Electronic Payment Systems 20-763 Lecture 2: Banking and Foreign ExchangeLecture OutlineWorld Banking SystemCentral BanksPayment System LayersCash TransactionMoney SupplyThe U.S. Money SupplyFunction of BanksWhat is a Bank Account?Benefit of a Bank DepositForeign ExchangeSlide 13Foreign Exchange ExampleSlide 15Clearance v. SettlementGross v. Net Settlement SystemsPayment GraphsGross SettlementNet SettlementSlide 21Slide 22Net v. Gross SettlementSlide 24Payment Orders (Checks)Check ProcessingU.S. Cheque ClearingClearing Payment Orders (Check)Settling Payment Orders (Checks)ChecksMajor IdeasSlide 32ELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSElectronic Payment Systems20-763Lecture 2:Banking and Foreign ExchangeELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSLecture Outline•World banking system•Central banks•Money supply measures•What banks do•Foreign exchangeELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSWorld Banking SystemSOURCE: TRANSACTION.NETBANK FORINTERNATIONAL SETTLEMENTS(A BANK FOR 45 CENTRAL BANKS, $130B)BASEL, SWITZERLANDINTERNATIONALMONETARY FUND(PUBLIC POLICY LENDER $300B)182 MEMBER COUNTRIESWASHINGTON, DCPRIVATE BANKS ANDCREDIT INSTITUTIONSWORLD BANKUNITED NATIONS AGENCY(DEVELOPMENT LENDER) 184 MEMBERSASSETS: $230BWASHINGTON, DCMIXED-OWNERSHIPCENTRAL BANKSBELGIUMBANK OF JAPANHONG KONG HKMAGOVERNMENT-OWNEDCENTRAL BANKSBANQUE DE FRANCEBANK OF ENGLANDPEOPLE’S BANK OF CHINACENTRAL BANK OF INDIAPRIVATELY OWNEDCENTRAL BANKSU.S. FEDERAL RESERVEDEUTSCHE BUNDESBANKSWISS NATIONAL BANKS. AFRICAN RESERVE BANKPRIVATE BANKS ANDCREDIT INSTITUTIONSPRIVATE BANKS ANDCREDIT INSTITUTIONSELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSCentral Banks•Legal tender (“real money”) is issued by central banks (and banks operating under their authority)–U.S.: Federal Reserve Bank•Non-central banks cannot hold legal tender (except in cash form). Why? (What form would it take?)•How do banks pay each other?–Through accounts in the central bank (directly or indirectly)INTERBANK SYSTEMSTransportation/ExchangesCLEARINGPayment System LayersClient A Client A1 Client A2Branch A1Branch A2Head Office BANK AClient B Client B1 Client B2Branch B1 Branch B2Head Office BANK BVALUE TRANSFERRED FROMBANK TO BANK ON BOOKSOF CENTRAL BANKSETTLEMENT BETWEENBRANCHES AND CUSTOMERS’ ACCOUNTS 1 2 3 3 3 2 2Risk/Credit ManagementBANKSBANKSSecuritiesFinancial marketsSOURCE: WORLD BANKCENTRAL BANKCENTRAL BANKFINAL SETTLEMENTELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSCash Transaction1. CENTRAL BANK ISSUES FIDUCIARY MONEY (ANTI-FORGERY) + (SERIAL NUMBERS)2. CENTRAL BANK SELLS CASH TO BUYER’S BANK3. BUYER’S BANK ALLOWS BUYER TO DRAW CASH FROM BUYER’S ACCOUNT4. BUYER PHYSICALLY GIVES CASH TO SELLER5. SELLER DEPOSITS CASH IN SELLER’S BANK ACCOUNT6. SELLER’S BANK CREDITS SELLER’S BANK ACCOUNT7. SELLER’S BANK SENDS CASH TO CENTRAL BANKCENTRALBANKBUYER’SBANKSELLER’SBANKBUYERSELLERELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSMoney Supply•Money supply (US, November 2003, in USD)–M0 (currency = coins & notes) 661B–M1 (spendable now) 1281B (liquid = M0 + non-interest deposits + travelers checks)M1 IS MONEY AVAILABLE FOR PAYMENTS–M2 (M1+ time deposits + bank CDs) 6.07T–M3 (M2 + large time deposits + institutional money funds) 8.86TELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSThe U.S. Money SupplyCurrency 661 (2/3 outside the U.S.)Non-bank travelers cheques 7Demand deposits 306Other checkable deposits 307 . M1 Total 1281 USDSavings 3155Small time deposits <100K 810 .Retail money market funds 825 M2 Total 6071 USDLarge time deposits >100K 876 .Institutional money funds 1129Bank agreements 502Eurodollars 282 M3 Total 8860 USD•. In billion USDNov. 30, 2003SOURCE: FEDERAL RESERVEELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSFunction of Banks•Central banks:–Issue fiduciary money (both token and notational)•All other (non-central) banks:–Issue notational scriptural money (bank accounts)•Not fiduciary (“real money”), not token•Non-central banks–Move notational money–Accept deposits (loans from depositors)–Loan deposits to others (borrowers)ELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSWhat is a Bank Account?•Notational representation of a loan to the bank from a depositor•Once the depositor puts money in his account, it becomes the bank’s money, not the depositor’s•When the bank deposits its money in the central bank, it becomes fiduciary (real) money•The bank then owes the depositor real money•Effect of deposit: bank ends up with more real moneyI HAVE$1000I DEPOSIT$200 IN THEBANKI HAVE $800.BANK OWESME $200 (MY“ACCOUNT”)BANK DEPOSITS $200IN CENTRAL BANKBANK HAS$200 MOREMONEY NOWMY ASSETS: $800 CASH +$200 OWED BY BANKBANK’S ASSETS: +$200 REAL MONEY - $200 DEBTMY ASSETS: $1000 CASHELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSBenefit of a Bank Deposit•Bank can–loan the money (more than was deposited!)–invest the money–move the money, e.g. make payments–buy foreign currency with the money•Reserve ratio–Fraction of deposits the bank must keep in the central bank–If the reserve ratio is 25%, then for a $1000 deposit, the bank can lend out $3000ELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT © 2004 MICHAEL I. SHAMOSForeign Exchange•Currency = token fiduciary money of a central bank•Every bank account is denominated in one currency•Most banks allow accounts in only one currency•All currencies have three-letter ISO currency codes:–USD (U.S. dollar)JPY (Japan yen)–GBP (Great Britain pound) CHF (Swiss franc)–HKD (Hong Kong dollar) EUR (Euro)•Usually, the first two letters indicate the country; third letter is the first letter of the currency name•Foreign exchange is a barter transaction–To buy GBP for USD, buyer has to find someone with GBP who wants USDELECTRONIC PAYMENT SYSTEMS 20-763 SPRING 2004 COPYRIGHT ©