Introduction

Chapter 1 - Introduction to cash management

Overview

This chapter looks at the role of the corporate treasurer and introduces a number of definitions

of cash management used by companies and banks.

Learning Objectives

A. To understand the role of treasury in large companies

B. To understand what cash management is and how it fits into treasury and impacts on

other treasury functions

C. To appreciate the benefits of good cash management

D. To be aware of the basic bank cash management model

1.1 The role of the treasurer

The treasurer's role has been evolving over many years, but it can still be a very different job

from company to company. Some treasurers spend most of their time managing cash, while

others concentrate on risk; there is also a new breed who are becoming managers of 'working

capital' rather than treasury managers in the accepted sense. To some extent, the differences

between the treasury role in different companies can be explained with reference to the

following:

• size;

• industry;

• country of domicile;

• level of international versus domestic business;

• corporate culture;

• personal style and experience of the treasurer;

• corporate history;

• life cycle/stage of development and

• the nature of business.

No doubt there are many other factors that influence the role of the treasurer and the staff that

work in his department. In some companies, additional non-treasury responsibilities can be

assigned to the treasurer as well. For example, one airline regards the treasury function as

essentially one of risk management, therefore it is not surprising that this company's treasurer is

also responsible for insurance. Nor is it surprising that the management of commodity risk

becomes important in industries which are closely tied to commodities, such as the oil industry,

or where commodities form a large part of the cost base (ie airlines or confectionery). It is also

fairly common, particularly in those companies where the treasury has developed out of the

chief accountant function, for an accountancy-trained treasurer to be given additional

responsibility for corporate tax. We also see a number of less fathomable company-specific

anomalies. For example, there is one multinational company where the group treasurer also

manages the real estate portfolio!

Although there will always be exceptions, the core responsibilities of treasury can generally be

divided into six broad areas as follows:

1.2  Foreign exchange

At its simplest level, this may be no more than the purchase or sale of currencies against a base

currency. Trades may be done on a standard spot basis (ie usually trade today for settlement

two working days ahead), but in certain cases one day ahead, 'Tomnext', for settlement the day

after the trade or today's settlement. Alternatively, they may be trades in the forward or futures

markets where trades that are fixed today will not settle for many days, weeks, months or even

years. Most of these types of trades will be carried out over the telephone with a bank dealer.

Increasingly, however, trades, particularly for small amounts, can be carried out electronically

with banks and other organisations using a PC and authorised software or via dedicated single

bank or multibank portals. (Dealing systems will be covered in detail in chapter 21 which

includes corporate treasury systems and foreign exchange portals).

1.3  Risk management

Risk management normally refers to two main types of risk in treasury, although the role has

been extended increasingly. The traditional areas of risk management of concern to the

treasurer relate to currency risk and interest rate risk. Currency risk is usually broken down

further into transaction risk, translation risk and economic risk.

Transaction risk is the simplest and most common. These risks relate to the differences

between the foreign exchange rates on the day that a business transaction is entered into and

the prevailing rates on the date of receipt or payment of funds that relate to it. Exchange rates

fluctuate and can either move favourably (resulting in an exchange gain) or adversely (resulting

in a loss). 'Hedging' on the date that the transaction first becomes known to the company will

lock in a fixed rate so that there is no risk to the company.

Translation risk is often referred to as 'balance sheet risk' and usually refers to the revaluation of

a balance sheet or profit and loss item to take account of movements in foreign exchange rates.

These are essentially accounting exposures, rather than relating to real transactions. For

example, the US subsidiary of a UK company earns profits of USD 10m each year. Last year,

the average USD/GBP exchange rate was GBP1 = USD1.50. This year, the US subsidiary

meets its USD10m target, but the average USD/GBP rate has moved to 1.60. This means that

the parent's profit and loss account includes profits from the US subsidiary that, on translation,

are GBP416,667 lower than the previous year. As these are not real gains or losses (ie there is

no cash effect) some companies do not bother to hedge them. On the other hand, other

companies do try to manage translation exposures, especially where movements in the balance

sheet figures give rise to breaches of loan covenants, such as debt/equity ratio levels.

Economic risks are usually associated with competitive strategies that can be used against a

rival company. Although economic exposures may relate to simple differences in cost bases, (ie

the cost of manufacturing clothes in South-East Asia compared with Germany) they can be

complicated by currency movements. If one takes the example of a US-based importer of

clothes from Venezuela and a US manufacturer of the same goods. In a period of steady

appreciation by the dollar, the former will have gained an economic advantage, whereas the

latter will have suffered an economic loss, reflected in either lower margins or, at the extreme,

lost sales.

The other standard area of risk management is interest rate risk. The risk that interest rates will

move against the company, making borrowings more expensive, or reducing returns on

investments. This can be extended to include market risk, ie the risk that the price of an asset

will move against you. This can be due to simple movements in the financial markets, such as

share prices, or a result of the impact of interest rate movements on the value of fixed-interest

instruments.

These types of risks can all be hedged using a variety of financial instruments, and will be

discussed in more detail in chapter 16 in terms of their impact on cash management.

Other types of risk that are increasingly being covered under this heading include: counterparty

risk (the risk that a counterparty will default on a trade or transaction); settlement risk (the risk

that settlement of a particular transaction may not occur); and, systemic risk (the risk that one of

the systems that the company or its bankers use will fail, resulting in a loss to the company).

1.4  Funding

This relates to the management of long-term debt (ie with a maturity in excess of one year). It

may be a simple term loan, or a more sophisticated instrument, such as a bond issue or

redeemable debentures. Debt under one year should be considered as a cash management

function.

1.5 Investments

Similarly, management of investments also refers only to items with a maturity of one year or

greater. Investments maturing in periods of less than one year should be considered a cash

management function.

1.6 Bank relations

This function is different to those listed above because it does not involve any treasury

operations directly. Indeed, it can almost be regarded as the treasury department' s public

relations function. However, the role is sufficiently important that some large companies employ

a dedicated senior treasury professional (often on a full-time basis) to keep its banks advised of

its needs and activities and to provide a focal point for bank negotiations and selection.

Regardless of size, all companies need to keep track of the business it transacts with each

bank, with a view to meeting current and future banking needs. There is also a need to track the

performance of banks and to ensure that the relationship is mutually beneficial. Whether it

adopts a transaction or relationship-based approach to purchasing bank services, the exact

form of a company' s relationship with its banks is a frequently discussed subject and never

more so than at times of reduced liquidity.

1.7  Cash management

Last, but by no means least, comes cash management. In many ways, this is the most difficult

area to define and means very different things to different companies. In some companies, it

can include handling petty cash, supplying (and buying back) currency for staff-travel purposes

or even management of the postage stamps! Definitions among companies may differ widely,

but the more important disparity is between what cash management means to banks and

companies.

One question in a study carried out every two years by The Bank Relationship Consultancy and

The University of Bath was designed in order to shed light on this issue. Corporate respondents

were asked to define what cash management meant in their organisations. The responses from

almost 1,200 companies confirmed the diversity of views.

A definition of cash management for companies, which has found favour amongst many

treasury departments, can be found in the Institute of Chartered Accountants' handbook

"Guidance to Good Practice Cash Management".

Although this is a good definition, it should, in the authors' view, be extended a little. 'receipts'

should include 'items in the course of collection', and 'payments' should include 'items in the

course of being paid'. In addition, we would like to reiterate that 'short-term borrowings' and

'short-term investments' should refer to items 'of less than one-year maturity'. This will include

bank and money market deposits and intra-day, overnight and short-term overdrafts.

No matter how good this definition is, it needs to be compared to the bankers' definition of cash

management. The following definition was drawn up by a group of 15 banks which represented

the largest in the global and pan-European cash management markets:

1.7  Cash management

Last, but by no means least, comes cash management. In many ways, this is the most difficult

area to define and means very different things to different companies. In some companies, it

can include handling petty cash, supplying (and buying back) currency for staff-travel purposes

or even management of the postage stamps! Definitions among companies may differ widely,

but the more important disparity is between what cash management means to banks and

companies.

One question in a study carried out every two years by The Bank Relationship Consultancy and

The University of Bath was designed in order to shed light on this issue. Corporate respondents

were asked to define what cash management meant in their organisations. The responses from

almost 1,200 companies confirmed the diversity of views.

 

 

A definition of cash management for companies, which has found favour amongst many

treasury departments, can be found in the Institute of Chartered Accountants' handbook

"Guidance to Good Practice Cash Management".

 

 

Although this is a good definition, it should, in the authors' view, be extended a little. 'receipts'

should include 'items in the course of collection', and 'payments' should include 'items in the

course of being paid'. In addition, we would like to reiterate that 'short-term borrowings' and

'short-term investments' should refer to items 'of less than one-year maturity'. This will include

bank and money market deposits and intra-day, overnight and short-term overdrafts.

No matter how good this definition is, it needs to be compared to the bankers' definition of cash

management. The following definition was drawn up by a group of 15 banks which represented

the largest in the global and pan-European cash management markets:

 

 

 

It is interesting to note the similarities and differences between this and the corporate definition.

In terms of similarities, both companies and banks agree that electronic banking is neither a

cash management function nor a product. It is just a delivery mechanism, which may or may not

add value, depending on the supplier and the way the information is used. In terms of

differences, the bankers' definition is a list of the products and services that they sell, in contrast

to the practitioners' focus on what they are trying to achieve.

It is not surprising that companies complain that banks do not understand corporate cash

management and only want to sell products that do not do exactly what they want. But we also

hear banks complaining that companies do not understand banking and money transmission.

Both are talking a different language. But in the end, the customer is king and major companies

are not looking to buy products and features: they are looking for solutions and benefits.

Consequently, innovative banks are replacing their old 'electronic banking' and 'money

transmission' departments with more customer-focused cash management divisions, which offer

a consultative approach to cash management and customised solutions-based services.

Much time is spent quantifying the benefits of cash management, both by companies and

banks. Again, the Institute of Chartered Accountants handbook lists the benefits of good cash

management to companies as follows:

1.8  Better control of financial risk

Control of financial risk is a clear benefit of good cash management to the company. Even a

profitable company can become bankrupt if it runs out of cash. Good cash management

techniques will be reflected in the balance sheet, as well as the profit and loss account.

1.9  Opportunity for profit

Many treasury managers will claim that their departments are set up as cost centres rather than

profit centres. However, in the current business environment, few corporate functions continue

to exist for long if they do not contribute positively to the company' s bottom line. It might be

better to turn this statement on its head and to suggest that good cash management offers an

opportunity to reduce costs and enhance financial returns. But this new statement hides two

additional problems; measurement and risk. First, how does one isolate - and measure - the

extra value added from treasury operations? Secondly, how much risk should the treasury

department take on in order to improve profitability? Both these questions go beyond the scope

of this manual but should nevertheless be borne in mind.

1.10  Strengthened balance sheet

It is perfectly possible to identify whether a company observes good cash management practice

by studying its annual report and accounts. It is easy to calculate liquidity ratios, compare

average debtor and creditor outstanding days, note funds in the bank against borrowings, or

check for interest cover etc. Be warned however that ratios are not always helpful in isolation,

and must be considered in relation to industry norms and trends. Remember also that as a

balance sheet is a snapshot in time, amounts shown under cash at the bank will be cashbook

items and will not take account of items in the course of being cleared.

1.11 Increased confidence with customers, suppliers and shareholders

Well-managed cash positions are important to customers, suppliers and shareholders.

Particularly in the case of long-term relationships, customers entering into business with a new

supplier will need to be convinced of the suppliers future profitability. They will also want to

know if a supplier is able to fund its existing manufacturing processes, invest in new technology

to maintain quality and competitiveness as well as be a reliable supplier.

Suppliers want to be assured that they will be paid. Most companies will make credit enquiries

on their customers before doing business with them. Information and reports such as those

produced by Dun & Bradstreet provide basic assessments of companies' cash

management/payments track records (ie how much credit they have taken in the past).

Additionally, bank references can be taken.

Shareholders will be interested in a company's cash management record for two reasons. First,

they will want to be assured that the company in which they are investing will have enough cash

to fund working capital and to continue in business. Secondly, they will want to be assured that

there is enough cash to pay them a dividend. Increasingly, at shareholder meetings, company

directors have to explain treasury and cash management policies particularly to institutional

investors. This information can be used to generate confidence that the management have their

business under control and an understanding of a companys hedging policy allows fund

managers to adjust their own risk positions.

1.12 Role of cash management in different types of companies

Cash management is an essential task for all companies but larger companies, particularly

multinational companies (MNCs) have additional challenges. In small- or medium-size

companies, where predominantly only one domestic cash flow needs to be managed, cash

management is often very much a part-time function. Particularly if the Accounts Payable (A/P)

and Accounts Receivable (A/R) functions are managed by another area - often under the control

of the 'Chief Accountant' or 'Financial Controller'. This function may be using rudimentary and

home-grown systems.

In MNC's where the cash flows may relate to many different legal entities for many geographic

locations, and may be denominated in different currencies, the cash management function

becomes an important full-time role and will require sophisticated systems for data collection,

analysis and decision support.

1.13 Cash management and banking

The most basic cash management product offered by banks is the current account. All

companies need a bank account and the ability to collect funds into it and disburse funds out of

it. Moreover, they need a bank to effect these transactions with timeliness and accuracy. They

also need a method of tracking balances and transactions, and a way to manage surpluses and

shortfalls. These are the basics of cash management, and the sophisticated products that will

be discussed in future chapters are all derivatives of these basic functions.

1.14 Summary

This introductory chapter has discussed the role of the treasurer and explained where cash

management fits within that role. It should be apparent at this stage that, although the models

show neat compartmentalisation, all activities are interrelated. This picture will continue to

emerge as the course develops.

1.15  Key points

the role of the treasurer varies from organisation to organisation;

within treasury, cash management can encapsulate different responsibilities;

bankers and treasurers tend to approach cash management from different perspectives.

Bankers as products and features, treasurers as tasks and benefits; and

basic cash management can be encapsulated by the cash management environment

diagram 1.6. More sophisticated practices build on these basics.

Instruments and Infrastructure

Chapter 2 - Back to Basics - banks and bank accounts

1. Overview

This introductory chapter looks at banking relationships, types of bank accounts and account

holders.

Learning objectives

A. To appreciate the different potential relationships between a company and a bank

B. To understand the differences between types of bank accounts

C. To appreciate the different types of account holders and the bank requirements for

opening such accounts

2.1 Banker / customers relationship [Italicised part of this section non-examinable]

It is important that the relationship between a bank and its customers takes on a proper set of

rules and regulations so that there can be no doubt that either party is aware of their

responsibilities to each other. While this is not a full legal summary, some of the key points are

covered in this chapter. In some countries, a bank must comply with legal statutes before it can

be authorised to accept deposits from companies or institutions. In other countries banking is

not governed by statute, but by central bank regulations. In the UK, for example, the Banking

Act of 1979 (later confirmed and updated by the 1987 Act) sets out the terms under which a

bank must operate. These include:

• having a high reputation and standing in the community;

• providing a wide range of banking products and services to include the acceptance of monies

for current and deposit accounts and the provision of borrowing facilities and

• having net assets of at least GBP5m.

What constitutes a banking customer varies country by country. Again in some countries that

will be defined by statute, by central bank regulations or legal precedent, based on case law. In

the UK, to be recognised as a customer under the legal definition of the term, a person or

corporate entity must have entered into a contract to open an account in their name. This was

established in the case of Ladbroke & Co vs Todd (1914). Additionally, legal precedent also

states that an account does not need to have been opened for any length of time.

In another case, Foley vs Hill, (1848), it was established that the basic relationship between

banker and customer is that of debtor/creditor. The bank holds money for a customer and this

money has to be repaid by the bank at some stage in the future (ie the banker is acting as the

‘debtor’, and the customer as the ‘creditor’). When the customer is borrowing from the bank, the

situation is reversed. This definition is common to many countries.

2.2 The main duties of a bank

Again these may be set out in law or in central bank requirements. In some cases individual

banks will put in place service level agreements or banking charters to describe these.

Generally, a bank has:

• a duty of care to handle customers’ business in a safe and professional manner;

• to honour customers’ cheques, provided that there are available funds and that there are no

legal reasons for refusing payment;

• to comply with any express (written) instruction from the customer, ie a standing order;

• to maintain secrecy about customers’ affairs unless compelled to do otherwise within a narrow

band of legal justifications;

• to give reasonable notice if it wishes to close an account;

• to provide a balance of account on request and to send statements to customers on a regular

basis;

• to receive customers’ money and cheques and credit them to the correct accounts;

• to repay money on demand during banking hours;

• to advise customers immediately of any improper event affecting the account and

• to exercise proper care and skill when performing all its duties so that it can earn the legal

protection given to it by the statutes, central bank regulations, or through the courts.

The customer's main duty is to exercise reasonable care in issuing instructions such as writing

cheques so that forgery is not easily possible; more recently, customers are required to take

care and protect passwords and tokens so that fraudulent funds transfer instructions cannot be

issued.

2.3 Types of bank account

In this section we will examine the different types of bank account and also the different sorts of

documentation that a banks seeks to obtain.

2.3.1 Current account

The current account is the standard, traditional bank account. There are little or no restrictions

on the type of transaction that can be passed over this type of account and a chequebook is

normally available. The US banks often refer to these accounts as 'demand deposit'

or 'checking accounts'. This latter description is quite often used in Europe in countries where

large numbers of cheques are used. Increasingly however, cheques are not used for corporate-

to-corporate business in more advanced European countries. For example, in the Netherlands

and Germany where cheques are not used for corporate payments, giro or electronic funds

transfers are the norm. The current account provides immediate access to funds and, subject to

agreement, can be overdrawn in some jurisdictions and used as a means of borrowing. Until the

last few years, no interest was ever paid on credit balances. Competitive pressure, however,

has meant that some form of interest bearing arrangements can be negotiated in many

countries. In some countries however payment of interest on current accounts is prohibited by

law or by local banking regulations (eg USA). In others interest may be payable only to 'non-

residents' (eg France).

2.3.2 Deposit or savings accounts

The traditional means by which a bank's customer can obtain interest on surplus credit balances

has been to open a deposit account. These come in various forms, but, generally speaking, the

greater the restrictions placed on the account (ie the less liquid) the higher the interest paid.

Chequebooks are not normally available and, indeed, few banks will agree to pay direct debits

or standing orders from this sort of account. For a 'time deposit' , notice is often required from

the customer in advance of any withdrawal. If the bank is not given prior notice, it is likely to levy

an interest penalty, either in the form of a specific charge or by means of a back-valued debit to

the account. In some countries, companies are not allowed to hold savings accounts, whilst in

others there may be minimum terms applied to deposits.

2.3.3 Composite accounts or interest bearing accounts

As mentioned above, where permitted by law, many banks will agree to pay interest on a

current account. This is sometimes called a composite account since it is an amalgam of both a

current and a deposit account. The level of interest paid is sometimes tiered according to the

extent to which the balance is in credit, and is normally set below the prevailing money market

rates:

 

(ON = Overnight, WK = One Week, M = Month).

The bank seeks to cover its operating costs either by means of specific transactional charges, a

regular fixed fee, or some form of non-interest bearing balance above which interest will be

paid. Generally, these accounts provide all the benefits of a current account and a short-term

call deposit account. They should not, however, be used for substantial amounts of money,

because the interest rates are still below those available on the money markets.

2.3.4 Money market deposits

Whenever possible, larger amounts of money should be invested in the money markets.

Deposits need not be invested for a fixed period and can either be simply left on call, invested

overnight or for longer periods. By obtaining competitive quotes direct from banks and/or using

screen-based rate information, good interest rates can be negotiated. In most markets the best

rates are only obtainable for amounts over a certain threshold. Each market threshold will differ.

Often the threshold is one million currency units. We will look at the money markets in more

detail in chapter 14 (Short-term investments).

2.3.5 Overdrafts

In many countries a current account can be overdrawn with prior approval from the providing

bank. The overdraft is a very flexible form of borrowing and, providing prior arrangement is

made with the bank, competitive terms can be negotiated. Non pre arranged overdrafts normally

carry heavy penalty interest rates. Although more flexible, overdrafts are, however, normally

more expensive than the terms that might be arranged for a fixed-term loan. Nevertheless, the

overdraft remains one of the most flexible forms of finance because borrowings can be repaid or

reduced whenever surplus cash balances allow. Overdrafts are usually granted for periods of

one year and are typically renewable, even though banks insist that they are repayable on

demand'. As overdrafts may be drawn down through the issuance of cheques, they are often

provided by a company's cheque issuing bank.

2.3.6 Loan accounts

When a more long-term/permanent borrowing is envisaged, a separate loan facility may be

appropriate. The amount of money borrowed is simply debited to a loan account and credited or

transferred to a current account, from where it can be used as required. Regular reductions to

the loan amount will be made on a pre-agreed basis, often by standing orders or regular

transfers from current account. More competitive terms can often be negotiated for loans.

This facility may be taken from a lead bank or any other bank, and would not be restricted to a

clearing bank.

.4 Different types of account holder

Bank accounts can be opened by private individuals, companies and organisations. In this

section we will briefly outline the different types.

2.4.1 Personal customers

A personal account can be opened by any individual who can sign his or her own name, but

because in most countries minors (persons not considered adults in law) cannot make legally

binding contracts, banks normally restrict the issue of any form of credit facility or credit card to

those customers who are recognised as adults.

Opening an account at a bank requires only a limited amount of information from the

prospective account holder: his or her name, permanent address, occupation and specimen

signature. However, in order to comply with money laundering regulations, banks are

increasingly required to make rigorous checks on an individuals identity (see section 9.13

"Money laundering").

2.4.2 Joint accounts

When a bank opens an account for two or more people (or entities), they require an explicit

instruction, or mandate, as to who is required to sign when funds are withdrawn from the

account. Typically, any one of the account holders can withdraw balances from the account.

The mandate, which is signed by all the parties to the account, usually incorporates a statement

acknowledging that, in the event of any borrowing, all parties are jointly and severally liable to

the bank. This means that if one person overdraws the account without the consent of the

others then all the parties to the account are still liable for the debt. In simple terms, this means

that any one individual can become solely responsible for the entire debt.

2.4.3 Sole traders

Many businesses are simply private individuals trading under a business name, and, as such,

the procedures required for opening the account are similar to those required for opening a

personal account, with the exception that proof of the trading name/business capacity must be

provided. In some cases, formal permission may be required to use certain words in the trading

name eg 'Royal' , 'Windsor' , 'Chemist' , 'Bank' .

In some countries the government, or the banks themselves run small business development

programmes. Often banks offer free banking to new businesses (including partnerships and

sometimes even companies) in their first year, after which time a business tariff is applied. This

tariff is typically higher than that applied to personal accounts.

2.4.4 Partnership accounts

These accounts are opened when two or more persons enter into business together as

partners. Such partnerships can range from small local businesses up to the very large firms of

solicitors and accountants. Much the same features apply to these accounts as those for the

sole trader, except that partners bear the same liability to the bank as joint account holders (ie

each partner is liable for all the liabilities of the partnership - unlike limited companies). If the

partnership is governed by a formal partnership agreement then the bank will request a copy of

this.

2.4.5 Limited liability (corporations)

Limited companies are often regarded by banks as the most important category of account

holder. This is because they are a most-profitable source of income to the bank, given the vast

variety of services they can require.

Before a company can open an account, the bank will require the company to produce a set of

documents and complete a number of forms. Forms and documents vary by country, however

some items are fairly commonly requested:

account mandate incorporating specimen signatures. This will be provided by the bank

for completion by the company;

certificate of incorporation - the birth certificate of the company;

board resolution authorising the opening of a bank account and the signatories;

documents of existence. In the UK memorandum and articles of association which

govern the rules and regulations of the company and say what it can and cannot do;

certificate of commencement to trade - this is required by all public companies before

they can commence business. In some countries in Europe this may take the form of a

Value Added Tax (VAT) registration certificate; or a corporation tax code number and

signature cards with specimens of each signatory's signature.

Similar requirements exist in most countries and, since money laundering legislation has been

implemented in many jurisdictions, signatories will often have to provide certified copies of

passports or similar documentation. In Germany and France, some banks will require all

documentation to be translated into the local language.

In law, a company is classed as a separate legal person and the law relating to companies is

very complex. The main point which should be appreciated is that a company is owned by

shareholders, but managed on their behalf by directors who may be shareholders. As far as any

borrowing is concerned, a shareholder is only liable for the amount of share capital he owns

unless he has provided any form of personal guarantee. This contrasts quite dramatically with

sole trader and partnership accounts (where the individuals are personally liable). 

2.4.6 Trustee accounts

A trust has been defined as: "an equitable obligation imposing upon a person (who is called a

trustee) the duty of dealing with property over which he has control (which is called the trust

property), for the benefit of persons (who are called the beneficiaries or cestuis que trust) of

whom he may himself be one, and any one of whom may enforce the obligation" [Underhill].

Banks normally require to see a trust deed when opening bank accounts for trustees and are

expected to ensure all transactions across accounts are in accordance with the trust deed.

2.4.7 Resident and non-resident accounts

In most countries banks differentiate between those accounts owned by residents and those

owned by non-residents. Often different charging methods are applied and movements between

resident and non-resident accounts (over a certain value) have to be reported to the Central

Bank (for balance of payment purposes). In some countries where exchange control regulations

are in force, approval may have to be sought from the Central Bank prior to transfers between

residents and non-residents being allowed.

Transfers between residents and accounts held overseas will be treated in the same manner.

Chapter 3 - Back to Basics - collection and payment instruments

Overview

This chapter looks at the various payment and collection instruments used domestically (ie

within the borders of one country). It also introduces the important concepts, such as 'float',

'value dating', and 'finality', which will be built upon later in the course.

Learning objectives

A. To understand the concepts of:

float;

value dating and

finality.

and how they may be different for each instrument used

B. To understand the different instruments used to make payments and receive collections, both

paper-based and electronic items, in various countries

C. To be able to discuss the pros and cons for using each type of instrument

D. To understand the different importance placed on instruments by different countries.

3.1 Collection and payment instruments

Debits are payments made from an account and credits are payments into the account - usually

called 'receipts'. In the course of this chapter, we will look at different types of credit and debit

transactions. Wherever appropriate, we examine how both the debit and the credit are applied

to the respective accounts that are involved, and the concepts of float, value dating and finality.

Diagram 3.1

Float

The general definition of float is

'The time lost between a payor making a payment and a beneficiary receiving value'

In fact this is a definition of 'bank float'. There are other types of float.

(The concept of float is discussed further in chapter 22)

Diagram 3.2

 Value dating

Definition of value:

Value is the moment when funds cease to be useable to the originating party and instead

become useable funds to the beneficiary in the sense that they can reduce overdraft balances,

earn interest or be withdrawn

Definition of forward value dating:

The time between a bank being notified of a transaction in favour of a customer and the

customer receiving future value for the item.

Definition of back value dating:

The time between a bank being notified of a transaction to the customer’s account and the item

being valued on a date prior to the date of the transaction.

An example of forward valuing would be when a bank collects value for cheques cleared in five

days, but does not give value to the customer until day six.

An example of back valuing might be processing items received late on a Friday, early on the

following Monday, but giving Friday's date.

In some countries banks will take a day's value for outgoing international funds transfers by

effectively value dating the debit entry to the customers account one day before they pay over

the funds to their correspondent. (Value dating is discussed again later in this chapter and in

chapter 10).

Diagram 3.3

Finality

Definition

The time after which a payment is considered to become irrevocable and cannot be returned

without the permission of the beneficiary account holder.

It is important to establish when finality of payment occurs so as to limit:

risk of non-payment, ie, the risk that an item is recalled by the originator or the

originating bank (eg, a stopped cheque) and

unnecessary loss of value in both the collection and the payment cycle.

It should also be noted that finality varies by instrument.

3.2 Domestic collection and payment instruments

Collection and payment instruments generally fall into the following categories:

Paper based

Cash

Cheques

Bank transfers or giros

Postal giros

Bills of exchange

Promissory notes

Banker' s drafts

Electronic

Urgent electronic funds transfer

Standard electronic funds transfer or giros or

Automated clearing house payments

Credit/charge cards

Debit cards

Standing order

Direct debit

Electronic bills of exchange

3.2.1 Cash

Cash is the most basic medium of exchange and was, of course, in use long before the

commercial banking system ever existed. Banks tend to regard cash as a necessary evil. Only

in exceptional circumstances does it earn interest when held and it is expensive to handle by

either companies or banks. Part of the obligation of a bank, however, is to honour and cash its

customers' cheques. In fact, the history of banking is littered with 'runs' on banks that have

failed to maintain sufficient liquidity (ie enough funds to meet all current, foreseen and

unforeseen obligations).

As far as the bank account is concerned, a cash withdrawal is simply debited to the account,

usually on a same-day basis (eg, when a cheque has been cleared [or ‘cashed’] at the account-

holding branch). Similarly, cash deposits should normally be credited to the account for value on

the same-day.

3.2.2 Cheques

The cheque is by far the most common instrument or means of exchange used in countries

such as Spain, Italy, the USA and the UK, but cheques are not so widely used in other areas,

such as Central and Eastern Europe and the Nordic countries. The following table identifies the

terminology used with cheques and those elements that make the cheque acceptable as a

method for the transfer of money.

Payee The name of the person or company to whom the money is to be

paid. When cashing funds, 'cash' , or 'self' can be written here.

Drawer The person or company issuing the cheque.

Drawee The name of the bank and branch where the account is held.

Amount In the event of any doubt, the amount written in words takes

precedence over the figures in the UK. Due to automation, the

amount written in figures prevails in many other countries (eg

USA).

Date The date on which the cheque was issued.

Bank/Branch Number Identifies the bank and the branch so that bank clearing Number

departments can sort and deliver the cheque to the correct bank,

branch and account. The bank and branch code are encoded onto

the cheque usually with magnetic ink using a standard known as

Magnetic Ink Character Recognition (MICR).

MICR ·Magnetic Ink Character Recognition (MICR) is the standard used

to encode bank /branch numbers on cheques with magnetic ink

and

Account Numbers The individual number of the customer' s account. This is MICR

Number encoded for the clearing/sorting process.

Cheque Numbers Consecutive number of the cheque. This is also included in

Number MICR.

The drawer of the cheque, ie, issuer, normally gives or sends the cheque to the beneficiary who

then pays it into his/her bank account. A credit to the bank account, which can comprise one or

more cheques or cash on a single credit slip, appears on the account as a single amount. In

fact, the value (see chapter 4) applied to the cash and the cheques will usually be different. If

cheques and cash are deposited on a single credit slip they are often processed as if all the

items are cheques ie, value takes longer.

The bank accepting the cheque for deposit is known as the 'collecting bank' .

The cheque is then processed through the clearing system (described in chapter 6) and

presented for payment at the drawee bank. At this point, the drawee bank debits the drawer' s

account. The proceeds are credited to the beneficiary' s bank usually to its clearing settlement

account held at the central bank.

Cheques are subject to various types of float (discussed further in chapter 22) relating to

production time;

postage time;

recipient handling;

clearing time and

value dating.

In countries that have a high volume of cheque usage, cheque clearing is, with some notable

exceptions, a highly automated process, and therefore attracts low costs.

There is, however, an element of uncertainty in terms of finality of payment by cheque. It is

possible that the cheque may be returned (bounced) either because of lack of funds, technical

reasons (words and figures 'disagree' , post-dated, not signed, etc), or the drawer could have

countermanded payment by placing a 'stop' on the cheque with the drawee branch.

Clearing times vary dramatically depending on the country concerned and the city or town in

which the cheque is drawn. Typically, local cheques, drawn in the same town will be cleared

within one to three days. In remote areas such as North India a cheque might take up to two

weeks to clear.

In some countries post-dated cheques are not allowed to be processed, whereas in others (eg

Spain) they are common and reasonably acceptable.

3.2.3 Paper-based bank transfers or bank giros

Bank transfers or bank giros are paper-based instruments that can be used to pay funds into a

beneficiary’s account. If the account is not held at the bank or branch of deposit, the item has to

go through a credit clearing. The various types of giros range from a simple blank form

completed in a bank, which is lodged with the bank cashier either with cash or cheques

attached, to the more sophisticated ‘accept’ giro used in countries such as The Netherlands and

the Nordic (Sweden, Norway, Denmark, Iceland and Finland) countries. Accept giros are

normally supplied and completed by the beneficiary and will be sent to the payor along with an

invoice. The payor will sign the giro (ie, accept it) and forward it to his/her bank. The bank will

debit the payer’s account and put the giro in the clearing system. Details included in a giro are

normally:

Amount

Recipient bank details

name;

address and

bank code.

Recipient account details

name and

account number.

Deposit date

Details of payor

name and

reference.

Remittance details

In some countries the physical forms are cleared and pass through the clearing system in the

same way as cheques (eg UK). In more sophisticated countries, giros are dematerialised (ie the

details are captured electronically at the depositing bank) and only the information passes

through the clearing system (eg The Netherlands and Nordic countries).

Giros normally take one to three days to pass through the banking system, thus creating float.

Unless printed with an invoice, giros necessitate much manual work in their preparation,

physical delivery to the bank (mail or personal visit) and much manual handling in the bank. This

is therefore an expensive instrument to use. Banks may therefore charge the depositor and the

beneficiary, and may also take some compensation through value dating.

To be of maximum use to the beneficiary, a full description of the transaction (ie name of

depositor, reference, and transaction reference) needs to pass through the system to enable full

reconciliation. This often does not happen and such detail is frequently truncated when the item

is dematerialised.

Companies that regularly receive a large volume of giro payments will probably take an

electronic report of the details, either on disk or by data transmission which they will use to

update their Accounts Receivable systems.

3.2.4 Postal giros

Postal giros are similar to bank giros, but are often operated through a separate clearing circuit

run by the local post office. Depositors will initiate the transactions at a post office. In some

countries, the post office and bank circuits are connected and operate to the same standards

(eg, UK, the Netherlands), but in others the two are separate or do not interconnect well (eg,

Switzerland). In the latter case, it may be necessary for companies to hold an account with the

post office as well as with a bank to ensure that the full remittance detail is received to enable

reconciliation.

Again, many postal giro systems enable beneficiaries to receive details of transactions received

via disk or data transmission.

3.2.5 Bills of exchange

Although often regarded as an international and foreign currency based instrument, bills of

exchange are often used domestically, particularly in continental Europe. A good definition of a

bill of exchange is provided by the UK' s Bills of Exchange Act 1882, Section 3:

(1) "A bill of exchange is an unconditional order in writing, addressed by one

person to another, signed by the person giving it, requiring the person to whom

it is addressed to pay on demand or at a fixed or determinable future time a

sum certain in money to or to the order of a specified person, or to bearer.

(2) An instrument which does not comply with these conditions, or which orders

any act to be done in addition to the payment of money, is not a bill of

exchange. Once accepted it is a legally binding document on all parties."

In fact a cheque is a bill of exchange drawn on a bank and payable on demand [1].

It should be remembered that a bill of exchange is often a dual instrument. It is both a method of

payment and a method of granting the payee credit. If the drawee (payor) is sufficiently

creditworthy, the drawer (payee) may be able to discount the value of the bill prior to maturity.

Bills can, and often are, drawn payable at the drawee' s bank, and would therefore be debited to

the drawee' s account on presentation/maturity. Clearing bills often creates float and finality of

payment will normally be a number of days after presentment/maturity in case the bill is returned

unpaid (rather like a cheque).

3.2.6 Promissory note

This instrument is similar to a bill, and used extensively in continental Europe for trade-related

transactions between counterparties that are usually well known to each other. Part IV of the

UK' s Bills of Exchange Act 1882 is devoted to promissory notes. Section 83 defines a

promissory note as follows: "A promissory note is an unconditional promise in writing made by

one person to another, signed by the maker, engaging to pay, on demand or at a fixed or

determinable future time, a sum certain in money, to, or to the order of, a specified person or to

bearer."

A promissory note does not have the legal standing of a bill of exchange and may not be able to

be discounted, unless the drawer is considered a strong credit risk.

3.2.7 Banker's drafts

A banker' s draft is similar to a cheque, but is in fact drawn by a branch of a particular bank on

its head office. It could, therefore, be regarded as a banker's cheque, the effect being that the

payment is 'guaranteed' by the bank. Until the development of same-day value electronic funds

transfers, the banker's draft was the most popular method for settling major transactions (house

or car purchase). It is still a popular method for paying for goods and services when the vendor

insists on payment in a form that ensures he gets his money at the same time as exchanging an

asset (delivery against payment). The company or person buying the banker's draft will pay for it

on issue, whereas the beneficiary will only obtain value once it clears (like a cheque). Therefore

the banker enjoys the float.

It should be noted, however, that, in the UK, building society or financial institution cheques,

although fundamentally different from banker' s drafts, frequently fulfil the same purpose. Unlike

a banker' s draft, where the cheque is effectively drawn by a bank on itself, the building society

draws a cheque on its own bankers.

Banker' s drafts, which may be denominated in any freely tradable currency, are normally

expensive to obtain, and if lost or stolen, they can be 'stopped' like a cheque.

3.2.8 Tested telex (or wire transfer)

Prior to the advent of electronic funds transfer systems and SWIFT, both bank-to-bank funds

transfers and large corporate-to-bank transfers were carried out using telex machines. Often

these messages would be unstructured and therefore processed manually at the recipient bank.

It was vital that the messages included a code or test key that could only be deciphered by the

receiving bank.

Banks would supply correspondents or corporate customers with sheets of code

numbers that would be ticked off in sequence and used as part of a number that

would be constructed as a test key. For example, a payment of USD2,101,787.94,

Value 6 June 2000 might have a test key constructed as follows:

First six whole currency amount

numbers

210178

Value date 060600

Random code from bank test

code sheet

172611

TOTAL = Test Key 443,389

Whilst this code could confirm the identity of the sending corporation and ensure that the

amount of the payment could not be altered after testing, it did not stop the beneficiary' s name

and bank details being changed, neither did it confirm that the person sending the instruction

had authority.

Tested telexes are still used occasionally, often as a back-up to an electronic funds transfer

service, between non-SWIFT member banks, or between low-tech companies and their banks.

3.2.9 Urgent electronic funds transfers

In most developed countries, high-value electronic payment systems clear funds on an urgent

(same-day) basis. In some cases, the word 'urgent' is not really appropriate, as settlement

occurs the day following initiation in less developed banking environments.

Normally urgent electronic payment systems do not create float, although they may create intra-

day credit exposure problems, and finality depends on the basis on which settlement occurs

(net settlement at the end of the day or real time gross settlement clearing transactions item by

item immediately). Both these issues are discussed further in chapters 5-9 on clearing and

settlement and payments.

These types of system are for credit transfers only, and items will be submitted to banks via

browser-based or electronic banking terminals, tape, disk, or computer-to-computer data

transmission.

3.2.10 Standard electronic funds transfers

These types of payments may be referred to as:

Automated bank transfers

Automated giros

Automated clearing house (ACH) transfers

(Automated clearing houses will be discussed in chapters 5 and 6)

They are essentially automated versions of the paper-based instruments discussed above.

They are usually future-dated payments, and may or may not create float, depending on the

country, the bank and the credit standing of the customer.

In some countries, standard electronic funds transfers may also create credit exposures where

the bank transmits the transactions to the clearing house and is liable to pay the clearing house

in one or two days' time, and to debit its customer. The risk to the bank is that the customer will

not have the funds on the debit day. Some banks will, therefore, debit less creditworthy

customers with immediate effect in order to clear that risk. More creditworthy customers may be

given a 'clearing facility' .

Finality of payment varies as settlement between participating banks normally takes place at the

end of the settlement day on a net basis. Therefore, finality often occurs the day following

settlement.

Items will typically be submitted by companies via electronic banking, tape, and disk or data

transmission. Such systems usually handle ‘one-off’, low value or non-urgent payments as well

as both repetitive debit and credit transfers such as standing orders and direct debits. In some

countries maximum amounts are imposed to prevent high value items being cleared on this

basis and thus limit systemic risk.

3.2.11 Standing orders

A standing order is an instruction given by an account holder to his/her bank to pay a

beneficiary a regular amount of money on a periodic basis (ie, monthly or quarterly). Examples

include mortgage and loan repayments, lease and rent payments, and insurance premiums.

The bank carries out the instruction by debiting the customer' s account and crediting the

beneficiary by forwarding a payment to his/her bank. While the customer is debited on day one,

the beneficiary normally has to wait two or three days for the credit to be processed by the

clearing system before obtaining value. In the interim, the benefit of the monies accrues to the

bank. This money left in the system in the course of the transaction is referred to by banks as

'float' , (chapter 22 deals with float in more detail). However, standing orders provide certainty in

terms of value date, and finality for the beneficiary is usually the day after he/she receives the

credit to his account.

A standing order can be cancelled either by the payor or his bank.

3.2.12 Direct debits

The direct debit is a similar payment method to the standing order, except that instead of the

remitter instigating the transfer, the beneficiary originates a debit which is transferred through

the clearing system to the account holder who is due to make the payment. In order to accept

direct debits on an account, banks in most countries will require the owner of the account to be

debited to give them authority prior to the commencement of the service. The account holder' s

consent to this authority is acknowledged in a direct debit mandate. Debits are originated via the

ACH system, which normally processes both the debit to the account holder and the credit to

the beneficiary at the same time. As a result, both credit and debit are usually applied to the

account on the same working day and there is no float benefit to the banks. In addition, this

system is an entirely electronic process and, therefore, the transactional charges levied by the

banks tend to be quite low. Like cheques, however, direct debits can be refused by banks and

finality of payment varies considerably from country to country. In some cases, finality can take

several weeks as direct debits can be governed by consumer protection laws.

3.2.13 Electronic bills of exchange

Certain European countries, such as France and Italy, make common use of electronic bills of

exchange. A beneficiary (drawer) electronically draws a bill on a drawee domiciled at the

drawee' s bank. The drawee will 'accept' the bill and it will be warehoused by the drawer' s bank

until maturity, at which point it is cleared via the local ACH (all of these processes are conducted

electronically). In France, where these bills are known as LCRs (Lettres de Change Relevé),

payment is passed to the holder four days after maturity and the drawee is debited three days

after maturity. Clearly, this creates float in the banking system and finality will take place on the

day following payment (ie start of business five days after maturity).

3.2.14 Financial EDI

Financial EDI (Electronic Data Interchange) payments are becoming more common and more

important with larger corporations. Financial EDI is the transmission of payment information in

standard formats, from customer to bank, bank to bank or bank to customer. This can be either

directly through a bank' s own telecommunications network or through a third party value-added

network (VAN) or a combination of both. EDI opens up new perspectives for payments, enabling

the concept of 'just in time' technology to be applied to financial transactions. This is partly

because financial EDI permits virtually endless amounts of transaction data to be included with

one concentrated electronic payment, using information or data direct from the payor' s logistics

(purchases or sales) systems.

Thus, it is possible for a single payment to represent many hundreds of individual invoice

amounts. Additionally, the data element of the message will supply the invoice details to assist

the supplier with reconciliation. The United Nations has led the way in developing this

technology by setting common standards. Its EDIFACT standard is the most widely used format

for financial EDI both domestically and internationally. Some countries and some industries

have developed their own domestic standards for EDI. In the US, for example, there are several

EDI standards. The most commonly used, ANSI ASC X12 is now compatible with EDIFACT.

[1] Unlike for cheques, however, it is the beneficiary who draws the cheque and the

person/institution to whom it is addressed who is the payor.

3.3 Plastic cards

It is important to remember to distinguish credit cards from charge cards, store cards, cash

dispenser and cheque guarantee cards.

Credit cards are used as a means of payment for goods and services by cardholders who effect

payment by authorising a debit to their credit card account. Each customer can buy goods and

services up to a given credit limit. A credit card account is completely separate from any bank

account and is, therefore, an independent source of credit. Traditionally, borrowing on credit

card accounts is more expensive than borrowing on overdraft or term loan. From the receiving

company’s point of view, credit cards are simply a payment mechanism that may be used by

some of its customers. Any ‘credit cards’ supplied to its staff are more accurately described as

charge cards, or purchasing cards (see next paragraph). In most countries, credit cards provide

extended credit as cardholders are allowed to pay off their credit card balances over a period of

time.

Charge cards are a similar means of payment to a credit card, but the full amount must be paid

when the account is rendered (normally monthly). Most charge card holders also pay an annual

fee. Cheque guarantee cards are a means of guaranteeing the payment of cheques up to a

stated amount. Cash dispenser cards are used to obtain cash from a cash dispenser machine

or automated teller machine (ATM). More recently, the development of the debit card has meant

that some of these plastic cards can be used to authorise an electronic debit to the cardholder’s

current account and a corresponding credit to the retailer’s account.

In many countries banks have combined the functions of the cash dispenser card, cheque

guarantee card, and debit card into a single card.

From the company’s point of view, there are several different charges that are relevant to these

cards. An annual fee will be levied for any charge cards supplied to employees. Far more

important to a retailer, however, are the charges levied by the merchant acquiring company

(normally a bank that ‘buys’ the transactions from the retailer at a discount). These include a

turnover fee charged by the credit card company which processes the credit card payments on

behalf of the retailer. The charges are negotiable and depend on the volumes of transactions,

the average transaction size, the method of processing and the credit quality of the transactions.

Float time and finality of payment on credit and charge cards vary not only from country to

country but also from company to company, depending on the deal negotiated with the

‘acquirer’ [1].

[1] An ‘acquirer’ is a financial institution - often a subsidiary of a bank - that ‘buys’ credit card

transactions, with recourse, from a retailer. The acquirer will present the transactions to the card

issuer for payment and will then pay the retailer the amount of the card transactions less a

discount - which covers their own and the card issuer’s fee for handling the transaction. This is

how retailers get paid.

3.4 Summary of payment and collection instruments in Europe

In summary, it is important to understand the payment norms in each country and the different

level of usage of instruments. Across European countries and the USA national characteristics

are apparent:

low use of cheques (Belgium, Germany, the Netherlands);

high use of cheques ( France, Greece, Ireland, Portugal, Spain, UK);

high use of ACH/giro system (Austria, Belgium, Finland, Germany, Italy, The

Netherlands, Norway, Sweden);

high use of Urgent EFT (Austria, Belgium, Finland, Germany, The Netherlands, UK);

high use of bank drafts (Greece, Portugal) and

high use of bills (France, Spain, Italy).

3.5 Payment instruments in other areas

Cheques are widely used in Asia-Pacific, the Middle East, USA, Canada and South America.

Several countries in the Asia-Pacific area have introduced giro-type services, but these tend to

be used mainly for consumer to business payments and direct debits.

3.6 Impact of payment and collection instruments on cash flow

The effective management of cash flow is an important part of a treasury function. Every

member of the treasury team can help to make sure that cash is received as quickly as possible

by encouraging the company’s customers to use the most efficient instruments. Treasury can

also ensure that the company uses the most appropriate methods of payment to suppliers. It is

important that the instruments in question are then factored into forecasting techniques.

Subsequently, forward projection of the anticipated inflows and outflows of cash allows a

business to assess whether it is likely to have short-term borrowing requirements or whether it

may be in a position to invest surplus funds. (Cash flow forecasting techniques are covered in

chapter 13).

While payment terms are often beyond the control of the cash management department,

efficient movement of cash into, out of, and within the company can have a significant impact on

cash flow and bank and interest charges.

Chapter 4 - Back to Basics - interest and bank charges

Overview

This final introductory chapter covers basic concepts such as interest calculation, bank charges

and ways to reduce them. (Bank tendering is dealt with in chapter 19: 'Selecting banks for cash

management purposes').

Learning objectives

A. To be able to calculate interest on a bank account

B. To understand the different types of bank charges levied for domestic services

C. To appreciate methods that can be used to reduce charges

D. To understand banks’ pricing/cost recovery strategies

4.1 Understanding domestic interest calculations

4.1.1 Value dates

When we discuss clearing systems in the following chapters we will see that cheques and

credits take several working days to clear. During this period, the 'value' of the items is not

available to the beneficiary. Clearly, the 'value date' applied to any transaction is different from

the date on which it appears on the bank statement (the ledger date). Taking the example of a

cheque drawn on a bank in one town and paid into an account at the account-holding branch in

another town, the credit will appear on the bank depositor's statement on the deposit day but

the 'value' will not be applied until some days later.

This difference between ledger date and value date has implications for the amount of interest

paid on the account. The important point is that the bank calculates interest on the 'cleared

balance' (ie only including transactions which have been cleared).

4.1.2 Interest calculations

A practical example of how a bank using the UK banking system works out the amount of

interest due to itself, or to a customer, on a current account, is provided in the next pages.

Many banks refer to this exercise as working out the 'decimals' or 'interest products' - a term

used for the calculation of interest payable. The example examines the basis of an overdraft

charge (ie the amount of interest due from a customer) on a non-credit interest-bearing current

account:

First, the bank established the number of days that a customer is overdrawn (by

reference to value dates) and then multiplied the overdrawn balance by the number

of days on which the customer was overdrawn at the balance in question). These

‘debit decimals’ are then added up.

The rest of the calculation involves using the customer's borrowing rate to

determine the amount of interest due to the bank.

Let us assume that the overdraft rate is 2% above the bank’s base rate of 4.0% ie

6%

1 day @ 600 = 600

3 days @ 1,100 = 3,300

2 days @ 1,000 = 2,000

7 days @ 1,205 = 8,435

10 days @ 1,605 = 16,050

TOTAL     = 30,385

Each 'debit decimal' represents an overdraft of one currency unit 1 for one day. So we can then

calculate the interest charge:

30.385 x 6.0% = 4.99

365*

*Note: The number of days used depends on the currency in question. For example Britain

(GBP) and Canada (CAD) use 365 days, but USA (USD) and Continental Europe (EUR) use

360 days.

The amount due to the bank (GBP4.99) will be charged to the customer's account, either at the

end of the month or the quarter.

Similarly, if the bank pays credit interest to the customer, it will calculate the interest in the same

way, based upon the credit balances.

Of course, these calculations are now worked out by computer, but it is useful to understand

how interest is calculated in order to check the bank calculations. Mistakes can and do occur

when information is incorrectly loaded into the bank's computer.

It is important to remember that calculation of interest only occurs after adjustment for any

amount of uncleared items. In the simple case of a cheque being paid into an account with a

zero balance and the same amount being paid out in cash the same day, the bank would

charge interest in respect of the uncleared effects for two or more days.

4.2 Bank charges

The fee levied by a bank for operating a customer's account for a period is known as

a bank charge. All banks have an extensive tariff of explicit charges for all the

services that they render, but these are normally negotiable by corporate

customers. These charges can be levied as a detailed tariff, a fixed charge or a

requirement to hold non-interest-bearing balances. The corporate customer should

always be aware of the basis on which charges are being paid.

The amount charged will vary according to several factors such as:

Balances maintained - A notional credit allowance on any non-interest-bearing

credit balances often offsets or reduces any charges

 

Turnover - Calculated based on debit or credit values through the

account

 

Number of entries - The more debits and credits the higher the charges. Each

type of transaction will have a different charge. But when

volume is sufficient, reductions can be negotiated.

 

Number of additional services

taken

- These additional charges can include stopped cheques,

returned cheques, ACH batch charges, statements

issued, pooling costs, management time, etc.

(Bank charges are discussed in more detail in chapter 10 - Foreign currency accounts)

4.3 Reducing bank charges

There are four broad areas that need to be considered when trying to reduce bank charges:

• understand the charging methods;

• review types of payments and methods of submission;

• reviewing existing arrangements and

• using better cash management techniques.

4.3.1 Understand charging methods

Customers should be aware that turnover charges rarely work to the customer's advantage and

that a fixed or per item tariff is normally more advantageous than either ad valorem or turnover-

based pricing. A 'sensitivity analysis' will enable the customer to identify the charges of most

importance to them. Interest rates and calculations should, of course, be checked as well as

commission charges.

Bank customers must understand how their charges are being calculated in order to be able to

reduce these costs.

Normally, there are no 'free' services given by banks, but there are services for which there is

no explicit charge. In fact, the cost for these services is often paid for by hidden charges

elsewhere.

However, hidden charges are less of an issue in those countries which have adopted Banking

Charters and/or the EC Directive on The Transparency of Banking Charges (see chapter 8

section 8.6).

4.3.2 Review types of payments and method of submission

Volumes of items need to be analysed to ensure that maximum use is being made of automated

low-cost payment methods such as future-dated electronic funds transfer, (giro or ACH) and

only minimal use is made of expensive same-day/urgent electronic funds transfers.

Banks tend to profit from economies of scale and will normally offer discounts for higher

volumes of items when they are automated. Moreover, spreading transactions between too

many banks often results in higher charges overall.

Payments that are delivered to the bank 'fully formatted' can be processed automatically using

straight-through-processing (STP) technology. These will also normally be charged at lower

rates than partially formatted payments that may require some manual intervention by the

bank's payment processing staff.

Unspecified supplementary charges should be avoided. These are particularly prevalent with

international payments and collections.

The increasing use of competitive tenders can be a powerful tool in reducing charges, but a

tender must be properly run if it is to be effective. The banks often seek commitment for several

years when submitting quotes and suggest the charges are linked to increases in the Retail

Pricing Index. This is usually not appropriate as an 'across the board' agreement. Often

corporate customers will offer their business for tender, enabling several banks to compete for

the company's custom. (Bank tenders (RFPs) are covered in detail in chapter 19.)

4.3.3 Reviewing existing arrangements

Companies often underestimate the delays inherent in their existing arrangements. Are cheques

that are received paid in promptly? Is there a quicker, more efficient, cheaper way of receiving

funds? Are the most cost-effective payment methods being used? Can the use of a courier help

accelerate the process?

An examination of payment procedures often leads to further economies.

4.3.4  Better cash management

Improved cash management techniques, from simple pooling or netting arrangements to more

sophisticated cash concentration facilities, can lead to significant reductions in costs or

improved investment returns (these techniques are discussed in detail in later sections of the

course).

Electronic banking has advantages and disadvantages, but can be an important tool that can be

used to improve cash management. However, companies should understand the increased

risks and responsibilities involved in its use.

Proper recognition of risk is also a fundamental function of better cash management.

In summary, companies should:

• seek competitive credit interest/debit interest on all balances;

• only pay a charge if they understand it and agree with it;

• compare terms and conditions available from other bank suppliers regularly;

• consider whether they can use the banking system more effectively and

• review their arrangements periodically, possibly using external independent advice.

Chapter 5 - Settlement and clearing systems

Overview

To provide an understanding of the main clearing and settlement system types and how they

impact on banks and banking customers.

Learning objectives

A. To understand the difference between 'net', 'gross', and intra-day or hybrid

settlement systems

B. To be able to identify these types of system and to understand their impact on

liquidity management

C. To understand intra-day exposure problems with net settlement systems

5.1 Settlement types

There are two basic ways that clearing systems settle*:

• end-of-period net settlement and

• real-time gross settlement.

A third option is a hybrid of these two, intra-day net settlement. This is practised by very few

systems (eg PNS in France)

*See glossary for definitions of clearing and settlement

5.2 Net settlement systems

To some extent, net settlement systems (NSS) represent the traditional approach to clearing,

where all the payments and receipts to clearing members are processed via a multilateral

netting system, resulting in one single amount being paid or received across each bank's

settlement account with the central bank at the end of each business period. Even in advanced

countries, cheque clearings are still settled on this basis (eg UK, Hong Kong). It is therefore not

surprising that when countries develop electronic clearing systems, settlement has initially been

based on the cheque model. Often low-value electronic automated clearing house systems

(ACH) settle on a net basis (eg BACS in the UK, ACH in the US, Autopay in Hong Kong), but

increasing settlement risks associated with NSS are causing concerns when used for high-value

transactions.

The problem with net settlement in high-value same-day clearing systems is that it gives rise to

intra-day exposures between participating banks. Funds received and credited to a customer's

account by a clearing bank (and possibly even withdrawn) do not become 'final' until settlement

occurs at the period end. The period may be a day or, in the cases of intra-day, net settlement

systems, part of a day. Therefore it is possible to build a large exposure to a clearing participant

that is unable to settle at the end of the period, leaving the receiving bank with a potential loss.

Some NSS do insist that participants lodge collateral to support these intra-day exposures.

