Payment Systems: How Money Moves Between Banks

What happens behind the scenes when money moves from one bank to another, including settlement systems like RTGS and NEFT.

When you transfer money to a friend at a different bank, it seems instant. Behind the scenes, banks must settle what they owe each other. This happens through payment systems, a crucial but often invisible part of the financial system.

Clearing and settlement

Every transfer involves two steps:

Clearing: working out who owes what to whom.
Settlement: actually moving money between banks, usually through their accounts at the central bank.

Banks hold accounts at the central bank, and final settlement happens by moving money between these accounts. Money at the central bank is the safest form of settlement, because it carries no risk of the central bank failing.

India’s main systems

RTGS, or Real Time Gross Settlement, settles large payments individually and immediately. It is mainly used for high-value transfers.
NEFT, or National Electronic Funds Transfer, settles payments in batches throughout the day. Since December 2019, NEFT operates around the clock.
IMPS and UPI, run by the National Payments Corporation of India, allow instant retail payments at any time. The banks involved then settle the net amounts through the RBI.

Both RTGS and NEFT are operated by the Reserve Bank of India, and RTGS became available around the clock in December 2020.

Gross versus net settlement

Gross settlement settles each payment separately in full, which is safer but requires more liquidity.
Net settlement adds up many payments and settles only the difference, which requires less money but creates risk if a bank fails before settlement.

Netting at the end of the day

Bank A's customers send 100 crore rupees to Bank B's customers during the day, while Bank B's customers send 90 crore rupees to Bank A's customers. Instead of moving 190 crore rupees, the two banks settle only the 10 crore rupee difference. Netting saves liquidity, but both banks must be able to pay when settlement happens.

Why it matters

Payment systems must be safe, fast and reliable. A failure could freeze commerce. Central banks oversee them closely and continue to modernise them. Cross-border payments remain slower and costlier, and the G20 has set goals to improve them.

Thinking money moves instantly between banks

Instant payment apps credit your account right away, but banks settle among themselves through central systems, sometimes in batches. The instant experience relies on trust in this settlement system.

Key takeaways

Payments involve clearing, working out obligations, and settlement, moving money.
Banks settle through accounts at the central bank.
India's systems include RTGS, NEFT, IMPS and UPI, with RTGS and NEFT available around the clock.
Gross settlement is safer; net settlement saves liquidity but carries risk.