer, so issuer risk replaces bank risk rather than disappearing. Gross settlement means the payer needs the full amount at the moment of payment. Finality at the protocol level is technical; whether a court treats the transfer as discharging a debt depends on the contract and the governing law, as it does for any other payment. And a transfer that cannot be reversed leaves errors and disputes to be resolved between the parties, by agreement or in court, with no return mechanism to fall back on.
Because the transfer and the settlement are one event, a single onchain payment can also be divided among several recipients inside the same transaction. That is what a payment router does. Shaka is one such router: the shares are agreed, and can be signed by each recipient, before the client pays; the client pays once; every party is paid at the same moment; and the router never holds the funds. A deal can have at most 20 recipients. It routes a payment; it is not an escrow service, a bank or a processor.
What does "settled" mean for a merchant: funds available or funds final?
For a merchant, "settled" usually means that the processor or the bank has paid the day's sales into the merchant's account, which makes the funds available but not necessarily final. Available funds can be spent; final funds cannot be taken back.
A processor may fund a merchant before the banks have settled among themselves, taking that risk itself under its contract. A bank may show an incoming batch transfer as available while the system still allows it to be returned. A card sale may have been settled between banks days ago and still be reversed through the dispute process of the card scheme.
In practice, three questions sort any incoming payment. Has the payment settled between the institutions, or is the credit an advance on a settlement still to come? Is that settlement final under the rules and the law of the system? And does a separate right of return or dispute survive finality, as it does for direct debits and cards? A wire through a real-time gross system answers yes, yes and, in the ordinary course, no. A card sale answers yes after a day or two, yes, and yes for the length of the scheme's dispute window.