At the end of each period all positions between participants are netted off and the participating

banks settle with each other across settlement accounts that are held specifically for this

purpose with the Central Bank in each country. Net payors to the system are debited and net

receivers are credited as appropriate.

5.3 Herstatt risk

This type of risk, also known as temporal risk, is named after Bank Herstatt that failed in the

mid-1970s and refers to risks which span more than one market or time zone - usually involving

foreign exchange or securities instruments. In the case of Bank Herstatt, the bank had entered

into a number of foreign exchange deals and received payment in the currency bought (USD),

but went into liquidation before it delivered the counter value European currencies. Bank

Herstatt’s failure to settle almost caused the collapse of the international banking system. In

more recent times similar problems occurred when BCCI and Barings Bank both failed.

The only way to eliminate settlement exposure of this nature entirely is to settle both

transactions at the same time using real-time gross settlement (RTGS) processes.

5.4 Real-time gross settlement systems

Because RTGS systems are designed to eliminate settlement risks, payments are cleared

singly and bilaterally as they occur. In recent years, RTGS systems have replaced net

settlement systems for high-value same-day transactions in most developed countries around

the world. In Europe all Emu and European Union countries have their same-day high-value

clearing systems working on an RTGS basis. Additionally, we are seeing countries in Asia

Pacific moving to real-time settlement of large transactions. For example, the RTGS system in

Hong Kong (CHATS) started operations in December 1996. More recently we have seen the

BOJNet Clearing system in Japan, RENTAS in Malaysia and PhilPaSS in the Philippines, all

operating in RTGS mode.

With RTGS a payment message is moved through the clearing house, so the paying bank’s

account with the central bank is debited and the receiving bank’s account is credited. As there

are no end-of-day procedures, such systems do not create intra-day exposures between

participants.

However, exposures may still arise between the settlement bank and the central bank if there

are insufficient funds in the settlement accounts. Different countries have different methods of

handling this.

In Switzerland, where the large-value clearing (SIC) was the first RTGS system in Europe, the

central bank does not allow settlement accounts to overdraw. Banks in Switzerland have real-

time access to their accounts and must check their balances before sending payments into the

system. Shortages must be funded from facilities granted by other banks.

In the euro-zone countries and the UK, the RTGS systems do permit settlement banks to

overdraw their settlement accounts intra-day with their national central banks, but any such

advance must be secured with the deposit of acceptable collateral.

The US Fedwire system operates on a similar basis.  The Federal Reserve Bank places limits

on the amount members may be overdrawn in their settlement account and reserves the right to

charge intra-day overdraft interest on any utilisation.

5.5 Types of clearing and settlement systems around the world

[not examinable]

5.5.1 Europe

Country RTGS System Net System

Austria ARTIS EBK

Belgium ELLIPS UVC/CEC

Denmark KRONOS Sumclearingen

Finland BOF/POPS PMJ

France TBF PNS/SIT

Germany RTGS+ RPS

Greece HERMES DIAS

Ireland IRIS EFTCo

Italy BI-REL BI-comp

Luxembourg LIPS-gross Lips-net

Netherlands TOPS Interpay

Portugal SPGT Telecompensacao

Spain SLBE SEPI

Sweden E-RIX(EUR)

K-RIX(SEK) BGC 

UK NewCHAPS (GBP & EUR) BACS

5.5.2 Asia-Pacific

Country RTGS System Net System

Australia RITS/HVCS (CS4) BECS (CS2)

China CNAPS Local Centres

Hong Kong CHATS ECG

Japan BOJNET Zengin

Korea Bokwire KFTC

Malaysia RENTAS IBG

New Zealand Austraclear/SCP ISL

Philippines PhilPass  PCHC

Singapore MEPS IBG

Taiwan CIFS (hybrid) IRS

Thailand BAHTNET Media Clearing

5.5.3 Americas

Country RTGS System Net System

USA Fedwire ACH

Argentina MEP  CECs

Canada LVTS ACSS

Mexico  SPEUA Pago interbancario

5.6 Hybrid clearing and settlement systems

These types of systems have been designed to reduce the need for collateral that a standard

net settlement system might need, whilst minimising the intra-day risk commonly associated

with them. They also provide intra-day, rather than end-of-day (or next-day) finality that is also a

common problem with standard end-of-day net settlement systems.

Such systems settle on a net basis, but at predefined periods throughout the working day. Like

traditional netting systems, such systems will settle across the settlement accounts held at the

central bank. In some countries the central bank may insist that banks maintain a separate

settlement account for these types of systems. In others they will insist that such settlement

accounts are pre-funded and will not allow banks to overdraw them, in contrast to an RTGS

settlement account which in many countries is allowed to be overdrawn during the working day

as long as collateral is deposited. A good example of such a hybrid system is CHIPS (see

section 6.4.6).

5.7 Continuous linked settlement (CLS)

The continuous linked settlement (CLS) system was created by the world’s largest foreign

exchange banks in response to central bank concerns about the impact of potential foreign

exchange settlement failure on the international financial system. Following the publication of

the Bank of International Settlements’ Report on Foreign Exchange Risk, the Allsop Report

(also known as the Orange Report), the twenty largest foreign exchange banks (G20) decided

to set up the continuous linked settlement system. Live since September 2002, CLS now has

more than 65 shareholders based in the United States, Europe and Asia-Pacific, which together

execute more than half of the world’s foreign exchange transactions. In the long run, it is

expected that CLS will process and settle up to 85% of all foreign exchange transactions

worldwide.

CLS is owned by CLS Group Holdings AG (CLS Group Holdings), a company incorporated

under the laws of Switzerland, and is regulated by the Federal Reserve as a bank holding

company in the United States. This holding company owns a number of operational companies.

The most important are CLS Bank International Inc, a US-based ‘Edge Act’ bank (banks that

operate under the ‘Edge Act’ can undertake only international business in the US.; they are not

allowed to compete for US domestic banking business) and UK-based CLS Services Ltd, which

manages and maintains the technical infrastructure that underpins CLS.

CLS Bank, which is regulated by the Federal Reserve Bank, the US central bank, acts as the

common counterparty between all participating banks with settlement taking place throughout

the working day A real-time net settlement system, CLS, even more than RTGS systems (which

are often set up for commercial payments), has the ability to eliminate Herstatt risk from the

international bank-to-bank foreign exchange markets, through simultaneous settlement of both

sides of a foreign exchange payment instruction. This contribution of CLS in reducing foreign

exchange cross-border settlement risk has been recognised and endorsed by the Bank of

International Settlements in its 1998 report on foreign exchange settlement risk.

CLS Bank currently handles transactions denominated in GBP, USD, JPY, EUR, CHF, CAD and

AUD, the most heavily traded currencies. Over time it will also process foreign exchange

transactions in DKK, SEK, NOK, HKD, SGD, and NZD. Operations are conducted from London,

which gives the maximum window of opportunity for the processing of foreign exchange

transactions between the different international currency centres (Asia-Pacific, Europe and

North America).

Participants

Participants in CLS can be subdivided into four categories:

settlement members can submit settlement instructions directly to CLS Bank on behalf

of themselves or their customers. The status of each instruction can be monitored

directly by the settlement member. Each settlement member has a multicurrency

account with the CLS Bank which enables it to move funds as required. As part of their

agreement with CLS Bank, settlement members are allowed to provide a branded CLS

service to their third party customers. To qualify as a settlement member a financial

institution must be a shareholder of the CLS Group and have adequate financial and

operational capability as well the ability to provide sufficient liquidity to meet any CLS

commitments;

user members are allowed to submit settlement instructions for themselves and their

customers, but, unlike settlement members, they do not have an account with CLS

Bank. Instead, they are sponsored by a settlement member who acts on their behalf.

Consequently, to be eligible for settlement each instruction submitted by a user member

must be authorised by a designated settlement member. Settlement occurs via the

designated settlement member’s account;

third parties are customers of settlement and user members. They have no formal

relationship with CLS Bank and can only access the service through a user or

settlement member. Third parties are third-party banks, custodians, non-bank financial

institutions and companies and

liquidity providers are major settlement members who have agreed to guarantee

liquidity in case a bank is unable to meet its liquidity obligations under CLS. In line with

the Lamfalussy recommendations on settlement systems, there are two liquidity

providers per currency zone.

CLS Bank infrastructure

CLS Bank holds RTGS settlement accounts with each of the participating central banks (Bank

of England, Reserve Bank of Australia, Bank of Canada, European Central Bank, Bank of

Japan, US Federal Reserve and Swiss National Bank). In addition, each of its settlement

members has multicurrency accounts with CLS Bank. Communications between CLS Bank,

settlement members, the national RTGS systems and third parties is effected via SWIFTNet

(See Section 7.11). Using this infrastructure, CLS settles transactions simultaneously in real

time.

Processing cycle

Diagram 5.1: CLS processing cycle

CLS has been set up so as to overlap the working day in the currency centre of each currency

that is processed. In practice, this means that all transactions have to be conducted within a

five-hour window.

Following a foreign exchange transaction, members submit instructions to CLS, which matches

the instructions and stores them in the system until value date for processing.

At the start of the settlement day (00:00) CLS Bank calculates a provisional pay-in schedule for

each member based on the instructions due to settle that day. This schedule includes the

minimum amount of each currency to pay and the times by which the payments must be made.

Up till 6:30 CET, start of the settlement day, members can submit settlement instructions

directly to CLS Bank for processing. Members are able to review their net pay-in totals at any

time before the start of the settlement day. Between 00:00 CET and 6:30, CLS identifies and

calculates any intraday SWAP opportunities between different members. By implementing so-

called inside/outside swaps (I/O SWAPS), ie, intraday swaps of two equal and opposite FX

positions, CLS reduces members’ overall intraday liquidity requirements while leaving their FX

positions unchanged. At 6:30 CET members receive their final pay-in schedule for that

settlement day. As payment requirements are based on the net position for each currency rather

than on gross transaction-by-transaction basis, funding requirements are substantially reduced.

Each settlement member pays in the required currency amounts either directly via an approved

payment system, if they are participants, or by using ‘nostro’ agents[1]. Once the first funding is

paid in, the settlement cycle starts at 07:00 CET. Members can track their positions continually

thus avoiding costly operational errors. While the members’ overall accounts need to remain

positive, they can use surpluses in any currencies to settle other currencies.

CLS Bank settles the instructions that have been validated and matched after checking that

both settlement member accounts are in credit and that settlement of the instruction will not

cause either settlement member to exceed its limits. Instructions that fail this check are queued

for the next cycle. They will be continually revisited till they settle. If trades fail to meet the

settlement criteria by the end of the working day, they will not be executed and no funds will be

exchanged.

This cycle is repeated every few minutes with a completion target time for all instructions of

09:00 CET.

Between 9:00- 12:00 CET all short and long positions are paid out so that there are no

outstanding funds left in the settlement accounts.

Implications for banks

CLS not only greatly reduces the risks associated with settling high-value foreign exchange

transactions using international fund transfers, it also has a positive impact on the cost involved

with such transactions. Like any netting system, it considerably reduces the number of bank-to-

bank payments, but unlike ‘traditional’ netting systems, it operates throughout the working day.

Additionally, it does not require the deposit of collateral, as most RTGS do, to cover daylight

overdrafts at each central bank.

CLS also gives banks the opportunity to re-engineer their liquidity management to take

advantage of the fact that less funds are tied up in the system either as collateral in the form of

money market instruments or as central bank balances. This re-engineering of liquidity

management is vital as the just-in time payment processes of CLS will impose greater demands

on a bank’s intra-day liquidity. Indeed, some commentators argue that while CLS has been

successful in eliminating foreign exchange settlement risk, it has, by shortening the foreign

exchange trading cycle, significantly enhanced the risk of a global ‘liquidity crunch’.

To take full advantage of the benefits of the system, banks will also need to remodel their

systems and working practices around the CLS timetable. They will have to build new, or modify

existing, systems to be able to pass on the benefits of lower risk settlements to their customer

(mainly other banks, but also larger companies). In addition, banks offering CLS services will be

forced to develop adequate reporting and tracking capabilities both for internal usage and for

their third-party customer base. The enhanced systems will also need to distinguish between

CLS and non-CLS trades.

Banks that act as correspondents for CLS users and members will have to upgrade so as to be

able to offer real-time payment execution and reporting.

These extra demands put on banks’ liquidity management and systems means that in the long

run CLS will probably lead to a rationalisation in the number of banks providing foreign

exchange services as a user or settlement member.

Implications for non-bank financial institutions and corporates

While initially focused on the inter-bank market, CLS is gradually extending its reach to other

markets. One of the most important areas being the securities market, where CLS is already

working with the world’s leading custodians to facilitate fund managers’ foreign exchange

transactions.

In the long run, CLS should also have a major impact on the corporate sector. On the most

fundamental level CLS offers treasurers greater certainty in terms of trade execution and hence

allows them to improve their cash management. It also eliminates the risks associated with

using different banks and different settlement systems. In addition, CLS offers considerable

advantages in terms of straight through processing and reporting opportunities for each of the

participating currency zones. Settlement members can now provide foreign exchange services

and intraday reporting on a global scale for all currencies involved. This will in turn allow

multinational companies to rationalise their correspondent banking arrangements and further

improve their global cash management.

In the meantime, companies will have to adapt to the new CLS-reality, whereby an ever

increasing number of trades will be conducted via CLS. While it remains as yet unclear how far

banks will be prepared to pass on the long-term cost savings benefits of CLS, corporates will

benefit from the reduction in foreign exchange risk offered by CLS. To benefit from the reduced

risk and potentially lower charges offered by CLS, companies will have to link up with a bank

that can offer CLS services. This can be a third-party bank (several of the settlement members

are selling their services as a white label package to smaller non-CLS eligible banks) or a user

or settlement member. While smaller occasional FX users might use CLS via third-party banks,

larger companies will be more inclined to select a settlement or user member bank so as to

minimise the costs associated with using a third party bank.

However, as under the CLS rules each third-party participant can only use one single third-party

services provider for all the currencies, selecting such a provider will require companies to

review carefully their long-term foreign exchange strategy. As with banks, the strict timelines

imposed by CLS will also put greater demands on companies. One of the consequences could

well be an increased outsourcing of corporate treasury back offices. Companies also need to

look afresh at their banking arrangements. As mentioned above, the CLS service provider will

execute and monitor the foreign exchange transactions for each currency and may, in some

cases, eliminate the need for having an account ‘in-country’ bank in each of the currency areas.

CLS also has important consequences for foreign exchange portals (See Section 21.18). Until

now, companies trading on multibank portals needed to put in place extensive credit risk

guarantees for each new counterparty. As CLS operates on a payment versus payment basis, it

should become easier for companies to trade with counterparty banks without having to

increase credit lines/limits.

[1] Nostro agents play a vital role in CLS as they need to be able to process swiftly the payment

instructions received from settlement members via the respective RTGS systems in which the

settlement members do not participate directly. ‘Nostro’ agents often act for several settlement

members. Given these strict requirements ‘nostro’ services are generally provided by the large

commercial banks in each of the currency zones.

Chapter 6 - Clearing systems around the world

Overview

Although this is a large section, it is not possible to look at all the clearing systems around the

world in a course like this. While some clearing systems are less developed and based solely on

manual paper-based exchanges, most are mechanised in some way. Here we will look at Hong

Kong, India, the US, the UK and Germany.

Between them, these countries offer examples of the various alternative methods for clearance

and settlement most commonly used around the world.

Learning objectives

 A.  To obtain an appreciation of how clearing systems in different countries operate

B.  To explain the process of cheque clearing

C.  To appreciate the use of direct debits and the ACH

D.  To explain how high-value electronic clearing systems operate in detail

E.  To understand the regulatory environments

F.  To understand some of the new technologies being introduced into clearing and

transactional banking

6.1 Different types of clearing systems

Each developed country has its own local domestic clearing system or systems with its own

rules, regulations and methods of operation. However, there are many similarities between

systems. Some countries will have three or more types of payment clearing system.

There are generally separate systems for clearing:

cheques cleared as paper and paper-based credits;

cheques dematerialised or truncated;

urgent and/or large-value payment and

non-urgent and/or low-value high-volume payment (ACH/giro payments, direct debits

and standing orders).

In some countries, there may be further systems used to clear local currency transactions

initiated overseas as well as locally based foreign currency transactions.

It is not possible to consider all countries, but in this chapter we will look at systems in countries

that are fairly representative and provide good examples of typical systems that are seen

globally.

Hong Kong is an example of a highly developed Asian centre while the USA is the home of the

currency that has historically dominated trading. Germany is the home of the European Central

Bank (ECB). The UK is the most important financial centre in Europe, but is outside the euro-

zone and India is a good example of a developing country where clearing payments is still a

challenge.

6.2 Hong Kong

6.2.1 Background

Unlike many other countries in Asia-Pacific, Hong Kong has no central bank as such. Instead, a

monetary authority, the Hong Kong Monetary Authority (HKMA) fulfils a similar type of role,

except that in addition to the HKMA three commercial banks issue bank notes in Hong Kong.

There are around 140 licensed banks as well as approximately 48 institutions with a restricted

license and approximately 50 depository companies. In addition, there are over 100 foreign

banks that maintain representative offices in Hong Kong.

Hong Kong is a very free (ie, low regulation) market. There are no foreign exchange controls

and there are active spot and forward foreign exchange markets. In terms of banking, there are

no reserve requirements imposed and, somewhat unusually, the Hong Kong dollar (HKD) is

pegged to the US dollar (USD) at a rate of HKD7.78 to USD1.

The Hong Kong clearing house is owned by the Hong Kong Association of Banks and is run on

its behalf by the Hong Kong Interbank Clearing Ltd (HKICL). All licensed banks participate as

settlement members. Banks with a restricted license may but are not obliged to become direct

participants. Banks that only wish to participate indirectly must buy their services from a

settlement bank and will hold a settlement account with that bank.

The settlement banks themselves hold a set of settlement accounts with the Hong Kong

Monetary Authority over which all clearing items are settled. The clearing systems in Hong Kong

also operate on Saturday mornings.

6.2.2 Cheque clearing

Cheques are cleared in Hong Kong in a similar way to the majority of cheque clearing systems

in other developed countries around the world. It is fair to say that the clearing system in Hong

Kong is based largely on the UK system.

Diagram 6.1 illustrates company A sending a cheque to company B in settlement of an invoice.

Company B will pay it into its local bank where it will be credited to its account with two days’

uncleared value. Bank B will then send the cheque to its processing department where it will be

encoded, microfilmed, batched and balanced. What is slightly unusual about Hong Kong is that

outward sorting of cheques into separate bundles by bank is done at the clearing house (in the

UK and other countries the banks themselves sort them into bundles or trays by bank).

Batches of balanced transactions are forwarded to the clearing house and are reconciled. They

are then sorted and dispatched to the drawee banks together with disk files of all the

transactions.

Once received at the drawee banks’ processing centres, the disks are loaded onto their

computers and items are deducted from customers’ (the drawers’) bank balances. The physical

cheques are then sorted by branch and account number and the items are physically delivered

to the bank branch on which they are drawn.

Unpaid cheques must be returned to the clearing house by 13:00 (local time) on deposit day +1

so that they can be returned to the collecting bank by 15:00 on D+1 in time for the clearing and

subsequent settlement. Settlement between bank A and bank B will occur across their

settlement accounts at the Hong Kong Monetary Authority at the close of business on the day

following the day of deposit for items received prior to the 5pm cut-off. Finality is 15.00 D+1.

The HKICL also clears US cheques. HKICL and its member banks are currently implementing

an industry-wide cheque truncation project using image technology. The new system is

expected to go live in the second half of 2003.

6.2.3 The ACH system

The electronic clearing (ECG) system includes Autopay and handles both low-value credit

transfers and direct debits (widely used in Hong Kong). To set up a direct debit, a debit and

creditor agreement (where the debtor completes a mandate which is sent to the debtor’s bank)

must first be put in place. The debtor’s bank verifies the arrangement and sets up its internal

records on its computer. The collecting bank provides a method to the creditor for initiating the

direct debit. The mechanism used for origination of both credits and direct debits can be as

simple as a paper-based system, where a company may fill out forms and present them to their

bank. But, in most cases, users are likely to present items on diskette, or by direct file transfer,

or through an electronic banking system.

Diagram 6.2 : ECG system (Hong Kong)

Diagram 6.2, which shows a transaction between a consumer and company A follows the

course of a direct debit transaction, but a credit transfer operates in exactly the same way.

Company A produces details of all direct debit transactions onto a disk and forwards them to the

clearing house. The clearing house sorts the transactions by bank and produces a file which is

forwarded to each bank. This will not only contain direct debit items but also credit items which

are processed through the same system. On day 2, the settlement accounts which the two

banks hold with the Monetary Authority will be debited and credited. On day 2 the consumer has

his account debited and the supplier’s bank will have their account credited. The actual

settlement takes place across the accounts at the Monetary Authority at about 13:00 (local time)

on day 2. The supplier’s account may not be credited until the next day as some banks take one

day’s float

6.2.4 Large-value payment system

Hong Kong’s large-value payment system is known as The Clearing House Automated Transfer

System) (CHATS) and is a real-time gross settlement system.

In this example, company A has sent a payment instruction to his bank, bank A. For larger

companies, particularly those with high volumes, this may be via an electronic banking system.

Middle-sized companies might use more traditional methods such as a signed letter or

completed bank form and the bank will have to process the item. Company A's account has

been debited and a payment message is sent through the clearing house. On receipt at the

clearing house, bank A's settlement account with the Monetary Authority will be immediately

debited and bank B's account will be immediately credited. The clearing house will then advise

bank B of the transaction whereupon bank B can credit company B.

A feature of this system is the acknowledgement between the clearing house and bank A that

the payment message has been received and processed. As with all other real-time gross

settlement systems, settlement occurs as the transaction is processed when entries are passed

across the settlement accounts.

Settlement of the non-RTGS clearings (ie, cheques and Autopay) takes place across CHATS at

the times indicated.

In addition to the HKD RTGS system, Hong Kong has also established a USD RTGS system.

USD CHATS is also operated by the HKICL with the HSBC banking group acting as the

settlement bank. Additionally, the HKMA is looking at establishing specific RTGS clearings for

EUR and JPY denominated transactions.

6.3 India [Non examinable]

6.3.1 Background

India has the second largest population in the world with the seventh largest land mass. The

abundance of low paid, but often skilled labour is one of the reasons why India has been

relatively slow to computerise banking, business and commerce. This is reflected in the way

banks and the clearing systems and processors operate:

the Indian rupee (INR) is not convertible and the central bank, the Reserve Bank of

India (RBI), has to approve majority of the cross-border transactions with foreign

entities. Following the enactment of the Foreign Exchange Management Act (FEMA) in

1999, significant authority has now been delegated to banks;

companies that are less than 51% Indian-owned are regarded as non-residents and are

subject to extra regulation;

the corporate tax rate in India for the financial year 2002-03 is 35% for domestic

companies and 40% for foreign companies with an additional surcharge of 5% for both

types of companies. There is a withholding tax of 10% on interest and dividends. All of

these may be reduced where tax treaties are in place;

there are over 297 banks operating with 68,000 branches (according to March 2001

figures). The system is dominated by state or semi-state-owned institutions, in particular

The State Bank of India (SBI) which with its seven associated banks has a network of

over 13,500 branches. Foreign banks are also widely represented;

the money and foreign exchange markets are very volatile and only about 50% of banks

have special authorisation for conducting foreign exchange deals and

banking centres on four major cities: Mumbai (Bombay), Kolkata (Calcutta), Chennai

(Madras) and New Delhi. Most banking activity is in Mumbai.

6.3.2 Payment and clearing systems

There is no national clearing system, but there are 14 clearing houses located in the four major

urban centres and ten other larger cities. These are controlled by the RBI. There are also 965

local clearing houses set up in towns run by the SBI and its associate banks and another 7 run

by other nationalised banks. Cheques drawn on branches of the same bank are cleared

internally.

The clearing process can be broadly subdivided on a geographical basis (local versus outstation

clearing) and an operational basis (manual versus electronic).

6.3.3 Local clearing/collections

Local clearing can be classified into four clearing processes

high-value cheque clearing;

interbank clearing;

magnetic ink character recognition clearing (MICR) and

non-MICR clearing.

6.3.3.1 High-value cheque clearing

A special clearing in which instruments of high value only (INR100,000 or above) drawn on

notified branches are presented for settlement only at Mumbai (Bombay), Delhi,

Kolkata(Calcutta), Chennai (Madras), Bangalore, Kanpur, Jaipur, Hyderabad, Bhubaneshwar,

Chandigarh, Thiruvananthapuram and Ahmedabad.

The cheques are required to be deposited in the bank by 11:00 (local time) at the latest, as

these have to be presented to the clearing house by 12:00 (local time). The following activities

have to be undertaken by the presenting bank in their offices before taking the cheques to the

clearing house:

manual/auto sorting of the instruments by drawee bank;

generating an input statement (list of items presented) giving details of number of

cheques and total value of the cheques, by each bank and

input statement data given on a disk to the RBI.

The cheques that have been sorted by bank are deposited in a mailbox earmarked for that

particular bank in the clearing house. The input data is given to the RBI on disk. It merges the

data received from all the banks and debits banks'settlement accounts maintained with it for the

amount of inward clearing received and credits the amount for outward clearing received. The

drawee banks collect the cheque instruments and process them at their own processing centre.

They debit their clients accordingly while the presenting banks pass on the credits due to their

clients. The credits in high-value cheque clearing are passed to the client on the same day, but

with next-day availability.

6.3.3.2 Interbank clearing

This is a special clearing system for banks' payment orders/cheques in respect of interbank

transactions like funds transfers, call money operations, settlement of clearing differences, etc.

It is irrespective of value. The clearing volumes are lower than those seen in the high-value

system as payments are to be made for specified purposes only.

The RBI has made it clear that interbank clearing should reflect only specific transactions

between banks and should not be used for customer transactions. The cut-off time for interbank

transactions is 14:30 (local time). The clearing house at the RBI meets at 15:00 for settlement.

Banks presenting items obtain same-day value across their settlement accounts at the RBI.

These timings are specific to the Mumbai clearing house and can be different in the other

centres.

6.3.3.3 MICR clearing

MICR clearing is in operation at the four metropolitan centres (ie, Mumbai (Bombay), Kolkata

(Calcutta), Chennai (Madras) and Delhi) plus 22 major cities. In Mumbai more than one million

cheques are processed daily by the clearing house.

Before presenting the cheques to the clearing house, the banks have to list the cheques,

prepare schedules and encode the cheque amounts. The cheques have to be presented in the

clearing house between 17:00 and 19:30 (local time) on weekdays or between 14.30 and 16:00

(local time) on Saturdays. Each bank has typically about three-to-four hours available to it after

the close of banking business to complete processing in order to be able to present the cheques

for same-day clearing.

The sorting and listing of cheques at the clearing house is carried out by high speed reader

systems. The different stages involved in the cheque processing at the clearing house are:

prime pass;

online reject re-entry;

adjustment and balancing, fine sort;

report generation and

manual sorting of rejected instruments by the drawee bank.

The processing operation is completed by the clearing house during the night.

The accounts of the drawee banks maintained at the RBI clearing house are debited the next

day for the amount of inward clearing received from all the presenting banks and the accounts

of the presenting banks are credited for the amount of the outward clearing received from them.

The drawee banks also collect the cheques drawn on them in the morning and have until 16:00

(local time) to return any unpaid or rejected cheques. The clearing house then debits the

account of the presenting bank for the amount of any returned cheques.

The process flow from the customer's point of view is:

Day 1 - The cheque is deposited by the customer in his account and the bank also sends the

item for clearing on the evening of day 1.

Day 2 - RBI credits the presenting bank's account and debits the drawee bank's account. The

collecting bank will credit the item to the customer's account but it will show as uncleared effects

and

Day 3 - The bank will change the status of the cheque deposited by the customer from

uncleared to cleared. The customer is only allowed withdrawal of funds once they have become

cleared. This is done as at the close of business. However, for corporate customers enjoying

overdraft lines, the system will give value day 2 as the bank has already been in funds on day 2.

6.3.3.4 Non-MICR clearing

The local clearing procedures outside the major centres where MICR cheques are not used, are

similar to those described above. However, the presenting banks have to sort the cheques by

drawee bank before delivering them to the clearing house. The inward clearing work is also

manually intensive as the drawee banks have to manually debit each of their customer's

account unlike in the MICR clearing where auto-posting takes place by using the inward clearing

data supplied by the RBI on a disk.

6.3.4 Outstation clearing / collections

The time taken for the collection of outstation cheques is between seven days to a month. The

law requires that cheques presented at one centre drawn on another centre have to be

physically delivered to the drawee centre. The existing intercity clearing procedures are:

6.3.4.1 Two-way intercity clearing

Two-way intercity clearing is for cheques received for collection at any of the four major

metropolitan centres (metros) and drawn on a drawee located in the other three metros (eg, a

cheque collected in Mumbai drawn on any of Kolkata, Chennai or New Delhi). The presenting

bank at the cheque collection centre deposits the cheques for collection at the local national

clearing cell (NCC). The collecting NCC sorts and lists the instrument by centre and sends the

items by courier to the NCC located at the drawee centre. The NCC at the drawee centre

presents the instruments to the local clearing. After settlement the NCC returns credit notes

along with the unpaid instruments to the collecting NCC by courier. The collecting NCC credits

the bank’s accounts and returns the unpaid cheques to the presenting bank. The collecting bank

thereafter credits the customer’s account. Processing by the NCCs takes five-to-six working

days.

6.3.4.2 One-way intercity clearing

Cheques drawn on a drawee located in any of the four metropolitan centres and collected at six

centres (Ahemdabad, Bendalore, Hyderabad, Nagpur, Kanpur and Thiruvananthapuram) are

cleared by sending them to the respective NCCs. The procedure is similar to the one described

in section 6.3.4.1.

6.3.4.3 Regional grid clearing

The small centres are linked only to the nearest metros. The cheques drawn on a drawee

located in the nearest metro are collected through these small centres and sent for clearing by

courier. The process used is the same as for one-way clearing described in section 6.3.4.1 and

2.

6.3.4.4 Normal outstation non-metro centre collections

Cheques drawn on centres outside the four major centres are sent by courier/post to the drawee

bank. The drawee bank will then send the instruments for local clearing, realise the proceeds,

produce a demand draft and send it by mail. It can take between seven and 30 days from the

time that the customer deposits the cheque at the bank to the time that the customer's account

is credited.

Diagram 6.4: Normal outstation – cheque collection

6.3.4.5 Special outstation cheque collection

Some banks have put in place better arrangements, particularly if they have local branches or

correspondents and can reduce the time to clear items to four or five days.

The process flow from the customer’s point of view is: 

Day 1 - The cheque is deposited by the customer in his account and the bank also

sends the item for clearing on the evening of day 1;

Day 2 - RBI credits the presenting bank’s account and debits the drawee bank’s

account. The collecting bank will credit the item to the customer’s account but it will

show as uncleared effects and

Day 3 – The bank will change the status of the cheque deposited by the customer from

uncleared to cleared. The customer is only allowed withdrawal of funds once they have

become cleared. This is done as at the close of business. However, for corporate

customers enjoying overdraft lines, the system will give value day 2 as the bank has

already been in funds on day 2.

Diagram 6.5: Special outstation cheque collection provided by some cash management

banks

6.3.5 Electronic clearing service (ECS)

6.3.5.1 Credit clearing

ECS credit clearing handles large volumes of low-value repetitive payments such as interest,

dividend and payroll in the major Indian cities.

The companies submit data on disks to their bank, which in turn submits the items on disks to

the clearing house. The clearing house processes the data and generates reports for each

receiving bank with full details of amounts, accounts and the branches to be credited along with

the remittance details of the payments to be made. The clearing house will then debit the paying

bank's account with the RBI and credit the account of the beneficiary banks. The banks then

pass on the debits and credits to their respective account holders.

At present, this scheme is operative in only 46 cities. Payment values are capped at

INR500,000.

6.3.5.2 Debit clearing

ECS – debit clearing handles pre-authorised direct debits to the customer’s account. These are

usually for utility and telephone bills, insurance premiums, lease instalments and loan

repayments in the metro. At present, this scheme is operative in only 18 locations. Payment

values are capped at INR 5,00,000.

6.3.6 Payment/funds transfer

6.3.6.1 Payment methods available

The payment methods available to companies are demand drafts, telegraphic transfers and mail

transfers. In addition, electronic funds transfer methods have recently been introduced. All,

except the electronic funds transfer, require significant manual processing at both the originating

and destination ends of the fund transfer. For the funds transfer to be effected, the remitting

bank branch either has to have its own branch or a correspondent bank at the destination

centre. The remitter's account is debited when the funds transfer is originated, but the funds will

usually remain with the issuing bank until the payout is made to the beneficiary. These paper-

based methods of fund transfer also create inter-branch accounting and reconciliation work.

6.3.6.2 Demand draft (DD)

This is a paper-based funds transfer. DD is a payment instrument issued by a bank branch in

favour of the specified beneficiary and payable at a branch of the bank at another centre. The

bank at the time of issuing the DD debits the customer's account. The customer then sends the

instrument to the beneficiary. The beneficiary deposits the instrument at his bank for processing

through the local clearing. Once cleared, the proceeds are credited to the beneficiary's account.

6.3.6.3 Telegraphic transfer (TT)

TT is an instruction issued by the branch of a bank to another outstation branch by telex for

payment of funds to a specified beneficiary. The instruction has a high level of security as it is

coded to protect sensitive particulars of the fund transfer message, eg amount and beneficiary

details. This form of funds transfer is an improvement over the DD as no physical movement of

the instrument takes place with the attendant risks of it being lost. However, in the event of the

beneficiary not having an account with the remitting bank, a local pay order is issued which the

beneficiary then deposits at the beneficiary's own bank for processing through the local clearing

system.

6.3.6.4 Mail transfer (MT)

The MT is an instruction sent by mail by a bank to its outstation branch requesting the latter to

credit the account of a specified account holder. The remitter's account is debited immediately

and the bank has use of the funds until the outstation branch pays the beneficiary. The time

taken for the proceeds to be received by the beneficiary is much longer (seven to ten days) due

to postal/courier transit times.

6.3.6.5 Electronic funds transfer

The RBI has set up an electronic fund transfer system (EFT). At present, this system covers 14

cities and there are plans to increase it to all 15 RBI centres subsequently.

The funds transfer requests received by banks on day 1 are sent electronically/ on disks to the

local clearing house. The clearing house consolidates the messages received from all banks

and sorts them into files by destination. The files are transmitted through a dedicated

communication network to all destination centres, which prepare output files for each bank and

transmit them to the main branch of the respective beneficiaries’ banks. Beneficiaries will have

their account credited on day 1 or 2 depending upon the predetermined cut off timings.

The development and expansion of EFT on a country-wide basis will require computerisation at

branch level across nationalised banks, where, at present, the level of technology is low. To

boost the development of e-commerce facilities, the Information Technology Act, 2000 was

passed. This Act provides a legal framework for activities carried out via electronic means and

provide legal sanctity to all electronic records.

RBI ultimately aims to establish an e-enabled RTGS system which would integrate all existing

payment and settlement systems. The objective is to have the system up and running towards

the end of 2003.

This section has been updated, courtesy of HSBC

6.4 The United States of America

6.4.1 Background

The United States of America is a large complex marketplace with an equally large and complex

banking system. Due to many years of restrictions on operations outside a bank's home state,

there are approximately 11,000 banks in the USA (many are one-branch operations). This has

meant that companies with operations right across the country have had to put in place fairly

complicated banking arrangements, and the banks themselves have had to enter into

arrangements and clearing processes that are unusual in developed environments. Added to

this, since the 1950s, the US dollar (USD) has been the primary currency for the settlement of

international trade transactions. Although many foreign banks maintain branches or strong

correspondent relationships in the US to serve their own and their customers' clearing needs,

many large non-US companies have found it necessary to establish bank accounts directly with

US banks when the volume of their USD transactions grows to a reasonable level.

In the last few years the number and value of international USD payments has grown

dramatically due to the growth in both international trade and in the volume of foreign exchange

trading. Equally, increases in the volume of domestic money market trading, the emergence of

more multinational corporations and the development of sophisticated cash management

services have all led to increases in money movement and hence the need for efficient clearing

and settlement systems.

New York continues to be the primary financial centre for international USD payments, although

other centres, such as Chicago in the Midwest and San Francisco on the West Coast, are also

important.

In New York, participants include institutions referred to as the 'money center banks' and the

'Edge Act'[1] offices of non-New York banks, together with the New York branches of foreign

banks.

6.4.2 The regulatory environment

The Federal Reserve System was created by the US Congress in 1913 to serve as the central

bank of the USA. Known as the 'Fed' , it:

supervises and regulates 'depository institutions' - the myriad of bank and bank-like

financial institutions;

manages the supply of money and credit in the economy;

issues notes and coins;

provides some banking services to the government and

makes short-term loans to and provides services for financial institutions.

Overseen by a Board of Governors, the Federal Reserve System consists of 12 regional

Federal Reserve banks (see diagram 6.7). These hold reserve and settlement accounts for their

member institutions and provide such services as the Fedwire money transfer service, cheque

clearing facilities, as well as the automated clearing house (ACH).

The Fed is self-supporting and earns its income by charging for its services.

Diagram 6.7: The federal reserve system: the regional federal reserve banks

 

DISTRICT

Boston

New York

Philadelphia

Cleveland

Richmond

Atlanta

Chicago

St. Louis

Minneapolis

Kansas City

Dallas

San Francisco includes Alaska and Hawaii

6.4.3 The automated clearing house - ACH

 

The ACH system is probably the simplest of the US money transfer systems, but the least

understood by both companies and bankers alike outside of the US.

It provides a funds-transfer system for the settlement of domestic transactions to US depository

institutions through a network of 42 regional ACHs. The regional ACHs are controlled by

financial institutions which are members of NACHA (the National Automated Clearing House

Association). Most ACHs are run by the regional Feds although some are privately run by

companies such as Visa.

Originally set up as a way of reducing cheque payments, the ACH was established in 1973 to

handle low-value high-volume, mainly repetitive payments on a batch basis. Using the ACH

network, consumer or corporate accounts at any NACHA financial institution can be debited or

credited electronically. Such transactions are strictly regulated through the 'Funds Transfer Act' ,

Regulation E and Regulation UCC4A (see chapter 24 for details of UCC4A).

Corporations use the ACH because it provides a low-cost and convenient alternative to cheques

or standard electronic funds transfers. Payroll, pension and annuity payments account for

around 96% of all ACH credit items, while approximately 75% of debit items are collections of

insurance premiums and other consumer bill payments. Remaining items mainly relate to

corporate cash concentration and trade payments. Interestingly, the recent annual growth of the

ACH system is largely due to the increase in its use by companies for larger value trade

settlements.

To implement an ACH payment programme, the originating company must obtain the approval

of the party to be debited or credited. The company then creates a computer file of transactions,

usually directly in ACH format with a specified value date, which it forwards to its bank for

processing. If it cannot do this, a company can make use of an ACH bureau, which can accept

transactions in any form, including paper. It will then convert the items to ACH format and

forward them on to the bank on the company's behalf as a computer file. Files may be

submitted on tape or disk, or via computer-to-computer files. Unlike Hong Kong or the UK,

where files are delivered directly to the clearing centre, ACH files have to be submitted via an

originating bank.

Having processed any items on the file for its own accounts, the bank forwards the file to its

regional ACH where items destined for banks in the same region are passed to the respective

receiving banks. Items for other regions are forwarded to the appropriate regional ACH (and

then on to the receiving banks).

Both originating and receiving banks debit or credit their customers and settle at the Fed on

settlement day. As the ACH process takes one or two days (depending on whether transactions

are local or inter-regional or debit or credit items) settlement will be either one or two days after

origination. Generally, there is no float associated with the ACH except for companies with poor

credit ratings, where their account may be debited on origination to reduce the bank's credit

exposure.

In normal circumstances US banks will regard an ACH service as having a two-day credit

exposure, and a facility will be required accordingly.

At present, ACH credit transactions are not normally considered

cleared or ‘final’ until 8:20EST on settlement day. Debits are not

considered final until opening of business the day following

settlement, while consumer debits can be returned up to 60 days in

the case of unauthorised transactions.

Diagram 6.7: Automated clearing house transaction flow

6.4.4 Access to the ACH from outside the USA

As the description above notes, the ACH system is a domestic payment system and is very

cheap. So, if a foreign company can have a USD bank account with a US bank, why can it not

get access to this very cheap domestic payments and collections system? In theory, it can if it

uses the right bank. Some US and international banks provide direct access to the US ACH

system cross-border.

Consider the following transaction scenario: An Italian pension fund, XYZ, wants to pay a US-

based pensioner the USD equivalent of his Italian EUR-denominated pension. He will instruct

his Italian bank: "Pay the USD equivalent of EUR2000 to Mr X at Y Bank, Chicago, account

number 12345" (transaction A). The Italian bank will take an exchange commission (usually

0.5%) and charge a fee for the funds transfer (typically between EUR10 and 20). We will

assume a total charge of EUR20.

If the Italian pension fund XYZ held an account in the US and was able to initiate an ACH

transfer from Italy, the charge for the underlying transaction would be less than USD1

(transaction B) plus, of course, a charge for the international communication link. A typical

charge for such a service might be a maximum of USD2 or 3.

From a bank revenue standpoint, transaction A brings in EUR20 but transaction B realises

USD3 at most. Additionally, transaction B may make the banker one day’s float because of time

zoning and the one-day delay on the ACH, but the earnings on the float are minimal. Therefore,

most banks will also charge a monthly electronic banking platform subscription as well as

service fees.

What are the differences in the bank's costs? This depends on which bank is used. If

transaction A was executed through a branch of an Italian high-street bank at a price of EUR20,

it is still possible that the bank would lose money on it by the time they incurred telegraphic,

SWIFT, correspondent bank and clearing charges. A fully automated international bank,

however, would earn an attractive profit if the transaction was electronically initiated. Some low-

cost operations might make as much as 50% above their marginal cost.

With transaction B, the major cost is the telecoms link which would be common to most banks

that provide this kind of service. Some banks may additionally reformat the payment into the US

ACH format before passing it to their partner or correspondent bank in the US. The total

marginal cost could easily be 80% of the per item price.

It is not surprising, therefore, that international banks have not been keen to sell offshore ACH

access until recently. Now, several major banks offer cross-border ACH services that not only

cover the US but many other countries as well. However, most corporate treasurers are more

concerned with collections in the US (and other countries) than payments these days, and are

often interested in cross-border ACH debit services. This type of service is currently available

from only a few major banks.

6.4.5 Cheque clearing in the USA

To be able to write cheques in USD drawn on a US bank, a company needs to open a demand

deposit account (DDA) - similar to the current account they might have in Europe but with a

couple of differences. First, no matter how much money is kept in a demand deposit account no

interest will be paid on it (it is currently against banking regulations to pay interest on corporate

DDAs, although this regulation is under review). Likewise, corporate overdrafts are not

permitted and other types of credit facilities need to be put in place to handle temporary cash

shortfalls. Companies based outside the US may draw cheques on their accounts held with US

banks for the settlement of international transactions. Companies might use this method when

the amount does not warrant the cost of a telegraphic or electronic payment:

when the beneficiary's bank account details are not known;

where an additional document needs to accompany the payment (eg a copy invoice)

and

where the drawer or issuer of the cheque can delay settlement by taking advantage of

mail and clearing 'float' (see chapter 22)

Beneficiaries, however, will be less than pleased to receive a USD cheque drawn on a financial

centre outside of the US because it will take them many weeks and high banking charges to

clear. Cheques paid into a beneficiary's bank account are deposited 'subject to final payment' ,

that is with recourse, because the drawee bank may refuse payment due to irregularities, lack of

funds or because the drawer has placed a stop payment instruction with his bank. A cheque that

is refused by the drawee bank is known as a 'returned item' and it will be debited to the

beneficiary's account.

6.4.6 Cheque collection systems

There are four ways to collect a cheque in the USA:

the Federal Reserve System provides a nationwide cheque collection facility. Each

regional Federal Reserve bank clears cheques between its own member banks and

forwards items to other regional Feds that are drawn on their members. Settlement

occurs through the members' reserve accounts held with the local Fed;

regional clearing house associations (such as the New York Clearing House

Association) provide cheque collection facilities for member banks, calculating net

settlement amounts between members and debiting or crediting their reserve accounts

at the appropriate regional Federal Reserve bank;

bilateral arrangements, known as 'direct send networks' , are made between

correspondent banks to exchange cheques drawn on each other as well as items drawn

on each other's clearing region. Settlement is made through the correspondent bank

accounts each holds for the other. These networks are established to reduce the cost of

clearing through the Fed or clearing house, as well as to improve on funds availability

and

cash letters are similar to direct send networks, although not as formalised and may not

operate bilaterally or every day. Cash letters usually consist of a number of cheques

listed on a paying in/deposit slip, which is delivered by courier or post directly to a local

bank in the clearing district on which the cheques are drawn. Once again, settlement is

effected across correspondent accounts.

To accelerate cheque processing, the US treasury department stipulated that cheques issued

by consumers can now be converted into ACH debits at point-of-sale (this includes phone and

online purchases) and lockbox and remittance locations. A similar ruling applies to corporate

cheques. However, due to concerns that the new measure might disrupt companies’ cash

management arrangements, the US treasury department is currently examining the feasibility of

allowing companies to seek exemption from the scheme. Nevertheless, the usage of these so-

called ‘e-checks’ is expected to increase dramatically over the coming years at the expense of

the traditional paper-based cheque. For 2002, volumes are expected to be around 400 million.

In a separate development, Congress is currently reviewing the abolition of the remaining legal

hurdles to full truncation. (For more details on truncation see sections 6.5.9.1 and 6.5.9.2)

Diagram 6.8: Clearing cheques in the USA

Most major US banks make use of all four collection methods, selecting the most appropriate for

each item, based on the location of the drawee bank, funds availability, price and any additional

costs such as post or courier charges. Cheques are sorted into bundles or cash letters by the

receiving bank - usually accompanied by a list of items enclosed and a total. The bundles will be

sorted according to the system used.

Despite repeated predictions of downturns in cheque volumes, they are still very popular with

both issuers and receivers; albeit at much lower levels than in the 1980s. Indeed, cheque

payments as a total percentage of non-cash payments have decreased over the last two years

in favour of electronic payments.

6.4.7 How a non-US-based company can make better use of US cheques

When looking at the use of cheques from outside the US we need to look at disbursements and

collections separately.

6.4.7.1 Disbursements

Companies dealing with customers in the US on a regular basis may wish to settle their lower

value transactions by cheque. For example, a number of London-based insurance companies

and brokers settle small claims in this way.

Although it is likely that the issuing company may have a standard chequebook, for major

issuers computerised cheque issuing facilities are available. Banks will readily supply cheque

forms in continuous format for this purpose and some banks will offer PC-based cheque printing

services that are available to users outside of the US. Such products print out cheques on the

issuer's premises and usually include a reconciliation module. Many enable a download from a

mainframe accounts payable system. Enveloping and transmission to the beneficiary are the

responsibility of the issuing company. Some banks offer a service where the customer transmits

a file to the bank, which then prints and dispatches the cheques to beneficiaries in the US.

Although more expensive than the print/dispatch-it-yourself products, these can still be more

cost effective than EFT, particularly if the bank is prepared to share the float with its customer.

Float sharing on cheque issuance products is becoming more common.

Disbursement float is defined as the time taken from the day on which the cheque is issued to

the day that it is debited to the drawer's account. With electronic cheque products, the bank

normally debits the drawer immediately and has the use of the funds until the cheque is

presented. Float sharing may be handled in one of two ways: Either by allowing the drawer to

pay for cheques issued a few days after issue, or by calculating the value of the float by item

and dividing up the interest gained on balances between the banker and the customer on a pre-

arranged basis.

6.4.7.2 Collections

A company which is being paid by cheque by its US customers should beware. This is probably

costing the receiver dearly if they are being sent to them outside of the US in terms of float and

collection charges.

In industries where payment by cheque is the norm, a regular receiver should take advantage of

a lockbox service.

Under such a scheme, a firm would invoice its customer and requests that the cheque and a

copy invoice is sent direct to the firm's lockbox service bank in the US. To obtain the best

service, a firm may need a lockbox service and a collection account in each region. Cleared

funds on the collection account can then be zero balanced by each bank to the firm's main US

bank from where they can be converted to the firm's base currency and repatriated to the firm's

home bank. (The use of lockboxes is discussed in chapter 22).

6.4.7.3 USD drawn on centres outside the USA

It is now possible to draw USD cheques on centres outside the USA and a clearing system has

been set up in some markets, such as London and Hong Kong, to clear them (see section

6.5.4). Such facilities would normally only be used to pay another beneficiary who has a USD

account in the same market, but would not be used to settle transactions in the USA because of

value delays. For example, insurance companies and brokers in London settle some USD

claims between each other in this fashion.

6.4.8 CHIPS - the Clearing House Interbank Payment System

The main features of CHIPS are:

run by the New York Clearing House Association, developed in the late 1960s and

commenced operations in 1971 with nine members;

now has 52 members and processes approximately 250,000 transactions per day by

volume and USD1.2 trillion by value (December 2002);

members are major banks, either headquartered in New York state, branches of foreign

banks, or Edge Act offices of US banks (banks based outside their home state or

country and licensed only to carry out international business);

operating hours are 12:30 to 17:00 with final pre-funding at 17:15 (Eastern time). These

hours enable all three major international time zones to participate;

system operates as a message switching centre and a recorder of transactions between

members;

a real-time multilateral netting system, CHIPS matches and settles payments on a

continuous basis using a patented algorithm;

participants are required to prefund their payment activity, so that payments are final

upon release;

pre-funding occurs between 12:30 am and 9:00 am;

because payments are pre-funded, the bulk of the payments can be processed at the

beginning of the working day; pre-funding occurs on the basis of the banks’ activity in

CHIPS. Each week CHIPS releases a pre-funding schedule for the following week

based on the previous week’s activities of each participant;

once released into the system a payment cannot be recalled;

two types of participants - settling member and non-settling member. The latter use

settling members and settle across correspondent accounts;

settling members settle across a dedicated CHIPS account held at the Federal Reserve

Bank of New York;

settlement is carried out across settling members’ accounts at the Federal Reserve

bank on a real-time multilateral net settlement basis so that there is no risk of daylight

overdraft exposure;

Settlement banks use proprietary links to communicate with CHIPS;

CHIPS handles over 90% of world’s interbank USD payments by value and

CHIPS offers a high degree of straight through processing; electronic data interchange

(EDI) features allow corporate end-users to send up to 9,000 characters of additional

information (remittance details, product specification etc) with the payment. In addition,

CHIPS uses a constantly updated universal identifier database (UIC) to verify and

match bank’s corporate customers with their account information. The UIC is similar in

concept to IBANS discussed in Chap 8.

6.4.9 Fedwire

Fedwire is the communications system set up and run by the Federal Reserve System. It now

has over 11,000 member institutions, most of which communicate with the Fedwire system by

online terminals, PCs or mainframe to mainframe computer links.

Fedwire provides the primary payment system in the US for domestic USD wire transfers (it

compares closely with CHATS in Hong Kong or CHAPS in the UK) and is used for settlement of

high-value same-day transactions. It operates on an RTGS basis. In an average day the system

will process around 200,000 payments.

Fedwire operates between the hours of 8:30 and 18:30 (Eastern time). Members settle their

obligations with each other across accounts held for the purpose at the appropriate regional

Federal Reserve bank. Under the ‘Monetary Control Act,’ 1980, most financial institutions

gained the right to maintain accounts with the Fed and to use Fedwire. Similarly, the

‘International Banking Act,’ 1978 enabled access to foreign banks’ branches.

There are basically two types of Fedwire transaction, bank-to-bank and third party transfers.

Bank-to-bank transactions consist of settlement transfers and interbank loan settlements. Third

party transfers are often used for the settlement of securities trades, commercial trade

payments and some eurodollar and foreign exchange settlements (the latter mainly for banks

outside New York that are not members of CHIPS). The US government also makes extensive

use of Fedwire to handle the payment of high-value obligations.

6.4.10 Settlement and finality

Under Federal Reserve regulations a transfer becomes final for the paying party’s point of view

as soon as the payment enters Fedwire, while the beneficiary obtains finality once the cleared

funds are received by the beneficiary’s bank.

6.4.11 Access to CHIPS and Fedwire from outside the USA

Non-US companies, which make regular transfers to the US, are already using these two

systems, whether they know it or not, even if they do not maintain an account in the US.

Diagram 6.9: Access to CHIPS and Fedwire from outside the US

Method 1 shows a situation where a UK company instructs its UK clearing bank to pay USD to a

US-based beneficiary using a standard electronic funds transfer system.

On receipt by the bank, the payment instruction is reformatted into a bank-to-bank SWIFT

message and transmitted to the UK bank's US correspondent bank through the SWIFT network.

On receipt by the US correspondent, the UK bank's ('nostro' ) account will be debited with the

value of the payment and a credit transfer will be passed to the beneficiary's bank via either

CHIPS or Fedwire. Settlement between the correspondent and the beneficiary bank occurs at

the appropriate Federal Reserve bank(s). In practice, most US banks have developed systems

to receive incoming SWIFT payments, to decide the best or most appropriate system to use for

settlement (ie CHIPS or Fedwire) and to automatically map, and then route, the SWIFT payment

into the required domestic format and system.

Method 2 shows a UK company which maintains a USD account in the US. The company will

use an EFT system supplied by the bank to log-on to that bank's telecommunications network in

order to transmit the instruction direct to the paying bank. The bank in turn will process the

payment through the appropriate system.

For obvious reasons, method 2 is more efficient and, consequently, should be cheaper for the

customer. Method 1 is fine for those who only make occasional transfers and cannot justify the

expense and time to manage an account offshore. However, those making regular transfers to

the US should consider method 2, particularly if they expect regular USD receivables as well.

 

Diagram 6.10: Comparison of US payment systems

 

[1] Banks that operate under the ‘Edge Act’ can undertake only international business in the US.

They are not allowed to compete for US domestic banking business.

6.5 The UK

6.5.1 Background

Over the last 300 years, the UK banking system has developed from its City of London

(London's financial district) base to encompass the whole of England and Wales as well as

linking in with Scotland and Northern Ireland. There are common systems across the whole of

the UK for electronic fund transfers. Cheque clearing, however, still takes a day longer in

Scotland and Northern Ireland.

6.5.2 The Association for Payment Clearing Services (APACS)

The UK clearing system is managed by APACS, the Association for Payment Clearing Services,

an umbrella organisation set up by the clearing banks in 1985.

Under the umbrella organisation there are three autonomous clearing companies:

BACS Ltd (Bankers Automated Clearing Service);

CHAPS Clearing Company Ltd (Clearing House Automated Payment System) and

the Cheque and Credit Clearing Company.

APACS also runs a series of interest groups for its members covering cash services, card

payments, payment services and city markets. There is also an operational grouping covering

the operations of the currency clearing; that is, the clearing of US dollar items drawn on London

branches of member banks.

In theory membership of APACS is open to any bank or building society, but costs and the

various criteria for membership means that there are only 31 members (see diagram 6.11). Not

all the members participate in all the clearing companies.

Other banks obtain access to the clearings by buying services from the member banks as a

sub-participant or agent. Having granted a bank sorting code number to sub-participant/agent

bank, the member bank then sorts and clears items for that bank in the same way as they would

for their own branches. Settlement of transactions cleared on this basis would be made across

correspondent bank accounts.

Diagram 6.11 APACS membership[Non examinable]

6.5.3 The Cheque and Credit Clearing Company

The Cheque and Credit Clearing Company operates the interbank clearing system for cheques

and paper-based credits (ie bank transfers or bank giro credits) in London for England and

Wales. Separate organisations cover Northern Ireland and Scotland, although they all interlink.

There are 12 direct members of the company mainly clearing cheques - many personal rather

than corporate. Since the introduction of debit cards, cheque volumes have steadily decreased.

The paper-based clearing works on a three-day cycle.

Diagram 6.12: Cheque and credit clearing

In the above diagram, company X receives a cheque and banks it on the day of receipt (day 1).

