DEFINITION of Net Settlement
Net settlement refers to the resolution of all of a bank's transactions at the end of the day. Since banks engage in so many electronic transactions, they cannot simply count their cash at the close of business. Instead, they have to add up all of their electronic credits and debits. The bank then sends its settlement file to a Federal Reserve Bank, which credits it with any funds due for interbank settlements.
BREAKING DOWN Net Settlement
A bank's net settlement is similar to an individual’s balancing his or her checkbook. If all of your transactions are in cash, all you need to do to is open your wallet and count the bills. However, since most people have money going out in the form of cash, checks, and debit and credit card transactions, and money coming in as cash, checks, and direct deposits; all transactions, including purchases, returns, bills paid, and paychecks received, must be netted to determine the full picture.
Net settlement can make it easier for banks to manage liquidity. Types of net settlement systems include bilateral and multilateral settlements. Bilateral settlement systems entail final settlement of all payments made between two banks over the course of a day to be settled at the close of business, typically via a transfer between their accounts at the central bank. A multilateral settlement consists of each bank having a net balance with the system as a whole, rather than with individual banks.
Net Settlement Versus Gross Settlement
Gross settlement opposes net settlement. In particular, a real-time gross settlement system is in contrast with net settlement systems, such as the U.K.’s BACS Payment Schemes Limited (previously the Bankers' Automated Clearing Services or BACS). With BACS, for example, transactions among institutions are accumulated during the day; at the close of business, a central bank will adjust the active institutional accounts by the net amounts of the funds exchanged.
Large-value interbank funds transfers usually use real-time gross settlement. These often require immediate and complete clearing, which a country’s central bank usually organizes. Real-time gross settlement can lessen an institution’s settlement risk overall as interbank settlement usually occurs in real-time throughout the day (instead of simply all together at the end of the day with net settlement). This specific form of gross settlement can eliminate the risk of a lag in completing the transaction. (Settlement risk is often called delivery risk.)
Real-time gross settlement can often incur a higher charge than net settlement processes, which bundle and net payments.