Clearing & Settlement: Understanding the Payment Process

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The clearing and settlement process is a crucial part of electronic payments and is often misunderstood by businesses. Every time a payment is initiated to send or collect funds, clearing and settlement activities happen in the background.

Electronic Payment Fundamentals

It is important to understand that with most electronic payments, including card and bank payments, the funds do not move from one financial institution to another for every individual transaction.

A process known as net settlement occurs, which is when each financial institution keeps track of how much they owe to each other based on all transactions between their account holders.

Rather than transferring the funds for each transaction individually, the institutions calculate the net amount owed and transfer that amount at the end of the settlement period.

Clearing & Settlement Example

During the week, Bank A and Bank B send and collect multiple payments to and from each other on behalf of their account holders. They keep track of all amounts owed and due, a process that is part of the clearing stage.

At the end of the week, Bank A has $100 owed to Bank B and $50 due from Bank B. Therefore Bank A owes Bank B $50 ($100 minus $50).

However, Bank B also has $80 owed to Bank A and $40 due from Bank A. Therefore Bank B owes Bank A $40 ($80 minus $40).

To settle these amounts, the banks calculate the net balance:

Bank A owes Bank B $50, but Bank B owes Bank A $40.
The net difference is $10, with Bank A owing Bank B $10.

At the end of the week, Bank A will transfer Bank B the $10, which is part of the settlement stage.

This net settlement system can be scaled across many more banks to efficiently and accurately handle transactions.

What Is Clearing?

As explained in the example above, the clearing stage is the process of validating and reconciling payment instructions between each financial institution. The process is overseen by NACHA in the U.S. and Payments Canada in Canada.

The clearing stage covers key transaction details like:

The amounts being transferred
The bank account numbers involved
Any errors, discrepancies, returns or other issues that need to be addressed

What Is Settlement?

The settlement stage is the final transfer or settlement of funds between each financial institution. The settlement process is facilitated by the governing body for that country, such as NACHA or Payments Canada.

Settlement of funds into financial institutions and by proxy their customer accounts can take several days, depending on the system being used.

Why Is Clearing & Settlement Important

Accuracy - The clearing phase of electronic payments ensures that transactions are error-free and agreed upon by all parties.
Security - Both stages provide layers of protection against fraud or unauthorized transactions.
Efficiency - These systems ensure that billions of individual transactions can be processed efficiently by financial institutions.
Reliability - The clearing and settlement processes ensure that FIs and account holders can expect reliable fund distribution and access.