When X bank credits the company's account, the cheque will be reflected in the account ledger

balance, but will be shown as uncleared for three days (ie it will not show in the cleared balance

until day 3).

The cheque may be processed in the branch, but more recently most processing of cheques is

now handled in processing centres set up by clearing banks in major cities around the country.

At these centres, cheques are balanced against matching credits and the amount of the cheque

is encoded along the bottom to enable auto-processing. Cheques are then sorted by bank and

all items drawn on other banks are dispatched to the clearing house. Each bank exchanges

trays of cheques and takes their own items back to their processing centres, where they are

sorted by branch and debited to the drawer's account.

To facilitate processing, banks often make use of cheque truncation. This process involves

capturing essential information contained on a conventional paper cheque electronically. This

electronic information is then sent through the clearing system instead of the paper cheque.

Although truncation of cheques does not officially occur in the UK, some banks do not send all

cheques from the clearing centre to the drawer’s branch. Some only send large amounts for

physical checking (signature, date, words and amount agreed etc) keeping smaller value items

at the processing centre.

The debit to the drawer’s account and settlement between the two banks will occur across the

banks’ clearing settlement accounts at the Bank of England during day 3.

Following the introduction of the euro, the Cheque and Credit Clearing Company has set up a

bulk clearing for euro denominated cheques drawn on banks in the UK. The eurodebit clearing

is entirely paper-based as the relatively low volumes do as yet not justify the implementation of

truncation procedures.

6.5.4 UK currency clearings

Although it is the general rule that all currency items clear in the country of the currency, there

are some exceptions, most notably in the UK and Hong Kong (see section 6.2.4).

In the UK, this system is used mainly by the insurance industry, enables USD cheques drawn

on certain branches of the UK clearing banks (mainly those in the City of London) to be cleared

in London. Although cleared in London, settlement takes place across accounts held in New

York. Due to time zone differences, USD cheques clear and settle on a same-day basis.

6.5.5 CHAPS clearing company

CHAPS was launched in 1984. Originally this system cleared only GBP. - In 1999 a second

system, CHAPS Euro, was launched to clear EUR. This system is also linked to TARGET and

the other EU countries’ NCBs, which together with TARGET form Europe’s RTGS cross-border

EUR clearing system.

In August 2001, a new, enhanced RTGS system was launched: NewCHAPS regroups both

CHAPS Sterling and CHAPS Euro on a SWIFT-based common platform, creating a

multinational, dual currency clearing system. NewCHAPS incorporates a centrally provided

scheduling facility to support payment and liquidity management for both the sterling and euro

payment streams. This central scheduling facility is based around the Enquiry Link Workstation

which uses the new SWIFTNet communications infrastructure. This feature allows members to

retain control of their individual payment flows and liquidity management.

Payments made in NewCHAPS are unconditional, guaranteed and cannot be recalled after they

enter the system.

NewCHAPS is owned and controlled by its members, making it responsive to central system’s

integrity and requirements of the market place. A service level agreement insures routine,

exceptional circumstances and contingency scenarios are catered for. As an established

system, CHAPS has a proven capacity to undertake major developments and should be

resilient and robust when handling high-volume transactions. Its broad geographic coverage

and its links to SWIFT allow fast efficient service, with minimal delay to payments. As a result,

CHAPS is the second largest component of TARGET, after RTGSplus.

Diagram 6.13: Clearing house automated payments system (CHAPS)

Payments of any amount can be made across NewCHAPS, but transactions tend to be larger,

urgent payments. The average size of a GBP CHAPS payment is GBP3million.

On an average day over 100,000 items are processed through CHAPS, but on busy days peaks

have approached 250,000 items. As there are only a limited number of CHAPS settlement

banks, companies and other financial institutions buy their service from one of these banks,

usually via an electronic banking system.

Diagram 6.14: Company links to CHAPS

The diagram above shows Company A sending a payment to Company B. The former sends a

payment instruction through the EFT (electronic funds transfer) module of the electronic system

to the bank (Bank A). Bank A debits Company A’s account (credits a clearing account in its

books) and passes the payment order into the CHAPS system. The message, addressed to

Bank B is copied by the system to the Bank of England. At the Bank of England, Bank A’s

account is debited and Bank B’s account is credited. The payment is passed to Bank B, which

credits its customer’s account, Company B and advises the customer of receipt. This advice

may be electronic.

 

6.5.6 Bankers Automated Clearing Service (BACS)

BACS started operations in 1971 and provides an automated clearing house service mainly for

the delivery of low-value items. Most BACS transactions are for non-urgent items. On the credit

side, they include:

pensions and salaries;

third party trade payments and

standing orders.

Diagram 6.15: Customer Credit

On the debit side, direct debits are used for items such as:

utility bill collections;

insurance premium collections and

third party trade collections (less common but increasing).

Diagram 6.16: Direct debits

There are 14 settlement members of BACS, but many thousands of other banks and companies

are ‘sponsored’ by the settlement banks, enabling users to connect directly to BACS for the

transfer of transactions. The bulk (over 95%) of payment instructions are sent via BACSTEL, a

proprietary telecommunications link. A residual amount of instructions is sent via other media

including diskettes.

Although working to a three-day cycle, BACS itself creates no float and debits and credits are

passed between members’ and users’ accounts on the same day. Up to 60 million transactions

are handled on peak days.

Diagram 6.17: The BACS time cycle

Diagram 6.18: BACS – processing methods

6.5.7 Plastic cards

There are over 118m issued plastic cards in the UK (one of the highest per capita levels in

Europe). Of these, approximately 45m are credit or charge cards and 41m are debit cards. The

remainder include store cards, automated teller machine (ATM) cards, etc. Purchases by debit

cards have increased significantly since they were introduced in 1987, whereas transactions by

credit card have remained comparatively static.

Diagram 6.19 shows the breakdown of transactions through the UK clearings.

Diagram 6.19: Analysis of transactions through UK clearings

Standing order/direct debit = 29%

Cheques = 18%

Plastic cards = 52%

Other = 1%

6.5.8 UK availability schedule

Diagram: 6.20

Instrument Value to beneficiaryLoss of value to

payorWho initiates

MANUAL

Cash

Cheques

Giros/bank

transfers

Immediate

2-3 days

2-3 days

Immediate

2-3 days

Immediate

Payor

Payor

Payor

AUTOMATED

Standing order *

Direct debit *

Debit cards

Credit cards

Value date (3 days after

initiation)

Value date (3 days after

initiation)

1-2 days

2-3 days (average)

Value date

Value date

1-2 days

Up to 6 weeks

Payor's bank

Beneficiary

Payor

Payor

ELECTRONIC

CHAPSSame day Same day Payor or payor's bank

BACSValue date (3 days after

initiation)Value date

Debits - beneficiary

Credits - payor or payor's

bank

* Automated standing orders and direct debits are normally processed through BACS

6.5.9 Developments in clearing and processing

6.5.9.1 Cheque truncation

Truncation removes the need for much of the physical handling of paper items and may be

applied to both cheques and paper credits. Items paid in have their data captured (the MICR or

OCR codes plus the item amount) by the depositing bank and the ‘electronic’ image’ of the item

is sent through the clearing system. Cheques are processed in much the same way as direct

debits (see diagram 6.21).

Full cheque truncation at the bank branch of deposit is now undertaken in many countries in

Europe, including those that traditionally were considered to be less sophisticated banking

systems (eg, Spain and Italy). Despite being considered a more sophisticated banking

environment - the UK - currently does not practise truncation at depositing bank level - not

necessarily because of technical problems, but mainly because the highly developed banking

laws that exist will need to be amended to enable truncation to be introduced. However, as

indicated some banks truncate cheques on receipt at the drawee banks’ clearing centre and

only send items with high value to the branches on which they are drawn.

Diagram 6.21a: Standard method of clearing cheques

Diagram 6.21b: Clearing cheques through cheque truncation

Those countries that practise cheque truncation impose limits by item amount. For example, in

Belgium only items below EUR10,000 are truncated; items above this amount are still

processed physically. But in most countries, the limit has been set to a level at which the 80-20

rule applies (ie, 80% of items are truncated).

6.5.9.2 Dangers/problems of cheque truncation

With only roughly 20% of items being physically' cleared, low-value items are not checked for

correctness in terms of signatures or for technical errors (eg words and figures differ) in

countries which use truncation. This obviously presents problems in terms of potential frauds.

However, as truncation limits are generally low, this is fairly unlikely.

6.5.9.3 Image processing

People who deal with technology on a regular basis become ‘blasé’ about its continued

development as old software gets upgraded and hardware gets smaller and more powerful. But

every so often, some new breakthrough occurs that makes even the most hardened

technologist stop and think seriously about its ramifications. Image processing, particularly in

the area of document handling, is one such technology. It is about to change the handling of

documents in banks radically and the eventual spin-off for companies should be the

development of more efficient and cheaper services.

The basic concept of image processing takes its roots from micro-filming - copying real

documents, discarding the originals and working with the copy or filmed version. Anyone who

has worked with microfilms, even if they are computer-linked, will appreciate that this is a far

from perfect technology. With image processing, the idea is to capture an image of a document

(eg a cheque or credit) at high speed and to convert that image into data that can be mapped

straight into a computer for processing, eventual archiving as a digital image and retrieval when

necessary in a few seconds.

6.5.9.4 Cheque processing using image item processing

The key benefit in image item processing systems is that electronic images, processed through

a computerised system, can be processed more efficiently than paper documents. For example,

in image cheque operations, operators in the US who key-in amounts from cheque images can

process 2,500-3,000 items an hour, compared with 1,200-1,400 an hour when keying from

paper items. This efficiency will be further boosted when character recognition systems are

coupled with image processing, automating the keying-in function. Additionally, image item

processing can be coupled with intelligent software which performs the balancing function of

cheque processing (ie balancing cheques against the deposit slips). This has reduced staff by

half in installed sites.

The latest technique to be introduced is known as CAR (courtesy amount recognition). This

process actually enables the automated cheque reader/sorter to 'read' the hand-written amount

of a cheque. At present, tests have shown 50% accuracy. But even at this level, the implications

are vast. A bank processing two million items per day may employ up to 200 staff just to encode

items with amounts under existing methods. With image processing and CAR, this workforce

can be reduced potentially by half (with premises and equipment costs being similarly reduced).

This technology offers major savings and efficiencies in the areas of back office processing,

which companies should also expect to benefit from in terms of lower charges and better

service.

6.5.9.5 Image statement

Customers using cheque-based accounts can be offered an image statement containing

miniaturised copies of the cheques instead of the items themselves. Banks can structure

account pricing for retail customers to reflect the variety of statements offered. For example,

image statements might be USD2 per month cheaper for customers than accounts that receive

cheques back from a bank. From the bank's standpoint, revenues increase through fee income

or reduced overheads through lower processing costs. The latter should translate into lower

bank charges for high-volume users.

6.5.9.6 Account reconciliation processing (ARP)

This process can be used by financial institutions that provide a reconciliation service. With this

service, a commercial customer sends a list of cheques issued to the bank, and the bank

creates a ‘cheques-paid’ list, then compares the two. When discrepancies are noted, a copy of

the cheque is usually requested by the customer. Image technology greatly improves this

process by allowing for faster retrieval of items. In the US, image technology is often linked to a

bank’s ‘positive pay’ service (see 6.5.9.9).

6.5.9.7 Image storage and retrieval

Experience in the US shows that inquiries about 'checking accounts' are answered with image

systems in 25% of the time taken traditionally.

6.5.9.8 Image interchange

Once standards are established and image statements exist, cheque or credits can be truncated

at the bank of deposit, clearing the image quickly, while reducing processing costs considerably

because only the image of the item is 'cleared'.

6.5.9.9 Image payment control/Positive pay

High-value payment control, where images of large-value items are transmitted to corporate

issuers to verify payment and control fraud.

The other method to combat cheque fraud is positive pay or match pay, a service used to

combat cheque fraud, whereby the bank only pays those cheques with serial numbers and cash

amounts that match those in an issue file supplied by the company.

6.5.9.10 Image archive

Through use of optical disk storage systems, storage and retrieval can be faster and more

effective, although some image storage systems can be quite expensive for large volumes of

items. A means of reducing costs would be to store image statements rather than actual items.

The cost of these systems ranges from USD2m to USD20m. The cost is usually justified by

operational savings due to improved productivity and a pay-back period of three-to-five years.

Retention period for archiving cheques and financial documents varies around the world. In the

UK, items are stored by banks for seven years.

6.6 Germany

6.6.1 Background

The German banking system is often perceived as resistant to change and as having an

inflexible approach to pricing and fee structures. In recent years improved technology and the

introduction of the EUR have brought about innovation and improvement.

6.6.2 Clearing systems

6.6.2.1 High-value

High-value payments are cleared via RTGSplus, the Deutsche Bundesbank’s real-time

gross settlement (RTGS) payment system linked to TARGET. Launched in November

2001, RTGSplus replaced the former RTGS system, ELS and the automated netting

system EAF, combining the liquidity-saving features of the latter with the speed and

finality offered by a TARGET-linked RTGS system. RTGS plus is one of the largest

RTGS systems in the world (in terms of volumes and values cleared) and a principal

component of TARGET, the EUR cross-border payment system.

6.6.2.2 Low-value

RPS – Retail Pricing System. An automated retail system. To German speakers it is

known as EMZ (“Elektronischer Massenzahlungsverkehr”). This is Germany’s ACH

system clearing credit transfers and direct debits.

6.6.2.3 Other

Private regional and national giro networks and the savings and co-operative banks'

giro networks "Spargironetz" and "Deutsche Genossenschaftsring".

6.6.3 RTGS plus

Since 1992, electronic submission of payment orders has been possible via the Deutsche

Bundesbank’s RTGS system, ELS and then RTGSplus. For the time being ELS continues to

operate as an auxiliary medium to TARGET. Payments will continue to be accepted until the

end of 2004 by the ELS access medium for those ELS participants who did not want to change

to RTGSplus. Payments from ELS participants to RTGSplus participants are made after

conversion into SWIFT format. In addition, payments made to ELS participants are also made in

SWIFT format.

RTGSplus is accessible to direct and indirect participants. All credit institutions and securities

firms with registered offices in the European Economic Area (EEA) can participate directly.

There are currently 74 direct participants in RTGSplus and thousands of indirect participants.

Payments no longer need to be submitted individually; however, they have to take the form of

euro-denominated electronic credit transfer. The system uses internationally established SWIFT

standards and services. Combining the advantages of both ELS and EAF with the use of SWIFT

standards makes RTGSplus much more cost effective.

The system’s opening hours are between 07:00 and 18:00 CET and it accepts items to be

cleared via TARGET for same-day value until 17:00 from corporate customers. Interbank

settlements/payments may be made until 18:00. Two types of payment can be submitted:

Express payments. These are priority payments, which are to be executed immediately.

These include settlement payments via TARGET and time critical payments. There is

access to all of the supplied liquidity and

Limit payments. These payments are to be processed above all in a liquidity saving

manner, ie, only when there are sufficient cleared funds will the payment go through.

These include domestic customer payments and foreign exchange payments not

suitable for TARGET. Settling limits can reduce the liquidity that banks need to supply.

Members can monitor and access their positions real- time using the RTGSplus’ Information

and Control System (ICS). ICS offers participants access via SWIFTNet applications or for

those who have not yet migrated to SWIFTNet, a dedicated virtual private network (VPN).

All credit transfers submitted are processed with immediate finality (ie, there is no initial

batching). The submitter’s account is debited before the payment is routed. Single orders which

have insufficient cover remain in a queue until receipt of cover.

Early finality of payments is ensured by:

the use of limits options;

the ability to modify liquidity throughout the day and

submitting participant’s credit balances in RTGSplus and the reciprocal payments made

by other members are taken in account by RTGSplus when it calculates the submitting

participant’s cover limits queues.

Since each order is executed only upon sufficient cover, settlement failures or unwinding cannot

occur. Thus the receiving bank is not exposed to credit or liquidity risk and it can make the funds

received available to the beneficiary unconditionally. Credit transfers are final as soon as the

funds have been credited to the beneficiary’s account.

RTGSplus has a higher percentage of customer payments and hence the average value of the

payments submitted to RTGSplus (EUR2m) is lower than the average value of the payments

submitted to the other TARGET RTGS systems.

6.6.4 RPS

RPS – Retail Payment System also know as as EMZ (Elektronischer

Massenzahlungsverkehr).

About one-third of the payment orders handled by the Bundesbank’s retail payment system

(RPS) are credit transfers – collection items such as direct debits and truncated cheques make

up the other two-thirds. It is the core of the Bundesbank’s domestic retail payments. On peak

days, the number of orders processed is close to 25 million.

Any bank or public authority with a Bundesbank account has access to the RPS. Orders

denominated in EUR are presented in paperless form in the standard German DTA (exchange

of data media) format. Additionally, items can be delivered on data media (magnetic tapes or

diskettes). Cheques below EUR3,000 are fully truncated in the so-called paperless cheque

collection procedure (BSE procedure). Cheques in excess of EUR3,000 are also cleared

electronically, but the original vouchers need to be presented physically for verification in the

large-value cheque procedure (GSE procedure).

The system is used by Bundesbank account holders to:

process ‘priority 3’ payments (non-urgent overnight payment orders);

collect direct debits and

deliver cheque data records.

The standard run time is a business day. Payments submitted by DTA in the morning are

available to payees in the late evening of the same day. Submissions sent by data media (tape

or disk) are available on the business day following their submission. Processing is done on a

continuous batch basis, including through the night. Payments can be submitted to the

Bundesbank branches or directly to the computer centres.

In brief the system has the following features:

short run times (usually less than 24 hours due to overnight processing) and low rates

and

float-free processing and remote access.

Discussions are under way to extend the number of communication protocols that can be used

for submission of files. In addition, the Bundesbank and the banking industry are discussing the

possibility of introducing standard SWIFT messaging. RPS is also expected to be connected to

EBA’s STEP2 (see section 8.8.3), once this is operational.

6.6.5 Other local transfer systems

Many private credit institutions have their own national or regional giro networks. Stiff

competition between them works against a common system for payment. However, small banks

with local catchment areas have agreed processing and settlement procedures. These systems

are known as Spargironetz for savings banks and Deutsche Genossenschaftsring for co-

operative banks.

Chapter 7 - The international banking system

Overview

This chapter describes the infrastructure that is used as the basis for international banking.

Learning objectives

A. How correspondent and inter-branch banking works

B. The use of ‘nostro’ (‘due from’) accounts and ‘vostro’ (‘due to’) accounts

C. The services provided by SWIFT and its background

D. How SWIFT works operationally

E. How international funds transfers are made using SWIFT

7.1 Correspondent banking

In terms of infrastructure, the main difference between international banking and domestic

banking is that they involve different sets of organisations. In the case of a simple money

transfer to a relative abroad, although the payor may sign a form or give authority for the

transfer at the normal high street branch, that branch merely acts as a post office. The actual

work is carried out by the international division of the bank at one of its regional international

centres. Corporate customers often bypass the high street branches and deal directly with

banks’ international divisions or make use of the branches of foreign banks based in their

home country for international business. The expertise of the international division or foreign

bank is mainly centred on its knowledge of its overseas branch and correspondent banking

network and in having an automated access to both. Although most international banks will

make extensive use of their own branches, in countries where they have no branches (or

where their branch is not a member of the local clearing system), they need to make

arrangements for transactions to be handled by a reputable local bank. Such arrangements

are known as ‘correspondent bank relationships’.

Correspondent bank relationships are normally bilateral with each bank holding a

bank account in its own country for use by the other. To monitor the entries which

pass through its overseas account, the account holding bank will open a mirror

account in its own books, against which it will reconcile its bank statement.

Correspondent bank accounts are known as ‘nostro’ accounts and mirror accounts

held in account holders’ own books are known as ‘vostro’ (sometimes ‘loro’)

accounts, or - to use American terminology – ‘due from’ and ‘due to’ accounts.

Instructions to receive or pay funds may be sent to the overseas branch or

correspondent by tested telex but more commonly via SWIFT.

The figure illustrates the accounting entries that might be passed in a simple transaction

where a UK remitter sends USD1,500 to a beneficiary in the US by telegraphic transfer. In this

example, the beneficiary holds an account with the correspondent bank used by Bank A.

The customer instructs the bank to send USD1,500 to a beneficiary in the US and to debit his

account with the GBP equivalent. The accounting entries in the UK will be a debit to the

customer (GBP1,000 equivalent of USD1,500) and credit to the remitting bank' s 'vostro'

account. A tested telex or SWIFT message (see section 7.2) will be sent to the correspondent.

This in effect says: "Debit my account with you ('Nostro' Account) with USD 1,500 and pay to

the beneficiary Mr. X' s account number 1234567, value 29 September 2000."

Some banks provide corporate customers with international electronic banking systems which

are connected to the providing bank' s branches and subsidiaries. These systems enable

account information to be made available and for electronic funds transfer instructions to be

initiated from accounts at remote branches. Much corporate information and most corporate

funds transfers, are transferred bank-to-bank via the SWIFT network.

7.2 SWIFT (The Society for Worldwide Interbank Financial Telecommunications)

Set up in 1973, SWIFT is a telecommunications network owned and used exclusively by 7,200

banks and certain types of financial institutions for the exchange of financial data between

members. It operates in 190 countries. Contrary to some misconceptions, it is not a payment

system, clearing system, or a settlement system.

SWIFT uses a set of strict standards which (when used correctly) enables standardised

messages to be generated, received and interfaced by bank computers and local clearing

systems in a fully automated way. This concept of automated messages passing all the way

from the generator of the payment through to the receiver is known as ‘straight through

processing’ (STP).

Banks themselves make extensive use of SWIFT to send messages to each other in respect of

bank-to-bank business. They also pass messages relating to corporate business through this

network. The most commonly used message is the international funds transfer message

(MT103), closely followed by ‘advice to receive messages’ (MT210). Although used for simple

third party payments, the main use of these messages is for foreign currency contract

settlements. Additionally, SWIFT is used for reporting customers’ bank account details between

different banks (or branches of the same bank). This use of the SWIFT MT940 message

standard (a customer statement message) enables the receiving bank to provide customers

with ‘multibank reporting’ via their own electronic banking system.

In most countries, electronic links have been built between SWIFT and the local electronic

clearing system. For example, most members of CHAPS (Clearing House Automated Payment

System) in the UK and CHIPS (Clearing House Interbank Payment System) in New York have

installed a direct link between SWIFT and their system which enables a correctly formatted

incoming payment, received from an overseas branch or correspondent, to be streamed directly

into the local clearing.

7.3 SWIFT - A brief overview

SWIFT is a non-profit-making organisation, owned by its member banks. It was established as a

network to exchange messages about transactions and transaction details between banks (and

some non-bank financial institutions). The system:

Provides:

- standardised message formats for all transactions

- high security – using ‘Public Key Infrastructure’ (See Chapter 20)

- high availability - (little ‘down time’)

- operates through operations centres and regional processors

Processes:

- data from sending bank is sorted and immediately despatched to receiving banks. The

system transmits data, not funds (it is not a payment, clearing or settlement system).

Member banks still need a correspondent bank to settle financial transactions.

Cost to Banks:

- one-off membership fee

- annual charges

- per item charges which reduce as their volumes of business increase.

Advantages:

- standard message formats enable automated handling

- fast and secure

- beneficiary bank gets speedy receipt of messages

- reduced errors

Disadvantages:

- beneficiary reliant on the receiving bank for notification of receipt of funds (ie, there is

no corporate link to SWIFT). However, the introduction of SWIFTNet and its Closed

User Groups should help address this problem (see section 7.11).

7.4 SWIFT codes

SWIFT standards are used extensively in international cash management (and international

banking in general). SWIFT has developed sets of standards covering various types of

bank transactions.

Message Series Types of transactions covered

100 Customer payments

200 Bank-to-bank applications

300 Foreign exchange and money market transactions

400 Documentary collections

500 Securities transactions

700 Trade transactions (letters of credit etc)

900 Balance and transaction reporting

The main SWIFT messages used for cash management are:

7.4.1  Credit transfers

7.4.1.1  Execution of credit transfer

MT100 CUSTOMER TRANSFER

Conveys a funds transfer instruction in which the ordering customer or the beneficiary customer,

or both, are non-financial institutions. This message type will be abolished in November 2003

and is now largely replaced by the MT103 message type.

MT102 MASS PAYMENT MESSAGE

Conveys mass payment instructions between financial institutions for clean payments (ie, no

documents attached). Each message can contain multiple transactions. It has a subset

MT102+, which allows for greater straight through processing.

MT103 SINGLE CUSTOMER CREDIT TRANSFER MESSAGE

Conveys a funds transfer instruction in which the ordering customer or the beneficiary customer,

or both, are non-financial institutions. This message is in effect an extended and structured

version of the MT100, which will be abolished by November 2003. MT103 can be subdivided

into three sub-categories:

the MT103 Core, ie, the standard MT103;

the MT103+, which allows greater STP and 

the MT103 REMIT, allows the inclusion of text in a different format (eg, EDIFACT, ANSI

…).

MT105 EDIFACT ENVELOPE

Used as an electronic envelope to convey an EDIFACT message – usually a payment order.

MT106 EDIFACT ENVELOPE

Used as an electronic envelope to convey an EDIFACT message – usually a payment order. A

MT106 message has a greater capacity than a MT105 message.

7.4.1.2  Request for credit transfer

MT101 REQUEST FOR TRANSFER

Customer payment request – sent by a bank, on behalf of a customer, to a receiving bank to

move funds from the customer’s account at the receiving bank. The message can be used like a

drawn down message to concentrate funds back to the sending bank or to make a payment to a

third party. See section 7.9 for an explanation and diagrams on the use of this message.

7.4.2  Debit transfers

7.4.2.1  Clean debit transfers

MT104 CUSTOMER DIRECT DEBIT

Conveys a customer direct debit instruction between financial institutions.

MT105 EDIFACT ENVELOPE

Used as an envelope to convey and EDIFACT message – often DIRDEB (direct debit).

MT106 EDIFACT ENVELOPE

Used as an envelope to convey an EDIFACT message – usually an extended DIRDEB (direct

debit with additional remittance details).

MT200 FINANCIAL INSTITUTION TRANSFER FOR ITS OWN ACCOUNT

Used to request the movement of funds from an account that the receiver services for the

sender to an account that the sender has, in the same currency, with another financial

institution.

MT202 GENERAL FINANCIAL INSTITUTION TRANSFER

Used to order the movement of funds to another (beneficiary) financial institution. Often called a

‘cover payment’.

7.4.2.2 Pre-advising

MT110 ADVICE OF CHEQUE

Advises the drawee bank, or confirms to an enquiring bank, the details concerning the cheque

referred to in the message. A MT110 is often used to advise the issue of cashier cheques (1) or

drafts.

MT210 NOTICE TO RECEIVE (OR ADVICE TO RECEIVE)

This message type is sent by an account owner to one of its account servicing institutions. It is

an advance notice to the account servicing institution that it will receive funds to be credited to

the sender’s account.

MT 900 CONFIRMATION OF DEBIT

Advice of a debit entry on a bank account.

MT910 CONFIRMATION OF CREDIT

Advice of a credit entry across a bank account.

MT940 CUSTOMER STATEMENT MESSAGE

This message type is sent by an account servicing institution (reporting institution) to a financial

institution (concentrating institution) which has been authorised by the account owner to receive

it. It is used to transmit detailed information about all the entries booked to the account.

MT941 BALANCE REPORT

Interim balance sent during the working day to a financial institution on behalf of an account

holder.

MT942 INTERIM TRANSACTION REPORT

Transmits detailed and/or summary information about entries debited or credited to the account

on an intra-day basis. Some banks use these messages internally to enable them to report in

‘close to real-time mode’.

MT950 FINANCIAL INSTITUTIONS STATEMENT MESSAGE

Transmits detailed information about all entries, whether or not caused by a message, booked

to the account.

(1) Also known as a bank cheque or bank draft, a cashier cheque is a cheque drawn by a bank

against its own funds

7.5 Currency codes

The ISO currency codes (International Standards Organisation) have been adopted by SWIFT

and are used extensively in SWIFT message standards (and in this course). For example:

AED UAE Dirham GBP UK Sterling

AUD Australian Dollar HKD Hong Kong Dollar

BHD Bahraini Dinar JPY Japanese Yen

CAD Canadian Dollar MYR Malaysian Ringgit

CNY Chinese Reminbi SGD Singapore Dollar

DKK Danish Krona SEK Swedish Krona

EUR Euro USD US Dollar

7.6 How SWIFT works

The diagram shows how transaction messages move through the SWIFT system. In the case

given in Section 7.1 where a UK remitter sent USD1,500 to a beneficiary in the US, SWIFT

would have been used as follows:

Once the UK bank has passed its account entries, it generates SWIFT messages to its local

SWIFT centre. Local centres established in each SWIFT country are secured ‘nodes’ which link

into the SWIFT network. (Nodes are local connection points set up in each country or area to

enable users to connect to a network). In the case of SWIFT, these nodes (in effect, computer-

based switches) have a degree of intelligence and can effect direct transactions to the

appropriate SWIFT operations centre. (For example, the UK links to a centre in The

Netherlands). The operations centre directs the message to the appropriate operations centre

handling traffic for the country of the beneficiary, and the receiving operational centre will then

pass the message down to the node that the receiving bank uses. Links to nodes work on a

real-time basis, so the message should take a few seconds to reach the receiving bank.

7.7 Cover and serial payment methods

7.7.1 Cover method

Under this method the originating bank sends the MT103 directly to the beneficiary bank and

informs that bank from which bank it will receive funds in cover.

This method is usually used when the originating bank has no relationship with the beneficiary

bank. In such a case it will send an MT202 cover payment order to its correspondent instructing

it to pay the funds to the beneficiary bank.

In this case the MT103 is used as an advice. Some banks will post this immediately (under

reserve) to the beneficiary customers account, but will reverse the entry later in the day if the

funds do not arrive. This method is illustrated in Diagram 7.3.

7.7.2 Serial method

In some countries the serial method is used for either or both domestic and international

payments. Under this method the MT103 is used to both give an instruction to credit a

beneficiary and to debit the ‘nostro’ account of the sending bank.

The correspondent then forwards the MT103 (or a local clearing equivalent) to the next bank in

the chain. The chain is completed when the beneficiary bank receives the last message. (This

method is illustrated in Section 8.2)

7.8 International payments and SWIFT

In Section 7.6 we explained the operational connections of SWIFT. Now we will look at the

message flow. The example given makes use of the cover method. In this case, the beneficiary

holds an account with a small bank (‘Detroit Bank’).

The UK company receives an invoice from the US and instructs its bank (‘London Bank’) to

make an electronic funds transfer to company X in the US at Detroit Bank.

Diagram 7.3: Transaction involving correspondents as ‘pay through bank’ - highlighting

types of messages used- cover method

London Bank will carry out the foreign exchange transaction, debit the UK company’s account

(and credit its USD ‘vostro’ account) and will then send a payment order (MT103) to Detroit

Bank. This MT103 message, in effect, says: “When you receive USD1,500 from London Bank,

please pay to your customer Company X - on behalf of Company A UK.”

The next stage is to get the money to Detroit Bank. London Bank does not have a

correspondent relationship with Detroit Bank. London Bank will, therefore, send a cover

payment message (MT202) to their correspondent in New York (JP Morgan Chase). This

message will say: “Debit our account with you and pay Detroit Bank, for the account of

Company X, USD1,500 on behalf of Company A.”

Unfortunately, Detroit Bank has no correspondent relationship with JP Morgan Chase (London

Bank’s New York correspondent), and is not a member of the CHIPS Clearing System in New

York. Detroit Bank clears its dollars in New York through Bankers Trust. JP Morgan Chase will

establish this by reference to clearing tables and will, therefore, send a payment order to

Bankers Trust through the New York Clearing System (CHIPS). This will be worded: “Please

pay to Detroit Bank, account Company X, USD1,500 on behalf of London Bank favour account

Company A.”

On receipt, Bankers Trust will send an advice of credit to Detroit Bank. Detroit Bank will match

this with the original MT103 message received from London Bank. They will then credit

Company X’s account and send them an advice.

The only missing element of the transaction is the settlement between JP Morgan Chase and

Bankers Trust for the CHIPS transaction.

Diagram 7.4: Settlement of international payments

This diagram 7.4 shows that settlement occurs across the settlement accounts held at the

Federal Reserve Bank in New York.

This example illustrates the complexity of international payments and the potential number of

parties involved. In this instance the following were involved:

Originator (payor)

Originating bank

SWIFT

Beneficiary bank

SWIFT

Intermediary or pay through bank 1

CHIPS

Intermediary or pay through bank 2

Beneficiary bank

Federal Reserve Bank

Beneficiary

This explains:

1. why international payments are expensive; and

2. why things can go wrong with international payments (and why they take so

long to sort out).

Value should be given to Detroit Bank on the value date. This might be the origination date (or

the day following if the payment cut-off times for CHIPS were missed). Alternatively, payments

may be originated in advance for forward value dates. In some cases value may not be given to

the beneficiary on the value date, as settlement occurs after the close of business that day. The

question of whether Detroit Bank will allow its customer to withdraw the funds same-day

(creating a ‘daylight overdraft’), or make the customer wait until opening the next day, will be

subject to agreement between them.

7.9 Multibank payments via SWIFT

An MT103 message, which is generated by the bank executing a payment, whether it is used in

serial mode, or in cover mode (with an MT202), directs the receiving bank to debit a sending

bank’s ‘nostro’ account.

An MT101 message directs the receiving bank to debit a customer’s account and to make a

payment.

The customer in question would normally authorise the receiving bank to honour MT101

instructions in advance. Additionally, the two banks will have in place a bilateral agreement

covering MT101s for all their customers. This allows all instructions emanating from the other

party to be honoured, provided that the messages are fully structured.

In this simple example the MT101 message triggers another payment order – an MT103 – back

to the lead bank where the concentration account is held. In this case the two banks have

correspondent relations with each other. If not, the MT103 may pass to an intermediary bank if

used in serial mode – or a M202 cover message could be used to the intermediary.

7.10  Multi reporting via SWIFT

Multibank reporting is illustrated in diagram 7.7. A customer can use one lead bank and one

electronic banking system to collect

Most banks’ systems currently only enable them to send account data once at the end of each

business day to another bank. Few banks’ systems can send intra-day messages to other

banks.

Within banks it is very common for the banks’ own systems to generate SWIFT standard (or)

equivalent messages.

Often a bank can generate MT941 (bank balances) and MT942 (transaction details) during the

working day (as well as MT940s at the close of business) from its own accounts to update its

own systems and to transmit them via SWIFT from their overseas offices to a central computer

and then on to customers through their electronic banking service.

This enables a lead cash management bank to provide close to real-time reporting on its own

account, but it will normally only be able to provide yesterday’s details from other banks.

7.11 SWIFTNet

To take full advantage of the opportunities offered by browser-based technology, SWIFT has

decided to replace its existing FIN messaging services with a new IP-based platform SWIFTNet.

The new platform is already used as a communications channel by key market infrastructures

such as Continuous Linked Settlement, The Bank of England Enquiry Link and the German

RTGSPlus system (see section 6.6). Interactive and highly secure, SWIFTNet offers advanced

IP-messaging solutions and remote secure browsing capabilities. Security is based on a single

Public Key Infrastructure (see chapter 20). Currently, all the existing 7200 SWIFT members are

being migrated from the existing X25 network to SWIFTNet. This migration process should be

completed by 2004. SWIFTNet provides users with a single window connectivity that allows

access to the full range of SWIFT’s IP-based services and offers enhanced straight through

processing potential.

SWIFTNet consists of three complementary messaging services:

SWIFTNet InterACT, which allows users to exchange messages on a real-time or store-and-

forward basis using XML standards. It offers real interactivity with request messages triggering

immediate response messages. As such, SWIFTNet InterACT is aimed at mission or time-

critical applications such as Continuous Linked Settlement (CLS) and Real Time Gross

Settlement (RTGS) Systems. SWIFTNet InterACT is able to support tailored solutions for

market infrastructures, closed user groups (see below) and financial institutions;

SWIFTNet FileACT is suited for the exchange of bulk messages, including recurrent payments

and supports any content or format. To ensure interoperability files are preceded by a standard

file description. Like SWIFTNet InterACT, it offers real interactivity and provides tailored

solutions for market infrastructures, closed user groups and financial institutions and

SWIFTNet Browse offers secure browser-based access to service providers’ websites (for

instance, correspondent banks can use SWIFTNet Browse to consult their ‘nostro’ accounts). It

also provides direct access to the secure messaging features of SWIFTNet InterACT and

SWIFTNet.

Connection to the SwiftNet messaging services is effected via SWIFTNet Link (which ensures

the technical interoperability with SWIFT’s secure IP network (SIPN)) and SWIFTNet Interface,

either via a person-to-application interface or an application-application interface.

Non-financial institutions’ access to SWIFTNet

With SWIFTNet companies can finally access the SWIFT network. Under the new concept of

Member Administered Closed User Groups (CUGs), companies can access SWIFTNet as

‘Service Participants’ of one or more of these Member Administered CUGs. By doing so, they

can communicate with their financial institutions over the SWIFT network via a single window.

CUG membership will also allow companies to improve considerably their straight through

processing by integrating the SWIFT interface with their treasury systems and/or ERP

applications. The robustness and high security offered by SWIFT is another attraction,

particularly for the top-end of the corporate market where highly secure and speedy delivery

channels are essential. By joining multiple CUGs, companies can effectively use SWIFTNet as

their standard connection method for all their bank communications. The browsing facilities

offered by SWIFTNet also offer corporates the possibility to obtain intra-day information on all

their accounts. This facility combined with the other SWIFTNet features will help companies to

improve their global liquidity management. All in all, SWIFTNet has the potential for becoming

the corporate-bank communication channel of choice in the years to come. In addition,

SWIFTNet could also be used as a system integration tool within companies to link ERPs,

payment factories etc.

From the banks’ point of view, the use of SWIFTNet as a standard platform with FIN as the

standard messaging capability is equally cost-effective. While some banks may have some

reservations about abandoning their proprietary systems (risk of increased competition, high

level of money and time invested in these proprietary systems etc), it is likely that in the long run

the cost benefits of SWIFTNet will force these banks to overcome their initial reluctance.

From a cash management point of view, SWIFTNet currently presents the following features:

enhanced cash reporting based on XML standards. SWIFTNet allows members to

create their own cash reporting closed user group, whereby their corporate or

correspondent bank customers can access their ‘nostro’ accounts online or obtain real-

time updates via a web-based workstation;

bulk payments processing using SWIFTNet FileACT. This facility supports domestic

and cross-border bulk payments solutions offered by domestic and cross-border

infrastructures as well as by individual banks and clubs and

online payments initiation via ePaymentsPlus, a secure end-to-end online cross-

border and multicurrency payments service. ePaymentsPlus can be offered as a

branded platform by banks to their corporate customers providing them with services

such as factoring, discounting and asset purchasing. In addition to online initiation,

assurance of identity of the trading partners and assurance of payment, ePaymentsPlus

also offers corporate customers the possibility of tracking and reconciling transactions

via a real-time transaction status information facility.

Chapter 8 - International electronic payments and collections

Overview

This chapter discusses the various electronic payment and collection instruments used to move

money between parties in different countries, and how such instruments clear. It contrasts

cross-border transfers with domestic transfers, and looks at the different processes involved

when using systems such as TARGET, Euro 1 in Europe, correspondent banking or when using

a multinational network bank.

Learning objectives

A. To understand the attributes of the various instruments used in international banking

and how they are cleared

B. To understand how electronic funds transfers are cleared

C. To understand the difference between domestic clearing, cross-border clearing using a

correspondent bank and cross-border clearing using a multinational bank

D. To understand the many different clearing methods used for euro-denominated

transactions

E. To be able to differentiate between these methods

F. To understand in which circumstances each will be used

G. The main issues in terms of:

o intra-day liquidity;

o operating times;

o pricing;

o linkages and transition.

8.1 International collection and payment instruments

International collection and payment instruments are remarkably similar in nature to those used

domestically and can be broadly

Electronic

• urgent EFT;

• non-urgent EFT;

• credit/charge cards and

• direct debits.

Non- electronic and paper-based

• currency cheques;

• money orders;

• mail transfers;

• banker’s drafts;

• bills of exchange and

• letters of credit.

Types of payments (and cash management)

• domestic:

debit an account in country A and pay to a beneficiary in country A;

• international:

debit an account in country A and pay to a beneficiary in country B and

• cross-border:

payor x based in country A debits own account in country B to pay a beneficiary in country B.

8.2 Making international payments

This chapter will build on the earlier chapters and will examine how to make payments in a

foreign currency using electronic methods (non-electronic methods will be covered in chapter 9,

including the instruments listed in this section 8.1). We shall start by examining the issue of

holding accounts overseas, using as an example a European company holding a USD account

in the United States. A company (or individual) based outside the United States can open a

USD account in the United States and transact business in much the same way as a US

resident. Such an account is subject to the laws and exchange control regulations existing in the

account holder's country of residence as well as those in the United States. Although this

example could be applied to other countries, regulations vary from country to country. In some

locations, local exchange control or taxes can make such an arrangement impractical. With

recent changes in Europe, EU member states now allow their companies to hold accounts

offshore freely. Many other countries in Asia and Latin America also allow this, but often subject

to prior central bank approval. However, in many emerging markets restrictions will apply.

Maintaining an account overseas has some advantages as well as some practical difficulties.

Paying into an account several thousand miles away can be difficult, as may be obtaining

balances, statements or other information on the account, or instructing the bank to make

payments. For these, and many other reasons, banks have for many years also offered

accounts in various currencies to their customers from the branch nearest to the customer’s

domicile. US banks in London pioneered this service in response to the development of the

eurodollar market in the 1960s. Today, it is possible to maintain accounts in all major currencies

with a single bank based in London or in any other major financial centre. It is important to note,

however, that even though these accounts are offered by local branches, the currency still

remains physically in the country of origin and the bank itself maintains its own bank accounts

(‘nostro’ accounts) in the country of each currency. It is through this account that all customer

payments and receipts are actually settled.

In the example outlined above it was suggested that a company (or an individual) can open an

account in the United States to make and receive payments in USD. If this company opens an

account with a bank in London instead of the United States, the bank located in London

maintains the USD account in the United States (ie, its ‘nostro’ or ‘due from’ account). Entries

over the customer’s account are reflected as entries over the bank’s own account in USD in the

United States. This enables the bank in London to maintain accounts for lots of customers in

USD and pass all the entries over one ‘real’ USD account maintained in the United States. In

fact, if one customer of the London bank makes a payment in USD to another company that

also maintained their USD account at the same bank, the bank in London effectively just passes

the appropriate entries in its own books. There is no ‘real’ movement of funds over the bank’s

USD account in the United States.

This important principle must be remembered: even though banks offer currency accounts from

branches around the world, ultimate settlement will take place across their 'nostro' accounts in

the currency centre (ie, the currency remains in its country or currency centre).

As a further example, consider the situation in which two trading partners deal with each other in

a third currency. In this example , a company in Singapore needs to pay USD to a beneficiary in

Hong Kong.

In this transaction neither the Singapore bank nor the Hong Kong bank has branches in New

York that can clear USD. They are both using intermediary banks. Here the bank is using the

SWIFT serial method, where it sends the MT103 to its correspondent (not the beneficiary) and

no MT202 cover payment is issued. Bank C will put an MT103 equivalent into the CHIPS

system. Additionally, although not shown on the diagram an ‘advice to receive’ message

(MT210) might be sent from Bank B to Bank A (on request of the customer) to put Bank A on

notice that: “for value 26 January 2001”, you will receive from Bank C to your account at Bank D

USD10,000 for account of Company A Hong Kong on behalf of Company B Singapore.”

This message enables Bank A to position for the receipt of funds so that they can start to earn,

and, therefore, pay, interest from the value date, and will also enable it to check that it receives

value on the correct date to the correct account.

8.3 Treasurers’ requirements regarding cross-border payments

Generally, when making international payments, treasurers want a carbon copy of the service

that they enjoy in their domestic environment. They want to be able to send a batch of payment

instructions to the bank before an agreed cut-off time in the knowledge that, by doing so, the

bank will undertake to process them within an agreed time frame and pass value to the

beneficiary’s bank on the requested value date. Furthermore, they expect to pay a fair price for

this level of service, and do not want fees deducted from the principal that the beneficiary is due

to receive. Nor do they expect to have to pay wide margins when there is a foreign exchange

element involved in the transaction.

8.4 Domestic payment clearing systems

As discussed in chapter 6, domestic electronic payments usually follow similar patterns in most

countries. The payor (company ABC) wants to send a payment to a beneficiary (company XYZ)

for settlement of a trade debt. ABC will instruct its bank to make the payment and, if it is a

member of the clearing house, that bank will send the beneficiary’s bank a payment order.

Finally, settlement of the transaction will occur across the two banks’ respective settlement

accounts held at the central bank. If either bank is not a member of the clearing system, then

they will have to use a member bank (often referred to as a ‘pay-through’, participant or

settlement bank) to act on their behalf.

Again, in most countries, there is a two-tier payment system: those for high-value transactions

that can usually be settled on a same-day basis; and those for lower value, often repetitive

payments where the settlement date is not critical or is at some pre-determined date in the

future. This latter type of system is normally known as the automated clearing house (ACH), or

giro system. Some banks are members of both types of clearing, while others may only

participate in one, or might simply channel their transactions through another member bank.

8.5 International payments

8.5.1  International payments using correspondent banks

Whilst similar to domestic payments in principle, international payments add several levels of

complexity to the process. First, the payor’s bank (originating bank) has to convert the payment

instruction into a form that will be recognisable as a valid payment in the beneficiary’s country.

This usually means a currency conversion and a reformatting of the information in the original

instruction. Secondly, the paying bank must deliver the payment into the clearing system of the

beneficiary’s country. If the originating bank does not have a branch in that country, or its

branch is not a member of the clearing system, it will have to use a local bank (ie, a

correspondent) to act for it in clearing the item. This adds complexity and, of course, cost to the

transaction. More importantly, it means that the paying bank effectively loses control of the

transaction.

Diagram 8.3: International payment into the USA using correspondent banks (using

SWIFT cover method)

Companies ideally want to be able to treat international payments like domestic payments,

enjoying at least as good transactional terms.

8.5.2  International payments using a global bank

A few major banks can offer this level of service to its customers on a global basis. These banks

are members of the clearing system in most of the countries where they are established.

Customers, irrespective of their location, can access their accounts electronically and connect to

the banks using access to a global network in their home country in order to trigger a payment

that they need to make in a different country and another time zone. The bank will convert the

payment instruction into the form required to enable it to pass, in a fully automated fashion, into

the clearing system in the beneficiary country. This can be achieved either via the local branch

of the global bank (method 1) or in the case of a few banks, directly into the clearing system

(method 2) in the beneficiary’s country (see diagram 8.4). This drastically reduces the use of

correspondents, minimises costs and enables the bank to maintain control of the transaction

through the clearing process until it is exchanged with the beneficiary bank.

In effect, the global banks are providing a link between their customers in one country and the

clearing systems in another; a value-added service which banks using correspondents cannot

match.

Diagram 8.4: International payments using a global bank

8.5.3 Cross-border collections by credit card

Another method of collecting low-value receivables - particularly from individual consumers - is

by credit card. Credit card processing in single countries is well established, but accepting credit

cards from a number of countries is not so straightforward. First, if invoicing in a company’s

home currency rather than the buyer’s, the cardholder is paying in an unfamiliar currency.

Moreover, the local currency amount that will eventually be debited to the cardholder’s account

will not be known in advance (although systems are being introduced to provide this

information). If invoicing in the buyer’s currency the company will have to make arrangements

with an ‘acquirer’ in each country in which it has buyers. This means being subject to different

service levels and pricing in each country. Invoicing in the buyer’s currency may be more

attractive, but it can mean extra work for the seller in terms of price setting, accounting and

statement reconciliation.

At present, the underlying agreements that acquirers and card issuers have to sign with Visa

and Mastercard effectively preclude the general acquisition of cross-border transactions in

Europe. As this is anti-competitive, and generally militates against the free flow of cross-border

trade, it can only be a matter of time before this arrangement has to be discontinued.

However, even now there are grey areas. Under present regulations, transactions can only be

acquired in the country in which they are ‘processed’. But, if a Swiss subscriber orders a

magazine or book which is despatched from the US, identification of the country in which the

transaction is processed is not possible. This type of ‘international’ transaction can be acquired

cross-border.

This anomaly has given some card acquirers the opportunity to develop an improved service.

Initially aimed at airlines, a few banks have extended their service to cover multi-currency card

processing for some companies. Such services cover exactly the situation described and enable

users to quote invoice details to customers in their home currency. This means that customers

know the exact amount that will be charged against their account in advance. (Note: only freely

tradable currencies can be included.) Linking international credit card transactions to the

outsourcing process means that lockbox companies can process credit cards as agents for the

company (in exactly the same way the company would itself) and transmit transactions to the

acquirer electronically for authorisation and processing. In this case, the acquirer submits the

currency transactions to (and will be paid by) the card issuer, while the company can be paid in

a currency of its choice for all currencies collected. Some acquirers can accept transactions in

up to 60 different currencies, and currently offer this range to airline customers where the card

rules are slightly different.

This service enables companies that may be relatively small credit card players in each market

to attract competitive pricing. By creating larger economies of scale they obtain standard terms

and conditions and only have to manage a single acquirer relationship across a region or even

globally.

8.5.4 Cross-border direct debits

Direct debits are often associated with domestic, low-value collections for standard amounts,

covering items such as subscriptions or insurance premiums. It is only relatively recently that

this well-established and cheap form of domestic collection has been ‘internationalised’ and

used for the collection of higher value trade receivables. Some banks have designed their

services for the high-value, low-volume market while others have aimed products at the high-

volume, lower value users. However, both types of services will normally handle both types of

transactions.

An international direct debit service operates in much the same manner as its domestic

equivalent. However it may operate using an internationally recognised standard such as the

United Nations’ EDIFACT ‘DIRDEB’ message standard. Items are delivered into each country’s

clearing system by either a local branch of the service provider or one of its correspondents,

from where funds collected can be remitted either to a currency account held in the originator’s

home currency or converted to the receiver’s base currency and repatriated. Companies using

this service must send a file of transactions to the service-providing bank. There the items are

reformatted into the receiving country’s local automated clearing house (ACH) format and either

transmitted via a private data network or SWIFT (using the interbank file transfer service and the

MT102 message standard) to the appropriate bank in each country. Some banks offer a

guaranteed availability schedule for each country. Users of this service include a number of

publishers and wine and liquor exporters, which use these systems to collect trade receivables

cross-border.

8.5.5 Cross-border/international automated payments

Having looked at the methods for clearing international payments, we shall now consider the

different types of automated payments that are cleared through these systems.

Same-day value systems (RTGS) tend to cater strictly for large-size electronic funds transfers

that are time critical. ACH systems tend to handle instruments such as standing orders and low-

value electronic funds transfers and future-dated payments.

In the case of standing orders, where the payor instructs his bank to pay or ‘push’ a fixed

amount of money on a regular basis to a beneficiary, the beneficiary has no control over the

transaction. Even if the payment were to be made on the same day as a direct debit (see

section 3.2.12), the additional time to pass through the clearing would still mean that the

beneficiary would normally receive the funds some days later than if he had initiated a direct

debit transaction. With direct debits the beneficiary initiates the payment from the payor’s

account. This will be done in advance to ensure funds are received on value day. With direct

debits the receiver (creditor) is in control. Direct debits can work both domestically or

internationally. However, there are a number of legal hurdles, which we discuss in sections

8.8.1 and 8.8.2.

Lower value telegraphic or cable transfers issued by individuals or smaller businesses that need

to make occasional payments overseas are also cleared through ACH-type settlement systems.

These instruments normally start with the completion of a bank application form and are usually

initially processed in a manual fashion.

Large corporations making regular payments will normally use a proprietary electronic funds

transfer system supplied by one of the major banks or treasury software providers. This enables

the customer to compile a file of payments on a personal computer and to transmit them direct

to their bank via a dial-up telephone link. Some banks, as well as providing PC access, may be

able to take files of payments directly from customers’ mainframe computers. Some have a

facility to take a secure file of payments into their payment system directly from their customers’

own accounts payable system.

One area in which global banks can really add value for their multinational clients is through

their ability to process a mixed batch of high-value, same-day transactions, forward value-dated

transactions and lower value items. Although in the past ACH systems have been associated

with smaller value repetitive payments, in practice, their reliability and low cost also makes them

attractive for forward-dated, larger-value items. A number of banks and major companies are

now altering their systems and processes to take more advantage of them.

However, care needs to be taken. ACH systems in some countries have maximum payment

amounts so that they can only be used for lower value items (eg, Poland).

Much work has been undertaken in the EU over the past few years to improve cross-border

funds transfers, particularly in terms of lower value, less-urgent items. A steady flow of

European Commission papers and working parties and the Cross-border Payments Directive

(introduced 1999) and the recently enacted Cross-border EUR payments regulation (introduced

2002) have persuaded banks to pool resources to build pan-European payment networks to

either replace, or run in parallel with, traditional correspondent banking networks.

Examples of pan-European initiatives from payment clubs are: Euro-Giro (from the Giro banks),

Tipanet (from the co-operative banks) and IBOS (from The Royal Bank of Scotland, BSCH and

other banks). They have done much to introduce fast and cost effective cross-border funds

transfers for the man in the street and small businesses. More recently IBOS has extended its

reach to include banks in Asia and North America.

8.6 Cross-border payments and receipts in Europe

The introduction of the euro has given rise to new, specifically designed, channels for high-value

cross-border payments which have lead to many competing systems, an over-supply of services

and service providers and reductions in prices. Whilst addressing the merits (and otherwise) of

the various cross-border payment options, it is also important to compare each method in terms

of process.

8.6.1 Low-value cross-border payments and receipts

Until now, the only effective cross-border arrangements have been for larger value items,

however, the efforts of the European authorities to promote a more efficient, and hence less

expensive processing, of low-value items are starting to bear fruit. Cross-border low-value

payments are covered by the Cross-border Payments Directive, (EC Directive 97/5), which

came into force on 1 January 1999, and encompasses all cross-border credit transfers below

EUR50,000, and the EU Regulation on Cross-border Payments denominated in EUR (EC

Regulation 2560/2001). The scope of this regulation which came into force on 31 December

2001 covers all EUR-denominated electronic cross-border payments below EUR 12,500 within

the EU as of 1 July 2002 (with the important exemption of credit transfers, which will only be

included as at 1 July 2003). The threshold for cross-border payments denominated in EUR to

which this application applies will be raised to EUR50,000 as of 1 January 2006. Both aim to

facilitate low-value cross-border payments by creating greater transparency, by reducing or, in

the case of the regulation, eliminating the extra cost involved with cross-border payments (see

sections 24.25 and 24.26 for more detailed descriptions of both regulations). The main

difference between the directive and the regulation is that the former covers all cross-border

credit transfers regardless of the currency, while the regulation only applies to EUR payments.

In addition, while, the practical implications of the Cross-border Payments Directive have been

fairly limited, it is expected that the new Regulation on cross-border payments in euro will have

a much wider impact.

However, although the objective of the European authorities is to reduce the overall cost of

cross-border payments for small businesses and consumers, the new Regulation may

paradoxically lead to higher overall charges. Banks may indeed try to recoup the extra costs

involved with the implementation of the new regulation by increasing the cost for domestic

transfers and/or by introducing charges for transactions such as domestic credit transfers which

in some countries are currently made free of charge. Nevertheless, it remains to be seen how

far consumers and national governments will be prepared to accept these extra charges. It is,

therefore, hoped that the new Regulation will speed up the creation of a single European ACH

as a more efficient cross-border bulk payment system would undoubtedly reduce the cost

implications of the new Regulation for banks. The most promising development is the STEP2

initiative which we will discuss in Section 8.7 alongside the clearing systems that are currently

available for cross-border payments, ie, TARGET [1] (urgent), EURO1 (semi-urgent) as well as

STEP1 (retail).

