Remember having to queue up in the bank to make one deposit or another? For example, paying your first term school fees into your institution’s account or sending funds to a family or friend living in another state. Many people don’t know that these regular payments utilize a system called net settlement.
That’s why, in this article, the net settlement system is properly detailed, with a two-bank transaction example, and a table highlighting the differences between net and gross settlements.
What is Net Settlement?
Net settlement is a common procedure used in executing banking transactions. The net settlement procedure involves bulk compilation and reconciliation of the credits and debits that takes place within a specified period.
Usually, banks make use of this except when otherwise stated.
It is one of two major methods of settlement. However, it is the preferred method and the reason is that it saves operational costs and requires the use of fewer resources. When employing net settlement, banks would wait until the close of a business day before processing any transaction request.
This ensures that all possible transactions for that day have been initiated and recorded and that there are no requests in progress.
How the Net Settlement System Works in Nigeria
Batch Transfers
The thing about net settlement is that transactions are not processed individually. All transactions are, instead, processed in batches - usually at the end of a business day. You can think of this settlement method as making use of a collection period and a settlement period.
During the collection period, banks actively receive and record transaction/payment requests made by their customers. The payment amount, the recipient’s name, and the recipient’s bank account number: everything is collated.
At a particular time, the bank closes the collection period. They stop receiving transaction/payment requests until the commencement of the next collection period. This makes way for the second phase which is the settlement period, to begin.
The settlement period begins with a review of all requests collected.
The bank ensures that the details necessary for each payment are correct and complete. It then aggregates its record and sends it to a central system. This central system differs for different countries and regions. In the U.S, the central settlement system is the Federal Reserve Bank whereas, in Nigeria, it is the NIBSS.
NIBSS stands for Nigeria Inter-Bank Settlement System. You can get a full read of its history and functions in this article.
The NIBSS performs the actual act of settlement, initiating (inter-bank) transfers from the originating bank to every bank listed in the collated payment requests.
An Illustration of How the Net Settlement System Works
Let’s illustrate this with an example involving only two banks.
Imagine that GTBank customers initiate payment transactions where they send money to UBA customers. Similarly, on the same day, UBA customers initiate payment transactions where they send money to GTBank customers.
As a reminder, none of these payments are processed during work hours. Instead, they’re all bundled up until all the requests have been turned in.
Now let’s say that the transactions initiated by GTBank customers total NGN 20,000,000 while those initiated by UBA customers total NGN 16,000,000. The resulting transaction can happen in one of two ways. Either:
- GTBank sends 20 million naira to UBA and then UBA sends 16 million naira to GTBank, or
- UBA sends 16 million naira to GTBank and then GTBank sends 20 million naira to UBA.
Both ways are the same since they involve two transactions, one from GTBank and the other from UBA. However, this is not very effective considering the time and resources necessary. So what happens is that both banks send their aggregate transaction data for the day to the NIBSS.
The Role of NIBSS
The role of the NIBSS is to conduct inter-bank settlements.
You see, every Nigerian bank has a well-funded account domiciled within the Central Bank of Nigeria (CBN). The NIBSS, as a settlement system, also has access to these backend accounts, through which it conducts net transactions.
A net value transaction takes into account the difference between two transactions. From our example, the net transaction will be a 4 million naira payment from GTBank to UBA (20 million from GTB - 16 million from UBA).
The NIBSS, therefore, makes the calculation and moves four million naira from GTBank to UBA. This resolves the disparity in accounts and settles the net transaction logged in by both institutions.
The respective banks, having settled their transactions, will now move to credit and debit customer accounts according to the payments initiated.
Gross Settlement vs Net Settlement: The Differences
Remember we said that net settlement is one of two major methods of settlement used within the banking sector? Well, the other settlement method is known as Gross settlement. The differences between these two methods are listed below:
| Factor | Gross Settlement | Net Settlement |
|—|—|—|
| Irreversibility | Gross settlements cannot be reversed. Once a transaction has been processed using this system, it cannot be undone. This implies the need to carefully review transaction data. | Net settlement transactions are reversible. If you make a transfer to the wrong address, your bank can help reverse the transaction and get your funds back into your account. |
| Number of transactions | Transactions are processed one at a time. | Transactions are processed in batches with several requests being completed at a time. |
| Frequency of transactions | Gross settlement transactions are made frequently to accommodate the processing of every request made to the system. These transactions may occur throughout an entire day. | Net settlement transactions are far less frequent compared to gross settlement transactions. Usually, they are processed once a day. |
| Cost | Gross settlement transactions incur high costs. | Net settlement transactions bear low costs. This is due to a number of factors, including the lower priority of the transactions and low-security requirements. |
| Priority | Transactions made through gross settlement systems are of high priority. They are processed immediately to avoid any inconveniences to the sender and recipient. | Net settlement payments are considered to be low priority, meaning that there is no urgency from the sender or recipient. |
| Transaction value/amount | Gross settlement is used strictly for high-value transactions each involving thousands or millions of dollars. | Net settlement facilitates small-value transactions from regular everyday activities. Transfer of tens or hundreds of dollars is usually made using this system. |
Similarities Between Gross and Net Settlements in Nigeria
Of course, there are huge differences in the structure of the gross and net settlement systems. These differences go into the volume of transactions that take place and even the time of these transactions. The disparity notwithstanding, gross and net settlement systems both make use of the NIBSS.
Conclusion
By now, we expect that you’re well grounded on net settlement and even understand how it compares to gross settlement. This should give you a good idea of how the Nigerian financial system works.