Deferred Net Settlement (DNS)

Deferred net settlement (DNS) is a method of settling payments in which a payment system accumulates instructions over a period, calculates what each participant owes to or is owed by the others, and transfers only the resulting net amounts at predetermined times, often once or several times a day. It is the main alternative to real-time gross settlement (RTGS), in which each payment settles individually and immediately.

DNS greatly reduces the amount of money participants need to settle their obligations, but it delays payment finality until the settlement cycle completes. During that interval participants are exposed to each other, which creates credit and liquidity risk.

Participants submit payment instructions throughout the cycle. The system records them but does not move funds. At the cut-off, it applies netting: either bilateral netting between each pair of participants, or multilateral netting in which each participant ends with a single net position against the system as a whole. Net debtors then pay in, and net creditors are paid out, usually across accounts at the central bank so that settlement is in central bank money, or across the books of a settlement bank.

Many retail systems use DNS, including automated clearing houses such as the ACH network in the United States and card scheme settlement. High-value systems increasingly use RTGS or hybrid models; CHIPS, for example, moved from end-of-day net settlement to a design that releases payments with real-time finality against prefunded balances.

Suppose three banks exchange the following payments during a day: Bank A owes Bank B 100, Bank B owes Bank C 80, Bank C owes Bank A 50, and Bank B owes Bank A 30. The gross value is 260.

• Bank A receives 80 and pays 100: net position −20.
• Bank B receives 100 and pays 110: net position −10.
• Bank C receives 80 and pays 50: net position +30.

At settlement, A pays in 20 and B pays in 10, and C receives 30. Only 30 moves instead of 260, a liquidity saving of almost 90% in this case.

The cost of that saving is exposure. Until settlement, a payee may have credited its customer on the strength of an instruction that has not yet settled. If a net debtor fails before paying in, the system may have to recalculate positions without the failed participant's payments, a process called unwinding, which can leave other participants unexpectedly short and spread the failure. This settlement risk is related to, but different from, Herstatt risk in foreign exchange.

International standards have addressed the problem since the 1990 Lamfalussy report, which set the minimum standard that a multilateral netting system should be able to complete settlement even if the participant with the largest single net debit position cannot settle. Today the Principles for Financial Market Infrastructures, issued by the Committee on Payments and Market Infrastructures (CPMI) and IOSCO, require systemically important systems to manage credit and liquidity risk and to define clearly when settlement becomes final. Common tools include net debit caps, collateral pools, loss-sharing agreements and legal certainty for netting under insolvency law.

RTGS eliminates interbank credit exposure but demands much more liquidity, since each payment needs funds in the settlement account at the moment it is sent. Systems such as Fedwire and CHAPS are RTGS systems that rely on intraday credit from the central bank and on liquidity-saving mechanisms. Hybrid designs offset queued payments continuously and settle the resulting nets in real time, combining some of the liquidity efficiency of DNS with the finality of RTGS.

In foreign exchange, the same trade-off appears at a different level: CLS combines multilateral netting of funding requirements with payment versus payment (PvP) settlement, while a central counterparty (CCP) nets obligations in securities and derivatives markets by becoming the buyer to every seller and the seller to every buyer.