8.6.2 International bank account number

The other important development in the area of cross-border payments is the introduction of the

international bank account number (IBAN). Under the impulse of the European Commission,

banks across Europe have agreed to standardise the identification of European bank accounts

so as to facilitate straight through processing of cross-border payments. The international bank

account number is a alphanumeric code and consists of an ISO 3166 two-letter country code,

followed by two check digits and the domestic account number or basic bank account number

(BBAN). The length of the IBAN differs from country to country in function of the length of

domestic account numbers, but the total number of digits cannot exceed 34 characters. Some

countries such as the UK also include a bank code, which is inserted before the domestic

account number. In addition to the EU countries, IBANs are being issued by the countries

belonging to the European Economic Area (EEA), Iceland, Norway and Switzerland as well as

the EU accession countries, Hungary, Poland and the Czech Republic.

Example of an IBAN

GB19LOYD 3508 2500 7568 22[2]

Whereby

GB is the country code;

19 is the check code;

LOYD is the bank code and

3508 2500 7568 22 is the domestic account number (BBAN).

It is important that IBANs are used in connection with the associated Bank Identification Code

(BIC). Operational since April 2001, use of IBANs is obligatory for payments that fall under the

above-mentioned European payments regulation for low-value payments ((EC Regulation

2560/2001). As a result, SWIFT decided that all MT102+ and MT103+ messages need to

contain, amongst others, the beneficiary’s correct IBAN to be valid. To ensure the correctness of

the IBAN, SWIFT users are required to check the validity of the check codes beforehand.

From a corporate point of view, it is important to remember that companies that are unable to

provide their supplier’s correct IBANs, will be charged for the extra processing costs. Some

countries such as Luxembourg and Italy will even allow the use of IBANs for domestic transfers

alongside their domestic account numbers (BBAs).

[1] Strictly speaking, TARGET is not a clearing system. This is discussed in more detail in 8.7.1

[2] In electronic format the digits are contiguous.

8.7 TARGET

8.7.1 Introduction to TARGET

When discussing the concept of real-time gross settlement systems (RTGS) (Section 5.4) we

indicated that each EU country (whether a Emu-participant or not) may participate in the EU-

wide TARGET system, provided it has the ability to clear EUR on a RTGS basis.

A cornerstone of the EU is the free movement of funds between member states. Prior to 1999,

while this principle was recognised, systemic problems created, at least temporary, delays in

such movements. With this in mind, the EU has implemented a system to move euro-

denominated funds transfers cross-border as quickly and efficiently as national electronic

payments operate. Before examining how the system works and its potential benefits and

shortcomings, it is necessary to understand that TARGET (Trans-European Automated Real-

time Gross Settlement Express Transfer system) has been put in place for two reasons. Firstly,

as a tool of the new European Central Bank (ECB) and secondly, as a method of moving

commercial EUR payments between counterparties located in different EU member states.

What is plain is that TARGET is a compromise. If there were an ideal world where politics and

money were of no consequence, a new cross-border payment clearing mechanism would have

been set up for moving EUR funds transfers between parties in different European countries on

a same-day value and real-time gross settlement (RTGS) basis. As this was not possible, it was

decided to link one real-time gross settlement system in each country to all others. TARGET

provides that link, but, on its own, TARGET cannot do anything, so to call it a payment or

clearing system is incorrect. It is really no more than a real-time communication channel linking

the domestic EUR payment clearing systems of each country.

More importantly, TARGET is a means for the ECB to manage and move EUR liquidity between

national central banks (NCBs) in the Economic & Monetary Union (Emu) member countries and,

as such, it is used as an instrument for controlling money supply and implementing monetary

policy.

8.7.2 Participation in TARGET

Participation in TARGET is limited to a single RTGS system per country which must

meet the common standards agreed in 1993. No discrimination is allowed between

home-based banks and banks based in other EU countries. This regulation also

means that EU member banks can obtain remote connection to domestic RTGS

systems, so long as they meet the non-discriminatory criteria set out for national

clearing membership.

Denmark KRONOS Italy BI-REL

Germany RTGSplus Austria ARTIS

Sweden E-RIX France TBF

Finland BOF Netherlands TOP

UK NewCHAPS* Luxembourg LIPS

Belgium ELLIPS Greece HERMES

Portugal SPGT Spain SLBE

Ireland IRIS

*CHAPSEuro

8.7.1 Introduction to TARGET

When discussing the concept of real-time gross settlement systems (RTGS) (Section 5.4) we

indicated that each EU country (whether a Emu-participant or not) may participate in the EU-

wide TARGET system, provided it has the ability to clear EUR on a RTGS basis.

A cornerstone of the EU is the free movement of funds between member states. Prior to 1999,

while this principle was recognised, systemic problems created, at least temporary, delays in

such movements. With this in mind, the EU has implemented a system to move euro-

denominated funds transfers cross-border as quickly and efficiently as national electronic

payments operate. Before examining how the system works and its potential benefits and

shortcomings, it is necessary to understand that TARGET (Trans-European Automated Real-

time Gross Settlement Express Transfer system) has been put in place for two reasons. Firstly,

as a tool of the new European Central Bank (ECB) and secondly, as a method of moving

commercial EUR payments between counterparties located in different EU member states.

What is plain is that TARGET is a compromise. If there were an ideal world where politics and

money were of no consequence, a new cross-border payment clearing mechanism would have

been set up for moving EUR funds transfers between parties in different European countries on

a same-day value and real-time gross settlement (RTGS) basis. As this was not possible, it was

decided to link one real-time gross settlement system in each country to all others. TARGET

provides that link, but, on its own, TARGET cannot do anything, so to call it a payment or

clearing system is incorrect. It is really no more than a real-time communication channel linking

the domestic EUR payment clearing systems of each country.

More importantly, TARGET is a means for the ECB to manage and move EUR liquidity between

national central banks (NCBs) in the Economic & Monetary Union (Emu) member countries and,

as such, it is used as an instrument for controlling money supply and implementing monetary

policy.

8.7.2 Participation in TARGET

Participation in TARGET is limited to a single RTGS system per country which must

meet the common standards agreed in 1993. No discrimination is allowed between

home-based banks and banks based in other EU countries. This regulation also

means that EU member banks can obtain remote connection to domestic RTGS

systems, so long as they meet the non-discriminatory criteria set out for national

clearing membership.

Denmark KRONOS Italy BI-REL

Germany RTGSplus Austria ARTIS

Sweden E-RIX France TBF

Finland BOF Netherlands TOP

UK NewCHAPS* Luxembourg LIPS

Belgium ELLIPS Greece HERMES

Portugal SPGT Spain SLBE

Ireland IRIS

*CHAPSEuro

EU countries that are not in the euro-zone (UK, Denmark, Sweden) are allowed to connect to

TARGET so long as they can process EUR on a RTGS basis as a foreign currency.

Any recognised financial institution that is a member of one national RTGS system and has a

settlement account with a national central bank in the EU has the right to use TARGET.

In addition, the European Central Bank (ECB) participates as a full member of the TARGET

Interlinking system via its own settlement system, the ECB Payment mechanism (EPM). The

EPM system provides payment and associated accounting facilities for the ECB as well as

offering a real-time correspondent banking service to a restricted group of ECB customers, ie,

non-EU central banks, European and international organisations and clearing and settlement

organisations including EBA (see section 8.8) and CLS (see section 5.7). Communications are

effected via the SWIFT network.

The European Monetary Institute (EMI), the forerunner to the ECB, identified a number of

features in the national RTGS systems that needed to be standard in Europe. These are:

provision of intra-day liquidity;

operating times;

pricing policies;

security and

system availability and back up.

For example liquidity is needed to prevent payment gridlocks that could otherwise occur. NCBs

will make interest-free funds available to RTGS members, either through the extension of credit

against suitable collateral (securities) or the use of intra-day repurchase agreements. Any

collateral held for monetary policy purposes will also be considered as covering intra-day

facilities. However, this collateral represents a cost to the banks and it is possible that banks will

seek to recover these costs from customers that use the systems.

8.7.3 Principles

TARGET is a decentralised system with a few central functions managed by the ECB. Most

processing is done by national RTGS systems, with TARGET providing a bilateral exchange

mechanism via ‘interlinking’.

TARGET operates like an RTGS system itself, processing payments one by one on a

continuous basis, facilitating immediate settlement and finality of payment at the respective NCB

so long as adequate balances or overdraft facilities are in place with the sending bank’s NCB.

As the receiving bank is never credited before the sending bank is debited, there are no intra-

day credit risks between participating banks. Funds received through TARGET are therefore

unconditional, irrevocable and the receiver is not prone to liquidity, credit or counterparty risks.

The delay between debit/credit should be a matter of a few minutes.

The interlinking procedures are only available to NCBs and the ECB.

8.7.4 Straight through processing (STP)

At present TARGET supports only two SWIFT message standards: MT103/MT103+ (customer

payment) and MT202 (bank-to-bank transfer or cover payment)*.

To aid STP these standard messages must be fully formatted when they leave the originating

bank (or NCB). TARGET has no facility for repairing incomplete payments. One mandatory field

is the use of BICs – Bank Identification Codes. These will enable payments to be correctly

routed by the receiving NCBs to the beneficiary banks.

As TARGET provides end-to-end transmission of data between member banks, it also has a

feature to send either a positive or negative acknowledgement back to the sending bank within

30 minutes, a feature that until TARGET few country-based RTGS systems possessed. The

appropriate NCB is responsible for forwarding acknowledgements on to sending banks.

*MT103 and its variant MT103+ replace the MT100 message type, which is due to be phased

out by the end of 2003.

8.7.5  Working hours

TARGET operates for eleven hours from 07.00 to 18.00 Central European time each working

weekday with the exception of six major European holidays (New Year’s Day, Good Friday,

Easter Monday, 1 May (Labour Day), Christmas Day and 26 December. Consequently, the

TARGET business day overlaps with the opening hours of the US Fedwire System as well as

the end-of-day operating hours of the Bank of Japan Payment System.

Corporate payments cease at 17.00 and the last hour of operation is reserved for bank-to-bank

settlement activity and settlement of the pan-European net settlement systems.

Local RTGS systems linked to TARGET are allowed to close down each day only after being

advised to do so by the ECB. In some circumstances processing may continue after the official

hours if there are backlogs of payments to clear.

In October 2000, TARGET implemented an information system, TARGET Information System

(TIS) so as to allow participants to gain simultaneous access to standardised information on the

status of the TARGET system via the information providers Reuters, Telerate/Bridge and

Bloomberg.

8.7.6  TARGET2

The governing council of the ECB has agreed to implement an upgrade of TARGET in the

coming years to reflect the increasing integration of the euro-zone and the converging business

needs of its main users. TARGET2 should also be able to cope with the enlargement of the

European Union and the euro-zone.

It is with this last point in mind that the ECB has decided that the shared component in

TARGET2 will take the form of an IT-platform that can be commonly used by NCB members on

a voluntary basis. As a result, NCBs will no longer be required to maintain their own platforms.

This approach should prevent an unnecessary fragmentation of the IT infrastructure and

increase cost efficiency.

TARGET2 will have a far more harmonised service level than the present system. There will be

a broadly defined core service, which will include all those services and functions that are

offered by all TARGET2 components. Additionnally, NCBs will have the possibility of providing

some complementary national services.

After consultation with the TARGET users, the ECB will put in place a project plan with the view

of implementing TARGET2 before 2005.

In addition, the ECB decided that EU accession countries will be allowed to chose whether or

not they want to join TARGET from the onset. The ECB will examine with the NCBs of the

accession countries the different connection options available for those who wish to join,

including a scenario whereby future members can avoid the need for their own euro RTGS

platform.

8.7.7 How companies access TARGET

Corporate customers, whose payments pass through TARGET, send payment instructions to

their banks in the normal manner. In diagram 8.5, instructions are sent by data transmission

from an electronic banking system. Payments are sent from the receiving bank through the local

RTGS system to the appropriate NCB. As all RTGS systems linked to TARGET accept EUR

payments only, the bank receiving transactions from a company in a legacy currency must

convert it to EUR prior to it entering the national RTGS system. Once delivered to the NCB, the

payment enters TARGET and the respective ‘interlinking’ accounts are credited. On receipt at

the receiving NCB, ‘reciprocal’ interlinking accounts are credited and the funds passed into the

receiving RTGS system are directed to the recipient bank. Finally, the beneficiary is credited.

8.7.8  Summary of TARGET procedure

1. Customer sends payment order to bank

2. Bank sends payment to the NCB via national RTGS system

3. Sending NCB checks validity, balance and/or collateral, and converts payment to

receiving NCB format. NCB adds security features

4. Sending NCB effects payment by using interlinking procedure provided by TARGET

5. Receiving NCB checks security features, converts to domestic standards and sends

payment via national RTGS to receiving bank

6. Bank credits beneficiary’s account.

An acknowledgement of receipt is generated by the receiving RTGSs and sent back to the

sending NCB. If this is not received within 30 minutes, the sending NCB must investigate.

8.7.9 What implications does TARGET have for companies?

The way TARGET affects corporate cash management depends on the banks currently being

used and the arrangements that have been put in place. We can distinguish two types:

8.7.9.1  Using correspondent banks

Diagram 8.6 shows Company X currently using a domestic bank (A) in country 1. On receipt of

the payment instruction, Bank A will debit the customer’s account for the local currency

equivalent of the original currency amount and send a SWIFT message to Bank C, its

correspondent in country 2. Bank C will debit Bank A’s account in its books and direct a

payment via the local clearing to Bank B, the beneficiary bank, Bank B, will credit the

beneficiary’s account and send him an advice.

This is the traditional method of moving funds cross-border (not just in Europe – but globally)

that is unpopular with many multinational companies. This is because there are three banks

involved, all of which want to be paid for their services:

Bank A will charge the remitter a fee for the payment, a ‘cable’ charge (even though

using SWIFT will only cost about EUR0.5 some banks may charge up EUR10), and

some will charge a fee to cover the costs of the correspondent bank used;

Bank C will either charge Bank A by debiting their ‘nostro’ account, deduct its charge

from the payment, or hold on to the payment for a period (usually one day) and invest

the value, or it may use a combination of these and

Bank B may deduct an amount from the incoming payment, charge its customer a

specific fee, or hold on to the payment and take a day’s value, or again some

combination of these.

In this situation it is logical that Bank A would prefer to switch to TARGET to avoid the high

correspondent charges, unless of course it banks with a pan-european bank that has direct

access to the local clearing. Indeed, any company having to use a domestic bank (we shall

discuss the situation for companies that can access the services of a pan-regional/multinational

bank in 8.7.9.2) for cross-border payments should seek to ensure that all its urgent high-value

cross-border payments are handled via TARGET. This solution offers the potential for lower

costs as well as guaranteeing beneficiaries’ delivery of the full amount remitted without loss of

value.

The old idea of banks using each other’s services based purely on reciprocity is now dying out

in the USA and Europe, although it still exists in Asia. Instead, most major banks select the

banks they work with in the same manner as a company would, and are negotiating service

level agreements and pricing schedules such that they can pass on competitive service levels,

guaranteed availability of funds and fixed prices to their own customers.

Some banks, which have been foreseeing less of a future for traditional correspondent banking

in Europe after Emu, have formed themselves into payment clubs, dealing with each other using

strict service levels, fixed prices, and guaranteed availability of funds.

It is difficult, if not impossible, to generalise about the advantages of traditional correspondent

banking. While it still remains an useful tool for cross-border payments involving emerging

markets or countries whose banks are not part of international payment clubs, its disadvantages

can be extensive within an increasingly economically unified area such as Europe:

several banks involved with each transaction - each will want to be compensated;

not (normally) possible to make same-day value payments;

without service level agreements between correspondents, there cannot be a

standardised service, known and fixed pricing, or a guaranteed availability of funds;

problem resolution becomes difficult with so many parties working to different standards

and

more expensive and less efficient for users. Often involves double charging and value

losses.

8.7.9.2  Using a pan-regional(multinational) bank

Diagram 8.7 shows the system offered by a few pan-European/multinational banks.

Once the customers send their payment orders to the nearest branch of the multinational bank,

the remitter's account is debited and a payment message is produced. With method B, the

multinational bank passes the payment either through SWIFT, but more likely through its own

proprietary network, and through its local branch in the beneficiary country. Through automatic

links, the payment is streamed directly into the local clearing system to the beneficiary bank.

Where this works without manual intervention, it is known as straight through processing. A few

multinational banks have taken this fast and efficient concept one stage further and use method

A, bypassing the local branch altogether (which in truth adds no value) and linking directly from

a central payments processor into the electronic clearing system in each country.

What are the cost aspects of this arrangement?

Bank/branch A will charge the remitter a fee which will cover the cost of the whole

process right up until the payment leaves the local clearing system in country 2 and

only the beneficiary bank needs to be compensated.

In this situation, same-day value funds are ensured (given that cut-off times are met) and one

bank takes total responsibility for the payment right up to hand-over to the beneficiary bank.

Increasingly, such banks are guaranteeing delivery times, service levels and accuracy.

Why would a company that is already enjoying a facility like this want to move to a system

based on TARGET? The answer is that they would not. TARGET costs make the overall costs

higher than the multinational bank solution, and the involvement of two banks, two NCBs, two

RTGS systems, and two interlinking sections of TARGET is less efficient and probably more

prone to errors and operational problems than the multinational bank system.

This system, currently used by many multinational companies for their urgent and high-value

payments, is likely to continue to be the most appropriate for most, even if their underlying

account and liquidity management structures may change because of Emu. Only a few

multinational banks are currently able to offer this service, either by using their own branches as

correspondents with direct membership of the national clearing systems, or, in some cases, by

connecting directly to the national clearing systems from one central processing centre. It is true

to say that US banks are further advanced in this than their European competitors, although

there are now several European banks that are building clearing links to enable them to offer

this service, both within Europe and in Asia Pacific.

The benefits of this approach are many:

standard service levels across regions;

standard pricing across euro-zone;

same-day value for all EUR transactions;

only one principal payment bank needed for whole region;

service already available on a multi-currency basis;

usually avoids the imposition of beneficiary or lifting charges (ad valorem charges made

for payments between residents and non-residents);

problems resolved more easily as one bank alone is in control of the process up until

the payment leaves the national clearing system and

easier to manage from a corporate standpoint. Provides one-stop shopping!

While the disadvantages are few:

risks attached to ‘putting all your eggs in one basket’ (counterparty risks and systemic

risks);

the system works best when all disbursement accounts are held with the same bank.

This may cause relationship problems with national/in-country banks which will still be

needed for collection purposes and

probably too expensive for non-urgent payments or in-country urgent euro payments,

which should be available domestically at a lower cost.

So bearing in mind that the largest users of high-value, same-day payment systems are well

catered for, where does the volume come from to enable TARGET to obtain sufficient activity to

benefit from economies of scale and thus for its prices to be reduced? The main source would

appear to be interbank transactions (but, of course, these are likely to be substantially reduced

due to CLS) and those made on behalf of mid-sized companies that continue to make cross-

border payments through domestic banks.

It would appear from pronouncements by some major banks, that few of their corporate

payments pass through TARGET; much of the system’s non-ECB traffic consists of bank-to-

bank payments in settlement of interbank transactions. It is also apparent that many banks are

not giving companies the choice of which payment circuits are to be used and how funds will

move. In many cases, companies will merely determine the value dates of their payments,

leaving their banks to make the necessary decisions on how to get the payment to the

beneficiary on time. However, a few banks may provide the user with some choice, and

differentiate each type in terms of price and service levels.

Looking at the technical infrastructure of TARGET, it is difficult to envisage high volumes of

payments moving through it. As discussed above, each transaction involves a minimum of two

commercial banks (and possibly as many as four if the remitting and beneficiary banks are not

direct clearing members), two NCBs, two real-time gross settlement clearing systems (RTGS),

two interlinking systems and the telecommunications system that links them. The average value

of the transactions passing through TARGET in 2000 was EUR16m (EUR88m between 17:00-

18:00, when traffic is limited to interbank payments).

The merit of TARGET is to be found in its speed and hours of operation. In terms of speed, the

system provides the ability to move EUR anywhere within the EU (including the ‘out’ countries, if

they can process EUR as a foreign currency in an RTGS mode) within a few minutes. This

enables many multinationals to manage their liquidity in the same manner as the ECB, in the

event they have access to TARGET rather than relying on correspondent banking. However,

even if banks do not facilitate direct corporate access to TARGET, the longer and common

working hours that the national clearing systems have to operate to accommodate TARGET still

permit other payment channels to achieve a similar end result.

The disadvantages of TARGET for companies are threefold: the extra costs; the problems of

guaranteeing service levels; and the difficulties of tracing lost, delayed, or mis-routed payments.

With so many parties involved, all demanding payment for their services, higher pricing will be

levied for TARGET-based cross-border payments. Turning to service levels, much as is the

case with existing correspondent banking arrangements, service-providing banks are reliant on

the co-operation of recipient or pay-through banks to execute payments received via TARGET

on a priority basis. However, it is virtually impossible for a service provider to guarantee service

levels to a remitting bank. Finally, any company which has experienced a lost payment under

the correspondent banking system will know of the frustration and level of senior staff

involvement that can accrue when tracing lost or delayed payments, and then in pursuing

interest compensation claims. Because of the system’s structure a lost TARGET payment is

potentially even more difficult to trace and sort out.

8.7.10 Spin-off benefits of TARGET

TARGET is having a number of other effects and benefits on banks’ services to corporate

treasuries. The fact that TARGET requires national RTGS clearing systems to operate for

longer and matching hours has major positive ramifications for companies. However, this

combined with the fact that TARGET operates during many national holidays, creates a number

of problems for the banks as it forces them to work longer hours and adapt their systems.

First, the positive issues for companies:

The extra opening hours provide corporate treasuries with greater capabilities to manage their

liquidity on a same-day, pan-European basis (this is particularly attractive to those with a

centralised structure). It also encourages a regionalised treasury approach. It is also extremely

beneficial to US companies, which, until the arrival of TARGET, had not been able to conceive

of managing their European cash on a same-day basis, given the time zone differentials and

early payment cut-off times of the national clearing systems.

This very issue causes several problems for the banks:

as companies are starting to move their pan-European cash on a same-day basis, they

are looking to obtain same-day, or better still, real-time information on balances and

transactions to be able to do this effectively;

prior to Emu many multinational corporations (MNCs) set up individual currency cash-

pools for each currency (normally based in the country of the currency). With Emu, it is

logical for MNCs to expect to be able to run one EUR cash-pool, irrespective of whether

they are scenario I or II companies. As yet not all bank systems can fully handle this

requirement.

to make a EUR cash-pool work, it is again logical that fewer banks are needed across

Europe. It is likely that the less sophisticated cash management banks, from a

technology stand point, will end up by being eliminated and 

the outdated concept of ‘resident and non-resident’ accounts has been artificially kept

alive by banks in some countries since the single market was introduced. This means

discriminating against non-nationals in terms of higher bank charges (lifting charges).

This will now have to disappear (as it has in the UK). It is not only discriminatory, and a

hangover from old cartel structures, but also a barrier to the free movement of funds

within the EU. Countries that continue to levy such charges are increasingly finding that,

thanks to TARGET, MNCs are making payments and receiving EUR funds to accounts

held in countries that have abandoned such practices.

8.8 The Euro Banking Association

The Euro Banking Association (EBA) was founded initially in 1985 to promote the ECU and

facilitate its use by developing and managing the ECU clearing system. It also functions as an

interbank forum for the development of cross-border payments within the EU and in particular

the euro-zone. Following the launch of the euro, EBA developed the old ECU clearing into a

highly successful cross-border high value euro clearing, EURO1. Following the implementation

of the cross-border directive on low-value payments (EC Directive 97/5) (For more details see

section 24.25.) EBA decided in 1999 to develop a European retail cross-border clearing system.

At the time, EBA concluded that a staged process (the so-called straight through electronic

processing (STEP) programme) would be the best way to achieve this goal. In the first stage,

EBA created a system for low-value cross-border payments STEP1, using the EURO1 platform.

In a second stage, EBA intends to implement a pan-European ACH for cross-border bulk

payments, STEP2, which is currently in its trial phase.

EBA has delegated both EURO1 and STEP1 to a dedicated clearing company, EBA Clearing.

Like SWIFT, the EBA is owned by its bank members. In December 2002 there were 179 banks

from 21 countries participating in EBA. 74 of these EBA members were direct participants of

EURO1 with another 14 being indirect participants. In addition, there were 94 EBA members

participating in STEP1. Banks which have a registered office or a branch office in a Member

State of the EU as well as banks which have their registered office in one of the EU Accession

countries are eligible for EBA membership.

8.8.1 EBA - EURO1

The EBA system, EURO1, operates in much the same manner as the previous ECU clearing

system from which it stems. Payments are settled bilaterally at the end of each working day

through its member banks’ settlement accounts at the European Central Bank. Moving funds

between non-members is only possible if such banks buy a service from a member bank,

adding a little to complexity and costs.

The net settlement basis, resulting in intra-day credit risks between members could be seen as

a disadvantage for EURO1. As the system settles through accounts held with the ECB only

once a day, individual banks must decide when funds will be made available to beneficiaries. To

facilitate this process, EURO1 provides an information service including intra-day position

reporting and pre-advice statements. As many banks do not want to make funds available until

they receive settlement, same-day value with next-day availability is offered by many banks up

to agreed cut-off times. This type of arrangement would have an adverse effect if a bank ceased

trading owing large sums of money.

A possible solution may be for the EBA system to move to a system of intra-day net settlement

(ie, settling a number of times during the day) at some stage, to reduce risks and to enable

same-day availability of funds.

However, the IMF has deemed in 2001 that EBA’s Single Obligation Structure is legally sound

under the BIS 1O Core Principles for Systematically Important Payment Systems (the so-called

Lamfalussy standards). Under the Single Obligation Structure, participants only have a single

net obligation/claim throughout the day, the amount of which is adapted on a net basis following

each transaction throughout the day. This single obligation or claim is valid and enforceable at

each and any time throughout the settlement day. Payment messages that have been

successfully processed are therefore irrevocable and final. In addition, each member has a debit

and credit cap. A maximum credit and debit cap of maximum EUR1billion is imposed on all

banks. Payment messages that would lead to a breach of the debit or credit cap are queued.

Furthermore, EURO1 imposes loss-sharing arrangements on its members and the ECB also

holds a cash-pool of EUR1bn on behalf of EBA members to act as an emergency source of

liquidity should any member fail to make its end-of-day settlement payment.

The legal single obligation structure combined with the liquidity and loss sharing arrangements

underpinning the system allow certainty of daily settlement and, accordingly, significantly limit

potential systemic risk.

As payments are slower than in TARGET, banks tend to use this system when a non-urgent

transaction is required. The main benefit of the EBA system is that the banks using it pay less

than 25% of the cost of a TARGET transaction. As a result, the average daily volume through

EBA continues to increase, averaging around 150,000 in November 2002.

Euro1 infrastructure

The system’s infrastructure is based around SWIFT and uses their FIN-copy service, where

copies of messages between member banks are automatically sent to the ECB. Processing

starts at 7:30 CET and cut-off time for submitting payment messages is 16:00CET. Payment

messages can be submitted up to five settlement days ahead of value date. Currently, EURO1

accepts MT100, MT102 MT103, MT202 and MT400 messages. As of January, EURO1 has

expanded its services to include debit transfers and is now able to accept MT104 and MT204

message types. In practice, usage of direct debit messages will only increase gradually as

banks have to set up user groups as well as overcome the legal difficulties that currently impede

efficient cross-border debit traffic within the EU.

Membership of EURO1 is open to any bank registered within an OECD country with a

registered branch in the EU and that fulfils certain financial criteria such as a minimum capital of

EUR1.25bn and short-term credit ratings of at least P2 (Moody’s) or A2 (Standard & Poors) or

equivalent. Participants must be able to access TARGET and be a direct settlement participant

in one of the national payment systems.

8.8.2 EBA - step 1

This system has been designed for cross-border low-value and retail payments denominated in

EUR which are less urgent and hence not appropriate for EURO1. It is the first phase of a

straight through payment (STP) system.

It is designed to reduce the time taken to process payments through traditional correspondent

banking channels in line with various papers and directives issued by the EU Commission.

Admission criteria are very flexible: any bank with a registered office or branch in the EU is

eligible for membership. However, banks that act as ‘settlement banks’ for the other participants

have to fulfil the more strict conditions used for EURO1 membership. In effect, most of the

settlement members are the same banks that use EURO1. To avoid any systemic risks, STEP1

automatically rejects messages that exceed either the sending or the receiving capacity of the

participants as defined in the code of conduct. In addition, STEP1 participants have a ‘zero debit

cap’, ie, a participant’s position resulting from processed payment messages is not allowed to

be negative.

The infrastructure is again based on SWIFT. Currently STEP1 is able to process MT103,

MT202, MT400 and the multiple payment message MT102 (for banks participating in a ‘closed

user group’). MT100 messages are also accepted but are due to be phased out in line with the

general industry practice. As of January 2003, STEP1 will also allow the exchange of direct

debit messages (MT104 and MT204) for participants that have appropriate bilateral

arrangements in place. However, it is expected that direct debit traffic will only develop very

gradually as banks have to set up user groups as well as overcome the legal difficulties that

currently impede efficient cross-border debit traffic within the EU. Payment messages can be

submitted five days prior to the value date. Initially set up as a D+1 clearing, STEP1 is now able

to process on a same-day basis. Cut-off time for same-day settlement is 9:30 CET. At 9:45, the

participating banks and their settlement banks receive notification of their exact funding

requirements for that day so as to bring their positions to zero. If a participant or its settlement

bank is unable to provide the necessary funding by the start of the processing cycle, payments

exceeding the required zero balance, will be queued and, if not covered later during the day,

automatically value date-adjusted to the next business day. The actual processing takes place

after 10:30CET together with the processing of the EURO1 payments.

Pricing to banks for STEP1 transactions is even lower than those for EURO1.

8.8.3 EBA - STEP2

STEP2 is the second phase in the implementation of a straight-through processing system for

low-value cross-border payments. With STEP2, EBA will create the first pan-European ACH for

processing low-value bulk payments. It is expected that STEP2 will go live into its pilot phase in

April 2003. 32 banks will be participating in the pilot phase. The technical operation will be in the

hands of the Italian interbank operator SIA, which has been selected by EBA to build and

operate the new platform. The first release of the system will allow the processing of Credit

Transfers In a second stage STEP2 will also provide Direct Debit processing. The payment

messages will be based on the MT103+ message structure presented in a formatted file. In

addition, EBA and SWIFT are looking to put in place an XML-based bulk payment message.

The processing cycle

Once validated, payment messages will be sorted into bilateral sub-files (one sub-file per

addressed participant) in accordance with the routing criteria established by the participants

through a central routing directory. For each sub-file resulting from the sorting of the payment

instructions sent by one participant, STEP2 will establish the amount of the bilateral payment

obligation between the sending bank and the addressed participant and generate a settlement

payment message for processing in EURO1. Upon settlement, STEP2 will send a report on all

submitted instructions as well as the necessary audit and reconciliation data.

As is the case for STEP1, STEP2 will be open to all financial institutions that have their

registered office or a branch in the EU. In addition, participants will have to meet a number of

yet to be defined technical and operational requirements.

8.8.4 EBA- STEP3

With its STEP3 initiative, the EBA hopes to exploit the opportunities offered by e-commerce.

EBA is currently evaluating the proposed creation of a platform for capturing multicurrency

payment orders initiated by corporate customers of participating banks (e-ba platform).

In a separate development, EBA has signed a memorandum of understanding with the New

York Clearing House (CHIPS), under the terms of which both organisations have agreed to look

into the feasibility of a currency-independent international electronic payment capability.

8.9 SEPA

In the light of the increasing pressure from the European authorities to create a Single European

payment area (SEPA), as exemplified by the recent Regulation on Cross-border Payments

denominated in EUR (EC Regulation 2560/2001), the European Banking industry recently

decided to set up a dedicated body to deal with this very issue. Comprising 50 senior executives

of Europe's major banks and representatives of the domestic/ commercial bank, savings bank

and co-operative banks associations, the European Payments Council (EPC) remit is to bring

about SEPA. To achieve this goal it has set up a number of working groups which will seek to

identify and eliminate the remaining obstacles that hamper the creation of an efficient single

European payments and collections area. In the meantime, the European Commission is

looking into creating a legal framework for the single payment area within the internal market.

The proposed draft version, which is currently being revised following consultation with the

stakeholders, has identified differentiation between residents and non-resident accounts,

national value-dating practices and VAT issues as some of the obstacles to a well-functioning

internal market.

8.10 National RTGS systems within the European Union

Under the European System of Central Bank (ESCB) rules, each European country has a

RTGS-system that is linked to TARGET. The most important European same-day payment

systems are the UK’s NewCHAPS and its NewCHAPS Euro Component (see section 6.5.5),

Germany’s RTGSplus (see section 6.6), France’s TBF and Spain’s SBLE. With the advent of

the euro and the gradual elimination of the residual obstacles to a truly single European

payment area, competition between the different RTGS-systems is bound to increase,

particularly within the euro-zone. Therefore, it is likely that some of the smaller systems will

eventually disappear or amalgamate much in the same way as is happening already in the

securities markets within the euro-zone.

8.11 Arbitraging payment systems [Non-examinable]

One major impact on account structures might be caused by MNCs trying to arbitrage their

access to EUR clearing services. Post-Emu, companies have been given a number of options in

terms of how they receive or pay EUR:

• continue to receive and pay EUR at country level (company structure B);

• receive and pay EUR from locally held but centrally controlled account (company structure A);

• receive and pay EUR from an account held in their home country and

• receive and pay all EUR from the cheapest and most efficient location.

This latter option depends on competitive forces, but it could be possible for a German company

to structure an arrangement where it was more efficient for it to collect and pay EUR through a

bank in Belgium than using a bank in Germany. This will mean setting up what, on the surface,

might seem an illogical account structure, whereby customers of a German company pay to an

account domiciled in Belgium. In extreme cases (although somewhat unlikely) a company based

in Germany paying and receiving EUR electronically might not need to operate a bank account

at all in Germany.

Companies dealing with overseas customers might want to do this to avoid lifting charges and

beneficiary deductions.

8.12 What are the most appropriate alternatives for companies?

Given the choice of all the methods available, it is difficult to see how the banks with pan-

European networks can be beaten when it comes to urgent high-value cross-border EUR

payments. In addition, many such banks also have very efficient low-value payment methods,

and can effectively offer one-stop shopping for all EUR payments across the region. For

companies which do not want to work with these types of banks, using banks that can offer a

combination of TARGET and the EBA systems may be more appropriate, whilst working with a

payment club or bank alliance, may prove more suitable for yet other customers.

Chapter 9 - Non-electronic international payments and collections

Overview

This chapter looks at paper-based instruments and how they are used in international banking.

Learning objectives

A. To understand the different methods of clearing currency cheques

B. To understand how lockbox services operate

C. To understand credit card collections

D. To understand the two main documentary collection/payment methods

9.1 Foreign currency cheques

If a company holds a foreign currency account, either in its own country or in the country of the

currency, in many cases the bank providing the account will issue a chequebook on the account

(in those countries or currencies where cheques are acceptable and where local banking

regulations allow). This will enable a company to make payment for international transactions in

exactly the same way as for domestic transactions.

However, what may be best for the issuing company may well not suit the receiver for several

reasons.

Firstly, a cheque drawn on an account outside of its currency centre will be expensive to collect

and could take several weeks to clear. For example, a USD cheque drawn on a bank in

Frankfurt sent to a beneficiary in France. Such cheques (usually referred to as ‘triangular

cheques’) are often not well ‘received’, or may be regarded as unacceptable by beneficiary

companies. Whereas a USD cheque drawn on a US bank given to a beneficiary that also holds

a USD account in the US would clear quickly and would be regarded as perfectly acceptable to

the receiving company.

Secondly, in some countries cheques are rarely, if ever, used. Countries such as the

Netherlands, Germany and the Scandinavian countries tend to pay and receive funds through

the giro or automated clearing house, and cheques are not regarded as a normal means of

payment between companies. Note: this may not be the case with consumer-to-business

payments where different norms often exist.

Note: this may not be the case with consumer-to-business payments where different norms

often exist.

9.2 Obtaining value for foreign currency cheques

When receiving a currency cheque drawn on a bank in another country, to obtain value for it, it

must be cleared either by being ‘sent for collection’ or ‘negotiated’.

9.2.1  Cheques for collection

To send a currency cheque for collection, a company must list the cheques deposited on a

paying-in slip or ticket (a different slip for each currency) which is then sent to the company’s

bank. The bank will send the cheques in a batch, together with others received in the same

currency from other customers. The bundle could be sent to the bank’s own branch in the

country of the currency (if that branch is a member of the cheque clearing system). However, it

is more likely to be sent to its local correspondent bank in that country (those bundles of

cheques with covering credits are often referred to as ‘cash letters’). On receipt the local bank

will put the cheques into the clearing and, when paid, will credit the value of the cheques (less

any charges it may levy) to the presenting bank’s ‘nostro’ account in their books. Once the

presenting bank has been notified that the funds have been received in their account, they will

credit the company’s account in their books (debiting the ‘nostro’ account). In the case of

countries with slow clearing systems it might be several weeks before the depositing company

is credited with the cleared funds. If only a local currency account is maintained by the customer

with the collecting bank, the bank will convert the amount received from the foreign amount

collected to local currency and credit the customer’s account with the proceeds - less their

charges.

If a French company holds an account in Germany but receives euro-denominated cheques

drawn on German banks, the fastest way to get value would be to send a ‘cash letter’ direct to

the bank in Germany (ie, a deposit slip plus cheques). This can save several days handling by a

French bank’s international division and will generally save significant costs. Indeed, while

France and Germany share a common currency, paper-based items are still cleared on a

national basis. In this example, the company’s euro account in Germany would be credited with

cleared funds.

To reduce the cost and timing of currency cheque collections a few basic actions can be taken.

Companies should seek to minimise:

non-value-added service at the local bank/branch:

–         deliver directly to international branch;

–         send direct to their bank’s correspondent and

–         send direct to own bank account overseas (if one held);

postage time:

–         use a courier for large amounts drawn on overseas centres and

–         use bank’s internal branch-to-branch courier service;

collection times:

–         consider weekends and public holidays[1];

–         use couriers domestically where local post is poor (eg Italy, Greece, South Africa)

and

–         open a lockbox;

costs:

–         use the above techniques to substitute low local cost for a high cross-border cost

and

–         balance cost against extra interest earned on high-value cheques;

clearing time:

–         deliver direct to a bank in the centre;

–         understand clearing availability schedule;

–         understand cut-off times and

–         understand local conventions with float and

charges due to conversions:

–         if cheques are regularly received and payments are made outwards in the same

currency, consider opening a currency account to reduce conversion costs (and to

provide a natural hedge).

9.2.2  Cheques for negotiation

This process is similar to a ‘bill discounted’. Banks will purchase the cheques ‘with recourse’

and credit a customer’s account immediately with the local currency equivalent of the cheque,

less the amount which covers the interest on the value of the cheque while the bank is clearing

it, plus exchange commission. With some banks, the exchange rate reflects both elements. The

amount of the interest deducted will depend on the currency of the cheque and the time it will

take for the bank to be given good value by its correspondent. ‘With recourse’ means that in the

event that the cheque is returned unpaid, the customer’s account will be debited.

Negotiation is usually favoured by customers with cash flow deficits (or overdrafts close to their

limits), even though the charges are higher than those for collections, as they receive funds

immediately into their account. Negotiation is also attractive where currencies are fluctuating

adversely. Overall, collections are usually cheaper and are, therefore, used when the depositor

is not in urgent need of cleared funds.

[1] Ideally collections should be held a sufficient number of days before the weekend or public

holiday to have the items cleared before the start of the weekend or holiday.

9.3 Banker’s drafts

A banker's draft is a cheque drawn by one bank on another and consequently is subject to all

the rules and regulations of cheques. Generally, they are requested by exporters that want to

exchange the risk of the importer for the risk of a bank. However, banker's drafts do not

necessarily provide a guarantee of payment and are often the target of fraud or forgery - so

normal precautions that would be taken when using cheques should also be taken when using

banker's drafts.

A buyer or importer may purchase a foreign currency draft from his bank drawn on a bank (or

possibly a branch of the importer's bank) in the exporter's country. This enables the exporter to

obtain funds faster and with less cost. Bank drafts normally clear like a cheque in the country on

which they are drawn. The buyer of the draft (the remitter or payor) can pay the bank in his own

local currency and will be debited immediately the draft is issued. The bank takes the value of

any float until the draft is presented and debited to their 'nostro' account.

As a deterrent to fraud, normally a bank issuing a draft will send a SWIFT message to the bank

it is drawn on MT110 advice of cheque) which effectively confirms the validity of the draft and

authorises payment.

9.4 The lockbox concept

Where a company is receiving large numbers of cheques from abroad, it might want to consider

using a lockbox service. Introduced in the 1940s in the USA as a domestic product, lockbox

services are now available in many countries and are supplied both by bank and non-bank

financial services companies.

Lockboxes can be particularly useful when used in cross-border collections. Typically, users

might be companies which invoice overseas customers in their (ie the latter's) home currency.

When the seller invoices the foreign buyer, on the invoice the buyer will be asked to send the

remittance to a post office box in the buyer's country rather than an overseas address.

Some companies use a lockbox service as a means of outsourcing their trade collections,

replacing or supplementing the services of the cashiering and/or accounts receivable

departments. Such companies may use lockbox services both domestically and internationally.

Lockboxes were originally designed to speed up the collection of cheques and have developed

over the years to handle credit cards, giro transactions, direct debits, physical cash and virtually

any other collection instrument, including electronic payments. Part of the value of lockboxes, in

addition to speeding up the collection process, is also the transmission of remittance details

which can be used to update account receivables systems automatically. Items received in the

post office box are either collected by a messenger each day or the post office may deliver them

to the lockbox company.

9.5 Lockbox processing

In a well-automated lockbox company, items for each client are passed to an operator working

at a machine called a rapid extract desk. Letters are fed into the machine, slit and opened to

enable the operator to remove the contents. Once removed the items - usually consisting of a

payment plus a remittance advice - are sorted into appropriate trays for further processing.

Typically, payment will be by cheque, although some less sophisticated buyers will enclose

postal orders, or even bank notes.

Obvious errors (ie, the payment amount on the cheque does not match the remittance advice

amount, or an unsigned cheque has been received) are also spotted during this process.

The majority of remittances received are straightforward and the cheques and remittance

advices that relate to them are separated and passed in trays to a reader/encoder machine. The

machine can read both the MICR code (magnetic ink character recognition) at the foot of each

cheque, and also the OCR code (optical character recognition) that may appear on the

remittance advices used by some companies. The operators load a batch of cheques into the

machine’s hopper. The machine reads the MICR line and the operator enters the amount

(value), which the machine encodes onto the cheque to complete the MICR code line. The

whole line of data is captured and stored. Additionally, during this process the cheque is ‘cross

stamped’ to identify the bank of deposit (collecting bank). An audit trail is printed on the reverse

of the cheque, and for some clients, the item will be microfilmed and/or electronically imaged to

scan the front and back. At the end of the batch a bank docket control voucher (DCV) is added

in to which the total of all the cheques processed is encoded. Some equipment can sort and

bundle the cheques by bank to reduce processing at the bank of deposit, and, therefore, to

reduce bank costs.

The remittance advices are then batch processed. It is possible for invoicing companies to

attach forms to customer invoices which include all the relevant information for processing in

one line of OCR code (some companies use bar coding instead). This is read and captured by

the lockbox company to a data file. To balance the batch, the total of cheques is compared with

the total of remittance advices. Any errors are found and corrected. Each batch of processed

cheques is forwarded to the clearing system via the collecting bank's nearest clearing centre.

Owing to standard branch cut-offs, items sent to bank clearing centres in this manner will attract

later cut-off times and can often be cleared a day faster than the normal method of processing

via a bank branch office.

The lockbox company is then able to provide information on the items processed to their clients

in a variety of ways including computer-to-computer data transmission, disk or tape.

As well as processing cheques, postal and money orders and cash, lockbox companies will also

process credit card-based transactions. Details of credit cards are manually captured from

remittance advices, stored and electronically transmitted to the credit card acquirers on a batch

basis at the end of each day. Some lockbox companies will also handle “not present” card

transactions over the telephone through linked call centres.

Major benefits to companies in outsourcing their remittance processing are:

• they are resourced to handle extreme fluctuations in volume – this saves a company hiring a

large workforce or buying expensive machinery;

• larger volumes gives those economies of scale, greater use of building and machinery,

several shifts, etc. Savings can be passed on to clients;

• can improve internal controls and

• items normally reach the banking system faster than a company could achieve itself.

9.6  Sample lockbox study

In this case study, a company has a subsidiary based in Boston, which is shipping items all over

the USA. The company's credit terms to customers are "payment due end month following

invoice month" (most customers pay by cheque, there is no seasonality in the sales pattern and

sales are usually around USD2,750,000 per month with 1300 receipts processed per annum).

But a recent visit to the subsidiary found that receivables were being processed in an average of

90 days, rather than 45.

The local staff are asked to look into the problem. In their report they say that a study by

independent consultants has found that use of lockboxes in four locations would reduce

average mail times by four days and cheque clearing by one day for 80% of customers (88% of

sales). The cost of each item processed is 13 cents with a monthly service charge of USD1,000

which is paid for by leaving interest free balances with the bank at a nominal rate of interest of

5%. The company's cost of funds is 7%.

The question is, should they go ahead with the lockboxes and what savings overall will the

subsidiary have made?

This gives a gross saving of USD28,234 against costs of USD12,169 plus there will be other

benefits in terms of internal cost savings (staff etc) and non quantifiable benefits such as

increases in efficiency which might have to be set against any potential reporting costs.

Generally, a lockbox service improves significantly the time taken to collect cross-border

payments and can reduce the usual costs of collecting such payments as well as float

inefficiencies. Typically, customers also reduce administration costs and can open up new

markets to attract new business without the traditional problems that cross-border collections

often imply.

9.7 Giro credits

In most major countries in Europe the bank or postal giro credit is a very popular method of

settling both private and business obligations (for this reason Belgium and Germany make little

use of cheques). Thus, some European-based lockbox companies are able to collect and

process giro credits for their clients in addition to cheques and credit cards. Giro credits are very

popular across the region providing as they do a cheap and effective method of payment both

for sellers of goods and services and their clients.

European lockbox companies can also arrange for clients' banks or post banks to send them

details of the credits received directly to their accounts, usually by disk or data transmission.

From these, the lockbox company can reformat the information their client needs to update his

records as well as carrying out first-line bank account reconciliation. The lockbox company can

add these details to the files sent to clients that already contain remittance information from

those customers paying by cheque or credit card.

9.8 Methods of settling international trade payments

International trade transactions can be settled in a number of ways:

open account;

clean collection;

documentary collection:

–         against payment or

–         against acceptance;

revocable documentary letter of credit;

irrevocable documentary letter of credit:

–         unconfirmed or

–         confirmed or

advance payment.

An international trade transaction is said to have been settled by ‘open account’ when a buyer

settles after an agreed period by making payment using one of the methods mentioned in

chapter 8, section 1. This may be settled using a simple payment or ‘clean collection’, where the

buyer sends the seller a currency cheque or bill of exchange and the seller will negotiate or

collect the item as described in section 9.2. No documentation is moved through the banking

system with an open account transaction.

However, open account transactions assume that there is a level of trust between the seller and

the buyer. Trust works both ways, the buyer wants to be sure that the goods are received and

the seller wants to ensure that payment will be made. With open account transactions, the buyer

usually has the goods before the payment, so the major issue is will the seller be paid.

9.9 Documentary collections

Documentary collection is a method that can reduce the risks of non-payment, and is

particularly appropriate where a seller is dealing with a new customer. This process is very

straightforward and may be used domestically, but is more commonly used internationally. In

this case, the documentation and the collection instrument pass through the banking system

(see diagram 9.2).

The following is an explanation of the steps in the documentary export collection process.

1. the buyer/importer and seller/exporter agree on the terms of the sale, shipping dates,

etc and that payment will be made on a documentary collection basis. Goods are

ordered;

2. the seller/exporter, through a freight-forwarder, delivers the goods to the point of

departure. The freight-forwarder prepares the necessary documentation based on

instructions received from the exporter. These documents represent title to the goods;

3. export documents and instructions are delivered to the exporter/seller’s bank (remitting

bank) by either the exporter or the freight forwarder;

4. following the instructions of the exporter, the bank processes the documents and

forwards them to the importer/buyer’s bank (collecting bank) with a cover letter detailing

the delivery/payment instructions;

5. the importer/buyer’s bank (collecting bank), on receipt of documents, contacts the

importer/buyer and requests payments or acceptance of the trade draft;

6. after payment or acceptance of the draft, documents (bill of lading) are released to the

importer/buyer by the importer/buyer’s bank;

7. the importer/buyer’s bank (collecting bank) remits funds to the exporter/seller’s bank

(remitting bank) or advises that the draft has been accepted;

8. The importer utilises the documents to pick up the merchandise and

9. on receipt of good funds, the exporter/seller’s bank credits the account of the

exporter/seller.

Whilst in this case the importer (buyer) will not get hold of the documents of title until he pays

the collecting bank, if the importer no longer wants the goods, and does not feel inclined to pay

the bank, there is not much that can be done without going into legal proceedings. So this

method does not provide a guarantee of payment, it just affords some level of comfort and

control as well as allowing the exporter to retain title to the goods.

Diagram 9.2: Documentary export collections cycle

9.10 Letters of credit

A letter of credit (L/C) is a means whereby an exporter or importer can exchange the credit risk

of customers for that of a bank. The letter of credit provides a guarantee of payment as long as

the correct documents are delivered within the timescale specified under the letter of credit

agreement. Both export and import letters of credit are issued on demand by banks to

prospective buyers. Payment is made to the beneficiary when the documents required under the

terms of the L/C are found to be conform by the issuing (ie, the importer/buyer’s) bank and, if

applicable, the confirming or negotiating bank[1]. 

Diagram 9.3 : Letter of Credit Transaction

1. an order is sent to the seller/exporter. It has been agreed during negotiations that

payment will be by documentary (letter of ) credit (L/C);

2. buyer/importer sends L/C application to his bank, the issuing bank;

3. bank does a credit check to determine if importer/buyer is creditworthy;

4. buyer/importer’s bank opens L/C and advises bank in seller/exporter’s country, the

advising bank;

5. advising bank advises seller/exporter of L/C in the seller/exporter’s favour;

6. seller/exporter ships the goods;

7. documents of title (invoices, bill of lading, insurance certificate etc.) sent by

seller/exporter to advising bank;

8. if the seller/exporter has agreed a credit period with the buyer/importer then a bill of

exchange (draft) may be attached to the documents. If no credit period is agreed, this

document will be a sight draft, ie, a draft without credit period;

9. advising bank sends documents to issuing bank;

10. either the buyer/importer pays and is given the documents of title by the

buyer/importer’s bank (known as “documents against payments”) or if there is a credit

period, the issuing bank will accept (sign) the draft (bill) and the buyer/importer will be

given the documents and. 

11. buyer/importer obtains documents of title and can collect goods from shipping agent or

customs.

12. The importer's bank sends payment to the bank in the exporter's country. This payment

is made immediately if it is a sight draft or on due date if it is a time draft.

13. The bank in the exporter's country pays the exporter when due, either immediatley, or at

the end of the credit period.

Features of letters of credit:

1. SINGLE OR MULTIPLE TRANSACTIONS. Letters of credit generally refer to one

transaction but can also be issued for any number of transactions. In the latter case, the

L/C acts like a bank guarantee enabling the buyer to purchase on open account,

provided the amount outstanding to the seller does not exceed a specified level. Often,

it is controlled by limiting the amount that the buyer can purchase on a weekly or

monthly basis;

2. BANK GUARANTEES. Letters of credit are generally irrevocable. This means that if all

required documentation is presented, the issuing bank must honour all drafts presented

by the seller (generally to its bank). Also, changes must be agreed to by all parties to

the transactions. Once ongoing business relationships have been established, however,

the seller may require only revocable letters of credit (cheaper but do not carry the

issuing bank’s guarantee). Revocable letters of credit may be used, for example, when

joint-venture partners trade with each other and

3. CURRENCY. Letters of credit may specify payment in either the importer’s, the

exporter’s or a third currency. Generally, only one of the parties bears the exchange

rate risk.

It should be noted that the L/C is itself not strictly a method of payment, but a guarantee that a

payment will take place if certain agreed conditions are met. The payment itself is usually made

by means of a draft or bill, drawn under the letter of credit. There are currently a number of

initiatives that aim to dematerialise the letter of credit process. Among the most prominent

initiatives are Bolero and Tradecard.

[1] Sometimes, the issuing bank will ask or allow a bank in the exporter/seller’s country to add

its own irrevocable undertaking to honour the payment in case the issuing bank should default.

Generally, the confirming bank will be the advising bank, ie the bank appointed by the issuing

bank to advise the beneficiary of the conditions of the L/C. Sometimes the issuing bank will ask

a bank in the exporter/seller’s country, usually the advising bank, to negotiate a credit on its

behalf, in which case the beneficiary will be advanced money against presentation of the

required documents. Interest rate will be charged on this advance till the bank has been

reimbursed by the issuing bank.

9.11 Money laundering

Money laundering is a description of the practice of recycling money obtained illegally, in such a

way that the funds appear to be legitimate. The practice is frequently connected with 'organised'

crime and drug trafficking in particular. Both banks and companies need to understand the drive

currently being undertaken by governments around the world to stamp the practice out.

In implementing measures to eradicate money laundering, which unfortunately usually involve

employing money movement and cash management techniques, legitimate businesses and

their banks can be adversely affected.

9.11.1  Account opening

Many countries now have very strict regulations about opening bank accounts for non-resident

companies. In France, for example, a foreign company wanting to open an account must submit

French translations of its memorandum and articles and certificate of incorporation. Signatories

may also be requested to deposit copies of identification documents such as passports, certified

by a recognised bank in the company’s country of incorporation. Corporate searches and Dun &

Bradstreet-type enquiries may also be made. This slows down the account opening process

considerably and all costs get charged back to the account-opening customer. This due

diligence on new account holders is part of what is now referred to as the ‘know your customer

principle’ applied internationally with a view to stamping out the movements of illegal funds.

9.11.2  Account operating

Maintenance of proper records of all transactions passing through the banking system, audit

trails and back-up material are important aspects of providing proof that transactions are

legitimate. In most developed countries, banks in particular are now expected to identify, query

and (potentially) report to the police, transactions that appear to be out of the normal business

area of their customers. In some countries central banks may require documentary evidence of

transactions to be lodged by companies trading with overseas counterparties.

9.11.3  Legislation

Most countries now have money laundering regulations. For example, in the UK, ‘The Money

Laundering Regulations’ first implemented in 1993 and updated in 2001, 2002 and 2003

(enforced as of June 2003) and the EU’s Second Banking Co-ordination Directive cover firms

engaged in financial activities and this is construed to include the financial dealings of

companies through their corporate treasuries. For money laundering purposes this imposes

obligations on companies to adequately identify all counterparties, customers and agents with

whom they may be carrying out business. There are some exemptions as to the need to

thoroughly check the bona fides of trading partners; however this does not exempt them from

keeping proper and verifiable records, including details of the origination of funds (banks and

account details) and details of remittance made and their locations.

To help counter money laundering, the Joint Money Laundering Steering Group (JMLSG), which

regroups all UK Trade Associations in the Financial Services Industry, has drafted a series of

practical guidelines. These JMSLG guidance notes are regularly updated and are recognised by

the UK Treasury Department (HM Treasury). (The legislative framework is dealt with in more

detail in section 24. 27.).

Several countries have introduced obligatory cash payment reporting above certain thresholds.

For example, in the USA all federal cash transactions above USDD10,000 have to be reported.

9.11.4  Money laundering phases

There can be up to three phases of money laundering, placements, layering and integration.

Placement is the investment of illicit funds. This can be through areas such as property

purchase. Layering is the completion of many transactions between the placement and the

integration of the cash to be laundered into the banking system, thus making it difficult to trace

or to follow an accurate audit trail. Integration is the channelling of the illicit funds into the

legitimate market, the ultimate goal.

