How centralized banking system looks? Let’s understand this complex traditional banking system by breaking it down layer-by-layer.

Layer 1. Say Bob wants to pay Sasha 10$. Both hold an account with the same bank ‘Deutsche bank’.

Since no money is leaving or entering the bank, they just have to update their accounting system to balance out. So here is how the process will look:

– Bob tells the bank to credit Sasha’s account with 10$.

– Deutsche bank then debits the funds from Bob’s account and credit 10$ to Sasha’s account.

It is done with the Deutsche bank core banking system and They owe now Sasha 10$ more and Bob, 10$ less.

Layer 2. But what if Sasha has a bank account with a different bank, say HSBC. What happens then?

It’s easy for Deutsche Bank to reduce or increase balance in their own system but how to deal with HSBC. If we want HSBC to owe Sasha’s more, they need to owe somebody a little less. So how to persuade HSBC to increase Sasha’s balance by 10$?

The answer to this situation is if Deutsche bank held an account with HSBC and HSBC does the same. Both hold balances with each other and adjust them to make it work out in their respective banking system.

So this is how our challenge in Layer 2 will be solved,

– Deutsche bank reduces 10$ from Bob’s account and adds it to the HSBC account held at their bank.

– Instructs HSBC about the transaction (via SWIFT) that they have increased HSBC balance by 10$ and in turn would like Sasha’s account held at HSBC to be increased by 10$.

– HSBC acknowledging the message debits from Deutsche bank account’s balance and credits Sasha’s with 10$.

Layer 3. The above arrangement works well, but it has problems – Cost and Liquidity.

SWIFT is not cheap: If Deutsche Bank had to send a SWIFT message to HSBC every time Bob pays 10$ to Sasha or other HSBC customers, Bob may face hefty charges for settlement.

Liquidity issue: Think about how much money Deutsche bank would need to have tied up at all its correspondent banks every day. They would need to maintain sizeable balances at all the other banks just in case their customers wanted to send money to a recipient at HSBC or SBI or CITI or wherever. This cash could be invested or lent or otherwise put to other use.

Solution: In theory, all customer transaction from Deutsche bank to HSBC and Vice Versa balances out to very less amount. So what if we kept track of all the payments during the day and only settled the balance?

By adopting this approach, each bank could hold a whole lot less cash at all its corresponding banks. Such an arrangement could cut down the cost and liquidity demands and banks could put their money to work more effectively.

This thinking gave birth to ‘Net settlement systems’. In such an arrangement,

– Messages (or files) are sent to a central “clearing” system, which keeps track of all the payments.

– On the fixed schedule, “clearing system” calculates the net amount owed by each bank to each other.

– Banks then settle amongst themselves by transferring money to/from the accounts they hold with each other.

Layer 4. But this approach also introduces a problem – Delay.

Banks might issue payment instruction in the morning but the receiving bank doesn’t receive the funds until later. The receiving bank, therefore, has to wait until they receive the net settlement, just in case the sending bank goes bust in the interim. This introduces a delay.

To solve this, We need a system like the first one (Bob pays Sasha at the same bank) because it’s really quick. So, If the banks could all hold accounts with a bank that cannot go bust, a bank that sat in the middle of the system ‘central bank’. This thought process motivated the idea of Real-Time Gross Settlement system.

If all banks in a country hold accounts with the central bank, then they can move money between themselves simply by instructing the central bank to debit one account and credit the other. They allow real-time movements of funds between accounts held by banks at their respective central bank.

This final leg works out well but also has limitations.

Remember, settlement in “real-time” means a payment transaction is not subjected to any waiting period. This coordination drives up the cost.

Therefore, settlement in real-time is subject to certain conditions such as payments have to be above a certain threshold. Moreover, all the above-mentioned arrangements are subject to clearing on a certain working hour or day.

Can blockchain replace central banks system

Transferring money in the above traditional systems is time-consuming and requires intermediaries, each of which takes a service charge. Blockchain reduces middlemen while increasing security. Use of blockchain can improve transaction time and save billions.

Many banks have started creating their own blockchain and digital currency such as JP Morgan and Mizuho Financial Group of Japan. At this stage, banks are building a layer 1 solution (remember – Bob wants to pay Sasha 10$. Both hold an account with the same bank) for their customers.

Reference: Richard Brown’s Blog

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