Payment and Settlement Systems in the Forex Market

By: Donald Saunders

Every forex (foreign exchange) transaction involved the transfer of funds between two nations and that means that it also involves the payment and settlement systems of the two countries concerned in the transaction. For this reason national payment and settlement systems play a key role in the day to day operations of the forex market.

Today there are a wide variety of payment systems which are legally acceptable within the United States and payments can be made for example in cash, by check, using an automated clearing house or using an electronic funds transfer.

In terms of the sheer number of transactions the vast majority of payments in the United States today are made in cash or by check, however, in terms of value, the greatest amount of money is paid by electronic funds transfer. For this reason the electronic funds transfer system is a key component of the Unites States payment and settlement system and it is this system which is used to make inter-bank transfers between dealers in the forex market.

There are two main electronic funds transfer systems operating in the United States today.

The first is the Clearing House Inter-bank Payments System (CHIPS) which is a private system operated by the New York Clearing House and the second is a system operated by the Federal Reserve Bank and known as Fedwire.

Using Fedwire a regional Federal Reserve Bank debits the account of the sending bank and credits the account of the receiving bank so that the transfer is effectively immediate and this is often referred to as a RTGS (real time gross settlement) system. By contrast individual transactions are not settled during the course of the trading day using CHIPS but are settled at the close of each day's business as a net settlement for each individual CHIPS account holder. Final settlement of CHIPS obligations is made using Fedwire.

Other countries operate systems similar to those in the United States. In the United Kingdom for example settlement is made through the Clearing House Association Payments System (CHAPS) with settlement being made through the Bank of England, while in the European Community a system linking the banks of member states and known as Target is used to settle transactions involving the Euro.

The United States settlement system is particularly important in the world of forex trading because the majority of global foreign exchange transactions involve the US dollar with daily settlements running into trillions of dollars. Indeed, the bulk of the transactions processed through CHIPS every day are foreign exchange transaction settlements.

Although modern technology has done much to transform foreign exchange trading one element which still concerns many people is that of 'settlement risk'. In other words, the risk that you will pay out the currency you are selling but not receive the currency you are buying. Considerable efforts have been made in recent years to reduce settlement risk in the foreign exchange markets and today the vast majority of forex traders would consider this risk to be minimal.

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