Chapter 10 - Foreign currency accounts

Overview

This chapter looks at the need for - and use made of - currency accounts. It covers some of the

areas that need to be considered when evaluating the effective use of currency accounts, then

explores the operational reasons why an account should either be held centrally (in one location

with all other accounts) or locally in the country of the currency (the currency centre).

Learning objectives

A. To identify when currency accounts need to be opened or closed

B. To appreciate the cost/benefit arguments and the impact on risks

C. To understand in detail the operational pros and cons of account location for

operational banking purposes (Chapter 12 on cash pooling and chapter 18

efficient account structures discuss location in terms of liquidity management)

D. To appreciate the terms and conditions relating to accounts and to be able to

identify differences between countries, currencies and banks

E. To recognise the need for additional services attached to accounts

F. To appreciate the impact of account ownership on regulatory issues

10.1 When to open currency accounts

10.1.1  Introduction

The time to open a currency account is when the volumes and values of transactions in a

particular currency have reached the right level for the company concerned. What is right or

cost effective will vary considerably from company to company. The following gives examples:

10.1.2 Company in Singapore

Scenario

A company invoices Singapore-manufactured goods in EUR to clients in France. Orders are

irregular, and during last year the company received five payments averaging EUR100,000

each. The company has no selling expenses in France.

Solution

As all production expenses are in Singapore dollars (SGD), even if a currency account was in

place, the company would have no need to hold EUR. It would merely create an ongoing

exposure. In this instance the company should not need to hold a currency account and would

do better to sell the EUR for SGD, a currency it actually needs (we do not discuss the hedging

issues here).

10.1.3 Company in the United States of America

Scenario

A company in the USA invoices goods in EUR to customers in the Netherlands. Orders for

annual magazine subscriptions average around USD60 per item. There are 15,000 orders per

year, but the company has no expenses in the Netherlands.

Solution

Despite the low value and the one-way flow, the volumes alone make the use of an EUR

account necessary. This account will probably be cleared out regularly and EUR funds sold for

USD which are then remitted to the US.

10.1.4  Company in Hong Kong

Scenario

A company exports goods to Malaysia on a regular basis. The average value of goods invoiced

in Malaysian ringgit is MYR50,000 and there are approximately 20 such sales per year. The

company has a small sales office in Kuala Lumpur, so has some local expenses and they also

buy some raw materials from Malaysia which are exported to Hong Kong. Annual payments for

imports the previous year totalled MYR650,000.

Solution

It is obvious that such a company will need an MYR account to collect the amounts due from

sales, particularly as they have local expenses. In such a situation the currency account

performs three functions:

as a vehicle for collecting receivables;

as a vehicle for paying amounts due and

as a natural hedging mechanism.

Only the residual funds (MYR350,000 less local expenses) may need to be converted to Hong

Kong dollars (HKD), as and when required. It is likely for accounting and control purposes that

the local sales office may have its own separate account.

10.1.5 Company in Germany

Scenario

The company imports raw materials from Poland. Orders are monthly and are denominated in

USD. Average values are USD500,000 per month and the company has no sales to Poland, but

it did have two dollar-denominated sales last year, to customers in the US and Hong Kong,

totalling USD250,000.

Solution

This company probably does not need to use a currency account. It will need to buy substantial

amounts of USD to pay for its raw materials and, as these are regular purchases, this can

probably be achieved by way of a set of forward exchange contracts. The debit of the maturing

forward exchange contract could be dealt with via the company's local currency (EUR) account,

whereas a funds transfer directly to the supplier's bank in the US would fulfil the credit side of

the transaction (currency settlement). So, in terms of the payment side, a currency account

would add no value. (Note: some banks will not pay currency proceeds of an foreign exchange

contract away to third parties, in which case the credit side would need a currency account -

from which a USD remittance would have to be made. This is not so efficient). The amounts

collected were relatively low and 'ad hoc', thus could be sold for EUR on receipt.

10.2 When to close currency accounts

In an ideal banking structure companies should have as few accounts as possible because they

are costly to run and maintain (see section 10.8) and can create currency exposures. Therefore,

all accounts should be reviewed regularly to ensure that they are really needed, using similar

criteria for each one but recognising the particular purposes for which each account is used.

Trading patterns change; banking structures and accounts need to change with them.

10.3  Basic questions and answers

A decision on whether an account is needed or not can be reached by posing a few simple

questions:

1. Are the goods or services we supply invoiced in currency?

2. Are the goods or services we buy invoiced in currency?

3. Do we buy and sell in the same currencies?

If the answer to 1 is 'yes' but 2 is 'no' (or vice versa) for any currency, it is likely that a currency

account is not required. If the answer to 3 is 'yes' for any currency, then an account may be

needed, but if 'no' then probably not.

Some companies seem to believe that it is necessary to hold an account for every currency

received or paid away. Using the above criteria, this can be proved to be inefficient.

A simple cost/benefit analysis needs to be completed for each currency.

Following on from question 3, the questions listed in 4 should help a company decide on the

cost-effectiveness of opening a currency account.

4. What charges/costs do we incur without a currency account?

          - foreign exchange commission/spread;

          - interest loss (float);

          - transfer cost and

          - others

5. What will the charges/costs be if we use a currency account?

6. What are our foreign exchange and interest rate risks with and without currency accounts?

10.4 Where to hold currency accounts

10.4.1  Available locations

Once a decision is made that trading patterns make a currency account necessary, its location

needs to be considered. There are three main options:

1. Hold the account in the company’s home location (staying at home - SAH).

o US company banking with JP Morgan Chase New York, holds its USD and all

currency accounts at the same location.

2. Hold the account in the country of the currency (going native - GN).

o US Company hold accounts as follows:

GBP           NatWest London

EUR           Dresdner Frankfurt

EUR           Credit LyonnaisParis

USD          Chase New York

3. Hold all the accounts in a third location.

o This is often seen where an offshore treasury centre in Belgium, the

Netherlands, or Ireland, chooses to hold all its currency accounts in London. 

o Note:This scenario often occurs for reasons other than transactional operations, ie for liquidity

management (pooling) purposes, or to settle foreign exchange trades transacted through London. For the

purposes of the discussion that follows, such accounts should be considered exactly the same as staying

at home (SAH).

We shall now compare the operating impact of both structures:

10.4.2  Bank relationships

SAH - company can use same bank as used for local currency

account.

GN - company needs new relationship (possibly with a branch of

same bank?).

10.4.3  Transfers between LCY (local currency) and FCY (foreign currency)

SAH - easy transfer of funds - but also requires entries across bank's

vostro/nostro accounts.

GN - requires cross-border funds transfer.

Both options have cost and value dating, and possibly float, aspects that need to be

investigated. These will differ by currency, country and the bank used.

10.4.4  Cheque deposits

SAH - easy to pay in;

-

-

longer to clear and

more expensive to clear.

GN -

-

-

more difficult to pay in;

may need to use a lockbox or cash letter service and

cheap and fast to clear.

10.4.5  Cut-off times for payments and receipts

SAH - much earlier -

-

sometimes payment cut-offs are one day

prior and

sometimes lose one day' s value on receipts.

GN - much later - enables same-day value, in line with local

regulations, for payment and receipts.

10.4.6  Deposit/receipt of credit transfers from customers in country of currency

SAH - takes longer - payor must

arrange for funds

to be sent to the

receiving bank

nostro account

could lose a

day's value.

GN - credit from local payors will reach the account at the fastest

speed that the bank's system allows. However, the beneficiary

may have to wait several days for the bank's advice of the

receipt of funds (unless using cross-border electronic banking

to monitor the account, when it will typically be a next-day

advice).

10.4.7  Reporting and statements

SAH - The company could collect daily statement from bank along

with LCY accounts, or the account details could be reported

using same electronic banking system as used for LCY

accounts.

GN - If the bank supplies paper statements, the company may wait

many days for statement to arrive by post. If the bank can

report electronically, it may send a customer statement via

SWIFT to the customer's lead bank (MT940 message), or the

company may take another electronic banking system from the

account-providing bank.

10.4.8  Credit interest

SAH - Credit interest at close to market rates usually available.

GN - Credit interest not always available, but if so, is usually at lower

rates than SAH.

Note: Withholding tax rules and rates on interest paid will differ between locations.

10.4.9  Problem resolution and help

SAH -

-

No time difference problems and

No language problems.

GN -

-

Time zone differences can cause contact problems and

Will local banks have staff that speak same language as

customer?

10.4.10  Tax and permanent establishment

SAH - Neither should be a problem.

GN - Either or both could be a problem - needs to be fully

investigated.

10.4.11  Acceptability of cheques

SAH - a cheque drawn on a bank in a country that is not the country of

the currency is not normally acceptable to the beneficiary (eg

EUR cheque drawn on EUR account in London - sent to

German company);

-

-

slow and expensive to clear and

in some countries, chequebooks will not be allowed on foreign

currency accounts (eg Greece, Hong Kong).

GN -

-

cheques perfectly acceptable (with a few exceptions); and

fast and cheap to clear.

Note 1: Note that even within the euro-zone countries cheques are still cleared on a national basis, hence a EUR cheque drawn

on a bank in another euro-zone country than the customer’s country will not be acceptable.

Note 2: In some countries such as those in Central and Eastern Europe non-residents are generally not allowed to hold

chequebooks on offshore accounts.

Note 3: In many countries it is not current practice to settle corporate to corporate obligations using cheques (eg, Netherlands,

Germany, Poland).

10.4.12  Delivering payment instructions to bank

SAH - Easy - company can deliver signed letter or electronic funds

transfer

GN - Postage times preclude letters

-

-

-

Tested telex

Fax

Cross-border EFT

- cumbersome and old fashioned

- strong security risks

- can bank handle this?

In any case costs need to be compared as well as value dating practices and local banking

conventions.

10.4.13  Commission/banking charges

SAH - As all entries are doubled up (across companies' accounts and

banks 'nostro'/'vostro' accounts - plus SWIFT messages), costs

are normally higher.

GN - Lower local bank costs means local charges apply; these

should be cheaper.

10.5 Running a currency account

There are a number of terms and conditions that need to be agreed with the supplying banks.

10.5.1  Minimum balance

Some banks will require a minimum balance to be held on the account. This will preclude

facilities such as full zero balancing. In some cases this minimum balance will be non-interest

bearing.

10.5.2  Credit interest

10.5.2.1 Is credit interest payable? 

Generally, credit interest is payable on accounts held outside of the country of the currency. But,

in some cases, interest will not be payable on accounts held in the local centres. This may be

for a number of reasons:

local banking practice (eg Finland, Germany); and

local regulations (eg Hong Kong, Singapore, France for residents).

However, it is always worth asking for interest. Even if local rules do not allow for interest

earnings on current accounts, some allow for transfers to other types of interest bearing

accounts (or money market instruments).

10.5.2.2  What rate of interest is payable?

In some markets, the rate of interest may vary depending on the value of the balances held.

Tiered interest rates are frequently offered for current accounts or accounts with fluctuating

balances whereas, interest paid on fixed deposits will always be based on absolute rates.

This chart illustrates a typical tiered interest rate structure. Note that the first 10,000 units do not

attract any interest. Therefore, the rate of interest on a balance of 9,900 would be zero. A

balance of 49,000 would earn nothing on the first 10,000, 2.5% on the next 10,000, 3% on the

next, and 3.5% on the final 19,000. Calculations would be carried out daily on the cleared

balance.

Another interest rate structure that is often seen is the banded interest rate structure, whereby

interest is applied based on the band the deposit amount (in its entirety) falls into. So if banded

interest were applied to the balance of 49,000, the interest due would be 3.5% for the whole

amount.

10.5.3 Credit interest calculation

Companies should always check interest calculations, as even banks make mistakes. To do

this, the basis of the calculation must be understood. There are general conventions in most

countries, and some banks will vary them slightly. Generally, GBP calculations are based on

actual days in a 365-day year. However, some currencies, countries and banks use different

bases. Currency interest is often based on the American concept of a 360-day year, with the

main area of difference between:

actual days in a 360-day year and

30-day months in a 360-day year.

It is also necessary to know how often interest is paid, or added to the principal balance, so that

interest on interest can be computed.

10.5.4  Withholding tax

In many countries, banks deduct tax on interest earnings at source. These rates vary

considerably depending on:

country and

whether the customer is a resident or non-resident (see chapter 12).

If double taxation agreements are in place between the country where the deduction has been

taken and the country of residence of the customer, then a company may be able to reclaim

some (or all) of the amount withheld. Alternatively, they can be regarded as part payment to

home country taxes.

If set up correctly it is possible to set up cash pooling arrangements in the UK and The

Netherlands without withholding taxes being deducted at source.

10.5.5  Debit interest

It is important to ensure that a debit rate of interest is negotiated on the currency account when

it is set up, even if the company is not expecting to overdraw it. Banks' computer systems are

usually set up to apply very high penal rates of interest to unauthorised overdrafts. A

multinational company which accidentally draws against an uncleared position with an Italian

bank would be very unhappy if that bank levied the typical 8% to 10% default margin over the

cost of funds that is often loaded on the computer.

Interest calculations on debit balances can sometimes be carried out on a different basis from

credit balances in some countries and banks. These conventions need to be understood.

10.6 Bank charges on currency accounts

10.6.1  Value dating

The European cash management concept of 'value dating' is frequently confused with the US

banking system concept of 'availability' (for collections) or 'clearing' (for disbursements). Value

dating refers to the difference between value being received for transactions by banks and the

dates of debits to the payor and credits to the recipient for a transaction (which may be

significantly different to the transaction date). For example:

             Bank transaction Date Value date

Draw out cash 4 April 3 April

Deposit cash 4 April 5 April

Availability/clearing refers to the time required by the US banking system to present deposited

cheques against the drawee bank. American banks may retain some availability/clearing as a

form of compensation for services (ie, float), although the extent of such activity is relatively

trivial and for multinationals will be measured in hours rather than days. In contrast, value dating

is an important form of compensation for European banks. Although the EC Directive on the

Transparency of Banking Charges states that all charges, including value dating, should be

visible and advised to companies, value dating practices in some countries represent a hidden

extra charge in many cases.

Value dating and float earnings also form a large part of the revenue of banks in certain Asian

countries.

Close attention must be paid to bank account structures to ensure that bank charges or losses

of value are minimised. It is not unusual in some countries when moving funds between two

banks for both the remitting and receiving banks to each take one day’s value on a transaction.

For example, funds are debited to the payor on day one ( the date of the instruction), or even on

‘day minus one’ if the bank back-values transactions, passed to the receiving bank on day two

and passed onto the beneficiary on day three. With low-value cross-border payments,

combinations of float and value dating applied to transactions may range anywhere from four to

six days depending on the countries and banks involved.

Such practices are often in addition to other item or turnover-based charges.

10.6.2  Commission charges

This term can relate to various types of bank charges. It may be taken as:

an annual, quarterly or monthly payment;

in advance or arrears;

covering all or some bank services for the period and

a block debit for an aggregated number of item-based transaction charges.

10.6.3 Transaction charges

There are two types of transaction-based charges:

item-based and

value-based.

Item-based - will relate purely to an agreed fee per item type, and this fee will not change for

larger or smaller value transactions.

Value-based - these are 'ad valorem' or 'per mille' (per thousand) based charges which means

higher charges are made for higher value items. Some banks will set maximum and minimum

levels. For example, a German bank may express its charge as follows for cross border

payment:

'2 per mille, minimum EUR15, maximum EUR75.'

Which means that the bank will charge EUR2 per every thousand of the value of the payment,

with a minimum charge of EUR15 and a maximum of EUR75 ie, the bank would charge EUR75

for a payment of EUR37,500 or more.

10.6.4  Turnover charges

Turnover charges are normally calculated on a per mille basis, either on the value of the debit or

credit items passing through an account. France is the European country where banks make

most use of turnover charges to compensate themselves and this charging method is seen in

some Asian countries as well. In France the charges are normally around three per mille and

are taken quarterly.

10.6.5  Lifting charges

This fee is charged by banks when money is moved between resident and non-resident

accounts (or vice versa), ostensibly to compensate banks for having to report such transactions

to the respective central banks. Although charged in many countries in Europe, usually on a 'per

mille' basis, Germany is the country that causes most problems as the fee is fixed at 1.5 'per

mille' with no maximum. German banks often give the impression that this fee is non-negotiable,

but this is not the case, and foreign banks are likely to negotiate a low fixed fee instead. Lifting

fees are often payable in other countries, but usually are limited to a maximum amount.

10.6.6 Account maintenance fee

This charge is taken in order to compensate the bank for the cost of maintaining an account in

their books (or, more correctly, on their computer). An account with no balance and no activity

still costs the bank money to report and this charge is an attempt to cover that cost.

Increasingly, US banks will include the cost of providing electronic account reporting via

electronic banking systems (usually on a previous-day basis) in this fee. Clients that require

same-day information (where it is available) may be charged an additional fee.

10.6.7  Cable or telex charges

This charge is meant to reimburse the bank for the cost of using a cable, telex or SWIFT

message, usually in respect of a payment. Although it is designed for cost recovery, many

banks that have high levels of automation (ie straight through processing techniques with no

manual intervention that link directly into SWIFT or their own private networks) have such low

costs in this respect that this fee now has a profit element. When charged in conjunction with a

transaction fee it should be regarded as part of the overall payment cost.

10.6.8 Correspondent charges

These fees are charged by banks when making international payments via a correspondent

bank or another branch of the same bank. Modern banks that have service level and pricing

agreements with their correspondents should be able to levy a fixed fee - advisable in advance -

to the corporate customer. Less sophisticated banks that do not negotiate with correspondents

will merely pass onto customers whatever price they are charged.

Diagram 10.2:  Charges taken by banks for an international funds

In diagram 10.2 there are three banks involved and, not surprisingly, all expect to be

compensated. Some will make an item charge or may hold on to the payment for a day, taking

one day’s value. In some cases they may do both. This situation can be rationalised by

eliminating the correspondent bank either by using the German branch of the UK bank as the

pay-through bank or by using a bank in the UK that has a correspondent relationship with the

beneficiary’s bank.

In some countries it is local practice for charges to be taken from the amount of a payment so

that the beneficiary does not receive the full amount of the transaction. This is known as a

“beneficiary deduction” or in banking parlance a “bene deduct”. This makes account

reconciliation difficult and consequently this practice is not popular with companies. Some banks

will deduct a fixed charge, whilst other will deduct a charge based on the value of the payment.

This latter practice is particularly unpopular.

10.7 Billing/account analysis

Increasingly, banks are discovering that period-end billing or account analysis (a slightly more

sophisticated US version) is not only beneficial to them but also highly regarded by corporate

users. Period-end billing is generally liked by banks because:

their IT systems count transactions as they occur (no or low cost);

the cost of taking a fee for a transaction (eg funds transfer), is almost as high as making

the transfer: billing reduces this to one transaction per month;

other aspects of the corporate relationship can be included in the billing (eg allowance

for credit balances, overdraft fees and interest, etc) and

advices of debited transaction charges are not necessary, thus saving cost.

Companies like period-end billing because:

their account statement is not 'crowded' with lots of small transaction charges and they

do not receive large volumes of paper-based debit advices;

billing aids reconciliation of bank's calculation of charges against the company's own

records and

simplifies cash forecasting if all charges are taken once per period.

10.8 What is needed to manage a currency account?

 

10.8.1 Account statement

Statements and transaction details will be available by some or all of the following

methods:

Method Staying at home Going native

     

Paper based statement/advices yes slow - relies on post

Disk/tape of transaction details yes slow - relies on post

Fax yes yes

Data transmission yes yes

Electronic banking yes yes

SWIFT statement possible but often not necessary yes

 

10.8.2 Lockbox

Useful if reasonable volumes/values and buyers are invoiced in local currency and the supplier

has no local office. Company will need to hold in-country account for credit of receipts. (Lockbox

services are discussed in detail in chapter 9, section 9.4).

 

10.8.3  Cash letter services

Useful if buyers are invoiced in local currency, but are required to send cheques to supplier in

his home country. The cash letter service will speed up collection of the funds which could be

credited to the supplier's own currency account held in the country on which the cheques are

drawn, or could be credited to the supplier's bank's 'nostro' account. (The concept of cash letter

services was discussed in more detail in chapter 9, section 2.1).

 

10.8.4  Payment and transfer methods

Whichever location is used for a currency account, the account holder will want to

be able to make payments out of the account or repatriate funds. This will require a

payment instruction mechanism of some sort:

Method   Staying at home   Going native

         

Signed letter  yes

(Manual)  Postal system slows receipt

Telephone call   High risk to bank and company

Fax   High risk to bank and company

Tested fax   Rarely offered*   Better than fax or telephone

Tested telex   Manual intervention   Manual intervention

Electronic funds transfer   Low cost/secure   Low cost/secure

Mainframe to mainframe   yes   Probably not appropriate in all cases

Disk delivery   yes   Postal system slows receipt

* Domestic banks prefer companies use their electronic banking services for funds transfer

instructions

10.9  Cost/benefit

The cost/benefit and security and control aspects of all the services mentioned above need to

be investigated before a decision is made on which are most appropriate to use.

10.10  Multi-currency accounts

At their most simple, multi-currency accounts have a base currency into which payments and

receipts in any currency are converted on receipt at better than normal exchange rates.

Traditionally, the base currency has been USD or GBP, but could be any freely convertible

currency.

A more sophisticated version of this account also exists, but such accounts have largely been

replaced by multi-currency pooling. In the example illustrated in diagram 10.3 one main account,

denominated in a base currency, is made up of sub-accounts in different currencies all

maintained in the same bank branch.

These structures are complicated to manage, especially if one account is overdrawn and

another is in credit, and cannot be used for different legal entities owning sub-accounts. The

benefits are now difficult to ascertain, especially in locations where newer cash pooling products

are now being offered.

10.11 Account ownership

In many ways this final section could be the most important. When establishing a set of currency

accounts, the issue of ownership is very important. 'Ownership' determines 'residence' and

residence determines a whole host of issues:

availability of credit interest (eg France);

withholding tax liability;

impact of pooling (see chapters 12 & 18 on pooling and account structures)

who can access accounts and how? and

may create a taxable presence in some countries (eg Thailand).

To illustrate the ownership issues we will assume that the Bloggs Group plc is a UK-based

multinational. In Germany, it has a wholly owned subsidiary Bloggs GmbH. When Bloggs GmbH

opens a EUR account in Hamburg, this will be regarded as a resident account, but if Bloggs'

group treasury opens an account in Germany this would be a non-resident account. Therefore,

movements between the two will be subject to:

central bank reporting;

lifting charges and

higher transfer fees than resident-to-resident transfers.

The two accounts cannot be brought together in a cash pool as co-mingling of resident and non-

resident funds is not permitted in Germany (and in many other countries).

The group could try to get round this by setting up a joint account (if they could get a bank to

agree to it) as follows: 'Bloggs Group Ltd and Bloggs GmbH Joint Account'. But this would

without doubt be regarded as a non-resident account, with any funds paid in by third parties in

Germany being subject to reporting and lifting charges.

Depending on what the treasury at Bloggs Group was trying to achieve, the group treasury staff

could become signatories of the Bloggs GmbH resident account. But as soon as they remitted

funds back to the UK, or to the Bloggs Group EUR account, central bank reporting and lifting

charges would be levied.

In some locations it might be worthwhile making certain accounts look like non-resident

accounts to get around the resident/non-resident problems. Therefore the company might set up

account titles as follows:

Bloggs Group plc re: Bloggs GmbH

In this way, Bloggs Group (a non-resident) is the account owner, but is managing the funds as

agent for Bloggs GmbH. Movements from one non-resident to another are not reportable, and

not subject to lifting charges. However, if the accounts were used to collect local receivables

from residents than of course normal central bank reporting rules would have to be observed.

Finally, the in-house bank approach is somewhat similar to the ‘re account’ described above,

but there is an important difference. A currency account styled ‘The Bloggs Group’ would act

like a bank ‘nostro’ account and could be accessed by all Bloggs’ subsidiaries both for receipt of

currency and payments. Such accounts will always be regarded as non-resident

(These ownership issues will be discussed in more detail in the chapter 12 on pooling and

account structures).

In summary, account ownership must be considered in relation to local regulations, as they will

impact on:

resident/non-resident issues;

central bank reporting;

withholding tax liability;

lifting charges and pooling regulations.

Cash Management Techniques

Chapter 11 – Netting

Overview

Although a very simple concept, netting can be more complicated than expected at

first glance and increasingly it is becoming one of the main tools used by companies

with a centralised treasury or an in-house bank. Fundamentally, there are two types

of netting: bilateral and multilateral.

Bilateral netting Offsetting (either at individual invoice or account level)

receivables due from one entity (A) to another (B) against the

payables due from B to A. Only the net position moves between

the two entities (such a facility need not be centrally managed

and can operate intra-group or include some third party

amounts).

 

Multilateral

netting

The management of cross-border payments resulting in a net

receipt/payment to each participant in their own currency. Such

netting can be extended to include third parties.

Multilateral netting needs a netting centre, which usually

handles all foreign exchange exposures and foreign exchange

trading as well.

Thus, participants make/receive one payment to/from the

netting centre on settlement day in their home currency.

Third party currency payables may also be included (third party

receivables usually are not). The netting centre will either pay

the third party or the local subsidiary pays all third parties in

their domestic market as paying agent for the group.

Savings can be made with bilateral netting. However, it does not need any elaborate systems or

organisational structures to be put in place other than an agreement between two

counterparties. This section will concentrate on multilateral netting as it is the most used of the

two methods and has the greatest potential to save costs.

Learning objectives

A. To understand the traditional approach to netting and how the basic calculations are

carried out

B. To be able to calculate potential savings from netting in terms of eliminated flows,

foreign exchange cost reductions, etc

C. To understand how companies include third party transactions in netting

D. To identify the structural requirements and policies needed to implement netting

E. To obtain an appreciation of the way netting is now being used to settle any or all intra-

group currency movements, including financial flows

F. To be able to carry out a netting review

G. To understand how the netting cycle works and links with other treasury activities

H. To be able to state the typical benefits of netting

I. To be aware of the various services offered by banks.

J. To understand the concept of foreign exchange matching.

11.1 Intra-group trade transactions

At its simplest, multilateral netting is used to offset trade payables and receivables between

companies that trade together within the same group. Groups with small numbers of participants

and low volumes of transactions will collect transaction data at invoice level. Groups with large

numbers of participants and/or high volumes of transactions may collect data at account

or statement level (ie all trading parties run accounts for each other and submit account

statements as input to the netting centre).

11.2 Netting drivers

Typically, netting systems are receivables-based (where participants report what they are due to

receive) or payables-based (where they report what payables are due). But some groups’

participants report both receivables and payables so that reconciliation can be achieved and

inconsistencies identified during the trial net.

Each of the flows listed diagram 11.1 have been aggregated. The USD1,120,000 owed by

Singapore to Germany represents 25 transactions that have taken place over several weeks

and which would normally be settled individually against separate invoices. For the sake of

simplicity all flows in this diagram have been translated to a common base currency (USD). The

transactions can then be put into a simple spreadsheet as follows:

Netting provides an in-built check because the two totals (ie total payables and total

receivables) must be equal. As shown in diagram 11.3, this data can be further manipulated to

enable companies to identify the difference between the net flows and the gross flows. In this

way, it is possible to calculate the unnecessary flows that have been eliminated and hence

estimate potential savings.

This provides a much more streamlined structure.

In this very simple example, which assumes each participant pays or receives in its own

currency, use of netting has cut currency flows in and out from USD10,640,000 to

USD5,720,000 and cut the number of foreign exchange transactions from nine to five. The

process of netting also moves all the foreign exchange transactions into the netting centre

where larger blocks of currency can be traded by professional treasury staff. This takes away

the burden from the subsidiaries - which may have no real treasury expertise - and enables

better spreads to be obtained on fewer but larger transactions by properly trained dealers.

Without netting, the amount of currency traded with banks would have totalled USD5,320,000,

costing the group USD13,300 at a bank’s typical bid-offer spread of 0.25%. With netting, the

currency traded would have reduced by approximately 46%; if traded as a block by an

experienced treasury professional, the spread should be reduced. For example, a spread of

0.125% would have cost the group USD3,575, resulting in a saving in one netting cycle of

USD9,725. In a full year, similar sized nettings should save this small group USD116,700 in

foreign exchange spreads, and reduced cash movements by USD29,520,000 (ie 12 x

USD2,460,000). The benefits of netting to the reduction in money movement can be substantial;

eliminating these flows may prevent overdrafts and save losses of value caused by money

transfer systems. Each company will have its own view of valuing this saving. A simple way

would be to work on one value day’s loss of use of the funds, calculated at the average interest

rates seen for the currencies included.

To these savings we need to add the savings in cross-border transfer costs (and receipt costs),

which in many groups could net similar savings to the foreign exchange elimination. A further

benefit is that the discipline of timely settlement through netting reduces foreign exchange risk.

11.3 Third party trade payables

Increasingly, third party currency payments are included in netting systems by the more

sophisticated netting users. Third party creditors can be incorporated into the netting system in

exactly the same way as an internal participant. Payments to creditors can be made directly

from the netting centre to the third parties’ bank accounts. Or, they can be channelled via a

group participant (or treasury or in-house bank’s account) located in the same country which

can make the payment on behalf of the paying entity (ie acting as paying agent) by raising a

local funds transfer. This arrangement converts an expensive cross-border payment with a

foreign exchange conversion into a cheap local currency transaction.

11.4 Third party trade receipts

Third party trade receipts are more difficult to include in a multilateral netting system as they are

rarely under the control of the receiving company unless it has authority to extract the funds it is

owed by direct debit. However, some companies are using techniques attached to netting for

third party currency receivables. Firstly, groups that have set up ‘in-house banks’ can use the in-

house bank’s account in a currency centre to collect receivables. As items are received into this

account they can be included in the next netting cycle and payment can then be made to the

true receiving party in its home currency. For example, if the in-house bank becomes receiving

agent for all group currency receivables and is set up as a counterparty on the netting system, it

can reimburse the true receiving entity in its home currency through the next netting cycle. This

technique is often used in groups with in-house banks and/or whose subsidiaries are not

allowed to hold currency accounts in their own names.

Secondly, third party receivables can be included by groups that use local subsidiaries as

receiving agents for other group companies (ie, they may receive funds into their local currency

accounts on behalf of other group members). For example, a German subsidiary may invoice a

UK buyer in GBP and instruct the UK buyer to pay the amount due to a bank account held by

the German company’s UK sister company. Once received, the GBP funds will be entered into

the netting system and the German subsidiary will be paid in EUR during the next netting cycle.

Care needs to be taken as these types of situations can be construed to create inter-company

loans if a long time elapses between receipt of the funds and payment via the netting.

Companies that use these techniques will tend to run their netting more frequently (usually

weekly) to avoid the administration and costs attached to inter-company loans and issues such

as interest calculations and even corporate-to-corporate withholding tax.

11.5 Structural issues

Multilateral netting systems require some level of centralisation. A group must have a netting

centre; one co-ordination point for each netting scheme. This may be at a country level, regional

level or global level, and in some companies it might be all three.

11.6 Country level netting

Two types of country netting may be seen. Firstly, some groups run a system that amounts to

no more than a ‘pre-netting’, the outcome being forwarded to the regional or global currency

netting. Secondly, a multilateral, one country, one currency netting is also used by groups that

operate vertically integrated production processes via independent subsidiaries. This simple

type of netting is settled on a stand-alone basis. Diagram 11.5 shows how four local

subsidiaries, which trade with each other, copy invoices to the country treasury as they are

issued.

Calculations are carried out on a spreadsheet and settlement is performed by the treasurer by

passing one entry across the bank account of each subsidiary using pre-formatted electronic

funds transfer on an electronic banking system. See Diagram 11.6.

In this particular group, this country netting is carried out daily, and there is no credit period

allowed. Therefore, the more efficient the subsidiaries are at issuing invoices, the better their

cash flow.

11.7 Regional or global netting

Many groups run either a regional or global netting system, the participant subsidiaries in which

will depend on trading patterns and country regulations. Subsidiaries in some countries will not

be allowed to participate at all (eg Saudi Arabia, Russia, Pakistan and Brazil). Others will only

be allowed to participate on a ‘gross in, gross out’ basis (ie where all currency flows can only be

reduced to an aggregate of all the payments and all the receipts). The totals cannot be netted

out and two movements must be made: the aggregate of all the payments ‘in’ and the aggregate

of all the payments ‘out’ (eg China and India

11.8 Netting policies

For netting to be introduced successfully, participants must agree on issues such as the

currencies used for billing, the credit periods allowed, settlement dates and the exchange rates

to be used.

11.9 Currencies

Participants must agree on which currencies can be used for billing each other. These may

include the buyer’s currency, the seller’s currency, both, or a third currency. Some groups use

the EUR in Europe, whereas others, in USD-based businesses such as oil and chemicals, may

find the USD more suited to their cash flows.

11.10 Credit period

Some agreement as to credit periods needs to be established. Ideally, all participants should

have the same credit period. Often participants that are short of cash, or operating in countries

where credit is tight or interest rates high, may be given longer credit periods if they are net

payors, or may be paid early if they are net receivers. Frequently, leading and lagging

techniques (ie paying early to cash-poor subsidiaries, paying late to cash-rich subsidiaries) can

be linked to netting systems. If leading and lagging calculations are worked out properly, a

summary of the risks these techniques incur should be apparent. Leading and lagging

effectively creates inter-company (currency) loans which not only create currency exposures,

but also interest rate risks. Corporate policy may require these risks be hedged.

If leading and lagging techniques are being used then a more sophisticated netting system

needs to be used that can also calculate and track the exposures. Many treasury management

systems now have netting modules that can do this.

11.11  Settlement dates

It is important for administrative and cash flow planning purposes that all parties are aware of

the netting settlement dates. In most companies these are published many months in advance.

Netting periods vary between companies and can be run as frequently as daily or as

infrequently as quarterly. Most often they are monthly, or in the case of the biggest groups,

weekly.

11.12  Exchange rates

A method of calculating exchange rates that can be checked easily by all participants and that

can be demonstrated to be at arm’s length must be agreed. The methods used for determining

the rates differ from company to company. For example, some groups will establish exchange

rates for fixed periods for inter-company transactions. Others may set an internal rate of

exchange for each month, still others will use a spot market rate taken two days before

settlement.

11.13  Establishing multi-lateral netting

There are now a number of multinational groups that use netting as a core part of group

treasury or in-house banking, seeing it as a way of significantly reducing transactions that would

have traditionally passed through the external banking system. We have already discussed

sections 11.2 to 11.4 four types of trade transactions that can be processed through netting:

inter-company payables;

inter-company receivables;

third party payables and

third party receivables.

To these types of transactions can be added financial flows. These are often overlooked, but

can be substantial. The types of items in this category might include:

foreign currency for sale (ie a UK subsidiary receives USD and sells through the group

treasury or in-house bank for GBP; settlement occurs through the netting);

foreign currency purchases (reverse of above - a sub needs to buy currency and settle

in its base currency through the netting);

intra-group loans (a sub borrows from the centre and funds are delivered as part of the

netting settlement);

intra-group deposits (a sub which is ‘long’ in a currency lends its surplus to the centre;

the funds movement is linked into and settled via the netting);

payment and collection of inter-company interest on the above;

11.14  A netting study / review

When carrying out a netting study or review the following approach is recommended:

When charting the flows, in addition to creating spreadsheets to document the transactions

consider mapping the currency flows and identifying where the foreign exchange transactions

take place.

Mapping enables full identification of all foreign exchange activities, and enables the

management of currency risks to be centralised with the netting centre. This will centralise the

management of the risks, but does not eliminate them at subsidiary level; netting participants

are still liable for such risks. Other techniques which can do this (re-invoicing and in-house

factoring) will be discussed later.

The second step in the netting review is to identify the third party transactions.

11.15 A typical netting cycle

A typical netting cycle for a group using the new approach might look like:

A typical group's netting cycle is monthly and the various functions are spread out over a nine-

day period for study purposes, but, in practice, most time spans will be shorter (five or six

working days is about the average).

The cash forecast (on the 5th) enables treasury to:

identify subsidiaries with funds to lend;

identify subsidiaries that need to borrow and

identify those that will pay/receive interest on inter-company loans/deposits.

11.16  The benefits of netting

Many of the benefits of netting are very obvious and usually quantifiable. However, some are

not so obvious and provide non-monetary or non-quantifiable benefits. Those with a cost or

monetary value include:

reduced funds movement (ie one per participant per period);

reduced numbers of foreign exchange sales and purchases;

reduced foreign exchange margins as larger amounts are traded by professional

dealers;

reduced funds transfer costs;

guaranteed payment dates (provides certainty of cash flows and also enables

investment opportunities to be recognised and planned. Often this will also result in the

reduced use of overdrafts);

enables central management of foreign exchange exposures (this enables exposures

to be consolidated and netted out. Differences can be hedged using forecasts. Netting

settlement will often be used in settling the hedge (eg settlement of a forward contact

due to mature on netting settlement day is settled via the netting settlement account)

and

eliminates the need for subsidiaries to hold foreign currency accounts.

Those with a non-monetary value or non-quantifiable effects include:

better quality and more timely information on subsidiary cash flows (allows treasury

centre to plan/manage group liquidity better);

reduced administration in the group (not sending lots of transfers to trading partners,

not chasing receipts, items easier to reconcile etc) and

many managers appreciate the control needed and the fact that inter-company

disputes have to be ironed out.

11.17  Netting services

Companies wishing to introduce a netting system have three or four options available to them in

terms of obtaining a netting service. On one hand, they can take a managed service from a

bank, or a part-managed service from a bank. Alternatively, they can buy software, or develop

an in-house solution, and then run the system themselves.

11.18  Bank managed service

Only a few banks provide this service; the two market leaders have been in the business since

the 1960s. A bank-managed service is effectively a form of outsourcing that is generally run as

follows:

participants advise the bank of invoices received or issued (depending on whether the

system is payment or receivables driven). A wide variety of methods can be used to

get this information to the bank (eg terminal access, often as a module of an electronic

banking system, data transmission, email, telex, disk or fax). Some groups will use

several methods to suit individual subsidiaries;

the bank captures the data and loads it into its netting system;

it then runs the trial netting on a pre-defined date, using indicative foreign exchange

rates. Users of a bank service can agree the exchange rates used with the bank. Some

companies will advise the bank of their own internal rates of exchange, while others

will instruct the bank to use market-related rates;

the bank then advises participants of their net positions and approximates the amounts

they are due to receive or due to pay in their home currency. The methods used to

advise participants of the trial net (and subsequently of the real netting figures) vary.

But they tend to be fairly fast methods (such as data transmission to specific software

or to the netting module of an electronic banking system, fax or telex), because of

issues related to time delays;

participants will be given a short period to notify of any errors or omissions and will

advise the bank, or the group treasury’s netting controller, of the discrepancies. Again,

the person whom participants advise of discrepancies can vary according to the

arrangements made when the system was set up. Normally, only the netting controller

can instruct the bank to alter figures after the trial net;

two days before the agreed netting settlement date the full net will be run and the bank

will carry out the foreign exchange transactions on a spot basis and arrange for any

funds transfers that will result;

the bank will provide all participants with a detailed breakdown of all the transactions

that have been included in the netting (for bookkeeping and audit trail purposes),

together with the net position expressed in the participant’s home currency. For net

receivers, the bank will specify to which account it will deliver the funds. To net payors

it will either instruct the participant where to deliver funds or in some cases, an

arrangement may be in place where the bank will raise a direct debit to the

participant’s account;

each netting group will hold a set of netting settlement accounts with the bank, usually

one for each currency covered by the netting. On settlement day, entries are passed

across these - one per participant. If all goes to plan, the accounts should end up at the

close of business with zero balances. Most companies using this method will report

their netting settlement accounts via an electronic banking system. This allows them to

see the transactions posted to their accounts and check that items clear to zero (or

otherwise) and

finally the bank will work with the company’s netting controller to reconcile all items and

sort out any failed transactions.

The timetable for the managed service can be very flexible. The most common period is

monthly, although some companies will require weekly or bi-weekly runs.

11.19  Requirements for the managed service

The bank will require a master agreement to be signed with the bank by the group, and each

legal entity participating in the netting system will also be expected to sign the agreement. This

document will include an authority to the bank to trade the foreign exchange on behalf of each

participant and may include a direct debit authority in some cases. Each netting party must

agree to a specific method for submitting details of transactions and receiving reports from the

bank. Finally, a mandate will need to be completed by the group treasury for the netting

settlement accounts and any electronic banking systems that might be used.

11.20  Fees and charges for managed service

The bank will normally charge a one-off fee for setting up the netting scheme, plus an amount

for each netting party added. Fees will also be charged for managing the operations of the

netting, usually based on the number of transactions per active participant per netting cycle.

Obviously, the bank will take a spread when it buys and sells the currencies, and it will charge

for running the netting settlement accounts, probably an account maintenance or per entry fee.

If the settlement accounts are reported to the company electronically a reporting charge per

account is also likely. Additionally, some banks will charge for the funds transfers, direct debits

or inter-account transfers.

11.21  Part-managed service

With part-managed services banks carry out data collection and processing for a fee.

Meanwhile, the company is free to carry out the foreign exchange trading itself. Usually, the

bank providing the calculations service will be given the right to quote for the foreign exchange.

Under this method, the company can choose its own bank and location for its netting settlement

accounts. These can often be held offshore in the appropriate currency centres.

11.22  Software and do-it-yourself

A number of banks and software houses now offer netting software to companies that want to

run a netting system themselves. As well as a one-off purchase cost there may also be an

annual maintenance fee. Some companies develop their own systems. These may be simple

models, based on PC spreadsheets, where there are a few participants and low volumes of

transactions or may be large systems operating on mini-computers or mainframes in groups

with high volumes and large numbers of participants. While the ‘do-it-yourself’ route allows total

flexibility, netting can be a fairly stressful (and very resource intensive) activity for two or three

days each month. This is one reason why smaller treasury departments may prefer to

outsource.

11.23  Cashless netting

Advanced companies, where the treasury acts as an in-house bank, that have implemented

ERP systems, (enterprise resource planning) such as SAP, JD Edwards, Peoplesoft or Oracle,

have the ability to operate their netting operations on a cashless basis. That is, instead of

physically settling transactions by moving funds between bank accounts, the company will

merely pass entries across the in-house bank accounts that are held on the ERP system. This is

very efficient and has many very obvious benefits and probably only one serious disadvantage.

Like any other in-house bank transaction, as these do not pass through the real banking

system, a bank is unable to handle the central bank reporting of what are in effect cross-border

payments. Companies that carry out cashless netting have to undertake central bank reporting

themselves. A further potential disadvantage is the risk of ‘thin capitalisation’ problem (see

chapter 25). An example follows of the working of cashless netting.

The outcome is expressed in the in-house accounts held for each participant in the ERP system

(diagram 11.11).

NOTE: In-house bank accounts are usually interest bearing. Interest is usually set on an arm’s

length basis, but may be set to enable the treasury to make a ‘turn’ or spread on the rate.

(In-house banking is discussed further in chapter 17).

11.24  Foreign exchange matching

If techniques such as inter-company netting, reinvoicing and/or in-house factoring are being

undertaken, the only trade currency flows left to identify, manage and reduce should be those

relating to third parties (or subsidiaries) that are outside of these systems. This is where foreign

exchange matching can be used.

The basic concept of foreign exchange matching is simple. To identify similar, but opposite,

currency flows occurring during the same period, net them out and only trade the net positions

with banks. As diagram 12.9 shows this saves subsidiary 3 the costs of buying USD at or about

the same time as subsidiary 1 is selling USD.

Diagram 11.12: An example of foreign exchange matching

In more advanced groups, subsidiaries may well submit two cash forecasts - one in their home

currencies, reflecting only home currency flows, and a second that identifies all currency flows.

These flows can be used as the basis for quite sophisticated currency cash flow management,

and will enable the group treasurer to match expected but opposite currency flows and to only

hedge non-matched positions.

These types of calculations are normally carried out on a treasury management system

(discussed in chapter 21).

Chapter 12 - Pooling and cash concentration (and other techniques)

Overview

In this chapter we discuss the complex concept of pooling and cash concentration and, to a

lesser extent, foreign exchange (FX) matching. We will examine in detail how these essential

cash management techniques help companies manage the surpluses and funding requirements

of their different subsidiaries more efficiently as well as improve their overall balance sheet. In

addition, we will consider the different regulatory and practical challenges surrounding the

successful implementation of pooling and cash concentration. As efficient account management

(both domestic and foreign currency) is an important factor in pooling and cash concentration,

this chapter has to be read in conjunction with chapters 10 “Foreign currency accounts” and 18

“Efficient account structures”.

Learning objectives

A. To be able to define the basic types of notional pooling

B. To understand how interest is calculated on cash pools

C. To understand the more advanced forms of cash pooling

D. To appreciate the documentation that is required and the main provisions

E. To appreciate the ‘resident/non-resident’ issues

F. To understand zero balancing and cash concentration and to be able to differentiate

these services from notional pooling

G. To appreciate the links between these techniques and appropriate account structures

12.1  Introduction to pooling

There is probably more confusion about pooling than any other area of cash management.

In this chapter we will seek to present pooling and cash concentration in their most accepted

senses and the terminology used will be that which is generally accepted by the major cash

management banks and experienced multinational companies.

12.2 Pooling definition

'Pooling' occurs when debit balances are offset against credit balances, and the net position is

used as the basis for calculating interest. There is neither movement nor co-mingling of funds.

This is often referred to as 'interest offset pooling' or 'notional pooling'.

Amongst the benefits of pooling are:

eliminating or reducing debit balances;

minimising the payment of debit interest

maximising the interest earned on net credit balances;

improving the balance sheet by offsetting surplus balances against group debt;

reducing overall exposure to banks and reducing the requirement for funding facilities.

12.3 The benefits of pooling

The definition used in section 12.2 can be best illustrated with a simple diagram:

 

 

This is a fairly common situation with groups that have a decentralised approach to cash

management. Each company in the group makes its own banking arrangements and the

accounts may even be with different banks. However, this presents an inefficient picture when

viewed from a group perspective.

 

 

This is the type of structure seen in corporate groups with some form of centralised treasury

activity, (possibly a country, regional, or group treasury). For this structure to work all accounts

need to be with the same bank but not necessarily with the same branch.

Note: Although the interest cost at group level may be zero, if the accounts concerned are

owned by different legal entities both lenders and borrowers will have to receive and pay

interest on an arm's length basis. All pooling does is to keep the net cost in-house. Also

although the bank may not make an interest charge, it may levy an administration fee for

running the pool.

12.4 Pooling for credit purposes

The pooling structure illustrated in diagram 12.2 works well for groups where the subsidiaries

have widely fluctuating balances or where some are either semi-permanently in debit or in

credit. For example, a group with two manufacturing subsidiaries and two sales subsidiaries will

note that its manufacturing and sales companies have very different types of cash flows. It

would be normal for the bank, when putting together a pooling scheme for credit-worthy groups,

to apply one overall borrowing limit to the pool, but to restrict the participants’ utilisation. For

example, despite having a net zero position at the present time, the group shown in diagram

12.3 could have a credit facility linked to it as follows:

Group overdraft limit of 1m in the given currency of which no participant may utilise more than

500,000.

Banks often regarded this type of pooling as a ‘credit product’ rather than a cash management

tool, and credit interest may not be paid on an aggregate credit balance. In some countries, eg

USA, Malaysia and France, banks are prohibited from paying credit interest on current account

balances, so this would be the only type of pooling allowed.

12.5 Pooling for interest earning purposes

In a situation where the aggregate positions of a notional pool fluctuate between debit and credit

positions, most corporate treasuries will look to earn interest on the credit position.

 

 

A proactive treasurer, with a good forecasting routine, would seek to actively

manage surplus funds. Rather than leave funds to be passively 'managed' by the

bank, the surplus would be extracted from the pool and invested in an instrument

that might have a higher interest yield than interest earned on a passive current

account. These might be short-term money market instruments such as deposits, or

short-dated certificates of deposit or funds may be put into a money market

investment.

However, most proactive treasurers will put an 'insurance policy' in place to catch

funds that they are unable to manage proactively due to time zone differences, (eg,

a net GBP position belonging to a US group with a treasury in San Francisco). Or

there may be cut-off time reasons. (eg, a company in the UK positions its cash at

14:00 local time because it needs to make funds transfers relating to short-term

investments prior to the CHAPS system closing down at 15:00 local time, but items

are credited to their account after 14:00). Pooling, therefore, avoids leaving idle

funds in bank accounts (ie not earning interest) or reduces the need for short-term

borrowing on overdraft.

Banks rarely offer money market rates on low-value residual funds that end up in a

pool because they do not expect to run a company's cash management without a

fee; the margin between rates offered and the overnight interest rate (in some

cases) is that fee.

Whatever method is used for investing the funds, the question that arises in

diagram 12.3 is: "To whom does the GBP500,000 belong?" It cannot belong to

subsidaries 1 or 3 as they are in debt, and does not fully represent either 2 or 4's

positions. If the funds are left with the bank on a passive basis, the bank will make

the interest calculation based on an agreed formula. This formula often has two

elements, the 'external' and the 'internal'. The external element is likely to be based

upon an agreement with the bank on how aggregate balances will be treated for

interest calculation purposes at group level.

This might be something as follows:

Bank group pooling rates Bank rates available to a subsidiary

Net debit interest rate of 7.5% Debit rate 8%

Net credit interest rate of 6.5% Credit rate 6%

Once this has been agreed between the bank and the company, the group treasurer can then

decide how to apportion the rates between the participating companies.

Often the benefits are shared to give companies a better level of interest rates than they would

have received on a stand-alone basis, but the treasury would take the difference between the

bank rate and the internal rates as a fee for setting up and managing the structure. For

example, companies in credit might receive 6.25% and companies that are overdrawn might be

charged 7.75%. The result is that the benefit of the aggregate position is shared between the

participants and the treasury. In this case, the subsidiaries will be 0.25% better off by using the

pool. Some banks will carry out these calculations, but some companies prefer to do this

themselves.

For those companies that want to proactively manage pool surpluses, a decision needs to be

made on how to extract the funds from the pool to settle the investment. There are two basic

options here. In diagram 12.3, either subsidiary 2 or 4 could be made the 'pool leader' with

either account debited when funds are invested in the market (or an investment is made with the

group treasury). Likewise, investments can be made through a dummy treasury account in the

pool to bring the pool to zero. Thus the underlying participants' real account positions do not

change (See diagram 12.4).

This structure has much to recommend it and can work well in those countries where (a) the

treasury is resident, or (b) the treasury is non-resident, but there are no prohibitions on having

resident and non-resident accounts in the same pool. This structure does not work in those

countries that do not allow resident and non-resident accounts in the same pool. In this latter

case, the ‘pool leader’ concept has to be used. This is where the dummy account is “owned” by

one of the participants, even though it may be controlled by treasury. This creates loans

between subsidiaries. (This will be looked at in more detail in chapter 18 “Efficient account

structures”).

12.6 Interest rates

In practice, credit interest rates on cash pools may be tiered or banded (for a full explanation of

the differences between tiered and banded interest rate structures, see section 10.5.2.2) and

low value or residual funds may not attract interest at all.

The tiered steps usually vary by currency, a situation which obviously complicates interest

apportionment, and is one of the reasons why most bank pooling systems provide a facility to

calculate and allocate interest amongst the participants (usually called interest offset

reallocation). With banded interest rates, an aggregate balance of 250,000 would attract interest

at 6% on the whole balance. Each pooled account will be charged or paid interest depending

upon its contribution to the pool. For example, interest would be charged to the entity and

credited either to the main account of group treasury, the pool leader, or to a separate interest

account. The interest rates for each account in the pool are set by the corporate treasury,

depending on the rates it wishes to charge each entity. This is normally done by setting different

spreads for each entity and allows rates to be adjusted as required by only updating the base

rate.

To respect the ‘arm’s length rules’ applied by the various tax authorities, interest rates must be

close to market rates. In the example given in the diagram 12.5 the average credit interest rate

would be used.

12.7 Interest on pooling arrangements

In the examples of the calculation of interest accrual and pooling illustrated in section 12.8,

interest is accrued daily and posted monthly to the pooled accounts. The interest benefit from

the interest pooling accounts will be posted to a designated account at the end of the month.

Debit (DR) interest rates are recorded as single rates for each currency, and credit (CR) interest

rates are recorded as a set of tiered rates for each currency for each account.

For example:

12.8 Application of pooling benefit

 

    Daily balance range*

DR interest rates: 8.625%  

CR interest rates: 7.25% 0 to 250,000

  7.625% 250,001 to 500,000

  7.875% 500,001 to 1,000,000

  8.00% Over 1,000,000

* Interest calculation in example is based on 360 day period as practised in the USA and the

euro-zone (see 4.1.2)

The pooling interest benefit, using both tiered and banded interest rates, is calculated as the

difference between the sum of the net accrued interest of the participating accounts taken

individually and the net accrued interest of the aggregate balances.

For example:

Account 1

Opening balance : + 100,000

Transaction : + 400,000

Transaction : - 200,000

Closing balance : + 300,000

Tiered daily interest =

250,000 @ 7.25% = 50.35

50,000 @ 7.625% = 10.59

Total = 60.94

Account 2

Opening balance : + 500,000

Transaction : + 400,000

Transaction : - 20,000

Closing balance : + 880,000

Tiered daily interest =

250,000 @ 7.25% = 50.35

250,000 @ 7.625% = 52.95

380,000 @ 7.875% = 83.13

Total = 186.43

Aggregate position : 1,180,000

Tiered daily interest =

250,000 @ 7.25% = 50.35

250,000 @ 7.625% = 52.95

500,000 @ 7.875% = 109.38

180,000 @ 8.0% = 40.00

Total = 252.68

The interest pooling benefit (the difference between the aggregate of the pool and the sum of

the interest accrued on the participating accounts) for this structure is as follows:

252.68 - (60.94 + 186.43) = 5.31

In this example, the benefit arises because the combined credit balances move into a higher

interest tier. The benefit would, of course, have been greater had there been a debit balance on

one of the accounts to which normal overdraft charges had been applied. This amount (5.31)

would be posted as a credit to the designated interest account at the end of the month. This

account is normally owned by the treasury.

Alternatively, if we calculate the pooling benefit using “banded” interest we would obtain the

following results:

Account 1 + 300,000 @ 7.625% = 63.54

Account 2 + 880,000 @ 7.875% = 192.50

Total Account 1 and Account 2 = 256.04

Aggregate 1,180,000 @ 8.0% = 262.22

Benefit of pooling: 262.22 – 256.04 = 6.18

Clearly, banded interest on credit balances is more favourable to companies than tiered interest.

12.9 Advanced pooling techniques

There are now four types of pooling:

12.9.1 Single currency, one-country pooling

This is the most common type of pooling, which is generally available from banks operating in

countries where pooling is allowed or where it makes practical sense.

12.9.2 Single currency, cross-border pooling

This type of pooling would be used by a group that held, for example, USD or EUR accounts in

various countries and aggregated them across a region. Some oil companies practise this type

of pooling in Europe. This service requires much more from a bank’s infrastructure and fewer

banks are able to provide it. The demand for this type of pooling has increased significantly in

Europe since the introduction of the EUR

12.9.3 Multi-currency, one-country pooling

This type of pooling may be used by a company which runs a set of currency accounts in one

location with one bank (eg London or Amsterdam) which offsets debit balances in some

currencies against credit balances in others. While these services give the appearance of multi-

currency pooling, in effect the bank is sharing the spread between the borrowing and deposit

rates for each currency with its customer. Some banks providing international cash

management services now have products like this, but each works slightly differently. Other

banks will not provide this service as a matter of principle. In practice a company needs to have

virtually matching opposite positions in its currency accounts to make this product work

effectively.

12.9.4 Multi-currency, cross-border pooling

Limited services of this type, which enable a debit balance held in Frankfurt to be offset against

a credit balance held in Paris have been rolled out by some multinational banks. However, the

introduction of the EUR has somewhat reduced the need for this type of pooling in Europe, and

it is not seen in other locations.

With any of these pooling structures, thorough research needs to be undertaken before they are

put in place, particularly looking at the costs and benefits.

