Payment clearing is the stage between a payment instruction and its final settlement in which the institutions involved exchange, check and reconcile the transaction details and work out who owes what to whom. The Committee on Payments and Market Infrastructures defines clearing as the process of transmitting, reconciling and in some cases confirming transactions before settlement, possibly including netting and the establishment of final positions for settlement.
Clearing is often confused with settlement, the actual transfer of funds that discharges the obligation. The two can happen almost together, as in a real-time gross settlement (RTGS) system, or be separated by hours or days, as in batch systems. Clearing is carried out by clearing houses, automated clearing houses, card networks and central counterparties, under the oversight of central banks applying the Principles for Financial Market Infrastructures.
Payment clearing in plain terms
Think of a group of friends who pay for each other's meals over a month. Before anyone hands over cash, someone goes through all the receipts, checks that they are real, adds them up and works out that, overall, Ana owes Ben 30 and Ben owes Chen 10. That checking and adding up is clearing. Handing over the money at the end is settlement.
Banks do the same on a vast scale. Every day they send each other millions of payments. A clearing system collects them, checks they are properly formed, sorts them by bank and calculates the totals. Often many payments in each direction cancel out, so the banks only need to move the difference, which saves a great deal of money and effort.
How clearing works
A typical clearing cycle has four steps:
- Submission. Sending banks or acquirers submit payment instructions, singly or in files, before a cut-off time.
- Validation and matching. The clearing operator checks formats, account identifiers and limits, and rejects malformed items.
- Calculation of positions. The operator either keeps each payment separate (gross) or applies netting to produce one net amount per participant.
- Delivery to settlement. Final positions are passed to the settlement agent, usually the central bank, and the payment details are delivered to the receiving banks so they can credit customers.
Netting reduces the liquidity banks need. A simple illustration with three banks shows how:
| Bank | Sends | Receives | Net position |
|---|---|---|---|
| Bank A | 100 | 70 | Pays 30 |
| Bank B | 50 | 60 | Receives 10 |
| Bank C | 40 | 60 | Receives 20 |
Gross flows total 190, but only 30 needs to move in settlement. The trade-off is that, under deferred net settlement, banks are exposed to one another until the net positions settle, which is why clearing systems use collateral, limits and loss-sharing rules to manage settlement risk.
Clearing in different payment systems
Bank transfers. In the US, the ACH network has two operators, the Federal Reserve's FedACH and The Clearing House's EPN, which clear batches of credits and debits under Nacha rules; CHIPS clears large-value payments with continuous netting. In the UK, Bacs clears direct debits and bulk credits on a three-day cycle, while Faster Payments clears instantly with deferred net settlement at the Bank of England. In the euro area, SEPA transfers are cleared by automated clearing houses and instant payments can settle in TIPS.
Cards. In card schemes, "clearing" means the acquirer sending the captured transaction record to the network, which forwards it to the issuer and calculates interchange and fees. It follows payment capture and precedes the daily net settlement between acquirers and issuers.
Cheques. Cheque clearing has moved from physical exchange to images: the UK's Image Clearing System, India's Cheque Truncation System and Pakistan's NIFT-operated clearing all exchange scanned images rather than paper.
Securities and derivatives. Here clearing often involves a central counterparty that becomes buyer to every seller and seller to every buyer, a different model from payment clearing.
Risks, oversight and finality
Because clearing systems concentrate flows between many banks, a failure in one can spread. Central banks therefore oversee systemically important clearing systems and require clear rules on when a payment becomes irrevocable. In the EU, the Settlement Finality Directive protects designated systems' netting and finality rules from insolvency challenges; in the US, Fedwire and ACH finality are set by Federal Reserve regulations and operating rules. Payment finality matters to businesses because a payment that has cleared may still be reversible until it has settled, and some instruments, such as ACH debits, remain open to returns for set periods even after settlement. Banks match cleared items to settlement totals through settlement reconciliation and hold funds in a clearing account while items are in transit.