12.10 Due diligence

When considering undertaking pooling the following should be considered:

is pooling permitted?

is multi-entity pooling allowed or only single entity?

resident/non-resident issues:

o can resident and non-resident accounts both participate in pooling structures?

o are the rules different for resident and non-resident accounts? Can interest be

paid on both (eg residents cannot earn interest on EUR current accounts in

France, but non-residents can)?

tax issues:

o is withholding tax deducted from interest payments at source by the banks?

o are residents and non-residents treated differently for withholding tax

purposes?

o can debit interest be deducted in some countries as an allowable expense prior

to tax calculations?

o how would this be affected by pooling between tax regimes?

o is ‘thin capitalisation’ an issue? (see chapter 25 for details of this concept)

do the regulatory authorities allow accounts held in one country in one currency to be

offset against an account in another country and another currency;

how do the laws relating to offset cope with the multi-currency and cross-border

aspects? For example, if a GBP credit account held in London is offset against a EUR

debit account held in Frankfurt, will the bank have a legal right to offset the EUR debt

against the GBP credit account if the German entity becomes insolvent;

how does the bank cover the currency and interest rate exposures that this type of

service creates? This can be a particular problem for banks with stand-alone systems in

each country as it does not allow an instant overview of currency and interest rate

exposures;

are central bank reserve ratios imposed on banks calculated on net or gross positions?

To enable effective pooling they need to be able to be reported net, otherwise the cost

of reporting gross (and the cost of having to lodge free or low interest deposits with the

central bank) will have to be passed on to the customer;

most pooling methods, with the exception of hybrid systems (that combine pooling and

concentration) involve the use of a single bank (multibank pooling is normally achieved

using concentration techniques[1]). Concentration can be used to link in-country pooled

accounts, held with a domestic bank, with a set of centralised or overlay accounts held

with a co-ordinating bank (is discussed further in chapter 18 “Efficient account

structures”);

the requirements of the operating companies within the group can dictate the location

and services required from bank accounts. For example, a local account may be

needed for operating expenses, payroll, the collection of cheques. It has to be decided

whether these accounts are to be included within the pool (thus restricting the choice of

methods) or be excluded and managed on a local basis;

access to same-day value payments and later cut-off times may be required especially

by treasurers investing in the local money markets. Same-day value is normally only

achieved if the account is located in the relevant currency centre (EUR has no single

‘currency centre’), unless there is a particular time-zone advantage. Cut-off times are

important if the treasury attempts to fund local accounts on a same-day basis and

value dating practices affect the local management of cash and the movement of funds

cross-border and between banks, particularly in South-East Asia and Europe. Ideally,

the pooling system should use a bank, which offers a consistent value dating practice

for the movement of funds within its network. In a multibank environment, value dating

should be agreed with all the banks used.

The corporate user is responsible for determining the tax implications of any account structure.

Tax issues generally favour the location of pooled accounts in a single tax-efficient location (eg

The Netherlands or UK). Cash management and operational issues usually favour the location

of pooled accounts in the currency centre (defined in chapter 10 as ‘going native’).

A pooled/concentration account structure can provide an elegant tool for cash management

policy linking local cash management with centralised treasury management. (This is discussed

further in chapter 18).

[1] Concentration of cash is discussed in more detail in section 12.25

12.11 Timescales

Cash management should be viewed on three timescales:

today: Local cash managers are responsible for local currency balances on a today

basis, receiving and paying funds through the local clearing system and investing in

local money markets;

spot: Most currency treasury instruments are managed on a spot basis (ie two days

ahead) and the treasury will normally attempt to forecast cash two days ahead and

arrange appropriate funding or investments.

next day: It is possible to cover positions using the 'tom/next' foreign exchange market

and local overnight markets in a similar manner to bank trading rooms. This approach is

typically used by sophisticated central treasury operations.

An account structure should facilitate the above listed timescales of cash management and, in

particular, address the link between local cash management practised by the subsidiary and

regional cash management controlled by treasury. Concentration used in conjunction with

pooling allows autonomous local cash management with centralised control.

The inter-company treasury and cash management procedures should fit closely with the

pooled account structure, determining when funds are transferred to the pool, rates of interest

payable and how individual entities are funded. The inter-company policy differs if funds are

concentrated to a single account (in the name of a group treasury) or to a pooled account (in the

name of the entity).

Pooling account structures should be linked with the company's organisational and functional

structure as well as the cash management policy so that they can be used both for operational

and liquidity management purposes. The pooled account structure can be designed specifically

to meet each company's individual objectives.

The timezone impact of a particular account structure on cash management and concentration

should be considered. Depending on the location, some treasuries that manage funds in a pool

outside their time zone will have access to better cut-offs and local money markets, but will not

be able to reconcile on a same-day basis or invest funds received late in the day. Pooling

provides a solution to this problem. The participating entity will manage its offshore account

during its working day, either leaving a square position or taking advantage of the pooling (inter-

company) interest rates. The pool will provide an 'insurance policy', paying interest on any

uninvested balances or funding shortages at reasonable interest rates. If the pool is actively

managed by a regional treasury centre, credit balances can be invested on behalf of each entity

to maximise the returns; alternatively, shortages can be funded centrally using inter-company

loans or group borrowing facilities.

The cost of transfers is an important consideration if concentration of funds is to be done daily.

Commission fees are charged on commercial payments, but costs can usually be reduced if

executed within a single bank's network.

The introduction of the EUR has already affected bank pooling arrangements for European

currencies, with some multinationals putting in place one euro-pool covering all 12 euro-zone

countries.

Remember that cash pooling is 90% due diligence and 10% systems.

12.12 Service requirements, one country, one currency pooling

Once due diligence has been undertaken and the bank/customer wishes to go ahead, what

needs to be put in place to enable the service to commence? All or most of the following will be

required, depending on the type of service taken, the regulatory environment and the underlying

legal system:

pooling agreement:

o includes protection against changes in regulations or law and

o notice periods;

cross guarantees;

a legal right of set off;

tax indemnity (principally relating to withholding tax);

the ability of the bank to link accounts for the purposes of interest calculation and an

interest apportionment service covering both the reporting and allocation (ie collection

of debit interest and payment of credit interest).

12.13 The pooling agreement

Pooling agreements vary from bank to bank, but will contain the following sections: 

introduction:

o after a general section introducing the parties, the interpretation of the

terminology is usually set out;

representations and warranties:

o in this section, each participant agrees that by becoming a party to a pooling

arrangement it is not violating any law or regulation, or breaching any

covenants connected to any other agreements it may already have in place.

Most importantly, it states that there is no prior lien on any credit balances that

may be held with the bank;

agent or lead company:

o in this section, the participants appoint one company in the group as the pool

manager and co-ordination point with the bank. This will often be the legal entity

that houses the group or country treasury;

changes to the agreement:

o this deals with the addition or deletion of participating companies;

agreement on interest calculation and payment:

o this section sets out the basis on which interest will be calculated and

apportioned on the pooled funds and includes an authority for participants'

accounts to be debited with interest if they are net borrowers to the pool and

o interest formulae - a base plus or minus a percentage and payment frequency -

will be covered with a reference to a schedule, which will be attached to the

agreement;

changes in circumstances:

o this clause enables the bank to cease providing the pooling scheme if laws or

circumstances change to make it unlawful and

set off:

o this clause establishes the bank's right to set off any balances in the pool

should it need to do so, irrespective of ownership.

There also follows sections covering:

waivers;

assignments;

notices and demands;

certificates by bank officers;

provision for changing the agreement and

signatories.

The agreement is completed with the bank's right to regard the document either jointly (across

the whole group of participants) or severally and distinct - company by company.

The final clause will usually set out the legal jurisdiction. Following this the list of schedules to

be attached will follow. These are likely to cover:

name of pool manager;

names of all participating entities and their account details and

interest arrangements and payment dates.

As stated at the beginning of this section, agreements vary from bank to bank. Some

agreements also include cross guarantees from participants, but some banks prefer to use a

separate document for any guarantees required. Whether guarantees are included in the

agreement, or are taken in a separate document, they will be of a joint and several nature,

whereby each participant guarantees all other participants.

Enabling board resolutions will need to be provided as evidence of authority for the completion

of all the documentation.

12.14  Cross guarantees

In some countries, cross guarantees are now a regulatory requirement (eg the UK, see 12.19);

in others they may be an internal bank requirement. In some cases, particularly where the

aggregate position of the pool will always be a net credit balance, guarantee liabilities can be

restricted to the value of any credit balances held, rather than the usual, all embracing,

guarantees required by banks for credit purposes.

12.15  Legal right of set off

Banks will want to be assured that, in the event of an entity with a debit balance going into

receivership, they have the right to clear the debt from funds held in other pooling participants'

accounts. In some countries this can be a problem (eg Italy), particularly where accounts in the

pooling structure belong to different legal entities in the same group.

12.16  Tax indemnity

The bank will want to protect itself in the event that, despite its own due diligence (and possibly

due to misunderstanding, poor advice, or lack of due diligence on the part of the customer), the

scheme is deemed by a tax authority to be illegal or to constitute a tax liability. This situation

might arise where a bank pays interest gross to a group treasury which then apportions it to its

participants, some of whom are located in regimes that require withholding tax to be deducted

and paid by the borrowing party. In this case, the group treasury would be liable to deduct the

tax and to pay it over to the relevant authority (ie, it would not be the bank's responsibility).

12.17  Linking accounts for interest calculation purposes

Banks' abilities to link accounts for interest calculation purposes vary substantially. Some use

rudimentary systems, based on either rekeying or downloading files from accounting systems

into PC-based spreadsheets. But banks which use more sophisticated accounting systems can

perform these functions on the main branch accounting systems. Often the different types of

service are not apparent to the users.

12.18  Interest apportionment and allocation

The way in which banks and companies carry out interest apportionment and allocation varies.

Some banks can provide remote PC access to the main accounting system enabling the client

to carry out his own internal calculations and apportionment. Other banks may perform the

service for clients, after the group treasurer has set the apportionment rules (ie, the way the

interest rates are split to enable all parties to benefit).

12.19 UK regulations for pooling [Not examinable]

Following various EC Directives, the Lamfallussy report from the Bank for International

Settlements, and many requests from bodies (including The Association of Corporate

Treasurers) for clearer guidelines, the Bank of England (BoE) issued its paper "On-balance

sheet Netting and Cash Collateral" in December 1993. The regulations set out in detail the

Bank's views and rules on pooling for the first time. It is interesting to note that, following the

Bank of England's lead, a number of other EU countries issued similar guidelines. It would be

extremely useful in terms of planning cross-border pooling, if these regulations were common to

all EU countries. However, national differences have so far remained in place.

The BoE regulations relate only to any banks that it 'regulates'. US and Continental European-

based banks operating in the UK are regulated by their home central banks, and these banks

'report' to the Bank, but are not regulated by it. Therefore, to say that these rules apply to all

pooling in the UK, would not be correct. However, many foreign banks do fall in line with the

BoE's rules as they provide extra protection for the banks.

In the UK to enable a bank to be able to report 'netted-off balances' , ie the net position of

pooled accounts, the following is necessary:

the reporting bank must be able to demonstrate that the accounts are managed on a

net basis (this can be done by reference to the pooling agreement);

cross guarantees must be in place between all participants in the pooling scheme.

These may be limited in amount to the value of any credit balances held;

an independent legal opinion is necessary to confirm the validity of the set off

arrangements. If accounts held in jurisdictions other than the UK are included, or non-

resident entities are participating in the scheme, an additional side letter, specifically

covering the jurisdiction concerned is required to confirm that the right of set off extends

to this account;

the debit and credit balances relate to the same customer or customers in the same

group. Care needs to be taken with partly owned companies, particularly where

ownership is less than 51% and

according to the BoE, residency is no longer an issue and any freely convertible

currency can be included in a cash pool in the UK.

It is also worth noting the BoE position on facilities secured by cash, as this has similarities to

pooling. For example, a bank may allow a debit balance on a GBP account to be secured by a

deposit of funds in another currency. To enable the bank to report this on a net position to the

BoE, the following is necessary:

the cash must be held for the account of the customer on express terms that the credit

balance may not be withdrawn for the duration of the exposure and that the bank may

apply the balance on the credit account to discharge the borrowing obligations on the

debit account in the event that the borrower does not discharge them himself;

where facilities are partly secured by cash, the part covered may be reported by the

bank to the BoE under the 0% reporting band;

as with pooling, a legal opinion on the enforceability of the set off arrangements is

necessary and

if the funds securing the debt are held overseas by a branch of the same bank or

another bank, a legal charge must be taken over the deposit to qualify for 0% reporting.

12.20  Service requirements, one currency, cross-border pooling

In addition to the requirements given for the one-country pools, cross guarantees, legal right of

set off and legal advice on enforceability (covering the jurisdictions concerned) may also be

required by the bank.

The bank must have the ability to manage all the accounts on an aggregated basis as before,

but in this case the technology needed is far greater.

12.21  Service requirements, cross-currency pooling

Whether the pooling takes place in one location (ie where all the currency accounts are held

centrally) or whether they are notionally pooled across borders, the basic requirements are the

same. The following additional requirements to those given in 12.20 will be required:

multi-currency interest offset system and

multi-currency interest apportionment system.

If the pool is held centrally, a sweeping system to bring funds into the centrally held currency

account(s) will also be useful (see case study 1 in 12.24 ). Such a short-term financing facility is

normally available on demand, enabling drawdown in a variety of currencies.

Companies that use multi-currency pooling, but which also need to borrow over and above their

own netted funds, may require a multi-currency facility linked to the pooling scheme. This

enables companies to draw down funds to cover shortages as and when necessary in the most

appropriate currency.

If currency cash pools are run centrally, the location needs to be one in which there are no

withholding tax deductions, or where there are tax treaties which enable deducted tax to be

reclaimed. If run on a decentralised basis from in-country accounts, the withholding tax aspects

need to be studied in detail.

12.22  Resident and non-resident issues

In those countries that segregate resident and non-resident accounts, the two types of funds

cannot usually be brought together in the same cash pool, and it may be necessary to set up

two pooling schemes, one for resident accounts and one for non-resident accounts.

12.23 How banks charge for pooling services

The charging methods vary widely between banks, but generally banks will make some or all of

the following charges:

interest rate spread (ie a turn between the cost of the deposits and a good lending rate);

where special deposits have to be lodged by the banks with the central bank at low

interest rates based on pooling structures, the cost may be passed on to the customer;

set-up fee: For a complicated structure, a bank may charge a set-up fee based on the

number of accounts and entities participating in the scheme and the costs of complying

with the regulatory aspects and documentation;

management fee: this is often based on a per account, per month basis;

interest apportionment service charge: usually a fixed monthly fee and

additionally, all accounts in the scheme will be subject to account maintenance fees,

electronic bank reporting charges, fees for money movements into and out of the pool

and, if foreign exchanges are made, foreign exchange spreads must also be

considered.

12.24 Case studies

Case study 1 multi-currency pooling

A Swedish company runs cash pools in each country where it has subsidiaries. The head office

treasury in Stockholm runs a set of control accounts into which it moves 'core' net currency

positions, normally on a monthly basis. Net deficits are funded by drawing down the relative

currency from the multi-currency facility.

Diagram 12.6: Example of multi-currency pooling

The system used by this Swedish company as illustrated in diagram 12.6 was put in place by a

Swedish bank. It features:

subsidiary and treasury hold sub-accounts designated in their own names, in each

currency that they have transactions. All accounts are held in Sweden;

these are notionally pooled by currency - no funds movement involved;

net currency positions are notionally converted to SEK and offset;

net currency position if in:

o surplus - invested in appropriate currency,

o deficit - drawn down multi-currency facility in appropriate currency;

movements into and out of subsidiaries accounts by EFT (electronic funds transfer);

monitoring by electronic balance and transaction reporting;

interest apportionment carried out by bank on treasury department instructions and

treasury takes small 'turn' as management fee.

Case study 2 - single currency - multilateral account pooling

                        (joint venture accounts)

This structure is used by a major oil company based in Scandinavia and is provided by a major

Norwegian bank.

This pooling structure features:

participant accounts are designated in the names of the subsidiaries and joint venture

participants;

interest calculated and paid at parent account level;

only one bank account held per participant per currency;

group treasury carries out interest apportionment - all interest passed down to

participants' accounts;

hierarchical notional pooling by currency - no funds movement; and

movements into participants' sub-accounts by EFT.

 12.25 Cash concentration

Cash concentration is referred to by different names and is frequently confused with 'pooling',

mainly because cash pools are often set up by concentration. In countries where pooling is

prohibited, or does not make sense for regulatory reasons (eg US, Italy, Philippines, etc), cash

concentration may be used.

Cash concentration, often referred to as sweeping, comes in various forms, the most common

being zero balancing. This occurs when the bank automatically transfers all balances to one

central control account (the concentration account) at the close of business each day. These

accounts are often referred to by the US expression zero-balance accounts (ZBA). The second

type is the target balance account (TBA) where the bank may transfer all funds over a specified

amount to the central control account.

'Threshold zero balancing' is where no money moves until a threshold balance is accrued on the

account. Once this balance is met, all funds zero balance to the concentration account.

Diagram 12.8 shows the same cash pool as used to illustrate the pooling but this time created

by concentration.

The control account could be held with the same bank or a different bank (as long as funds can

still move on a same-day value basis). Or it might be held centrally in one country and used as

the link between the local cash pool and a pan-regional multi-currency pooling scheme. (More

detail, and further examples of how this idea works, can be found in the chapter 18 "Efficient

account structures").

In some countries, the control account may be interest-bearing and/or may have a group

overdraft limit attached to it in the event of the pool running into deficit. It will be the control

account which is debited when the treasury makes an investment.

Care needs to be taken in deciding the ownership of the control account. Funds moving into this

account will create inter-company loans between the account owners, and internal accounting

entries will need to be passed.

12.26 Types of balances concentrated

The types of balances that may be transferred to the control account vary by country (and by

bank within country) making it impossible to generalise. The following types of balance transfers

may be possible:

cleared credit balances only;

cleared credit balances and cleared debit balances and cleared and value dated

balances, debit or credit.

12.27  Offshore sweep

Offshore sweeping can be used in some countries where credit interest is prohibited on current

(demand deposit, or checking) accounts. This technique has been in place for many years in the

US where cleared USD balances are concentrated and then swept offshore overnight to the

Bahamas or Grand Cayman, (and re-credited to the current account the next day). Some

French and Swiss banks or branches effect this service by carrying out an overnight sweep to

London where good interest rates are payable (normally without withholding tax being

deducted).

12.28 Resident and non-resident issues

In those countries that segregate resident and non-resident accounts, the two types of funds

usually cannot be co-mingled, and it may be necessary to set up two concentration schemes -

one for resident accounts and one for non-resident accounts.

12.29 Cash management techniques and account structures

Chapter 10 "Foreign currency accounts" looked at two basic options - whether to hold the

accounts centrally in one location ('staying at home') or whether to hold them in their respective

currency centres ('going native').

To a large extent, account location often determines the type of cash management techniques

that can be used, and vice versa. So, if a company is keen to do cross-currency pooling, they

will need to keep a set of accounts (possibly just control accounts) in one central location.

Diagram 12.9: Liquidity management techniques

(Further discussion and examples will be given in chapter 18 "Efficient account structures").

Chapter 13 - Cash forecasting

Overview

This chapter discusses various cash forecasting techniques and should be read in conjunction

with the chapters covering short-term investment and debt (chapters 14 & 15) and the chapters

on netting and pooling (chapters 11 & 12) where some techniques involve the use of cash

forecasting.

There are a number of cash forecasting models. This chapter looks at the more common

techniques in detail and the less common and more technical methods in passing.

Learning objectives

A. To understand the different uses for cash forecasting

B. To appreciate the impact of different time horizons on forecasting

C. To understand the process in constructing forecasts using the detailed models

discussed

13.1 Introduction

Cash forecasting can be a valuable aid to the cash manager if it is prepared well and used

properly. In companies that make good use of cash forecasting it may be used as an aid for

some, or all, of the following:

to minimise cost of funds;

to maximise interest earnings;

liquidity management;

foreign exchange risk management;

financial control;

monitoring and setting strategic objectives and

budgeting for capital expenditure.

13.1.1  Minimising cost of funds

The knowledge that funds are required in advance of the requirement gives the cash manager

time to:

ensure adequate facilities are available;

look for surpluses from other parts of the group that can be used via inter-company

loans, to fund the shortages and

look for the cheapest source of funds in the market.

Having to provide liquidity at short notice, or even immediately if a deficit occurs, means that

there may not be time to identify the cheapest sources of funds.

13.1.2  Maximising interest earnings

This is a similar exercise to minimising the cost of funds; knowing that a surplus will occur in

advance enables the cash manager to look for the most effective ways to invest funds. This is

achieved in a manner which is a 'mirror image' to the above exercise:

look for parts of the group that could use this potential source of cheaper funds. This

may be a group company needing funds for a similar period to that of the identified

surplus, or it may be able to be used to refinance more expensive external financing

resources (eg bank borrowings) and

if not needed internally, notice will enable the cash manager to identify higher yielding

instruments. Accurate forecasting will enable surpluses to be invested, possibly on a

fixed term basis, to maximise returns.

13.1.3  Liquidity management

It is the cash manager's basic job to provide the company with sufficient liquidity to enable the

operating units to function. Minimising the cost of funds and maximising interest earnings are

two basic components of liquidity management. When assessing potential surpluses and

deficits of cash it is necessary not only to assess amounts and currencies, but also the periods

for which the surpluses or shortages will arise.

Intra-group funding, practised by most large groups, is always carried out more effectively if it is

based on planned and expected positions rather than a reaction to short-term situations. This is

particularly important where cross-currency and/or cross-border liquidity management are

concerned. Moving money cross-border can be expensive. As well as bank costs, 'hidden'

elements such as losses of value while the funds are in transit, the imposition of 'lifting charges'

or 'beneficiary deductions' in some countries also add to costs. Time-scales due to early cut-off

times may also make covering deficits difficult.

Cross-currency swaps are increasingly being used for this purpose (ie to move funds from one

location where there are surpluses to locations in deficit). Again, these work best where

amounts and tenors can be identified in advance. The swap 'locks in' exchange rates and

provides an automatic hedge.

Some companies fund subsidiaries for very short periods using swaps based on equally short-

term cash forecasts. They may be for periods as short as one or two days.

13.1.4  Foreign exchange risk management

Some companies require their business units to produce both local currency (home currency to

the unit) and foreign currency cash forecasts. This enables treasury to identify the size and

timings of currency flows and either 'match' them against opposite flows within the company, or

hedge them in the currency markets.

Identification of currency flows will enable the company to identify where currency accounts may

be necessary (or no longer necessary) and should form the second stage of an annual plan,

following on from an operating plan and operating budget. Like all forecasting, currency cash

flow forecasting is only useful for risk management purposes if it is regularly updated and

refined, as potential flows and estimates become more certain as they move from medium to

short-term, for example, and are able to be predicted with some accuracy.

13.1.5  Financial control

Cash forecasting can often be used to model payables and receivables against known sales

and purchases. This type of forecasting should be able to identify mismatches between credit

granted to customers and credit taken from suppliers to identify financing requirements. Such

forecasts may be reconciled against actuals to ensure that subsidiary companies are managing

their cash flows in line with plans and corporate policy.

13.1.6  Monitoring and setting strategic objectives

Various corporate strategies and objectives can be reviewed or monitored by comparing actual

cash flows relating to specific products, projects, or business units, against those planned.

13.1.7  Capital budgeting

This type of cash flow projection will often be carried out by companies to ascertain that they are

generating sufficient cash, not only to finance normal operating needs but also to finance the

acquisition of new capital goods (eg machinery). It is also often requested by banks, or finance

companies to ensure that potential borrowers are generating sufficient cash to enable them to

make loan and interest payments without jeopardising the other activities of the business.

This aspect is outside of the scope of this course.

13.2 Cash forecasting time horizons

For general business purposes, rather than for project purposes, there are traditionally three

time horizons:

short-term;

medium-term and

long-term.

Short-term cash forecasting will be used for periods from 'end of business today' forward to 30

days. The objective of short-term forecasting is to identify cash receipts and payments with

reasonable accuracy to aid day-to-day management of bank accounts.

It seeks to identify short-term funding requirements and short-term surpluses that can be used

for investment and will aid the cash manager in his borrowing and investment decisions. Short-

term forecasting should be the main tool used to ensure that there are no idle balances sitting

on non-interest or low-interest-bearing accounts.

Medium-term forecasting is used to estimate net cash positions for periods from one month to

one year. This seeks to establish overall averages, rather than detailed daily positions, and

gives the treasurer a feel for the overall funding/investment patterns expected over the year.

Typically, companies using medium-term forecasting have a rolling monthly forecast that might

be projected 12-months forward. In some volatile industries, where going as far forward as 12

months makes no sense, companies may only project forward three months. The forecasts can

be updated monthly or quarterly.

Monthly rolling forecasts are used extensively for liquidity management by larger companies to

plan actions related to credit lines or issues or sales of commercial paper. In cash-rich

companies, monthly forecasts will normally be the basis on which an investment programme is

planned. Finally, they may be used to monitor and adjust credit extension to customers or for

negotiating longer credit terms from suppliers.

Medium-term cash forecasts (ie rolling forward for one year) are a common monitoring tool used

by banks granting short-term facilities to companies. Companies that are in difficulty and require

close supervision may be required to submit forecasts to the bank each month, while those in

good standing may present them annually during the banks' review process to support the level

of facilities granted. Multinationals would rarely be requested by banks for forecasts, except to

support special facilities such as project finance.

Long-term forecasting covers periods in excess of one year and considers the longer-term

sales, purchases and product strategies of the company. Such forecasts may also be used to

support the acquisition of capital equipment that may be amortised over many years, to enable

management to gauge pay-back periods and potential profit contributions.

Long-term forecasting is usually based on accounting projections of revenues, expenses and

changes in balance sheet items. This will probably be produced on an accruals basis, with

adjustments for the effects of changes in assets and liabilities on the cash flow.

Some companies with long-term strategies make extensive use of this tool. Whilst an European

company may seek to estimate cash flows over a five-year period, some Japanese companies

are known to have produced forecasts going as far forward as 15 years.

The accuracy of forecasts, however well produced, becomes less and less reliable the further

they go out into the future and the practical use of forecasts in treasuries is similarly reduced the

longer the time horizon. Having said this, the fundamental basis on which all major treasury

management systems operate is cash flow forecasting. For example, a five-year loan or

investment (or any other instrument for that matter) will be broken down by the system into its

cash flows as follows:

inflow/outflow of principal at start of period;

repayment schedule (if any);

interest payments/receipts and

outflow/inflow of principal at end of period.

Such forecasts based on real treasury transactions will be highly accurate and have strong

practical impact.

The type of cash forecasting must be appropriate to each company’s business. The form and

application of cash forecasting will differ according to the type of business, the size of the cash

flows, the different time horizons used and the type and quality of the information on which it is

based.

13.3  Sensitivity

Longer-term forecasts need to be subjected to sensitivity analysis as things can change from

year to year. The sensitivity used will vary depending on the type of situation being modelled,

but may include:

currency fluctuations;

interest movements;

changes in rates of inflation;\

economic influences;

changes in the market place and

competitor strategies.

Therefore, companies using sensitivity analysis may produce several cash forecasts based on a

number of ‘what if’ scenarios.

13.4  The process

Flows should be divided by inflows and outflows and split into components. Components may

be split down into smaller categories.

Forecasts often include items with different levels of certainty, ranging between flows that are

assured or that can be forecasted to some extent and those that are less predictable.

The cash manager will need to identify sources of information for the forecasts. These may be:

last year’s actual cash flows;

sale projections;

purchase projections;

accounts payable and receivable data and

investment plans (capital budgeting) including acquisitions.

Sources will vary between industries and even companies within the same industry.

Accurate information will be more difficult to obtain in decentralised groups and its collection

may need to be delegated to remote business units. If business units are responsible for

supplying information it needs to be concise, on time and in an agreed format.

The experienced forecaster will become adept at data selection and organisation. Optimistic

subsidiaries that never meet cash targets will be identified, as well as those that underestimate

and end up with unplanned surpluses. Data will then be manipulated accordingly.

Customer payment records can similarly be studied to ascertain payment frequency. Some

large customers may only pay once per month, others will only include invoices received by an

internal cut-off period set by them. Some will always take more credit than they are officially

allowed; others will always pay on a fixed date, irrespective of the number of invoices to be

settled.

13.5 Short-term forecasting techniques

Short-term forecasting techniques, known as ‘operational cash forecasts’, are normally used for

periods of up to one month. Some companies use this technique for periods as long as three

months:

13.5.1  The receipts and disbursements model

This model will start with a separate schedule of receipts and payments. Receipts will include

funds from sales to customers, any unearned income or funds received from the sale of assets.

Payments will include purchases, payment of other expenses (manufacturing, wages, selling

and marketing costs, etc) interest payable and the purchase of any assets.

Some companies will add to this a minimum cash holding to cover unforeseen circumstances,

while others may seek to run cash at zero or in a slightly deficit (overdrawn) position.

Example 1: Receipts and disbursement forecast

  Week 1

(EUR000)

Week 2

(EUR000)

Week 3

(EUR000)

Cash receipts 2,000 2,200 1,900

Cash payments (1,740) (2,900) (2,000)

Net cash flow 260 (700) (100)

Cash at beginning 200 460 (240)

Cash at end 460 (240) (340)

Minimum cash required (100) (100) (100)

Finance needed - (340) (440)

Funds for investment 360    

Example 1 shows a simple forecast using a summarised receipts and disbursements technique

and a weekly time horizon.

In what follows all amounts are shown as '000s. In week one, cash receipts are expected to be

EUR2,000 and outgoings EUR1,740. This gives a net cash flow surplus of EUR260. If cash

carried forward from the previous period is EUR200, then the cash holding at the end of the

period will be EUR460. If company policy is that there must always be a minimum balance at

the bank of EUR100, there will be EUR360 available to invest.

Week two shows a deficit net cash position of EUR700. When deducting the cash brought

forward from the previous period, the model shows an end-of-period position of EUR240

(deficit). If we need to leave EUR100 in the bank account, this points to a financing need of

EUR40.

Example 2: Daily forecasting format

  DAY 1 DAY 2 DAY 3 ETC

Cash at beginning of day        

CASH RECEIPTS        

- Cash sales        

- Open account collections        

            Vehicles        

            Parts        

            All other        

- Miscellaneous income        

            Interest        

            All other        

- Borrowings        

TOTAL RECEIPTS        

CASH DISBURSEMENTS        

- Payroll        

- Vendor payments        

            Material        

            Parts        

            Facilities        

            Other        

- Taxes        

            Income tax        

            Import duty        

            Sales tax        

- Interest        

- Dividends        

- Debt retirement        

- All other        

TOTAL DISBURSEMENTS        

Cash at end-of-day        

Example 2 shows a format for a more detailed daily cash forecast using the same technique. In

this case no minimum cash holdings have been specified.

13.5.2  The distribution model

The distribution model looks at total estimated flows and allocates proportions of these flows to

the number of days in the period concerned with a view to estimating movements that will occur

on each day.

Proportions may be calculated by using simple averages, but these may be adjusted using

historical data (regression analysis) to cover known events such as patterns seen at month or

quarter ends, certain days of the week, pay-day, VAT payment dates, etc. Adjustments might

also incorporate seasonal changes (for example, in industries like the fashion business).

Example 3 Analysis of past distribution

In this case, we can estimate the funds clearing on each day of the week based on

cheques issued. From an analysis of past distributions, we can establish the average

percentage of cheques cleared each business day. The average value of cleared

items may differ somewhat depending on the day of the week (% effect).The extent

of this effect can be identified through the analysis of past distributions.

Analysis

    Day effect

Business day since

cheques issued

% of value

expected to clear

Day % effect

1 13 Monday -2

2 38 Tuesday 0

3 28 Wednesday 2

4 13 Thursday 1

5 8 Friday -1

If the company issues EUR100,000 worth of pay-cheques on Wednesday, 1 May, this

analysis can be used to estimate the value of cheques likely to be debited to the

account as follows:

Distribution forecast model usage

Date Business days after issueDay of week % clearing Forecast (EUR)

2 May 1 Thursday 13 + 1 = 14% 14,000

3 May 2 Friday 38 - 1 = 37% 37,000

6 May 3 Monday 28 - 2 = 26% 26,000

7 May 4 Tuesday 13 + 0 = 13% 13,000

8 May 5 Wednesday 8 + 2 = 10% 10,000

This can be a simple and effective method of looking at the disbursement side of the cash

forecast and could be used in combination with other methods to build up a forecasting model

based on past experience.

13.6  Medium-term forecasting

Medium-term forecasting may also be called ‘tactical forecasting’ and will be used for periods of

one-to-12 months. Either long- or short-term methods may be used or a combination of these

methods. Most companies tend to use short-term methods and the ‘receipts and disbursement’

method tends to be widely used. Results may then be reconciled to a projected balance sheet.

13.7 Long-term forecasting

The pro forma statement method, often referred to as ‘strategic forecasting’, may cover periods

of one-to-five years and is based on projected income statements and balance sheets. It is

normally derived from the corporate budgeting and planning system, usually looking ahead at

expected sales increases. The ratio of all the other main working capital items (cash, accounts

receivable, stocks, accounts payable, etc) and balance sheet items is calculated at the start of

the period and this ratio is maintained for each period going forward.

To start the process, a sales forecast is generated and the profit and loss account (P & L) and

balance sheet items that appear to be a constant percentage of sales are identified. Where

better quality information is available that will change the ratio, this is substituted. After

projecting the new P & L account and balance sheet, the ‘assets’ will not equal the ‘liabilities’

(plus equity). If the assets are less than the liabilities, the company has a cash surplus. If the

assets are more than the liabilities, the company has a cash deficit to finance.

In Example 4, we have an end-of-year position, a P & L account summary and simplified

balance sheet.

Example 4:  Pro forma statement method (start position)

Profit/loss account EURm

Sales 3,000

Cost of goods sold (2,250)

Selling/admin costs (300)

Depreciation (150)

Interest expense (57)

   

Income before tax 243

Less tax @ 34% (83)

Net income 160

Balance sheet EURm

Cash 150 Creditors

(payables)

75  

Receivables

(debtors)

450 Equity 900  

Stocks 300 Long-term loans 300 (10% interest

rate)

Net fixed assets 600 Preference shares 225 (12% interest

rate)

TOTAL ASSETS 1,500   1,500  

Our analysis of the previous year (and possibly other earlier years) identifies that the cost of

goods sold, selling, administration expenses, payables (creditors) and current assets are a

constant percentage of sales. Depreciation will be EUR75m and we know that the long-term

loans will reduce to EUR200m at the beginning of the year as a repayment is due to be made.

During the early part of the year a dividend of EUR36m is due to be paid. The task is to produce

forecasts for the end of the current year (ie 12 months ahead) and to identify the overall cash

position.

Example 5:  Projected profit and loss account

EURm

(i) Sales 3,300

(ii) Cost of goods sold (2,475)

(iii) Selling/admin costs (330)

(iv) Depreciation (75)

(v) Interest expense (47)

(vi) Net income before tax 373

(vii) Tax @ 34% (127)

(viii) Net income 246

(i)     From our sales forecast we have estimated that sales will increase by 10% to EUR3,300m

(ii)    As the cost of goods sold is 75% of the sales figure, this gives us (EUR2,475m)

(iii)   Selling and administration costs are 10% of sales [ie (EUR330m)]

(iv)   Depreciation is EUR75m as given

(v)    Interest expense will be 10% on the reduced loan level of EUR200m and 12% on the

preference shares, (EUR47m)

(vi)   This gives a net income before tax of EUR373m

(vii)  Tax at 34% equals (EUR127m)

(viii) This gives an after tax profit of EUR246m.

Example 6:  Projected balance sheet (EURm)

Cash 165 (5% of sales) Creditors 82.5 (approx 2.5% of

sales)

Receivables495 (15% of sales)Long-term

loans

200.0 *

Stock 330 (10% of sales)Preference

shares

225.0  

Net assets 525 (600-75

depreciation)

Equity 1,110.0  

Total

assets

1,515   Total

liabilities

1,617.5  

           

Calculating the balance sheet is straightforward. Only the equity needs explanation.

The assets are 102.5 less than the liabilities, therefore, in theory, we are predicting a surplus of

cash and can reduce the loans further (to 97.5) to balance the situation.

13.8 Other types of forecasting

As they strive for improved forecasting accuracy, other methods are available to companies.

13.8.1  Moving averages

This method calculates an average of the most recent amounts with a view to estimating future

amounts. With moving averages, there is no weighting used; all figures count equally. However,

the forecast can be adjusted to trends by using more observations to calculate the average.

Using a five week multiplier (as per the example) would result in a forecast adjusting to trends

better than a multiplier of, say, 12. With this method, the forecast will always be based on past

trends rather than current or expected trends.

Example 7:  Moving averages

Column one shows cash flow calculations based on a similar period in the previous year. While

there may be fluctuations between weeks, overall monthly flows in a five-week period tend to be

similar year-to-year. The calculation starts in week six, based on a five-week moving average.

Therefore, to calculate week 20, we take the average value of weeks 15 to 19.

The final column, 'errors' , highlights the difference between the moving average and the original

forecast and can be used as a benchmark against which to compare fluctuation between the

moving average, the base forecast and what actually happens when this period is reached.

If this does not prove to be accurate enough then the result may be adjusted using smoothing.

13.8.2 Exponential smoothing

Exponential smoothing takes simple moving averages and normally weights them so that more

recent observations are given greater weight in the calculation.

This, in effect, recognises recent forecast errors, and seeks to correct them. The

exponential smoothing equation is:

Ft + 1 = Ft + a (xt-Ft)

where Ft + 1 = cash forecast for the period (t+1)

Ft = cash forecast for the period t (ie period before)

a = smoothing constant (between 0 and 1)

xt = actual cash flow for period t

Therefore the forecast, using exponential smoothing for the next period, is equal to the last

period forecast plus a correction ‘a’ multiplied by the most recent error (xt-Ft)

A smoothing constant of 1.0 means that the forecast for the next period will be the same as the

actual cash flow for the current period.

The example 6 has a smoothing where a = .40

Example 8 Moving averages with exponential smoothing

13.8.3  Regression analysis

Regression analysis is another computer-based technique, which establishes linear

relationships between variables and predicts them forward.

13.9 How useful is cash forecasting?

Cash forecasting should ensure that the company has no nasty surprises as far as liquidity is

concerned. It should enable the cash manager to identify potential cash shortages and to take

remedial action. Such action might be:

delay making some payments;

reduce customer credit periods and seek to speed up cash collections;

establish new credit lines and

put management on notice to reduce certain types of non-essential expenditure (eg

redecorating the office).

In summary, cash forecasting is an essential tool to the cash manager if the forecasts are:

well prepared using reliable base data;

produced using time horizons appropriate to the company concerned;

updated regularly to reflect changes experienced, or known future events and

checked against actuals and refined over time to improve accuracy.

Unfortunately, many companies make poor use of cash forecasting and as a result the whole

process falls into disrepute.

13.10  Systems for cash forecasting

Although most cash forecasting is carried out using home-developed spreadsheets, companies

are increasingly using modules of the newer treasury management systems.

As treasury systems tend to break treasury instruments down into their base cash flows, use of

such systems allows the cash manager to identify some cash flows already. The cash manager

will therefore only have to worry about the operating unit figures, as treasury flows should be

easily determinable at any particular time.

13.11  Summary

Each company needs to devise a system relevant to its own pattern of cash flows, focusing on

those particular flows that have a significant effect on the company’s net positions.

Chapter 14 - Short-term investments

Overview

This chapter on short-term investments follows on from the previous chapter on cash

forecasting. It discusses the investment process and looks at some commonly used investment

instruments. It also teaches some of the basic mathematics used for calculating yields and

differentiates between methods used in the US and UK.

Learning objectives

A. To gain an overview of the investment decision process

B. To understand how yield curves can be used

C. To be able to differentiate between the different types of investment instruments

D. To understand the different ways interest rates are quoted on investment, and

to be able to carry out some simple calculations.

14.1 Investment of surpluses

We have already looked at techniques used by companies to concentrate funds into one centre

to enable bulk investment to take place and how interest-bearing accounts and/or pooling

techniques can be used as a way of gaining interest on highly liquid funds. For larger amounts,

however, interest-bearing bank accounts do not provide an adequate level of return to the

corporate (particularly in those countries where credit interest is only a notional amount). In such

cases, the treasurer will need to find additional higher interest-bearing investments in which to

invest.

14.2 The decision process

At its very simplest level, a treasurer have to know some simple things before seeking to find a

suitable investment instrument:

how much have I got to invest and in what currency;

how long have I got it for and where is it and

what is my attitude to risk?

In more sophisticated companies, treasurer may have performance targets and investment

policies to match as well or may have to offer surpluses to other group companies or a treasury

centre. These will have a major bearing on his eventual decision. Opportunity costs also need to

be considered. However, whatever his situation, the treasurer must have detailed cash flow

forecasts to be able to answer the fundamental questions.

As well as local and currency cash flow forecasts, the treasurer will need to consult any

standing instructions or internal policies relating to investments and then gather information on

current and forecast interest rates and possibly currency rates.

14.3 The investment decision process

The investment decision process is illustrated in diagram 14.1.

14.4 Determining short-term cash positions

This has been covered in detail in chapter 13, but can be summarised as:

Opening cleared balances

Less…Payments due to be made

Plus…Uncleared items that will become cleared and

Plus…Any cleared items to be received

To be accurate, the treasurer needs the information quickly and also needs to know local

clearing practices and banks' value dating practices for cheques and EFT.

As a general rule the longer the time frame of the forecast the less accurate it is.

14.5 Investment guidelines

Most well-organised treasury departments will have well-codified investment and foreign

exchange policies, which lay down guidelines for the treasurer based on parameters agreed by

the board (or a sub-committee).

Such policies will set out the company's views on areas such as:

currency exposure and hedging;

banks that can be used and limits;

investment instruments that can be used and limits;

use of automated sweeps to investment pools and bank/investment ratings.

14.6 The yield curve

The common method of looking at the return from an investment is by studying its yield curve.

This is a graphical representation of the relationship between the yield to maturity and the term

to maturity offered by fixed interest rate investments. Yields are largely affected by market views

of interest rates during the lifetime of the instrument. 

Consequently, yield curves may be flat or sloped either positively (see diagram 14.2 outlining

positively sloped yield curve) or negatively (see diagram 14.3 outlining inverse yield curve). The

standing (rating) of the issuer also affects the yield. Some element of risk is, therefore, included

in the yield. As investors often wish to remain liquid - lend short and borrow long - yields on

long-dated investments may include a positive risk premium to attract investors who might

otherwise look for shorter-dated issues.

Diagram 14.2 shows a positively sloped curve. This is regarded as the normal type of curve that

might be seen for longer-dated treasury bills. This curve would indicate that the market is

expecting treasury bill yields to increase over the next 12 months.

Diagram 14.3 shows a negatively sloped or inverted curve. This indicates that the normal

tendency for long-term yields to exceed short-term yields because of their less liquid nature has

been offset by expectations of rising interest rates and therefore falling short-term yields.

A treasurer can use yield curves in three ways:

to check market interest rate forecasts against the company's own views;

to identify instruments that may be mispriced (ie, their yield curve is off the average for

some reason). This may present a trading opportunity and

to assist in pricing new borrowings. Yields on instruments at given maturities, adjusted

for any risk premium, give a good guide as to the market's interest in any new bond

issues by similar companies.

Forecasts of interest rates (or yield curves) are often available free of charge from the banks.

14.7 Investment instruments

A range of instruments is available to the treasurer, from short-term instruments such as

banker's acceptances, commercial paper and money market deposits, to longer-dated

instruments such as US treasury bonds, which can have maturities up to 10 years.

14.8 Choosing between the different investment types

In choosing an investment, the treasurer (given a free choice) must consider a number of

factors, which need to be balanced and traded off against each other.

the need to make an adequate return;

the need to take regard of the areas of risk:

o credit risk;

o interest rate risk;

o capital risk;

o market risk and liquidity risk - the need to consider how quickly the instrument

be realised for cash.

14.9 Assessing return

Not all investments have interest calculated on the same basis. Some are calculated on a bond

basis (ie a 360-day year with 30 days in each month), whereas others are calculated on a

money market basis (actual number of days in a 360-day year [365 days for GBP]).

14.10 How rates are quoted

at a discount;

coupon or

yield to redemption.

A UK bank bill issued for three months at 97.5 will be redeemed at 100%.

The annualised interest rate on the bill can be calculated as follows:

Total return over three months = 2.5%

Three months  = 91 days

Annualised return 

= 

2.5 x365

97.5 91

 = 10.28%

Coupon instruments are those where specific interest payments are made at specific times. eg

bank deposit, gilt edged securities (government debt). Interest on GBP coupon instruments is

calculated on a 365-day year.

Yield to redemption relates to instruments in which a number of interest payments are made

during the lifetime of the instrument and the principal repaid may be greater than or less than

100%. It is calculated as the discount rate which, applied to future coupons and principal

payments, results in the current price.

Equally, the periodicity of interest payments needs to be assessed. Two instruments which both

carry an interest rate of 11% per annum will have different yields if one pays interest quarterly

and the other annually (the underlying assumption is that the quarterly interest can be

reinvested at the same rate). So, to be able to compare the yield of different types of

instruments, a simple calculation needs to be undertaken. For example, which is better - 10%

paid semi-annually or 10.25% paid annually?

If 10% is paid semi-annually and assuming that the interest payment is reinvested

at 10% then the following would be the total return at the end of one year in an

investment of USD100.

1st interest payment 100 x .10 x 180 = 5

360

Reinvesting the interest gives a new principal amount of 105 for the second six month period.

105 x .10

x180 = 5.25

360

Total return = 10.25 or the same as 10.25% paid annually

A simple algorithm, will give us the answer:-

where n is the number of times in a year that interest is paid; r is the interest rate expressed as

a decimal as for our example above:

Finally, when looking at investment returns, remember the tax aspects which will vary from

company to company, from instrument to instrument and from country to country.

 

Diagram 14.4  US INVESTMENT INSTRUMENTS

COMPARISON TABLE

Instrument Maturity Guarantee

of support

Liquidity Tax

status

Interest Quoted

price

Current

form

Commercial

paper

1 to 270

days

Obligation of

issuers;

some are

credit

enhanced by

a letter of

credit or

guarantee

Liquidity

varies with

quality of

issuer,

though

generally

held to

maturity

Interest

subject

to

federal

and

state

income

taxes

Normally

sold at a

discount

but can

be

interest-

bearing,

with face

value

paid at

maturity

Yield to

maturity

Book entry

Bankers’s

acceptances

1 to 180

days

Obligation of

accepting

bank

(Bank has

recourse to

borrower)

Liquidity

varies with

type and

quality of

accepting

bank

Interest

subject

to

federal

and

state

income

taxes

Sold at

discount

with face

value

paid at

maturity

Discount

rate

Evidenced

by written

confirmation

Repurchase

agreements

1 to 90

days

Securities

held as

collateral

None Interest

subject

to

federal

and

state

income

taxes

At

maturity

Yield to

maturity

Evidenced

by written

confirmation

Negotiable

certificates

of deposit

usually 7

days to 5

years

Obligation of

issuing bank

plus

USD100,000

deposit

Liquidity

varies with

quality of

issuer

Interest

subject

to

federal

and

Paid at

maturity

or semi-

annually

if

Yield to

maturity

Bearer or

registered

form

insurance

per depositor

when FDIC

insured

state

income

taxes

maturity

is over

one year

Treasury

bills

3

months

to 1 year

(usually

3, 6 or

12

months

value

paid)

Obligation of

US

government

International

market: very

liquid

Interest

subject

to

federal

income

tax;

exempt

from

state

and

local

taxes

Sold at a

discount

with face

value

paid at

maturity

Discount

rate

Book entry

Treasury

notes and

bonds

Notes: 2

to 10

years.

Bonds:

10 to 30

years

Obligation of

US

government

International

market: very

liquid

Interest

subject

to

federal

income

tax;

exempt

from

state

and

local

taxes

Semi-

annually

In 32nds

of USD1

per

USD100

(eg 102

3/32)

Book entry

and

registered or

bearer if

dated prior

to 1983

Treasury

STRIPS

3

months

to 30

years

Obligation of

US

government

International

market: very

liquid

Interest

subject

to

federal

income

tax;

Sold at a

discount

with face

value

paid at

maturity

Bond

equivalent

yield

Book entry

exempt

from

state

and

local

taxes

 

N.B. There are other instruments. Corporate bonds, asset backed deals and whole range of

property structures.

14.11 Eurodollar certificates of deposit - London issued

Introduced in 1966, London eurodollar certificates of deposit are issued by a wide range of

American, British and other international banks with offices in London. They are bearer receipts

issued as evidence of a eurodollar deposit for a stated period at a stated rate of interest. (It is

possible for eurodollar certificates of deposit to be issued in registered form but this practice is

unusual and registered certificates of deposit are not readily marketable).

Eurodollar certificates of deposit are issued in minimum denominations of USD25,000 and

thereafter in multiples of USD1,000. certificates of deposit are issued in periods from one month

to five years.

14.12 Method of calculating proceeds

1. Purchases and sales of short-term USD certificates of deposit (up to one year) are

calculated by the following simple formula:

The true yield over the period invested may be calculated by the following formula:

2. Medium-term USD certificates of deposit (period of one to five years) are calculated by

repeated discounting of the proceeds at maturity plus successive annual interest

payments.

eg a USD100,000 certificate of deposit is issued for five years at 7.5% is sold after one

year and 33 days at 7.25%

14.13 Sterling/GBP certificates of deposit

Introduced in 1968, sterling/GBP certificates of deposit are a useful investment instrument

available to institutional investors. They are receipts issued by domestic banks, building

societies and foreign banks in London as evidence of a deposit of GBP for a stated period at a

stated rate of interest. Those that are in paper form are bearer instruments and are thus freely

negotiable (and must be lodged with an authorised depository). However, most certificates of

deposit are ‘immobilised’ with a depository (usually the central money market office - CMO) and

are then transferred by book entry from one computer-based account to another. Companies

must have an account with a CMO member to be able to deal efficiently in the London money

markets.

Sterling/GBP certificates of deposit are issued in minimum denominations of GBP50,000 and

thereafter in multiples of GBP10,000 to a maximum of GBP1m.

The issuing banks (the primary market) generally issue for ‘straight’ periods from one month to

five years.

Sterling/GBP certificates of deposit are fully negotiable, their marketability being assured by the

secondary market. Because a sterling/GBP certificate of deposit may be sold in the secondary

market at any time, the holder has a higher degree of liquidity than with a conventional deposit.

 

Secondary market purchase price:

1. Purchases and sales of short-term GBP certificates of deposit (up to one year) are

calculated by the following simple formula:

Example

A certificate of deposit for GBP1m is issued at 7% for one year. It is bought by a

secondary buyer with 30 days to run at 6.25%.

                =         GBP1,064,531.52

The true yield over the period invested may be calculated by the following formula:

Using the yield calculation described above, we can see that the seller of the certificate

of deposit earns a return higher than the 7% coupon on the certificate of deposit, thus

illustrating the increase in capital that can be gained by holders of certificates of deposit

even when interest rates decline.

The following calculation shows yield on the certificate of deposit with just 30 days to

run:

2. Medium-term GBP certificate of deposit prices (period of one-to-five years)

are calculated by repeated discounting of the proceeds at maturity plus

successive annual interest payments.

eg               a GBP100,000 certificate of deposit is issued for four years at

6.5%, interest paid annually

Interest 1 year GBP6,500.00

2 year GBP6,500.00

3 year GBP6,500.00

4 year GBP6,517.808 (leap year)

3.

The certificate of deposit is sold after one year 181 days at 6.38%

Therefore, period to maturity two years 184 days

Discount for 4th year

Discount for 3rd year

Discount for 184 days in 2nd year

Therefore  proceeds = GBP103.405.13

N.B. In all other characteristics medium-term certificates of deposit are identical to short-term

certificates of deposit.

14.14 Euro-commercial paper

Euro-commercial paper is short-term unsecured promissory notes issued by corporations as

evidence of funds lent to those corporations.

Euro-commercial paper is issued in denominations of USD100,000 to USD1,000,000. It is

issued in maturities from one month to one year. The paper is issued in bearer form and

delivery and payment is effected in the same manner as in the USD CD market. No US

withholding tax is applied to interest payments on EUR commercial paper.

Proceeds are calculated on a discount to yield basis based on a 360-day year formula, ie

14.15 Sterling/GBP commercial paper

The market for sterling/GBP commercial paper commenced trading in 1986 and instruments

take the form of negotiable short-term promissory notes, payable to bearer. GBP commercial

paper may be used by UK-based or international companies or financial institutions, using the

market as a flexible way of raising short-term funds. Yields are similar to interbank deposit rates,

depending on the credit rating of the issuer. The average term outstanding is below 30 days.

14.16 UK Treasury bills

Treasury bills are obligations of the British government issued on a weekly basis by, and

payable at, the Bank of England. Treasury bills are issued in denominations of GBP5,000,

GBP10,000, GBP25,000, GBP50,000 and GBP250,000 and are normally repayable 91 days

after issue. Treasury bills are issued at a discount and in book form.

Treasury bills are regarded as the most liquid of all money market instruments with the lowest

risk, and thus command the finest rate. They qualify as reserve assets for the banking system.

14.17 Commercial bills of exchange

The bill of exchange has been used as a method of raising short-term finance since the

seventeenth century. Today it is one of the most convenient means of borrowing available to

commercial firms. Bills can be drawn in any currency but those drawn in GBP are the most

easily negotiable in London. They are used for financing the movement of goods, export, import

and inland trade, financing stock and accommodation finance, etc.

Bills were historically drawn for a period of 91 days, though one and two-month drawings have

become equally popular and six months is normally the maximum tenor.

14.18 Sterling/GBP bills of exchange

They are divided into three basic categories:

14.18.1 Eligible

This means that they are eligible for rediscount at the Bank of England. They qualify as reserve

assets for UK banks and normally command the finest rates. Up until the end of 1980 the list of

eligible banks was quite small, being mainly the English and Scottish clearing banks, the

accepting houses, the major Commonwealth banks and some Bank of England customers of

long standing. This list has now been extended to include a number of leading international

banks, with the current number at approximately 130.

From the investor's standpoint, eligible bill with LIBID may be up to 1/8% lower.  Ineligible bill

yields vary depending on market conditions but are likely to be between LIBID and LIBOR.

14.18.2 Ineligible bank bills

Ineligible bills cannot be rediscounted at the Bank of England. For a bill to be eligible for

rediscount it must:

be accepted by an eligible bank and

have a life of less than 186 days.

A bank that is not eligible itself cannot issue bills eligible for rediscount.

14.18.3 Trade bills

Trade bills are drawn by one trade customer and accepted by another, but do not carry a bank

endorsement. This is a fairly small market and yields very much depend on the quality of the

names.

14.19 Money Market Funds

Companies looking to invest short-term liquidity make increasingly use of money market funds

14.19.1 Definition of a money market fund

A money market fund is a stand alone pooled investment vehicle which actively invests its

assets in a diversified portfolio of high grade, short term money market instruments and which is

governed by the three fundamental principles of Safety, Liquidity and Yield, in that order.

The objective of a money market fund is to provide treasurers with an alternative to bank

deposits for short-term cash. The fundamental concept of preserving principal value whilst

yielding a competitive rate of return is achieved through the pooling of investments. Investors

benefit from participating in a more diverse and high quality portfolio than they could otherwise

achieve on an individual basis, as well as from the expertise of full time professional

management. A typical portfolio would consist of low risk, highly liquid instruments such as

repurchase agreements (repos), commercial paper, certificates of deposit, master notes, bank

deposits, floating rate notes and medium term notes.

For the purposes of this course the term ‘money market funds’ refers to those funds which

would fall within the accepted definition of money market funds in the United States, otherwise

known as “Rule 2a-7” funds after the defining SEC regulations governing such funds.

Money market funds first became available in the United Kingdom in the mid nineties and were,

from the beginning, designed specifically for institutional investors for the purposes of short-term

cash management. They have been assigned the triple-A rating from the main credit rating

agencies, Standard & Poors, Moody’s and Fitch . Such funds should not be confused with more

retail orientated cash and deposit funds or other short dated liquidity funds which may carry a

lower credit rating or which are unrated.

14.19.2 Historical background of money market funds

The concept of money market funds originated and developed in the United States back in the

mid seventies to satisfy cash investors’ requirements for stability and protection of purchasing

power that the fragmented US banking and Savings & Loans industries could not provide at that

time. To compound the problem, the Glass Steagall Act and Regulation Q limited banking

mergers and the payment of interest on demand deposit accounts, respectively.

The funds provided an effective solution to capital preservation, liquidity and competitive returns

and the product became so successful that by 1980 there was close to USD100billion under

management. Regulation soon followed in 1983 with the Securities and Exchange Commission

publishing a series of extensive regulations within the Investment Company Act 1940. These

were known as ‘Rule 2a-7’ and defined the fund construction, instrument eligibility, the

calculation of yields and all legal and fiscal matters. These new regulations ushered in a

transparency which allowed investors to compare and contrast equivalent funds based on a

standard framework.

However, because of the complexities and low margin of error stipulated by the regulations,

institutional investors began to demand third party confirmation that the rules were being

adhered to. The credit rating agencies were asked to draw up a clear rating process that could

calibrate money funds, on a continuous basis, within the confines of the regulations. US

investors now had the best of all worlds; government legislation defining the funds and a third

party consistently monitoring them.

All this laid the groundwork for the current explosion of money market funds which now sees

over 1,300 funds with a total of USD1.4trillion under management. This accounts for a quarter of

the US mutual fund industry as well as representing almost a third of the country’s store of

short-term cash assets.

14.19.3 The European movement

Various forms of money market funds have been around Europe for some time. In France they

were set up mainly for retail investors due to local tax and regulatory constraints. In the UK,

cash unit trusts were launched to offer private investors the ability to earn higher rates by

pooling their investments in wholesale cash deposits. In Luxembourg, Swiss and German Banks

offered funds to their customers wanting to move domestic cash out of their local jurisdictions.

However, the construction of equivalent Rule 2a-7 money market funds for the UK and

European markets began around the mid nineties with US investment groups seeing an

opportunity to capture offshore dollars in Europe, which then expanded to include the domestic

European currencies. The UK, which had experienced the fall of BCCI, was seen as a prime

market and a number of funds were set up in Dublin’s IFSC to exploit this opportunity. Similar

funds have now been replicated by other financial and banking groups in Dublin and also in the

Channel Islands and Luxembourg. To date, there are 24 providers of such money market funds

with assets under management in excess of USD40 billion in aggregate. The format of the

money market funds based in these jurisdictions is largely the same as the US based funds and

typically offers funds in USD, GBP and EUR.

14.19.4 The three principles governing money market funds

There are three principles governing the management of money market funds, Safety, Liquidity

and Yield. The operating regulations, which define the framework for these principles for funds

available in the UK and Europe, are of course not the same as those in the US. However, the

criteria, which frame the triple-A rating, are the same. The general guidelines set out below are,

therefore, drawn from a consolidation of current European legislation, the rating agencies triple-

A criteria and those regulations from Rule 2a-7 which the majority of offering companies deem

good practice for the long term acceptance of the funds.

Safety

This is the prime consideration of all events that transpire within money market funds. As the

funds being considered here are triple-A rated funds, the very rating alone shows that these

funds are considered as a better credit risk than all high street banks, which are usually at best

double. To maintain and demonstrate the funds are of a higher quality, a number of criteria have

to be met and satisfied. In all, there are five ‘risks’ that can be defined and addressed in order to

provide high security:

Credit risk - is largely controlled by the parameters issued by the credit rating agencies and

those regulations ‘imported’ from Rule 2a-7. The risk is that of loss of value due to credit default.

This is addressed by the criteria that all debt instruments bought by the funds must have a short

term rating of not less than A1/P1, the top tier short-term ratings assigned by Standard & Poor’s

and Moody’s respectively (Standard & Poor’s, which splits its top tier rating further, ie into A1+

and A1, requires that at least 50% of assets fall into the A1+ category).

An essential part of credit control in the US is the normal practice of money market fund

providers maintaining their own credit research department. It is considered insufficient to rely

just on the credit ratings issued by the agencies, as any move to place an issue on credit watch

could be accompanied by a price revaluation. Each money market fund provider undertakes

their own credit analysis, looking at corporate cash flow and profitability. Once a credit has

passed, it is placed on an approved buy list and is subject to on-going monitoring and review.

Should any approved credit’s rating be perceived to weaken, then the internal credit committee

takes the appropriate action which in the extreme is to drop the credit from the approved list and

recommend that any holdings be immediately liquidated. This practice has been largely followed

by US companies that provide money market funds in the UK and Europe.

Diversification risk - This is again largely defined by the credit rating agencies and Rule 2a-7 as

well as the relevant regulations of the jurisdiction in which a fund is based. The risk is that of a

credit default affecting a significant part of the fund. To limit this risk, USD funds must invest no

more than five percent of their value in any one issuer. This diversification limit has been

increased to ten percent for GBP and EUR-denominated funds due to market size and liquidity

issues. For repurchase agreement transactions, where the underlying collateral is government-

backed securities (ie of the highest credit quality), an individual trade is restricted to twenty

percent of net assets. Holdings are further diversified with respect to sector and industry type.

Interest rate risk (market risk) – Again this is largely defined by the credit rating agencies and

Rule 2a-7. Interest rate risk is that loss of value through adverse movements in interest rates.

This risk is limited by the criteria relating to the maturities of the issues making up the portfolio.

The main criterion is that the weighted average maturity (‘WAM’) of the portfolio must be no

more than 60 days. Individual issues can be bought with a term to maturity not exceeding 397

days, but typically investments bought are much shorter than this and as a consequence, the

WAM for the average fund tends to be around thirty days.

In practical terms, this has resulted in money market funds being managed according to a

constant net asset value strategy. This allows a transparency to evaluate the success of

maintaining principal value. Once a week, the portfolio is independently valued on a marked-to-

market basis. This valuation is then compared to the amortised cost of the portfolio and a net

asset value computed. A shortfall as small as 0.5 of one percent in the relative value computed

would be sufficient for a portfolio to lose its triple-A status. Much smaller movements than this

would trigger the introduction of a set of contingency plans to remedy the situation. By way of a

historical perspective, in the twenty five years of the existence of money market funds in the US,

not one triple-A fund has been known to trade below the $1 share value, or as it is called, ‘break

the buck’.

To add further comfort for investors, two of the rating agencies have, in addition to their credit

ratings, a market risk category of rating to evaluate the funds sensitivity to interest rate

movements and other market conditions. Funds with the very lowest sensitivity will have the

highest rating, which is MR1+ from Moody’s, and V1+ from Fitch .

Portfolio structure risk - This risk is defined as that loss of return through not taking the

appropriate action relative to the movements in interest rates, in fund liquidity and to maturing

credits. In other words, poor fund management. Here, there is little one can do to legislate other

than what has been done so far to build a common platform in order to allow a comparison of

past performance from different providers. However, experienced and long established

providers have set up stand alone money market investment desks, as distinct from other fixed

income desks, to manage the portfolios and service their clients. By combining yield curve

investment opportunities with careful liquidity management disciplines, providers should be able

to return a competitive yield to their investors.

Operational risk - This is governed largely by the regulations of the jurisdiction in which the

funds are based. This risk is that potential loss of assets through mismanagement, fraud or

bankruptcy of the parties operating the fund. The most important of the safety features is the

principle of separation of the asset management function from the custody of the assets. The

asset management is undertaken by an investment company, which is contracted by agreement

to act as investment advisor to the fund. No part of the portfolio, or transfer of monies in or out

of the portfolio, should ever pass through the investment company. The custody of the assets is

held by a third party, normally a recognised custody bank in a recognised jurisdiction,

completely off-balance sheet and to the order of the fund. Should the worst happen and the

investment manager and custodian fail, then the assets are totally recoverable for the investors.

As regards fraud or mismanagement, investment companies have for a long time now put in

place systems and procedures that comply with current legislation that go a long way to reduce

such possibilities

As a final note on security, money market funds based in Dublin, and other EU jurisdictions (but

not the Channel Islands), can apply for registration as a UCITS fund under the European UCITS

legislation. UCITS stands for ‘Undertakings for Collective Investment in Transferable Securities’

and is the European standard for the recognition of an investment fund as being of an

acceptable level for investor protection.

Liquidity

Liquidity is that quality of a money market fund which makes it comparable in usage to a bank

deposit arrangement. Triple-A funds make same day settlement a mandatory requirement as

their prime function is to present themselves as a suitable investment for short term cash.

The provision of same day liquidity lies in the structure of the portfolio. The usual format is to

divide the portfolio into two parts, the cash management part and the core part. The cash

management is the component invested in highly liquid securities with a maximum term to

maturity of seven days, typically comprising repos, deposits and master notes. The core is that

part that can be put out longer along the yield curve that comprises commercial paper, CDs,

Medium Term Notes and Forward Rate Agreements to pick up any extra yield. The split

between the two parts can be of any ratio, depending upon a number of different factors such as

size of fund, known demands on liquidity and the shape of the yield curve.

In practice, each fund will have a cut-off time each day by which instructions for investment or

withdrawal should be given. Cut-off times vary widely depending upon currency of portfolio and

fund provider.

Yield

After safety and liquidity have been satisfied, the third principle is the provision of a competitive

yield. As outlined above, the cash management part of a portfolio is intended to achieve

comparative overnight rates and the core part to add yield through investing along the curve.

Once the two parts have been finalised each day, the combined effect after charges should be a

yield that is comparable to overnight market rates.

In the same way that banks separate capital from interest, most money market funds separate

principal from income. Those that operate a constant net asset value pricing system maintain

their share price at a constant unit such as £1 a share. “Put a pound in, take a pound back”.

Separate from this, the cash is invested each day to earn income which is declared as a

dividend daily and accrued until the end of the month when it is paid out, either as cash or re-

invested in further shares at £1 to increase the shareholding. Accrued dividends remain within

the fund until payment date and continue to be invested on behalf of the investors.

The rates offered can be calculated either on a simple or an ‘effective’ rate basis, the latter

including an element of compounding. The usual method, as adopted from Rule 2a-7

regulations, is to calculate them on the simple 365 day basis.

The skill of the fund provider is to manage a fund’s WAM and cash management component

appropriately in the face of changing yield curve environments. Typically, the more volatile the

outlook the greater will be the cash management component and the shorter will be the WAM.

Nevertheless, one of the biggest advantages of a money market fund is the access to the best

rates available for a relatively small investment. Unlike the wholesale money markets where the

minimum thresholds for investment are still large, institutional money market funds’ minimum

requirement for initial investment can be as low as £100,000, or sometimes even lower. Other

stipulations can vary between providers, such as there being a minimum retention level in the

account or a minimum order size for transaction purposes. Otherwise, money market funds do

provide a very efficient method to access money market rates without the constraint of size.

Other considerations

Charges - Normally, there is only one charge of up to 50 basis points (one half of one percent)

made to cover all fund and management expenses. This charge is accrued daily and is

deducted from interest payments before they are paid away or credited to the shareholder’s

account.

Tax treatment - Money market funds operating in Dublin IFSC, Luxembourg and other ‘offshore’

locations will pay little or no tax themselves and dividends are paid gross, ie with no withholding

taxes. Under normal accounting principles, money market fund dividends received by

corporates are treated for tax purposes in the same way as bank deposit interest.

Accounting - Money market funds usually use an accrual basis of accounting with investments

‘marked-to-market’ at frequent intervals to meet credit agency requirements. Interest is

computed on a daily basis by the application of a daily interest factor to each shareholder

account. Interest is usually paid, or credited in new shares, to the shareholder account on a

monthly basis. At the fund’s discretion interim interest may be paid as part of a full account

redemption.

Regulatory - A money market fund will be regulated by the appropriate body in the jurisdiction in

which the fund is domiciled. In Dublin’s IFSC this will be the Central Bank of Ireland, in

Luxembourg the Commission de Surveillance du Secteur Financier (CSSF) and in the Channel

Islands the respective Financial Services Commissions. In addition, the investment fund

manager will be regulated in its domicile, (if in the UK, it will come under IMRO/FSA) and the

fund promoter will be regulated in its country of domicile if different from the investment

manager.

Structure - Money market funds are constructed as an open-ended investment company (OEIC)

with variable capital whose shares can be redeemed and reissued up to the maximum permitted

share capital. Investors become shareholders of the fund which can be constructed as an

individual fund or as an ‘umbrella fund’ where more than one currency portfolio exists within one

corporate entity. Typically the funds, or currency portfolios, currently being offered are US dollar,

sterling and euro. The shares will usually be priced at a constant net asset value (CNAV) in the

appropriate unit of currency, so that the principal remains a fixed amount with any interest being

paid out or credited in new shares on a monthly basis. However, a fund may also have an

accumulating share class where the interest is added daily to the net asset value. An ‘umbrella

fund’ may have further sub classes of a currency portfolio for marketing purposes as they can

differentiate charges, and other operational requirements without affecting the basic investment

portfolio. Full details of the construction of each fund and its objectives will be outlined in its fund

prospectus and any relevant supplement.

Reporting - A money market fund will normally be expected to send out a monthly settlement

statement to each shareholder’ showing all transactions in a shareholders account for that

period. Weekly and daily statements may also be available on request. Formal audited fund

accounts will be drawn up and sent out to shareholders on a 12-month basis and an unaudited

semi-annual (6 month) accounts as well.

A fund will also have to meet the various reporting requirements for the appropriate credit

agencies to retain their triple-A credit ratings. The main requirement here is the maintenance of

an updated counterparty list and the submission of a third party ‘marked-to-market’ valuation of

the fund’s investment portfolio on a weekly, or other regular period, basis.

14.19.5 Funds’ application to current treasury practice

The use of money market funds in current treasury practice is slowly taking hold as they

become better understood and more widely available. They are being targeted at the short-term

end of the cash management activities of treasurers. By short term, it is generally meant that the

benefits can be mostly clearly seen between overnight and thirty days. In practice, however,

treasurers will have rolling sums of cash for periods of much less than thirty days, which results

in a core amount being able to pick up near enough market rates with same day access.

The real benefits the funds bring can be directly related to the increasing pressures placed on

treasury departments by company boards in the area of overnight cash. These issues can be

summarised as follows, with a commentary in each case on how money market funds can

address the issue:

Counterparty security - Increasingly, boards are concerned with the quality of the counterparties

with which their company’s cash is being placed. Unfortunately, due to downgrades over the

years, there is now only one triple-A rated bank left in Europe that is rated by all three main

rating agencies.

The wide choice of money market funds with a triple-A rating can now once more provide easy

access to the highest credit rating that can be achieved.

Returns - Boards are ensuring that every part of their company is functioning to maximum

efficiency, and that includes looking to achieve market rates for overnight cash balances. This is

becoming increasingly difficult coupled with the previous requirement of only using the highest

rated banks. In effect, these two requirements have become almost mutually exclusive.

With the intention of money market funds to provide a return near enough to overnight market

rates, this and their triple-A rating, enables treasurers to achieve both.

Diversification - Boards are limiting the cash placed with counterparties to a maximum figure,

and/or setting a minimum number of banks over which cash must be spread. If a treasurer has a

small amount of cash to place out, forced diversification could impact the rates achievable; if a

large amount, maximum limits may force the treasurer to run out of suitable counterparties.

As a fund, money market funds provide intrinsic diversification through their spread of assets

within their portfolio; they are in effect a collection of counterparties. Therefore, irrespective of

the amount of cash to be placed out, high security, competitive rates and full diversification can

be achieved as a matter of course.

Access - The foregoing issues may encourage treasurers to remedy any impact on yield by

placing a greater proportion of their cash out longer along the yield curve. This ultimately

compromises liquidity should there be calls on the cash.

Money market funds mitigate this by providing same day access, together with competitive

rates, through their liquidity requirements and same day settlement procedures.

Time - All the above causes increased work for many treasury departments in arranging their

overnight cash positions. Maybe anything up to an hour a day can be spent on placing out the

overnight cash in any medium sized business.

A significant amount of time can be saved by using money market funds. Once an account has

been opened, all that is necessary to place cash in it, is to inform the fund that a transfer is

being made and then instruct the paying bank to effect the transfer. Once the cash has been

invested, no other action is necessary until the cash is required, in which case a simple

withdrawal instruction is all that is needed.

Cost - Ultimately, there is a cost in placing cash out over several counterparties, from personnel

time, phone calls and bank transfers, to following through with the administration. Other than the

charge in the fund, the only other charge is the cost of the one cash transfer into the fund. It is

the normal practice that the transfer back to the investor is paid for by the fund.

(This section of the manual was slightly adapted from an article written by Marc Doman,

Managing Director AIM Global Advisers, that was first published in the 2000 edition of the ACT

Treasurers’ Handbook)

14.20 Linking investment management with cash forecasting

The cash manager needs to consider on which time horizon he should make investments. Much

will depend on the forecasted need for cash over the year. Since cash and investments in

monetary instruments do not give as good a return as investments in the business, cash should

be tied-up as far as possible in the business or else, in the absence of profitable investments,

returned to the shareholders. But what time horizons should be considered?

In a cash-generative business we might observe the following annual pattern of cash balances.

This long-term cash flow forecast highlights temporary funding needs and periods when

surpluses will be available for investing short-term. Depending on the amounts involved and

where the surpluses and shortfalls occur, investments could be for discrete periods of time. In

this instance, given a timescale of a year, quarterly investment periods might be sensible

although monthly might be more prudent with adjustments being made on a daily or weekly

basis depending on the accuracy of the information.

Having decided on the time period, the next decision is often the amount. Take the

case where a cash manager is faced with a short-term forecast as follows:

Opening Balance GBP350,000

Day Net position Cumulative cash balance

1 GBP100,000 GBP450,000

2 GBP50,000 GBP500,000

3 GBP-70,000 GBP430,000

4 GBP-130,000 GBP300,000

5 GBP50,000 GBP350,000

6 GBP0 GBP350,000

7 GBP0 GBP350,000

Looked at graphically:

It is obvious that at least GBP300,000 is available for the full seven-day period. This can be

referred to as a core portion and could be put on a seven-day call deposit. This would leave a

balance ranging between GBP50,000 and GBP200,000 to be managed on a daily basis.

However, it is also obvious that raising the amount on seven-day call to GBP350,000 would gain

six days of seven-day interest on GBP50,000 (as illustrated by the light shaded area) and would

suffer one day's overdraft (as shown by the darker area). Whether this is a net gain or loss will

depend on the relative interest rates. Faced with the following set of rates:

seven -day notice 3.5%

call account 3.25% and

overdraft 4.5%

What should the cash manager do? If GBP300,000 is placed on deposit for seven days

GBP201.37 will be earned. Balances of GBP150,000 (day 1), GBP200,000 (day 2),

GBP130,000 (day 3) and GBP50,000 (days 5,6,7) will earn the call rate or: GBP630,000

x .0325/365 = GBP56.10, to give total earnings of GBP257.47. If GBP350,000 is invested for

the seven-day period this will earn GBP234.93 with only GBP29.38 earned on the call account

and one balance of GBP50,000 to be funded by overdraft, costing GBP6.16. This gives a net

total of GBP258.15. The table shows the calculations and indicates that the optimal amount to

invest for 7 days is GBP 350,000.

Chapter 15 - Financing short-term debts

Overview

This chapter also needs to be studied in conjunction with chapter 13 on cash forecasting. In this

chapter we consider the borrowing process and look at both internal and external sources of

funding. We also differentiate between the different types of funding available.

Learning objectives

A. To understand the basic decision-making processes involved with short-term funding

B. To identify possible internal sources of funds

C. To identify possible external sources of funds

15.1 Short-term debt finance

Financing short-term deficits is every bit as important to a company as investing short-term

surpluses. In many cases it is more important, as the way debt is managed can have a major

effect on the company's business activities, particularly its relationships with its suppliers.

Having too much cash uninvested is not wise. Having too little cash and no financing facilities

means going out of business.

Just as well-managed investments can yield higher interest rates for the company, likewise,

well-managed debt can save the company payment of excess debt interest and the fees

associated with many types of debt. Treasurers are in a position to contribute directly to

profitability by reducing their company's borrowing costs.

Interest rates are volatile, making the implementation of a borrowing facility one of the major

tasks of professional treasurers.

Just as balances have to be struck between the interest return and the risk of investments, so

too a balance needs to be struck between the cost of financing deficits and the certainty of

availability of an appropriate facility. Generally, companies find that it is rarely the right time to

seek borrowing facilities when you need them most. This can lead to the company paying high

rates and agreeing to stiff terms and conditions. The best time to put short-term facilities in

place is when the company has a fairly strong cash flow and when there is plenty of time to

shop around for the best prices and the less onerous terms and conditions.

It is the treasurer’s responsibility to ensure that such facilities are negotiated and funds are

available at short notice should cash flow shortages or unforeseen circumstances arise that

make short-term borrowing necessary.

It goes without saying that treasurers should ideally be able to predict with some accuracy short-

term deficits and surpluses. At least, they should be able to determine from their forecasting

system:

how much they need to finance and in what currency;

how long he will need to finance the deficit and where and

the maximum level of funding needed in a time period on a worst-view basis.

To put facilities in place it is first necessary to consider the various options available and their

cost. There will be a need to look at any security requirements and other terms and conditions

that may be imposed on the company. If the company already has other, possibly longer-term,

borrowings, treasurers will need to check the terms, conditions and covenants in those facilities

prior to putting further facilities in place. Some loan documents contain covenants that specify

liquidity ratios, debt to equity ratios or negative pledges which are put in place to ensure that the

company does not over-borrow or place one bank in a better position than another. Likewise,

the tax aspects of the facility need to be considered.

The decision process is very similar to that used in an investment decision.

The degree of accuracy will vary depending on the nature of the business, the time of the year

and the information and communications systems in place in the company

15.2 The financing decision process

The financing decision process is presented in diagram 15.1.

15.3 Choice of financing instruments

The company's choice of financing instruments may be limited by its policies and controls. For

example, a conservative company may not allow a GBP deficit to be financed from a USD

borrowing, swapped into GBP.

The type of financing may also be a limiting factor with, for instance, acceptance financing only

available up to 180 days.

Likewise, the banks that the company has relationships with may also limit prospective financing

opportunities. Although banks will take deposits from almost any company, the company's size,

balance sheet strength and credit rating will be weighed up carefully when it comes to

borrowing. Certain types of borrowing will not be available to smaller or weaker companies.

Again, closely allied to credit ratings are the various ratios that bankers and other providers of

finance look at, ie debt to equity and current assets to liabilities ratios.

15.4 Internal short-term funding

Before looking to borrow from the market, the treasurer should consider internal funding, ie

borrowing from another subsidiary or the holding company. This may be done through

concentrating surplus cash owned by various entities in a group. Either by carrying out a straight

loan between the entities, or a foreign exchange swap and loan if the surplus funds in the

group's cash pools are in other currencies than the one required, or some combination of the

two. This is the cheapest source of funding as there is no external flow of interest and the bank

margin can be avoided.

Example:

company X needs GBP15,000,000 for two months and will be charged sterling GBP

LIBOR plus 1% by a bank; and

company Z has cash surpluses in excess of GBP15,000,000 and has them invested in

the money markets at a rate that equates to sterling GBP LIBID (usually LIBOR less

0.125%).

In effect, the group has paid at least 1.125% (the bank spread) for the privilege of

borrowing its own funds. This equals approximately GBP28,125 in interest charges for

the two months.

This type of financing may be difficult in a group without a central treasury as subsidiaries which

are left to their own devices are apt to do what is best for them, rather than what is best for the

group overall. In a group with a central treasury, the treasury will usually become the common

counterparty, borrowing funds from subsidiaries with surpluses, and lending to those that have

shortages.

A central treasury that can monitor the cash flows of all subsidiaries is in an ideal place to look

for intra-group financing opportunities or, if allowed, intra-group currency swaps where there is a

mismatch between currencies of those subsidiaries that have surpluses and those that are in

deficit. Additionally, the group treasurer can ensure that subsidiaries located in markets with

high interest rates are given priority in terms of intra-group funds.

The tax treatment of interest payable and interest received must also be considered by the

treasurer so that internal funds find their way to the most efficient locations from a tax

standpoint. Cross-border and cross-currency intra-group financing can be full of difficulties such

as:

tax authority attention to interest rate levels charged/received (These should be at

arm’s length rates);

different treatment of withholding taxes on interest between resident and non-resident

companies;

differing tax treaties and double taxation agreements;

15.5 External short-term funding

Short-term external funding in the currency of the deficit and in the appropriate currency centre

has a number of advantages:

firstly, it has a ‘built-in’ hedge as cash required to repay the borrowing (and the

interest) will be sourced in the same currency; and

secondly, it is often (although not always) the case that borrowing local currency in the

currency centre can be the cheapest place to borrow it.

In all markets, certain factors are always important and affect both the level of borrowings

available and interest rates charged. These are:

financial strength of the company - Does it have a rating?;

key covenants – The tighter these are the cheaper the debt.;

industry of the company - Is it attractive to the bank;

availability of a parent guarantee or some other form of security and

bank’s perception of company’s ability to repay on time.

Care needs to be taken to ensure that any deficits identified really are of a short-term nature.

Longer-term borrowings will need to be financed by different methods.

Depending on issues such as the industry that the borrower is in or the purpose of the financing,

subsidised facilities may be available from government-related agencies (for exports or setting

up in economic development zones or for certain project-related transactions). If appropriate,

these should be investigated.

The various types of borrowings tend to come in to - and go out of - fashion. For example, bill

rates have been more advantageous than short-term bank loans and overdrafts at times.

Financing techniques, such as leasing and acceptance credits, have had periods when they

were attractive methods of financing.

For larger corporations, the methods available to raise short-term financing are vast and include

the issue of commercial paper or bonds. Smaller companies and those with weaker balance

sheets will find that they have fewer options available to them.

15.6 Criteria for selecting financing options

The following need to be considered:

‘all-in’ borrowing costs - interest rates, fees, charges and commissions. If interest is

floating, then no certainty of the actual cost is possible, although given the short-term

nature of the exposure interest rate, risk should not be a major issue;

the security that may be required or any comfort letters, negative pledges, warranties,

etc that may be requested by the lender;

terms and conditions - what level of flexibility is there to enable early repayment,

extension or draw-down in other currencies and

tax and balance sheet aspects of the borrowings. Will it be possible to set off all the

interest expense for tax purposes? Will (further) short-term debt distort the structure of

the balance sheet. Should some borrowing be switched to medium or long debt. How

will this new facility affect the company's credit rating?

There is always a trade-off between cost and convenience. The most convenient way to finance

short-term deficits is merely to overdraw an operational bank account. As funds flow in, the

facility is gradually repaid. However, for such convenience there is usually a penalty in terms of

higher costs. Proactive treasurers will find less convenient, but more cost effective methods of

financing debt. These could include using some form of fixed interest rate instrument, planning

maturities and hedging activities to minimise the risk of interest rates changes or currency

exchange rate fluctuations. As with short-term investing, analysis of expected funding

requirement will indicate whether or not there is a consistent core portion of 'short-term' debt

that could be funded using-longer-term instruments. In this scenario, minor fluctuations would

be 'absorbed' by an overdraft facility or, where it gives rise to surplus, depositing overnight.

15.7 Debt instruments

15.7.1  Overdrafts:

available on demand;

repayable on demand;

interest usually charged at a margin above the banks’ base rate, dependent on the

credit risk of the company. Therefore, rates are subject to fluctuations;

facility or arrangement fees may be payable;

subject to periodic review - usually annually;

security may be required and

interest paid quarterly? Semi-annually?

15.7.2  Bank term loans:

made available for fixed periods;

repayable at the end of the period;

interest may be calculated based on base rates or an interbank rate, plus a margin.

Therefore, full cost usually known at the outset of the borrowing;

arrangement fees may be payable;

security may be required and terms, conditions, covenants, etc may be tough and

interest usually paid at maturity or semi-annually.

There are many variants to the basic term loan, including syndication.

15.7.3  Commercial paper:

form of short-term (usually) unsecured promissory note;

repayable one day to 270 days (cannot be rolled over);

mainly denominated in USD. Euro commercial paper enables other currencies to be

used;

interest rates usually very low (depending on credit rating);

need to use a dealer to handle issue/discount them. Discount is not guaranteed - so

standby facilities may be required;

issues are credit rated – high-rated paper attracts the finest margins and

usually issued at a discount.

15.7.4  Money market advances:

available from one day up to one year - usually in multiples of GBP1m;

repayable at the end of the period;

interest interbank rates plus a narrow margin. Usually cheaper than overdrafts;

commitment fees usually levied on the whole facility - not just the amount drawn;

usually unsecured, therefore, only available to highly-rated borrowers;

can be arranged via brokers which receive a 0.0625% commission on the amount

borrowed;

interest premiums are paid for broken date borrowings and

available in USD and European currencies.

15.8 Factoring

Factoring involves the sale of company's debts to a factor, who will advance funds up to a

percentage of the invoice value (around 80%). The factor is responsible for collecting the

receivables from the debtors. The characteristics of this method include:

very short-term - up to three months;

interest rates are high: 3 to 3.5% over base rates; and

administration fees ranging between 1 to 3% of turnover will also be charged,

depending on the service provided. Costs vary based on the credit status of the

creditors.

Costs seem high but may be less unreasonable when compared with the trade discounts that a

company may have to pay to induce early or prompt payment (plus running an overdraft facility

in some cases). Although factoring is a method of financing, it does not adversely affect gearing

and so is popular with higher geared companies. Some factors will offer a level of protection

from bad debts.

Use of a factor is obvious to a company's customer and can often be a source of bad publicity

as it may be seen in some industries as an indication of financial weakness. However, factoring

can be a very cost effective method of maintaining liquidity for fast growing, small firms which do

not themselves have sufficient skills and time to apply to credit analysis of customers, timely

invoicing and chasing of late payors. Most factors (particularly those offering protection from bad

debts) will expect all invoices issued to be included - even those quick payors with good credit

records.

15.9 Invoice discounting

Invoice discounting - where the creditor sells his invoices at a discount - is similar to factoring.

However, in this case, the creditor remains responsible for collecting the debts:

short-term - up to three months and

interest high at up to 3% over base rate plus an administration fee which may be up to

1% of the turnover.

Unlike factoring, a company's customers will not be aware that invoice discounting is being

used. However, all invoices and all of a company's receivable cash flow pass through the

discounter.

15.10  Trade bills

Trade bills are negotiable instruments which are transferable by endorsement. The term 'trade

bill' usually means that the bill has not been endorsed by a bank. Such a bill is drawn on the

buyer, by the seller, and is accepted by the buyer (drawee). The term or the tenor of the bill may

be specified as maturing on a specific date or it may be expressed as a certain number of days

after sight or acceptance (periods vary between one and six months). The trade bill is almost

always connected with the sale of goods. Bills drawn on companies with a good credit risk may

be discounted by the holder with his bank. Although this is unusual in the UK, it is a well-

established means of short-term funding in Continental Europe and some Asian countries.

Discounting is the practice whereby the bank purchases the bill at the face value less an

amount that equates to the interest for the period until the bill matures. At maturity, the bank will

present the bill to the drawee for repayment. Discounting without recourse is available

dependent on the credit status of the drawee.

15.11  Acceptance credits

Acceptance credits are similar to trade bills, but use of the former eliminates the need to link

specific transactions to particular bills. In practice, an acceptance credit is a revolving line of

credit and is usually either drawn on a bank or endorsed by a bank. If drawn on or endorsed by

a bank of some standing, the bill can be discounted at fine rates.

The bank will charge an acceptance commission which will vary dependent on the drawee's

credit standing, but is usually between 0.125% and 0.5% per annum of the face value of the bill.

An acceptance credit facility is usually made available for a fixed period of 12 months and either

a commitment fee based on a percentage of the facility amount may be payable or some form of

agreement as to the minimum utilisation of the facility.

Once bills have been drawn and accepted, the bank will discount the bills at the current rate of

discount (interest) and can either hold the bills until maturity or sell them in the secondary bill

market. The bill itself should be backed by a trade transaction and have a maximum maturity of

six months.

Chapter 16 - Foreign Exchange and Cash Management

Overview

This chapter will examine why a cash manager needs a basic knowledge of foreign exchange. It

will also give a basic introduction to some of the terminology of foreign exchange and the

techniques used. The objective of this chapter is to give guidance on what to do but it will not go

into detail on why as this is beyond the scope of this manual.

This chapter attempts to introduce the various aspects of foreign exchange (FX) within the

context of where FX is being used. The language has been kept deliberately simple and non-

technical where possible. 

Learning objectives

A. To understand the place and importance of foreign exchange in international cash

management

B. To understand the basic vocabulary of foreign exchange

C. To learn how to read and interpret foreign exchange and money market information

D. To understand how to use the basic techniques of foreign exchange, ie spots, forwards

and swaps

16.1 Foreign Exchange and International Cash Management

Chapter One, Introduction to Cash Management, gave some interesting results from the Global

Cash Europe 98 survey about the role of the treasurer and those activities which were

perceived to fall within the area of cash management.

Diagram 1.2 showed that nearly 80% of those replying to the survey perceived foreign

exchange to be one of the activities legitimately falling within the responsibility of the cash

manager. Only bank relationship management, liquidity management and short term funding

scored higher.

16.2 Reading foreign exchange rates: spot rates

An international company has received a payment in a currency other than its own base

currency, but it needs to convert it as soon as possible into its own currency. To do this it will

execute a spot deal. A spot deal is a deal undertaken today at today’s market rate. This rate, or

price, in freely floating currencies, is a result of supply and demand. In normal circumstances,

although it is today’s rate, the actual settlement or cash flow takes place two business days

later. There are exceptions, for example, the Canadian dollar spot rate is actually a 1-day

forward rate. It is also possible to deal for same day settlement in major currencies (early in the

day) and for 1-day settlement, “tom next” in dealer jargon. The rates for these settlements will

take account of the interest rates of the currencies involved.

 Exchange rates are usually quoted as numbers of the base currency to one unit of the non-

base currency. Sterling and euro are usually an exception to this but not always. The way in

which the rates are written in this manual will tell you which is the unit one currency. When

dealing in the market, if in doubt, ask the dealer. There are also two rates quoted, one at which

the bank will buy the unit one currency from you and give you the other, and one at which the

bank will sell you the one unit currency in exchange for the other.

Example. A Swiss based company has US dollars (SWIFT code USD) in a USD account in

Switzerland which it needs to convert to Swiss Francs (SWIFT code CHF) as soon as possible.

The bank quotes a spot rate as follows:

 

USD           / CHF 1.4224 - 1.4234

one dollar    number of Swiss Francs

 

The company wishes to sell the USD, ie give dollars to the bank and receive a

number of Swiss Francs in return. Knowing which of the two Swiss Franc numbers to

use is easy if we remember two things. The first is that we will always take the

perspective of the company and not that of the bank, ie we will always be the ones

asking someone else to quote rates for us. We are market takers (the other party is

the market maker). The second is a simple rule that follows from point one above

and this is, think cynical!

 

Now back to our quote above. One of the two numbers in Swiss Francs represents

the number of Swiss Francs the bank will give you if you give them one dollar. Do

you think they will give you the most or the least number of Swiss Francs in return

for the dollar you give them? Correct, the least, so we now know that if we give the

bank one dollar they will give us 1.4224 Swiss Francs. Suppose then that the Swiss

company wishes to sell USD 10,000,000. They will give the bank USD10,000,000

and will in return get CHF14,224,000 ie simply multiply the number of USD by

1.4224.

 

16.2.1 Practice

 

Suppose a week later the Swiss company realises it needs the ten million dollars

again. It rings the bank for a spot quote and is given USD/CHF 1.4254 - 1.4264.

 

First question: has the USD strengthened or weakened?

 

The purpose of this question is just to get you to think about foreign exchange in

different ways to develop a facility with it.

 

You are correct, again, if you said strengthened. Why? Because there are now more

CHF to one USD than there were last time.

 

Second question: how many CHF will we need to give to get USD 10,000,000?

 

First step. To get one dollar from the bank, will we give the most or the least CHF

spot? Correct, the most. We, therefore, know that to get one USD we need to give

CHF1.4264. We need to get USD 10,000,000 so we will multiply USD 10,000,000 by

1.4264. We will have to give CHF14,264,000 . There will be some more practice on

reading spot rates at the end of this chapter.

 

NB. The two quotes are often referred to as the “bid” and “offer”, the bid is the rate

at which a bank will buy the unit currency and give the other currency and the offer

is the rate at which the bank will sell you the unit currency in exchange for the

other. For example, in the quote:

 

           USD/CHF 1.4254 - 1.4264

 

the bid is 1.4254 while the offer is 1.4264; the 0.0010 difference between the bid

and the offer is referred to as the 10 points “spread”.

16.3 Reading foreign exchange rates: forward rates

 

The same Swiss company knows that it will need to sell USD10,000,000 in three months time.

To be certain of the rate it will get in three months the Swiss company wishes to fix the rate

today through a forward contract.

 

A forward is a rate agreed today at which two parties will exchange two currencies on a

specified date in the future. To find the forward rate you again ring the bank to obtain a

quotation. The bank will give you the spot quotation together with a set of points that need to be

either added or subtracted from the spot rate. Points are simply a result of applying the interest

differential between the two currencies involved to the spot rate. How points are derived is

explained in Appendix 1.

 

To return to our example: the Swiss company rings the bank and asks for a three-month forward

rate. Let us use the second spot quote used above. The bank will quote as follows:

 

            Spot USD/CHF 1.4254 - 1.4264

            3-month points      133 -     127

 

The Swiss company wants to know what the forward outright rate is, or the rate written in full. To

obtain this rate we have to either add or subtract points. Luckily there is a simple rule to follow.

 

If points are: HIGH on the left                           low on the right

 

            Then subtract (-) the points

 

If points are: low on the left                             HIGH on the right

 

            Then add (+) the points.

 

In the case above points are HIGH on the left (133) and low on the right (127) so we subtract

them to give the forward outright rate (hereafter referred to as the forward)

 

            Spot USD/CHF  1.4254 - 1.4264

            3-month                    133 -           127

            3-month forward 1.4121 - 1.4137

 

Now we follow the same process as before to know which is our rate for this particular

transaction. We wish to know how many CHF we will receive for USD10,000,000. First which

rate is ours? We will give one USD to get the most or the least CHF? Correct, the least, so we

are on the left side or 1.4254 spot and 1.4121 is our forward rate. We will be giving

USD10,000,000 so we will get CHF14,121,000.

 

Again, just to summarise our thinking on this, suppose that, rather than having to sell

USD10,000,000 the Swiss company had a specific number of CHF it needed to get, say CHF

23,000,000. The process for finding the current rate to use is the same, i.e., we know we will be

giving up USD to get CHF so we will give one USD and get the least CHF, that is 1.4121. But

we need CHF23,000,000 so to find the number of USD necessary to produce this amount of

CHF we divide 23,000,000 by 1.4121 to give USD16,287,798.31.

16.4 Exceptions to Non Base/Base quotations

 

16.4.1 Sterling (GBP)

 

Normally exchange rates are quoted as numbers of the base currency to one non- base. As

shown above, as a Swiss company we would expect to see a quote of

 

USD/CHF 1.4254 - 1.4264 or number of CHF to one USD

 

or against GBP as number of CHF to one GBP ie

 

GBP / CHF 2.3295 - 2.3306

one GBP number of CHF

 

Question: if the Swiss company wishes to get one GBP how many CHF will it have

to give?

 

Answer: the most or 2.3306.

 

However, there are exceptions and GBP and often the USD are ones as well as the EUR. In the

UK we would also see:

 

GBP/CHF 2.3295 - 2.3306 as the quote

one GBP = number of CHF

 

But note, the currency that is written first is still the unit one currency, and the correct quote may

still be found using the same rules as given above.

 

Example. A UK company needs to purchase 10,000,000 Danish krone (DKK). The

spot quote is

GBP/DKK 10.8240 - 10.8255

 

Question: How many GBP will it need to give?

 

Step 1: Ask yourself “if the UK company gives the bank one GBP, will the bank give

it the most or the least DKK?” Think cynical, which is the rate most favourable to

the bank? Answer: “the least”.

Step 2: You now know that you will get DKK10.8240 if you give the bank one GBP.

You need DKK10,000,000 so to find how many GBP you will have to give in total

divide 10,000,000 by 10.8240.

Answer: GBP 923,872.88

 

16.4.2 The EURO (EUR)

 

You are a UK company and are about to receive 10,000,000 euros (EUR). You will

sell these spot. The bank quotes:

 

EUR/GBP 0.6358 - 0.6369

one EUR = number of GBP

 

This is about the only currency where the GBP is quoted this way, but notice the

first currency quoted is the unit 1 currency. So, since you will be giving EUR (one) to

get GBP, you will get the least so the spot is 0.6358, or a total of GBP 6,358,000.

 

Question: A German company is due to receive GBP15,000,000 which it will sell

spot. How many euros will it receive from the bank?

 

Step 1 Ask yourself “if I wish to get one EUR will I have to give the bank the most or

the least number of GBP”?

Answer: “the most” or 0.6369. You now know the rate, so to find out how many

euros you will receive if you give the bank GBP15,000,000 divide 15,000,000 by

0.6369 = EUR 23,551,577.96

Note: You will also see the quote the other way around ie GBP/EUR. To convert the

quote above just take the reciprocal (divide 1 by the number) and write them down

with the lowest figure on the left.

 

 

You will see rates quoted both ways in the financial press and media.

 

Example. The German company wishes to buy GBP7,500,000 one month forward

and is quoted

 

Spot EUR/GBP 0.6358 - 0.6369

1-month points        12 - 14

1-month forward 0.6370 - 0.6383

 

Note points are low on the left HIGH on the right, so we added.

Question: How many EUR will the German company have to give to get

GBP7,500,000?

 

Answer: They will be giving one EUR so will get the least number of GBP, 0.6358 at

spot plus 12 points to give 0.6370 as the forward. We know that one EUR will only

produce 0.6370 GBP therefore we know we will need more than 7,500,000 Euro to

produce GBP7,500,000. Therefore we divide 7,500,000 by 0.6370 which equals

EUR11,773,940.35.

 

Example. A US company is receiving EUR10,000,000 in three months' time which it

wishes to sell forward. The bank quotes the following

 

Spot EUR/USD 0.8686 - 0.8690

3-month points 33 30

 

The company will be giving EUR (unit one currency) getting USD and is therefore on the left

hand side of the market. Spot rate is 0.8686 and the forward 0.8653 (high-low then subtract

points) and will therefore receive USD8,653,000.

16.5 Caveat on Points

 

16.5.1

 

When a bank quotes points for a forward it usually just gives you two numbers ie as in the last

quote 33-30, with no decimal place, as well as the spot rate. Always write them down by placing

the last digit of the points, under the last digit of the spot quotation, that is:

 

               0.8686

                    33                        

 

Two things are worth pointing out here:

there is an implied, but not stated 0.00 in front of the 33 and

every figure given by the dealer in the spot quote is important. Do not think zeroes have

no meaning.

Suppose the dealer quoted a spot rate of:

 

               GBP/USD 1.4200 - 1.4210 and points of 46 – 40

 

We should write this as:

 

               GBP/USD 1.4200 - 1.4210

                                     46 -       40

 

but DO NOT knock the zeroes off, because if you did there would be a danger of

doing this:

 

               1.42 - 1.421

                 46 -     40

 

which is NOT correct.

 

16.5.2

 

Not every currency is quoted to four decimal places. For example the Japanese Yen is usually

quoted to two decimal places.

 

So, for instance, if spot were GBP/JPY 133.79 - 133.85 and 6-month points were given as 134 -

125 we would write it as follows:

 

               Spot GBP/JPY          133.79 - 133.85

               6-month points                1 34           1 25

               6-month forward        132.45  132.60

 

16.5.3

 

You will also come across situations where the dealer does quote you points with

decimals. These are easy to handle if you just remember to follow the previous

guidance.

 

That is, spot GBP/USD 1.4200 - 1.4210 and forward points of 23.6 - 21.7. We simply

put the last “whole” number of the points under the last numbers of the spot quote

as follows:

 

               Spot GBP/USD         1.4200 - 1.4210

               1-month points               236               217

               1-month forward       1.41764 1.41883

 

16.5.4

 

There are occasions when, rather than follow the High-Low-subtract, Low-High-add rule, we

have to do what the dealer explicitly tells us to do, as in the GBP Thai Baht quote below

 

               Spot GBP/THB       62.13 - 62.38

               1 month points           -18           +27

               1 month forward      61.95 - 62.65

 

Note, as the dealer gave us a minus sign in front of the 18, we have subtracted these points and

as there is a plus sign in front of the 27 we have added those points.

16.6 Interim Summary

We have looked at two circumstances when a cash manager needs to use the foreign exchange

market. These have involved a transfer of funds from one currency to another either spot or

forward and could be the result of a “one off” dividend payment or receipt, or trade payment or

receipt and so on. You are now familiar with how foreign exchange rates are quoted, will have

seen some of the variations that may occur, and how by following the same fundamental rules

the right answer may be obtained. You will have learnt how to adjust the spot rate, by the points,

to find what the forward outright rate is.

The situations given above were all “one way” transactions ie simply buying or selling a

currency. Sometimes we have situations where we have to deal with “two way” transactions ie

buying today and then selling later a currency or selling today and then buying the currency

back again later. The most cost effective and riskless way to do this is usually by using a swap

and we will consider this technique shortly. First we need to consider what the effect of buying

or selling forward is in terms of whether there is a gain or a loss to the company.

16.7 Cost or Earning of the Forward (or Net Finance Cost/Earning)

 

16.7.1 Calculations

 

Undertaking a transaction forward usually gives rise to different cash flows than

would occur if undertaking it spot. These differences may be expressed as per

annum costs or earnings.

 

Example 1. Let us take the situation where a US company is buying GBP1,000,000 forward 91

days to make a payment to a UK supplier. We have the following quote:

 

             Spot GBP/USD      1.4386 - 1.4392

             3-month pts (91 days)         82 -           74

             3-month forward    1.4304 - 1.4318

 

The US company is going to give USD to get GBP (unit one currency). The US

company is, on the right hand side of the quote with a forward of 1.4318 and will

therefore have to give USD1,431,800 on day 91. Had the US company done the

same deal at the spot rate of 1.4392 it would have cost USD 1,439,200. Therefore it

has taken 7,400 fewer USD to do the deal forward than to do it spot, an earning to

the company. This can be talked about in terms of “percent per annum” and the

percent earning may be derived in two ways:

 

(1)   Using the cash flow to convert to percent pa (on 360 day basis):

Benefit of forward (compared to the spot) divided by the spot amount

             USD7,400 / 1,439,200 x 360 / 91 x 100 = 2.03 percent pa.

 

(2)   Using the FX quotes themselves by employing the formula:

             points x 360  x 100 = Net Finance Cost or Earning ( NFC/E)

             spot     days

 

             and substituting the numbers from above

               0.0074 x 360 x 100 = 2.03 percent pa.

              1.4392     91

 

As the forward shows a benefit over the spot, we refer to this as an “earning”. Note

that the points are represented with the implied decimal point and the leading

zeroes, ie 0.0074.

 

In summary, the calculations in this example are done in the base (non-unit) currency (the USD)

and its value calculated by multiplying the amount in the non-base currency (GBP1,000,000) by

the rate. This in turn leads to the formula:

 

points x 360 x 100 = NFC/E

spot    days

 

There are cases where we wish to know the net finance cost or earning in the non-

base (unit) currency.

Then, how do we do the calculations? Also, which formula applies in this case?

 

Example 2. Let’s consider the situation of a UK company needing to buy

USD1,000,000 91 days forward. The quote is:

 

             Spot GBP / USD 1.4386 – 1.3492

             3-month points                82             74

             3-month forward     1.4304 1.4318

 

The UK company will have to give GBP 699,105.15 (@ 1.4304) forward and would only have to

give GBP 695,120.26 if done at the spot of 1.4386. The forward costs GBP 3,984.89 more, so is

a cost.

 

(1)   Using cash flows to convert to percent pa (on 360 day basis)

             GBP 3984.89 / 695,120.26 x 360 / 91 x 100 = 2.267866 percent pa cost

 

(2) Using the FX quotes by employing the formula:

             points x 360 x 100 = Net Finance Cost or Earning ( NFC/E)

             forward days

 

Substituting by the numbers above, we get:

 

0.0082 x 360 x 100 = 2.267866 percent pa.

                      1.4304  91

 

In contrast to the previous example, the calculations here are in the non-base (unit) currency

(the GBP) and its value calculated by dividing the amount in the base currency (USD1,000,000)

by the rate. This in turn leads to the formula:

 

points x 360 x 100 = NFC/E

forward  days

 

Editor’s note: the formuli can be formally derived using basic Algebra however such a derivation

is beyond the scope of this presentation.

 

 

16.7.3 Further issues

 

How do you tell whether it is a cost or an earning?

 

To answer, ask yourself “Would you be better off doing the forward than the spot?” If better in

the forward then it is an earning, if worse off, then a cost. Intuitively, you will follow certain steps

as the next example shows.

 

Let’s assume a UK company needs to sell USD forward, ie give USD to get GBP.

 

Is going forward a cost or an earning? Consider:

the company is giving USD to get one GBP;

points are high low;

therefore subtract the points;

hence give fewer USD to get one GBP in the future;

to give fewer to get one is a ‘good thing’;

a ‘good thing’ is an earning.

The net finance cost/earning in GBP (since we are dealing with a UK company) is

therefore calculated with the formula:

 

points x 360 x 100

forward days

 

which after substitution gives:

 

0.0074 / 1.4318 x 360 / 91 x 100 = 2.04%

 

Why might you wish to know what the net finance cost/earning is?

 

Before you go ahead with a transaction the NCF/E will give you a quick guide as to

the benefit or otherwise. The cash manager always has an alternative to covering a

transaction forward and that is to leave it open and transact it at the spot rate on

the day. Again, if the cash manager has a feel for what the costs or earnings of

covering are, then they may use this to balance their decision.

16.8 The Swap

 

Suppose you are a cash manager in a multinational company. You have one

subsidiary, let's say in Switzerland which has a surplus of Swiss Francs, which you

know will exist for three months, but you also know that there is a need for those

Swiss Francs by the Swiss Company to make a critical payment to a supplier in

three months. At the same time, you know you have a subsidiary in the UK which is

short of funds and which needs to borrow GBP 5,000,000 for this period of time. You

have two choices to consider.

 

16.8.1    Reading the money market rates

 

The first is to let each subsidiary handle its own affairs. The second is to use the surplus in one

company to fund the deficit in the other company.

 

We will consider first the subsidiaries acting independently. If this happens the

Swiss subsidiary would deposit its funds on the Swiss market. The current interest

rates quoted for the Swiss Franc are            1 5/8 – 1 1/2 pa for the 3-month period. 

 

The same approach is used for reading money market rates as for deciding which of

two foreign exchange quotes to use. The first figure above, 1 5/8, represents the

rate at which the bank is willing to lend you money, the second figure, 1 1/2, is the

rate it is willing to pay for you to lend the bank money, i.e. invest. If you want to

take money from the bank do you think they will charge you the higher or the lower

rate? Correct, the higher. Therefore, as 1 5/8 is higher than 1 1/2 (1 4/8), 1 5/8 is

our basic cost of borrowing. There is one minor complication and that is that the

rates quoted are what are called inter bank rates i.e., rates at which banks will lend

to, or borrow from, each other. This means that if the bank we borrow from itself

has a basic cost of funds of 1 5/8 it will have to add a margin, or spread, to make

some profit. The size of the spread to be added will depend to a large extent on the

credit worthiness of the customer.

 

If, as in this case, we wish to lend our money to the bank, i.e. make a deposit, they

will give us the lowest rate ie 1 1/2 %. Note no spread is deducted or added, just

use the straight rate given. (The rate given would vary to an extent with the size of

the deposit.)

 

Back to our problem. We now know the Swiss Company could deposit its funds for 3 months at

1 ½, but what about the UK subsidiary? The UK subsidiary is faced with money market rates in

the UK of                    4 5/32 – 4 1/32 and is able to borrow at LIBOR + ½ (LIBOR stands for the

London Interbank Borrowing Rate). This means borrowing at 4 5/32 + ½ which equals 4.65625

% pa for three months.

 

The UK subsidiary will need to borrow GBP 5,000,000 for three months, or 91 days, therefore its

interest cost will be

 

              5,000,000          x         0.0465625           x            91/365 = 58,043.66

 

             principal borrowed        interest decimalised             days divided by 365

day

                                                                               year, the basis on which

                                                                              GBPs are accrued.

 

The UK subsidiary will have to repay GBP 5,058,043.66 in 91 days to its bank.

 

At a spot rate of 2.3870 (we will see why in a moment) GBP5,000,000 is equal to

CHF11,935,000. If the Swiss subsidiary were to invest this amount it would earn:

 

              11,935,000     x       0.015       x       91/360            = 45,253.54

 

              principal invested        deposit rate          number of days in the

                                              decimalised         period divided by 360 as Swiss

                                                                       Francs are accrued on 360 day basis

 

or a total of CHF11,980,253.54 (principal + interest) at day 91.

 

The second choice you have is to borrow the CHF from the Swiss subsidiary and

lend to the UK subsidiary. Suppose the Swiss subsidiary agrees to this on the

condition that it has CHF11,980,253.54 at the end of the period, ie its position is no

worse than if it was left to its own devices.

 

As you will be selling CHF and buying GBP today, and selling GBP and buying CHF in

91 days, this is a two way transaction.

 

You should do this via a swap. A swap is a “pure time operation which is a

simultaneous spot and forward deal executed with one bank”. You may still obtain

competitive quotes from more than one bank but the spot and forward will be done

with the same bank.

 

16.8.2 Pricing the Swap

 

Because the bank sees both ends of the swap, the spot today and the forward in the

future, it is able to price the transaction in a different way to that based only on the

spot or the forward.

 

In this section we will learn some rules on how to approach the swap. They have

been deliberately kept simple to reflect what is required for this course.

 

The Steps

 

Remember:

1. The swap is a pure time operation. The currency, because it is bought today and sold

back again in the future, is effectively only being “used” for a period of time. Interest

rates reflect the cost of borrowing (or the earning if depositing) a currency for a time

period, ie the costs or earnings of “using” a currency.

2. In terms of the interest rates of the currencies involved, the costs or earnings (caused

by moving through time) is shown in the forward points.

3. We therefore look to see what we are doing in the forward part of the swap. That will tell

us which points are those we need to use.

4. Then, to keep life simple, for the spot part of the swap, use the spot on the same side

as the forward.

16.8.3

 

Let’s consider an analogy by way of illustration.

 

Suppose you are the owner of a Vauxhall Corsa Comfort 1.2i (a small runabout,

economical on fuel but not impressive) which would have rental value of GBP200 a

week and a sale value of GBP9,000.

 

You are due to go on a date and you wish to impress your partner. You have a rich

friend who owns a Rolls Royce, value GBP135,000, rental value GBP1000 per week.

The friend has hit a minor cash flow problem and wishes to use a more economical

car for a week. You decide to swap cars. What will you pay your friend?

 

Well, assuming no credit risk, the only costs at issue are the rental, or time costs.

Why? Because your friend only lets you have the Rolls Royce now, on condition that

you give it back in one week’s time. You on the other hand only let your friend have

the Corsa on condition that they give it back to you in one week’s time. So the only

payment that needs to be made is by you, to your friend, of GBP800, ie the

difference in their time, or rental, values (1000-200).

 

So the flows that take place are as follows:

 

Day 1. Drive to friend, leave Corsa pick up Rolls Royce

Day 7. Drive to friend, pick up Corsa, leave Rolls Royce and GBP800.

 

Note the underlying values of the cars are not important, because what is lent (sold

in the swap) and borrowed (bought in the swap) is received or given back at the

end, plus the payment for time.

 

16.8.4

 

Back to our example. The rates we are interested in are:

 

                Spot GBP/CHF                                  2.3870 - 2.3892

                3-month points                                       162 -     137

                3-month forward                                2.3708 - 2.3755

 

Step 1 What will we be doing in the forward? (this tells us the time costs or

earnings involved).

 

Well, we will have to pay back the CHF to the Swiss Co, so as we only have GBP we

will have to give GBP and receive CHF ie be on the left hand side of the market as

we will get the least CHF, a rate of 2.3708. Note the 162 points are the really

significant figure here.

 

Step 2 This will then mean that we will use the spot rate of 2.3870 (difference

between this rate and the forward of 2.3708 is 162 points)

 

Step 3 How will the deal look?

 

i) Question. How many CHF to borrow from the Swiss subsidiary?

   Answer. GBP5,000,000 is needed today, which at a spot of 2.3870 is

CHF11,935,000

 

ii) Question. How many CHF do we need to buy back for day 91?

    Answer. We already know the Swiss Co will be expecting (11,935,000 x 0.015 x

91/360) + 11,935,000 = 45,253.54 + 11,935,000 = 11,980,253.54

 

iii) Question. What will this cost us?

    Answer. We already know that the forward rate to give one GBP and receive in

return CHF is 2.3708, therefore 11,980,253.54 divided by 2.3708 = GBP

5,053,253.56

 

Summary of the deal

 

1) GBP subsidiary borrows directly, total repayment :                               

5,058,043.66

 

or

 

2) Swap

                 Spot                                                 Day 91

Sell CHF11,935,000@2.3870                          Buy CHF11,980,253.54 @ 2.3708

Buy GBP 5,000,000                                       Sell GBP                       5,053,253.56

 

This gives a lower cost to the UK subsidiary of    4,790.10

 

Therefore do the swap.

 

We could easily convert the outcome for the UK subsidiary into an effective

borrowing rate.

 

Principal at day 1                      5,000,000.00

Paid back at day 91                  5,053,253.56

Effective interest amount                53,253.56

 

Effective interest cost       53,253.56 x 365 x 100 = 4.27 %

                                        5,000,000    91

 

versus, the rate borrowing directly from the bank of 4.65625

 

There is obviously an advantage here, mainly because the company has utilised its own funds

rather than having to borrow from a bank at the borrow rate plus the spread. How the advantage

(of GBP4,790) would be shared amongst the parties involved, the Swiss subsidiary, the UK

subsidiary and the cash manager/central treasury, would depend on discussions similar to those

in chapter 12 on sharing the advantage of pooling.

 

16.8.5 Summary of Swap so far

The swap is a pure time operation so only the time costs or earning incurred by the

bank will be at issue.

The time costs or earning, essentially interest differentials, are reflected in the forward

points. Therefore, to know which points to use we have to look at what we are doing in

the forward part of the swap.

This will tell us what side of the market we are on.

This will tell us the points that are ours.

For simplicity’s sake, on the International Cash Management course, use the same side

for the spot (see Appendix 2 if you wish to examine this in more detail).

We have seen one use for the swap in moving group liquidity around to better use

it, in this case using a surplus in one part of the group to fund a deficit in another

part of the group.

 

We can practice using the swap in another circumstance, namely to perform a cross

border cash concentration exercise to improve our interest returns.

 

16.8.6 Cash Concentration

 

Up to a point, the more money we invest the better the return we receive. We know we earn a

higher rate of interest on a deposit of GBP100,000 than we do on one of GBP10. This principle

may be put into action to improve group returns.

Situation

 

The US based cash manager for an international group with subsidiaries in the UK

and Denmark is reviewing expected balances within the group for the next three

months. The UK subsidiary has a surplus for the next three months (91 days) of GBP

618,000 and the Danish subsidiary has a surplus of DKK 4,115,000 for the next

three months. The US company has a surplus of USD650,000 for the next three

months.

 

Looking at the rates below, the cash manager decides to concentrate the various

surpluses, using the swap, into USD. What benefit will this give? We will measure

overall benefit in terms of USD rates.

 

Interest Rate Bands – USD Equivalent      Interest rates in: USD    GBP    DKK

 

0 - 499,999                                                                              1          2         1 ½

500,000 - 999,999                                                                    1 ¼       3         2

1,000,000 and over                                                                  1 ¾       4 ½     3

 

Note: As the amount invested moves into a higher band, the higher rate of interest

will apply to the full amount on deposit.

 

Foreign Exchange Rates

 

GBP/USD                     1.4386     -            1.4392

3-month points                        82      -                      74

3-month forward            1.4304                  1.4318

 

USD/DKK                    8.4153     -            8.4186

3-month points                    345      -                  359

3-month forward           8.4498                   8.4545

 

Remember: The individual subsidiaries will wish to end up with the same earnings

that they would have had acting independently.

 

Step 1 We need to know what each subsidiary would earn with the balance it has.

The interest rate tiers are quoted in USD equivalent so we need to know what the

USD equivalent of each balance is. To do this we might as well use the spot rate

that we would use in the swap. To do this we need to think ahead to what we will be

doing in the forward part of the swap (remember it is the forward points that are

important and we will stay the same side).

 

Step 2 If we are raising USD today then: we will sell one GBP today to receive USD

and in the forward we will be giving USD to get one GBP. We thus refer to the right

hand side of the quote, with a forward of 1.4318 and a spot of 1.4392 (difference 74

points). For DKK we will sell DKK to get USD today so in the forward we will be

giving one USD to get DKK and will therefore be on the left hand side with a forward

of 8.4498 and a spot of 8.4153 (difference 345 points).

 

We have all the rates, now for the calculations.

 

Step 3 The position for each acting independently

 

i) How much will the Danish subsidiary be expecting to have in total at day 91?

At a spot of 8.4153, DKK4,115,000 will equal USD488,990. This means that the

Danish subsidiary would earn 1 ½ pa

4,115,000 x 0.015 x 91/360 = 15,602.71 so would expect 4,130,602.71 at day 91 so this is what

the US cash manager will have to buy forward.

 

ii) How much will the UK subsidiary be expecting to have in total at day 91? At a

spot of 1.4392, GBP618,000 will equal USD 889,426

This means that the UK subsidiary would earn 3% pa

618,000 x 0.03 x 91/365 = 4,622.30 so would expect 622,622.30 at day 91 so this is what the

US cash manager will have to buy forward.

 

iii) The US company has USD650,000 so will earn 1 ¼ pa

650,000 x 0.0125 x 91/360 = 2,053.82 to give a total of 652,053.82 at day 91

 

Step 4 Concentrate funds using the swap

 

Spot                                                                                             Day 91

Sell DKK 4,115,000                                                          Buy DKK 4,130, 602.71

@  8.4153                                                                         8.4498

*Get USD  488,990                                                          Give USD     488,840.29**

 

Sell GBP    618,000                                                          Buy GBP      622,622.30

@  1.4392                                                                         1.4318

*Get USD  889,426                                                          Give USD     891,470.61**

 

Total USD at Spot

* 488,990

* 889,426

  650,000

2,028,416 which may now be invested @ 1 ¾ pa

 

2,028,416 x 0.0175 x 91/360 = 8,972.92

 

To give total USD at day 91 of                                                       2,037,388.92

Less USD used to repay: Denmark                                                **488,840.29

                                       UK                                                       **891,470.61

 

Net                                                                                               657,078.02

Previous total acting independently                                                 652,053.82

Benefit gained from concentrating funds                                              5,024.20

16.9 Summary

 

The chapter has sought to accomplish the following:

highlight the importance of foreign exchange to the cash manager and thus underline

the need for those in communication with cash managers to have a basic knowledge of

the subject.

illustrate that foreign exchange is involved in:

o one-way flows ie trade transactions, importing or exporting and repatriation of

dividends.

o two-way flows where funds are moved out of and into countries for reasons of

funding or cash concentration.

o although not covered in this chapter FX is used in netting as well.

give a basic introduction to the language of foreign exchange ie spot, forward, swap.

help understand how to read foreign exchange and interest rates.

calculate the cost or benefit of doing a forward transaction

o think in terms of giving or getting the unit one currency and think cynical

introduce the swap and know how to work out what to do:

look to the forward transaction. This tells you which side of the market you are on and

consequently the points that are important –as these reflect the time costs or earnings involved

in the swap. Stay the same side for both the spot and the forward thus making sure those points

are used.

16.10 Appendix 1

 

Why are points a reflection of the interest rate differentials between the two currencies involved?

 

Assumption: complete freedom of movement for market professionals between the

markets.

 

Situation

Suppose interest rates in currency A were 5% and in currency B at 6 ½ % for one

year and the spot rate was A/B 2.000. We will only use single rate quotes for

simplicity. The question is, what would the forward rate have to be to stop market

professionals making arbitrage (see glossary) profit?

 

A bank for instance, with access to the market could borrow currency A at 5% and

invest in currency B at 6 ½ %. This would give it a profit of 1 ½ % in the absence of

any movement in the spot rate ie it is still at 2.000 when the bank needs to pay

back the borrowing in currency A.

 

Example Borrow one million of currency A, spot to B and invest B.

 

Borrowing Currency A 1,000,000 x 0.05 x 365 / 360 =                                    50,694

Total to pay back in one year =                                                                1,050,694

 

Spot to Currency B

                   1,000,000 x 2 = 2,000,000

Invest Currency B @ 6 ½ %

                   2,000,000 x 0.065 x 365 / 360 = 131,805.5556

Total currency B received in one year =                                                    2,131,806

 

If the spot were still at 2.0000 then the bank would sell 2,131,806 of currency B

at 2.0000 to give:                 

                                                    1,065,903 of currency A.

Since the bank only has to repay

                                                    1,050,694  

 

the bank makes a profit of                  15,209

 

Had the forward been set at 2.0000 then the bank would have made the profit risk

free. Given the two amounts (of currency A and currency B) at the end of the year

we can see that a forward of     2,131,805  = 2.0289494     or let's say 2.0289,

would eradicate the ability to make risk free profits.                                     

1,050,694

 

What would happen if it were not?

 

(1)   Suppose the forward rate was only 2.0189? Then:

 

Borrow A and invest in B as above, but cover forward at 2.0189

Borrow A 1,000,000 pay back 1,050,694.4444

Invest B and receive 2,131,805.5556

Cover this amount forward at 2.0189 get Currency A 1,055,924.293

And make a Risk Free (except counter party risk) profit of 5,229.84893

Since everyone would spot the same opportunity, the market would move to a

forward of 2.0289

 

(2)   Suppose the forward rate was 2.03

 

(3)   In this case the bank would Borrow B and Invest in A. Then:

 

Borrow 2,000,000 B at 6 ½ %, Spot to A at 2.000,

Invest 1,000,000 A at 5.00 and

Sell A forward at 2.03

 

2,000,000 B x 0.065 x 365 / 360 = 131,805.5556 total to repay 2,131,805.5556

Spot to A @ 2.000

1,000,000 A x 0.05 x 365 / 360 = 50,694.4444 total

 

Therefore  total received at end of year =  1,050,694.4444

which at a forward of 2.03 = 2,132,909.722

To give a risk free profit = 1,104.167

 

For those interested, the forward points may be worked out from the foreign exchange spot

rates and the interest rates using the formula below. The sign in front of the points will tell you

whether to add or subtract points, ie if I base is higher than Inb then the sign would be positive

so add the points, if Ibase is lower than Inb ie I base is 4 and  Inb is 6 then the interest

differential will be -2

 

The Points Formula

 

Points = Spot x (Ibase - Inb) days/360

                          1+(Inb x days/360)

 

Where Inb is the unit one currency interest rate

            Ibase is the other currency interest rate

 

So taking the example above:

 

2.0000 x (0.065 - 0.05)365/360 = 2,000 +   0.01520833

               1+(0.05 x 365/360)                   1.050694444

 

= 2.0000 x 0.014474551 =+ 0.0289491 or 289 points and add the points to give a

forward of 2.0289 which agrees with our calculations.

16.11 Appendix 2 [Caveat. Do not read this unless you really need to!]

 

Many will argue that using the spot on the left hand side is wrong in this instance

but no one will argue that 162 points are the significant figure for costing this swap.

So, will using a different spot rate really affect matters? The answer is yes but not a

lot. Let us use the spot on the right hand side this time.

 

At a spot rate of 2.3892 GBP5,000,000 is equal to CHF11,946, 000

 

The Swiss will therefore expect at day 91:

 

(11,946,000 x 0.015 x 91/360) + 11,946,000

= 45,295.25 + 11,946,000 = 11,991,295.25

 

So         

            Spot                                                      Day 91

Sell CHF 11,946,000                                   Buy CHF  11,991,295.25

            @2.3892              less 162 points          @ 2.3730

 

Buy GBP 5,000,000                                     Sell GBP    5,053,221.77

 

Cost in GBP using 2.3892 as spot      53,221.77

Cost in GBP using 2.3870 as spot       53,253.56

Small difference of                                    31.79

Corporate Structures and Organisation

Chapter 17 - Treasury Organisation

Overview

This chapter looks at the impact of treasury organisation on cash management and discusses

the major issues, both financial and non-financial, that shape treasury structures and locations.

This section brings together many of the areas already discussed and should be considered in

tandem with chapter 18 on efficient account structures.

Learning objectives

A. To understand different types of centralised and decentralised treasury and their impact

on cash management

B. To be able to discuss the advantages and disadvantages of each alternative

C. To understand how to carry out a centralisation study

D. To appreciate the major issues to consider when looking at treasury centre locations

E. To understand the differences between major treasury vehicle locations

F. To understand the concepts of shared service centre and payment factory

G. To have an understanding of the issues surrounding outsourcing and the use of service

application providers

H. To understand agent and commissionaire structures

17.1 The role of treasury

Before launching into the arguments relating to the virtues of centralisation as opposed to

decentralisation, it is worthwhile reminding ourselves of the strategic role of treasury. In most

groups, this role can be stated as:

minimising financial risks and maximising returns (within agreed risk parameters);

minimising the amount of capital needed to produce revenue;

helping the group meet its business goals and objectives;

matching the financial needs of the business units and

providing help and assistance from experienced staff.

Throughout this chapter these basic points need to be borne in mind.

17.2 Levels of treasury responsibility

Treasury responsibilities may be delegated from head office and might be decentralised at:

business unit;

subsidiary company or

country level

Likewise responsibilities may be centralised at some level:

country level;

regionally or

globally.

17.3 Decentralised treasury

The decentralised treasury may, as stated in 17.2, devolve responsibility to business unit,

subsidiary or country level.

Proponents of the decentralised treasury will point out the advantages, that it can:

match local operating companies’ or business units’ needs closer and faster than a

central treasury;

use employees with local knowledge of the local financial markets;

be the base for setting meaningful financial targets for operating units;

enable units to be totally autonomous and

enable head office treasury to remain small.

There are a number of significant disadvantages:

it is difficult to take advantage of economies of scale (ie, bulk-buying power with banks

and consolidated transactions);

group activities such as netting, pooling and intra-group lending may not be possible

and

it is probably not possible in most organisations to justify the cost of employing true

treasury professionals in all units. Management of treasury at this level usually requires

more people overall to handle the treasury process than in centralised groups.

17.4 Degrees of centralisation

There are several degrees of centralisation, each with its own ramifications.

 

17.4.1 Central responsibility

This is where the group treasury sets guidelines and policy and instructs local staff to some

degree. However, all actions and operations are carried out by the local staff which are likely to

have a dual reporting line, both to their local management (often a controller) and to the group

treasury. This structure has some advantages and some problems:

Advantages:

major decisions are taken in head office by experienced professionals based on a

global view;

actions are undertaken by local staff in the local markets;

outcomes will be reflected in the operating companies’ figures;

local participation ensures the commitment of units to the group strategy and

keeps local banks happy as they still get business.

Disadvantages:

group treasury becomes accountable for the actions of others, which it is unable to

control;

group treasury is a cost centre and a central overhead and will have to continually be

able to justify its existence;

does not enable economies of scale to be realised. Deals cannot be offset or

consolidated and units are free to select banks that they use;

decentralised dealing is more difficult to control. In practice, it may prove impossible to

monitor dealers’ activities and

group treasury must rely on full local co-operation and needs to be able to rely on

regular and accurate reporting (eg forecasts, currency position reporting, identifying

exposures, etc).

 

17.4.2 The in-house bank

This is an important development, which has already been touched on in other chapters and

consequently will be considered in detail later in this chapter. In-house banking is a strange

phenomenon because it can either be part of the ultimate centralisation strategy or a totally

decentralised structure. Thus it is important to decide and recognise where the decisions are

made and how any profits are shared. Decisions made at the centre mean that the in-house

bank is part of a centralised structure and will almost certainly operate along profit centre lines

and be commercially measured. Where decisions are made at unit level but all business is

transacted via the in-house bank, the benefits will probably need to be shared.

An in-house bank is therefore a vehicle where a group treasury acts as the primary source of all

banking services to operating units on an arm̢۪s length basis. It aggregates and nets out

internal transactions; only the differences are placed with real banks.

There are many advantages to this concept, including:

volumes enable the in-house bank to obtain real economies of scale which effectively

reduce the numbers of transactions with banks, bank margins and charges;

can take funds from cash-rich entities and pay them higher rates than a bank;

can lend to cash-poor subsidiaries at lower interest rates;

can introduce techniques, such as netting, pooling, reinvoicing and in-house factoring;

provides group with a centre of excellence staffed by qualified treasury professionals

and

should have its performance measured on commercial terms.

Disadvantages:

group treasury could still be reliant on local staff:

- for forecasts;

- to identify exposures;

- to ‘play the game’ (ie put all transactions through in-house bank) and

- to actually carry out most transactions (albeit with the in-house bank);

local banks lose business and

will reduce local involvement in some aspects of treasury, particularly day-to-day

contact with banks, leading to a lack of commitment.

 

17.4.3 Full centralisation

In this situation, all decisions - and most actions - are carried out centrally.

The advantages are the same as set out for in-house banking:

volumes enable the in-house bank to obtain real economies of scale which effectively

reduce numbers of transactions with banks, bank margins and charges;

can take funds from cash-rich entities and pay them higher rates than a bank;

can lend to cash-poor subsidiaries at lower interest rates;

can introduce techniques such as netting, pooling and reinvoicing;

provides group with a centre of excellence staffed by qualified treasury professionals

and

may have its performance measured on commercial terms.

The disadvantages are different from those with in-house banking to some extent:

the loss of responsibility and people, particularly if financial targets are taken away, will

mean loss of interest in banking and treasury matters by the subsidiaries;

there will be no-one for the local management to go to for local banking advice;

a larger group treasury will be needed, but

the group treasury will still be reliant on a set of disinterested subsidiaries for forecasts,

reporting, netting, input, etc.

17.5 Typical structures

Many treasury organisation structures are used by international and multinational companies.

Diagram 17.1 shows a fairly typical multinational structure where the group treasury is situated

at the same location as the head office and regional treasury centres report into it. Important

countries may have a full-time treasury resource reporting into the regional centre, but minor

countries will rely on part-time resources, staff often doubling as accountants, bookkeepers or

controllers.

17.6 Regional treasury centres

Regional treasury centres can operate effectively in both centralised and decentralised

organisations. Their primary role is to assist the group and its subsidiaries in identifying and

effectively managing treasury risks and liquidity in accordance with group policies.

The regional treasury focus is on geographical areas and currencies. The responsibilities of the

regional treasury centre span the subsidiaries and product groups within that area. Globalisation

of businesses has resulted in the formation of regional groupings of group entities that may

previously have been unrelated where a structured treasury management solution is now

required whether or not that business is centralised or decentralised.

The role of the regional treasury centre is to work with the operations and, in a centralised

structure, group treasury in the following areas:

assessment and control of the treasury risks faced by the company and how these are

affected by the business;

country by country banking reviews;

development and day-to-day management of in-country cash pooling/cash

concentration and

assistance and support for new companies as they join the group to establish

appropriate treasury arrangements.

In a centralised environment the regional centre may be required to act as the regional in-house

bank.

Historically, regional treasury centres have been perceived as minimal activity, tax-driven

structures. However, MNCs are now tending to separate tax structure/location decisions from

operational treasury centre location decisions for the following reasons:

to be effective the regional treasury centre needs to be located in the region it supports

and close to the key business operations in that region;

the location must be cost effective. Staff, office space and IT requirements can be

expensive in tax-favoured locations;

high quality treasury expertise must be readily available;

the location must be politically and economically stable and

it is preferable to site the regional treasury centre in a robust banking and regulation

environment.

17.7 Why regional treasury should be managed in the region

Some companies have tried to run a regional treasury operation from outside of the region. For

many non-cash management functions, such as exposure management, this can work. For

cash management it is a sub-optimal solution for the following reasons:

time zone differences can result in contact difficulties with subsidiaries and banks; local

cut-off times for clearing systems mean that same-day value transactions may not be

possible;

traditional regional treasury relies on local market expertise. It is not always possible to

provide this level of expertise outside of the region;

foreign currency markets may not be as deep or competitive outside of the region (eg

dealing European currencies in the USA);

it is often possible to set up regional treasuries in tax efficient locations, whereas the

group treasury function is normally not mobile and always resident in the same location

as head office, irrespective of tax ramifications;

negotiating pricing in the region will normally mean getting better bank pricing than

outside, where the ‘going rate’ may not be known and

regional treasuries are often able to take advantage of lower staff costs (eg India) than

head office.

17.8 Assessing the case for centralisation

Many companies carry out studies of what might be achieved by centralisation in terms of cost

savings, efficiency, economies of scale, economies of resources and increases in control. Such

studies normally involve setting up a small team with the task of:

collecting and analysing data;

identification of strategy alternatives;

providing a cost-benefit analysis;

making recommendations to management and

implementation.

There are many examples of very successful projects of this nature, but they can run into

problems, such as:

lack of senior management consensus or commitment;

disagreements about what should be centralised and what should remain

decentralised;

building the business case (particularly quantifying the costs and benefits);

agreeing corporate objectives for treasury and

persuading the subsidiaries to co-operate with the project.

It can often be useful to complete a responsibility matrix in which the various functions of

treasury or cash management are split up and responsibilities and rules are assigned to each:

This type of matrix can be helpful for discussions with subsidiaries worried about loss of power

and with a head office that needs to understand which units will be responsible for what

functions.

17.9 In-house banking

17.9.1 Overview

Many major corporations that operate highly-centralised treasury operations have taken the

concept one stage further and are operating their treasury in such a way that it resembles a

bank as far as its group companies are concerned. In-house banking effectively means that

group companies treat the central treasury as the main provider of banking services to the

group. The central treasury or in-house bank will then use, where necessary, real banks rather

like correspondent banks.

17.9.2 In-house bank’s functions

While the corporations that use the in-house banking concept often set themselves up in a

number of different ways and offer different functions, there is a strong degree of commonality

between the main services offered and a set of common reasons for using such treasury

vehicles.

The main reason for using an in-house bank is to reduce banking costs, both by minimising the

numbers of transactions undertaken with banks and maximising the size of those transactions

that need to be undertaken. Larger aggregated transactions, usually representing many smaller

individual transactions for group subsidiaries, can be carried out by specialist professional

treasury staff operating from one centre of excellence (either regionally or globally) more

efficiently and for less cost than at individual company level. In effect, in-house banks are a

method of reducing the numbers of banks used, disintermediating subsidiaries from their banks

and minimising banking costs.

The main functions carried out by in-house banks are detailed below, with more extensive

analysis of services provided in diagram 17.3:

long-term investment and funding;

foreign exchange and exposure management;

netting of inter-company flows and foreign exchange matching;

reinvoicing and/or factoring;

cash management and

central management of bank relationships.

17.9.3 Long-term investment and funding

Most large corporations that need to borrow or invest funds find it beneficial to aggregate (and

net out) their shortages or surpluses across the group with a view to borrowing or investing at

group level rather than at individual company level. The currency of borrowing will be

determined by currency exposure arising from trading flows and in the balance sheet. For

example, a group needs to fund the construction of a warehouse in Germany and all costs are

in EUR. If the German subsidiaries have a strong positive EUR cash flow, it may be best to

borrow in EUR and make interest and loan repayments from the EUR flows. Other factors

determining how the subsidiary is financed are: management style, tax considerations and local

regulations on inward investment.

Subsidiaries with long-term cash surpluses in other currencies may lend them to the in-house

bank; in turn, the in-house bank will then lend to the subsidiary building the warehouse in EUR.

Any foreign exchange exposures would be covered by the centre. These methods effectively

remove the bank spread and could save the group a number of percentage points between bid

and offered rates. However, where there are long-term surpluses, it may be necessary to

declare a dividend to forward the funds to the parent as certain tax regimes may treat such

loans as deemed distribution.

Where there is not a matching group shortage, longer-term surpluses can be aggregated and

invested as one large amount by the in-house bank into a suitable money market or securities

instrument. Larger amounts, invested by experienced treasury staff, will attract better rates of

return than smaller amounts invested by subsidiaries.

17.9.4 Foreign exchange and exposure management

Similarly, the in-house bank allows a company to aggregate and net out the group's foreign

currency trading requirements and manage the risks so that fewer, larger deals can be carried

out by the group with its banks. This practice, plus expert negotiations by in-house bank staff,

can reduce foreign exchange sale and purchasing spreads by as much as 0.25%. Highly

centralised groups may not only insist that all foreign exchange transactions are carried out

through the in-house bank, but go one stage further and eliminate the need for subsidiaries to

carry out foreign currency transactions altogether.

This can be carried out by reinvoicing, in-house factoring and/or including all foreign currency

intra-group and third party receivables and payables in a group netting system, thus enabling

subsidiaries to deal purely in their home currencies. This concept is discussed below.

17.9.5 Netting and foreign exchange matching

Multilateral netting, as practised by the large corporations with multi-currency flows, is a process

of offsetting payables owed by one subsidiary to all other subsidiaries against receivables due

to it from all other subsidiaries.

A multilateral netting structure needs a netting or clearing centre - usually provided by the in-

house bank or sub-contracted to an international bank. This netting centre handles all the

calculations, currency purchases and sales and exposure management, enabling participant

companies to make or receive a single payment on settlement day in their home currency.

(Netting is discussed in detail in chapter 11).

Additionally, some companies use the netting process to perform foreign exchange matching.

Subsidiaries that either need to sell or buy currency can do this via the netting system, settling

in their home currency, thus eliminating the need to hold foreign currency bank accounts, or to

buy or sell currency through local banks.

17.9.6 Reinvoicing and in-house factoring

Different groups find that either reinvoicing or internal factoring can be used both to centralise

foreign exchange risk and to minimise banking costs depending on their particular operating

structure or tax position. Few companies practise both techniques.

Reinvoicing is a process where subsidiaries, in lieu of billing in a currency other than their own,

will bill the central treasury or in-house bank in their home currency which in turn invoices the

customer in his home currency. The in-house bank effectively takes the foreign currency risk.

This technique also enables leading and lagging. ‘Leading’, is paying early to a cash-poor

subsidiary by the in-house bank, thus saving the subsidiary from drawing on bank credit

facilities. “Lagging”, means paying cash rich participants later. These two concepts can often be

achieved merely by granting different credit periods to each type of company.

In a group that uses factoring, the subsidiary sells the receivable to the in-house bank at a

discount. The discount is usually at a rate of interest lower than a subsidiary would pay to fund

itself via a local bank. Reimbursement is effected by the customer paying directly to the in-

house bank.

If well set up, settlement of either factoring or reinvoicing transactions can be included in the

netting, enabling one amount to be paid into or out of the in-house bank to each subsidiary for

each netting cycle.

17.9.7 Cash management

Cash management is the term often applied to the short-term management of a group's liquid

assets and liabilities. In-house banks set up and practise the following techniques:

bank selection;

use of interest-bearing bank accounts;

balance pooling and concentration;

auto-investment techniques;

short-term currency swaps;

interest apportionment and

short-term loans and deposits.

Large corporations now obtain better transactional banking terms by concentrating all their

banking activity through one bank in each country. (It is rarely possible to concentrate all

banking activity for one region through a single bank). This enables substantial economies of

scale, including negotiation of reduced per item charges, credit interest on operational bank

accounts, and interest offset pooling or balance concentration.

With pooling, balances are notionally aggregated by the bank for interest-earning purposes with

debit balances being offset against credit balances; the net position is that on which interest is

calculated. The in-house bank will often hold a dummy account in the pool to enable it either to

withdraw and self-invest surpluses, or to fund the pool in the event that it falls into deficit. With

pooling, there is no co-mingling or movement of funds among participants.

With cash concentration, use is made of the bank’s zero balancing systems to transfer

subsidiaries’ cleared balances to a central account that can then be used to invest surpluses or

on which debit interest is calculated. In most countries, banks are prepared to offer automated

investment facilities to large corporations, by transferring cleared balances to high interest

accounts or into overnight or short-term money market instruments.

Managing country cash pools (or concentration systems) from a central location enables the in-

house bank to provide cross-currency funding by ‘swapping’ surplus currencies for those

currencies which have deficit pools (thus further extending the concept of intra-group funding to

short-term positions). While such a technique is usually applied by in-house banks, to ‘core’

deficits and surpluses (often monthly or biweekly based on cash forecasts), some more

innovative organisations are practising the technique on an overnight basis. Using the swaps

technique means that only residual or unplanned positions need to be left on current accounts;

even these can attract a reasonable rate of return if these are interest-bearing and/or linked to

auto-invest systems.

Finally, with such group arrangements in place, the in-house bank needs to be able to issue

‘bank statements’ and to provide interest apportionment services.

(Pooling is discussed in chapter 12)

17.9.8 Central management of bank relationships

In-house banks normally take group responsibility for setting up and managing all group-

banking facilities for credit, transactional banking and trading purposes. This invariably leads to

two situations. First, a substantial reduction in the number of banks used, and secondly, a

concentration of business with banks that are particularly noted for their expertise in certain

areas of business (eg, trade services, cash management, exotic currencies). This approach is

usually expected to strengthen the group's overall bank relationships.

17.9.9 Systems

By their very nature, in-house banks have to be staffed by high calibre individuals, but bearing in

mind the functions that they have to provide and the time constraints imposed by the banking

systems in each country, automated systems are also a prerequisite. The very basic systems

requirements include:

multibank electronic balance and transaction reporting;

cash forecasting system;

electronic funds transfer capabilities;

electronic rates service (Reuters, Bloomberg etc)

treasury management system and

access to an accounting system.

For a central treasury or in-house bank to be able to manage cash on a day-to-day basis, it

must be able to monitor the group's bank accounts each day. Most leading banks' electronic

banking systems now enable other banks to report into them, either using the SWIFT network or

third party data exchange systems, thus enabling 'multibanked' companies to use just one bank'

s electronic banking system to monitor all their accounts. Some banks can also offer companies

the ability to initiate electronic funds transfer (EFT) instructions on a multibank basis. EFT is, of

course, necessary to move surpluses between accounts at different banks, -often in different

currencies - as well as to settle foreign exchange transactions with banks, to operate intra-group

netting transactions or to make third party payments.

Finally, and most importantly, in-house banks must use a comprehensive treasury management

system that will not only enable consolidated position reporting and management by currency or

country, but also facilitate management and reporting at subsidiary level. Such systems must

have strong multi-currency capabilities and provide management and exception reporting as

well as planning and forecasting functions.

Some large corporations build their own systems, but many choose to buy one of the many

treasury management packages that are now generally available.

17.9.10 Impact of in-house banks on the banking industry

It is clear that the growth of in-house banking is one more step towards corporate

disintermediation of banks. As more companies are moving towards centralised treasury

operations, the in-house bank concept is likely to become a natural progression, offering as it

does so many opportunities to reduce external transaction volumes, the numbers of banks used

and banking costs. While there will be many losers among banks, there will also be - as US

banks have found - a few winners that will end up with very significant relationships with major

corporations, often on a regional or global basis. Such banks are attracting multinational

customers through a combination of price, service quality, network coverage and integrated

systems.

17.10 Locating a treasury management centre (TMC)

The following provides a checklist of areas that need to be covered when selecting a location for

a treasury management centre (TMC):

17.10.1 Political and economic considerations

Needs a politically stable and economically strong location, ideally with laws and special

incentives for headquarters’ operations and treasury centres.

17.10.2 Exchange controls and banking regulations

The ideal location for a TMC will have no exchange controls to prevent the free flow of funds

through the centre (although there may be central bank reporting of some activities). There

should be no banking taxes or levies such as lifting charges.

17.10.3 Personnel

Good staff should be easily available, ideally well educated with financial and language skills.

Some locations impose minimum staffing levels on companies and these can be onerous,

particularly in countries where trained staff is scarce and salaries are high.

Some countries impose high penalties on companies seeking to reduce staff and these aspects

need to be considered for the future. Some expatriates may be needed and relocation and other

costs need to be factored in, as well as the availability of work permits.

17.10.4 Premises/infrastructure

The TMC may look for a location where it can take advantage of some existing corporate

infrastructure, in terms of:

premises;

administration services;

mainframe computer installation and

travel facilities and proximity to airport for travelling to other group facilities.

17.10.5 Taxation

The following tax features should be sought:

minimum local corporate rate;

low payroll taxes;

benefits of timing differences (between when tax is assessed and paid);

utilisation of any exchange losses or interest expense to be offset against profits;

ability to carry forward losses to future years;

no or minimum, withholding taxes on interest payments/receipts and dividends;

good set of double taxation treaties with other countries where the group operates and

centre where group is domiciled;

dissolution (if necessary) allowed at minimum cost and

low or no value-added taxes (particularly on banking services).

When setting up a TMC, tax is an important issue, but it is only one of many issues and it can

often be the least important when put into context against the others. Work out the best financial

structures for the operational needs of the group first, then look at them in terms of how well

they work for the TMC. Only then, should the tax ramifications be considered.

There are always trade-offs between what is best for business and treasury and what might be

considered best from a tax perspective. However, even in the most liberal regimes, companies

will have to bear some level of tax burden.

17.10.6 Legal

minimum documentation for start up and maintenance;

fast response times from authorities and

minimum annual requirements for audit, reporting, statutory filings, etc.

17.10.7 Treasury management environment

active foreign exchange market;

stable and innovative banking system and

minimum differences between resident and non-resident status.

17.10.8 Communications

Good communications systems for telephones, data transmission, fax and mail.

17.11 Strategic decisions to be made

17.11.1 Legal, tax and regulatory issues

The legal, exchange and tax ramifications of netting, reinvoicing and in-house factoring need to

be ascertained prior to a decision being made.

17.11.2 Corporate structure

Options available might be:

separate legal entity;

branch of head office or

division of an existing entity.

17.11.3 Fees and charges for services

How will the TMC charge for its service?

take a turn on or spread on interest and exchange rates;

specific fees or

cost plus basis allocated to subsidiaries using an agreed formula.

How will profits be treated?

accumulated at TMC;

shared by subsidiaries using centre;

paid as a dividend to parent or

shared between the TMC and the subsidiaries.

17.11.4 Hedging strategies

what should be hedged and when;

interest rate and exchange rate hedging instruments to be approved;

dealer limits and

rates used to mark-to-market or determine exposures and performance.

17.11.5 Inter-company and third party netting

what transactions to be included.

17.11.6 Exchange control and tax issues

restrictions on funds movement, inter-company loans etc;

tax treatment of inter-company loans/deposits;

17.12 The business case for a TMC

The business case for a TMC is often very difficult to prepare and some companies spend a lot

of time trying to calculate costs and benefits down to the last USD (or EUR).

The cost side is relatively easy to prepare; it is the benefits side that treasurers traditionally have

problems with. A rough rule of thumb that can be used is an improvement of 1.5% of the value

of nettable cash flows (ie all intragroup cash flows that can be matched) through the TMC. This

can be justified as follows:

17.12.1 Expert negotiations

The reasoning here is that an expert dealer in the TMC should realise an improvement of up to

0.25% by negotiating with banks on deposit and lending rates, and by placing foreign exchange

deals with specialist banks.

17.12.2 Removal of duplicate foreign exchange

Reductions in duplicate foreign exchange deals and narrowing spreads (0.25%) can be

achieved using techniques such as:

foreign exchange matching;

netting;

factoring or reinvoicing and

by trading larger blocks of currency less frequently.

17.12.3 Elimination of simultaneous borrowing/depositing

Simultaneous borrowing/depositing of 'own' funds (1%) can be eliminated by putting in place:

pooling and cash concentration;

inter-company loans and deposits and

thus reducing bank margins.

17.13 Size of operation

How many staff will be needed in your TMC? Can we run a brass plate operation, or consider

some form of outsourcing?

Brass plates: increasingly these are not an option and tax authorities are now normally

insisting on ‘substance’ - real people, offices and activity to enable companies to take

advantage of tax effective locations.

Outsourcing: this may suit companies with a relatively low level of activity in a region,

or where much of the work can be ‘put on auto pilot’, ie bank does zero balancing or

cash pooling, remits funds regularly to home country, etc (see section 17.18) and

Own operations: running a TMC yourself may mean having to meet local regulations

on staff, or even location, in some low tax countries. For example, you must employ a

minimum level of people and be located in the Dublin docks to be granted all the

concessions available to an Irish financial services centre (IFSC).

17.14 Treasury centre locations

17.14.1 Europe

In Europe there are a number of popular locations for TMCs:

Ireland                Irish financial services centre

Belgium               co-ordination centre

Luxembourg         co-ordination centre

Switzerland          co-ordination centre

The Netherlands   financial services centre

Dutch/Swiss         Dutch/Swiss Sandwich

UK                      No special vehicle

The ‘Dutch/Swiss Sandwich’ and the UK as a popular location need further explanation. The

Dutch/Swiss Sandwich is a structure that operates in Switzerland as a branch of a Dutch

financial services centre and, therefore, can take advantage of two tax breaks in Switzerland

and in the Netherlands. This is no longer allowed by the Dutch authorities, although some still

exist based on previous regulations. Despite a lack of special concessions in the UK for TMCs,

it is still a very popular location as it fairly tax efficient and benefits from a benign regulatory

environment and the presence of deep and efficient capital and foreign exchange markets,

which are among the largest in the world. Future harmonisation of taxes within the euro-zone

and the European Union as a whole may reduce the attractiveness of some of the locations

listed above. Under an agreement with the European Commission the Belgian, Luxembourg and

Dutch regimes and the remaining fiscal advantages offered by Ireland will be phased out by 31

December 2010 However, in a bid to attract further investment, Ireland has already lowered its

overall corporate taxation to a level close to that of the Irish financial services centre.

17.14.2 Asia Pacific

In Asia the three following centres are used:

Hong Kong;

Singapore and

Labuan (Malaysia)

Labuan is a new centre and still needs to prove itself to corporate treasurers. It is also an

Islamic banking centre.

17.14.3 Latin America 

Uruguay and

Miami (USA)

TMCs are less developed in Latin America although Uruguay is offering tax incentives for

treasury operations. Many multinationals prefer the off-shore approach and use Miami (or some

other US location) as the centre for Latin America.

17.15 Shared service centres

A shared service centre (SSC), like an in-house bank, is a unit that ‘sells’ group services to

other subsidiaries or business units, regulated by service level agreements. In fact an early step

on the way to using SSCs is standardising processes and setting up an in-house bank. A

precondition for SSCs is a corporate structure serving several countries in a geographic region.

Conditions also vary according to industry: corporations in the consumer packaged-goods and

technology sectors can benefit from SSC activity more immediately than, for example, the

capital goods sector where payments tend to be large and uneven. There is a long history of

large corporations using SSCs to cut costs in:

human resources;

facilities management;

procurement;

internal audit;

regional marketing;

product distribution;

tax and legal compliance;

travel arrangements;

expense processing;

information technology and

finance, particularly accounts payable and accounts receivable functions.

Setting up a SSC means going a step further and often combining the functions of the central

treasury with those listed above, to provide an independent service unit for all finance-related

matters and other corporate services that can be combined centrally. The establishment of a

SSC can lead to a significant reduction in costs and greater straight through processing. It also

allows companies to better focus on their core business. It is, therefore, not surprising that an

increasing number of multinational companies in North America, Europe and Asia have

implemented SSCs. Some companies even have started to include the sales function into their

SSCs, which, combined with a commissionaire structure (see section 17.19), can generate

important tax savings. The establishment of a SSC is a major operation for a company. It

requires in-depth preparation during which a wide variety of issues need to be reviewed. The

most important ones being:

functions that will be covered by the SSC;

payment types that will be processed;

which countries and currencies to include;

accounting issues;

setting up of an in-house bank;

link with treasury management system;

review of internal controls, operational procedures and security;

review of existing bank relationships;

re-engineering of cash management structures

impact on credit control;

technology issues (compatibility of systems, file formats etc) and

staff training.

Given the important ramifications for the whole company of setting up a SSC, it is prudent to

take a step-by-step approach. Historically, MNCs that are at the forefront of the development of

SSCs have adopted this strategy. Initial developments were limited to a number of countries

and a number of functions. In-house banks (see section 17.9) and payment factories (see

section 17.16) often have been the precursors of some of today’s largest SSCs.

It is also vital, given the impact setting up an SSC has upon a company, to obtain visible and

continuing endorsement from the board as well as from the different businesses and

departments (IT, accounting, legal, audit, and purchasing to name but a few). Creating a

steering group representing all parties involved is an essential part in focusing everyone’s mind

on the challenge ahead.

17.16 Payment factories

Payment factories add value to the accounts payable function and will normally see all payment

processing for a group of countries being operated on group level. This can be done via a

centralised facility, which also takes care of all administration and other ancillary functions such

as reporting. Several companies link their accounts payable systems directly to their banks. As

such, payment factories can, when combined with an in-house bank and a central treasury,

constitute the building blocks for a shared service centre, to which, other enterprise functions

such as general ledger, human resources, internal audit etc can be added.

However, this high degree of centralisation is not a necessary precondition to run successful

payment factories. This is why payment factories are also well suited for decentralised

companies and/or companies that are unwilling to engage in a radical overhaul of their internal

processes. In this scenario, subsidiaries maintain their own accounts payable administration

and the payment factory’s role is limited to communicating with the group’s bank(s) or financial

providers. This approach is sometimes referred to as a “virtual payment factory”. The payment

factory gathers all payment instructions for the group in one file and sends them on to the bank

through one electronic payment gateway, as opposed to the shared service centre where all

accounts payable processes are managed from a central location. However, even in

decentralised companies payment factories tend to cover central bank reporting and

management of intercompany transactions. The payment factory will receive centrally all

account and transaction information from the bank(s) and then distribute it to the relevant

subsidiaries for reconciliation purposes, usually electronically by email or web browser.

Regardless of the model adopted, payment factories can deliver important benefits: they can

generate significant cost savings by reducing the number of banks used and the overall cost of

transactions. This includes a reduction in expensive cross-border transactions. Some payment

factories’ solutions even allow for cross-border payments to be re-formatted and re-routed as

domestic payments using the lower cost ACH circuits rather than the high cost RTGS methods

usually associated with cross-border payments. They also help improve overall liquidity and risk

management.

Having a single gateway for the whole of the company’s payments as well as standardised

interfaces also leads to greater efficiency. As payment factories are connected electronically

with financial service providers, or even with public marketplaces, services can be bought for

the entire group on a worldwide basis. By acting for the whole group, payment factories are also

able to obtain better pricing. The greater transparency offered by payment factories also

contributes to increased security and more accurate cash forecasting.

Once, companies have well established payment factories, they often extend the concept to the

accounts receivable function with a collections factory. The number of countries covered can

also be increased. Some of the larger corporates even aggregate payments and collections

regionally or on a worldwide basis.

The actual payment and billing processes also offer important scope for automation and

standardisation. By eliminating as much as possible of the paper-based items and adopting

standard forms and procedures, payments and collections can be integrated into a transparent

financial supply chain going from financing to cash forecasting. Straight through processing can

further be improved by the inclusion of additional remittance data in the electronic formats

processing enabling automated reconciliation. The use of quality measurement standards

should ensure that both efficiency and cost advantages are achieved throughout the company.

17.17 Outsourcing

Outsourcing is the long-term contracting out of non-core business processes to a third party.

There are three types of outsourcing suppliers (also called business service suppliers):

banks (through dedicated agency treasury services);

specialist divisions of accounting firms or

specialist non-bank treasury management companies.

What can be outsourced?

all aspects of foreign exchange trading, deposit placements and funding;

foreign exchange risk evaluation;

cash forecasting, consolidation and planning;

treasury accounting and systems interfaces;

payment and confirmation processing;

full reconciliation of all relevant records (eg receivables matching);

cheque issuance and other payment processing;

trade services;

invoice issuance/electronic bill presentment and

cash and liquidity management (netting, cash pool management, overdraft

management, etc).

Which companies are likely to outsource treasury activities? The most likely candidates to

outsource are:

start-up companies or spin-offs too small to warrant their own dedicated treasury team;

growth companies concentrating on core competencies, that are prepared to let a

company with treasury as a core competence run their treasury operations for them and

companies entering in new overseas markets which may have treasury departments in

other locations, but need control and segregation of duties, while being unable to justify

the cost of a full blown treasury department.

However, as the demands on treasury continue to grow, outsourcing also attracts companies

with well-established treasury activities.

17.18 Application service providers (ASPs)

Application service providers (ASPs) offer subscription services that enable companies to

outsource their treasury system infrastructure. There is no need to purchase system software to

run-back office operations. All that is required is a secure leased line, dial-up or internet access

to the ASP’s system.

ASP services automatically consolidate client treasury data across multiple bank accounts and

services, thereby facilitating cash consolidation for payment and investment purposes. The main

selling point is enabling subscribers to avoid the expenses associated with installed software

solutions, such as;

licence purchase;

annual software maintenance costs;

maintaining automated links to the banks and

hiring dedicated IT resource attached to treasury.

Services are provided by two types of suppliers:

treasury systems companies themselves and

specialist treasury outsourcing companies that have ASP agreements with their

treasury system suppliers. These may be bank owned or independently owned.

This type of outsourcing can be particularly interesting for smaller companies that lack the

capital resources to buy the latest systems. Nevertheless, the services that ASPs can offer are

limited compared to that of traditional outsourcing providers or business service providers

(BSPs). In addition, there is an increasing overlap between BSPs, and ASPs, with many BSPs

now providing ASP solutions as part of their overall service package.

17.18.1 Impact of internet-type technology on use of ASPs and treasury outsourcing.

Chapter 20 discusses this in more detail, but the advent of browser-based access to systems

that may be located many thousands of miles away from users has helped ASPs and treasury

outsourcers demonstrate real benefits to potential clients. It is now possible for a company to

access, via the internet (or an intranet), state-of-the-art systems for a usage fee, rather than

having to fund the purchase of a system themselves. Additionally, with internet type technology

treasury outsourcers can provide their customers with close to real-time information on all

treasury activities. As a result, companies are now increasingly outsourcing treasury functions

on a global scale. Real-time access also means that companies are more comfortable with

outsourcing larger sections of their treasury function. Traditionally, companies limited their

treasury outsourcing to one of two functions. However, companies are now increasingly

prepared to outsource all of their day-to-day activities, leaving the treasurer free to concentrate

on the core strategy issues, and to provide consulting and advisory services to affiliates.

17.18.2 Benefits and future trends

Looking ahead, treasury and cash management outsourcing is likely to become an increasingly

important component of companies’ treasury strategy. As pressure grows on companies to

improve their balance sheet and deliver additional shareholder value, companies need to focus

on their core activities and will, therefore, look to outsource any activities that are not essential

to that core function. At the same time, it is likely that there will be a convergence between the

outsourcing services providers (ASPs, bank and system BSPs); companies will have access to

one-stop-shops providing them with the full range of treasury and cash management services

that are currently provided by group treasury and/or in-house banks and payment factories. This

will allow treasurers to concentrate on added-value activities such as determining and steering

the company’s overall treasury strategy. By offering an integrated and standardised treasury

and banking service gateway, the providers will also present corporates with the opportunity to

improve straight-through- processing throughout their network. Important cost savings, release

of tied-up capital, enhanced functionality, improved service delivery and the potential for greater

security are the other main tangible benefits of a correctly implemented outsourcing programme.

Given the long-term commitment outsourcing represents, companies will want to undertake a

rigorous and formal selection process. This process should cover issues such as:

financial stability of BSP or ASP. The likely consolidation could lead to the demise of

some of the weaker providers, particularly among the ASPs;

backup procedures in case of failure of the provider;

service levels and quality of delivery;

how to benchmark service delivery;

possibility to periodically review service contract;

audit trail and reporting;

professional indemnity insurance;

enforcement of confidentiality;

if linked to a bank or systems supplier, the BSP and ASP will need to provide

assurances that there is no potential conflict of interest;

functionality on offer;

facility of integration with corporate systems and procedures;

potential for customisation;

ability to support international subsidiaries;

ability of system to adapt smoothly to new trends in the marketplace and changing

corporate circumstances;

robustness of systems, security and risk management procedures;

facility of implementation;

implementation costs and

running costs.

Ideally, companies should be able to obtain testimonials from existing users. They also should

take the necessary time to familiarise themselves with the potential outsourcing partners to

ensure they are fully comfortable with the way they operate and communicate. If agreement is

reached, a service level agreement should be drawn up covering in detail all the points

mentioned as well as issues such as authorised instruments and counterparties, credit limits

etc. The company will also have to give detailed mandates to its relationship banks so that

these are fully aware to what extent authority has been delegated to the ASP or BSP. Internally,

the company has to ensure buy-in by all parts of the company, including all subsidiaries. The

company which enters an outsourcing agreement should also have the necessary

arrangements and resources in place to adequately manage the outsourcing partner during and

after implementation of the outsourcing agreement. The extent to which companies are willing to

outsource might differ, but naturally there are some core elements that need to remain in-house.

Strategy, for one, can never be outsourced, nor can treasurers afford to rely entirely on their

outsourcing partner to manage the company’s risk.

17.19 Agent and commissionaire structures

In this section, we take a closer look on how the structure of a company’s sales network can

affect its overall treasury management. When companies establish a distribution structure, they

have three options at their disposal:

buy-sell entity (distributor / subsidiary); 

commissionaire and

agent.

Each structure has different implications from a legal, fiscal and treasury management

perspective.

17.19.1 Buy-sell entities structure

The most widely used structure is that of buy-sell entities or distributors. These will buy and sell

goods in their own name and for their own account. Often buy-sell entities are controlled by the

group and can, therefore, be classified as traditional subsidiaries.

This traditional set-up, whereby the principal company (principal) sells goods to the subsidiary

which then sells on the product, can suffer from an adverse tax treatment. As the sales

subsidiary performs substantial functions and takes on significant commercial risks, it will be

rewarded accordingly. The profits thus generated will be taxed locally. In addition, the local tax

jurisdiction is likely to impose transfer pricing rules to ensure that the local subsidiary is in

position to generate taxable profit. The main advantage from the principal’s point of view is that

all risks and liabilities are passed on to the buy-sell entity. However, the principal concentrates

all his credit risk with one entity rather than with all his customers and has no control over the

commercialisation of his products and services to the end-customers. The principal will be taxed

in his home country on the products sold to its distributor.

17.19.2 Commissionaire structure

In cases were the classical arrangement is found to be fiscally disadvantageous multinationals

can use a commissionaire structure. A commissionaire acts in his own name for the account of

the principal. The principal is contractually bound to the commissionaire to deliver (through the

commissionaire) the products sold to the customer and the commissionaire is contractually

bound to the principal to remit the price received from the customer. In exchange, he receives a

commission from the principal. Unlike a buy-sell entity, a commissionaire only performs a limited

number of economic functions, leaving delivery of goods and collection of bad debts to the

principal. Under civil law jurisdictions (such as France or Germany.), customers and principal do

not have a legal relationship. In common law countries (eg the UK), the concept of

commissionaires does not exist, its closest equivalent being that of an agent with an

undisclosed principal. In case of a conflict, the customer can, if he is able to establish the

identity of the principal, make a legal claim against the principal. Under common law,

commissionaires that can conclude contracts under their own name are deemed to be

permanent establishments.

However in most European countries and countries where an OECD model tax treaty in place,

there is little risk of the principal being deemed to have constituted a permanent establishment

through a commissionaire arrangement.

As a result, the commissionaire can offer the MNC lower costs and a favourable tax treatment at

home rates (assuming that home rates are lower than the rates applicable in the

commissionaire’s territory). Thus, where practicable, the commissionaire approach should be

used where local tax rates are higher than home rates. The exception to this is where the goods

sold are imported into the EU with a high customs rate. Here, disadvantages may arise as the

customs value is taken as the price charged to the customer, not the net value of the goods

after payment of commission to the commissionaire.

17.19.3 Agent structure

Agency structures are used globally by many multinational corporates. The EC Commercial

Agents Directive 86/653 (December 1986) defines a commercial agent as ‘a self-employed

intermediary who has continuing authority to negotiate the sale or the purchase of goods on

behalf of another person (the principal), or to negotiate and conclude such transactions on

behalf of and in the name of that principal.

Agent agreements require local legal advice as legislations differ substantially from country to

country and such arrangements, particularly, if on an exclusive basis, might contravene local

competition laws as well as any other mandatory legislation applicable to the local agent.

The essence of an agent agreement is that an agent is appointed, almost always on a

commission basis, to sell goods on behalf of the principal. As the agent contracts on behalf of

his principal, the principal is bound by the agent and a direct contract is created between the

principal and the customer (but not between the agent and the customer). The agent does not

purchase goods for trading on his own account.

Agency agreements can take the following forms

sole agent:

The principal cannot appoint other agents in the agent’s agreed territory, but may obtain

orders directly from the agent’s territory without paying the agent commission and

exclusive agent:

The principal cannot appoint other agents in the agent’s agreed territory nor take orders

directly from that territory without compensating the agent.

Furthermore agents may be given authority to conclude contracts on behalf of the principal,

although often limits will be imposed upon the value or quantity of orders which may be

concluded. In this type of agency, agents have greater control over their fees.

Sometimes, agents can only introduce business to the principal, which the latter is free to

accept or not. However, once the introduction has been accepted and contracted, the agent is

entitled to the commission whether the principal performs the contract or not.

The principal is only responsible for the actions of an agent taken under the authority delegated

by the principal as part of a consensual agreement to which they alone are parties. The only

exception to this rule is when the principal represents to a third party, by words or conduct that

the agent can act on the principal’s behalf, in which case the principal will be deemed to have

authorised the principal. Where the agent acts outside the scope of the agreed authority, the

principal will not be bound by those acts unless the principal later ratifies them.

Normally, where an agent discloses the fact that the agent is acting on behalf of a principal, and

provided this is done within the scope of his authority, the agent will have no liabilities under the

contract between principal and the customer, the only exception being the ‘del credere’ agent.

This specific type of agent undertakes to indemnify the principal if the customer identified by the

agent fails to pay the principal under the contract concluded by the agent on behalf of the

principal.

An agent that does not act independently and who habitually exercises authority to enter into

binding contracts in the name of a principal is at risk of being considered a permanent

establishment of that principal. The nature of most agency agreements is exactly that, meaning

that the principal will be regarded as carrying on trade or business in the territory of the agent,

thereby incurring liability for local taxation.

If the agent does constitute a permanent establishment of the principal in the country in which

the agent is carrying out his duties, double tax treaties, where they exist, may protect the foreign

principal from double taxation.

17.19.4 Impact on treasury and cash management strategy

In the classical distributor/subsidiary structure, group treasury will generally have a greater

control over cash management at the subsidiary level. It is likely that all accounts are part of

cash concentration or cash pooling arrangement. Treasury is also likely to be responsible for the

subsidiaries’ cash flow management and financial risk management (FX exposure and interest

rate risk exposure). To optimise cash flow, treasury may use leading and lagging techniques.

Currency risk is generally concentrated at the head office with the inter-company invoicing being

conducted in local currency. While bank relationships are probably subject to central treasury

guidelines. However, the local subsidiary arrangement allows the company to act as a resident

entity vis-à-vis local customers. If on the other hand, the company opts for an agent or

commissionaire structure, it will no longer have a local (resident) company that invoices and

collects funds from the local customers. The agent supports the sales process of the principal

but is not the owner of the goods at any time. The accounts receivable is a balance sheet

position of the principal. This means that the local customer will become an importer and has a

payment obligation to the principal which is located abroad. This leads among others to the

payment of import duties. It also means that the customer will be asked to make a resident to

non-resident account movement which in many countries will trigger lifting fees and reporting

obligations. Both consequences might be commercially difficult to impose on the customers.

The agent could take over the reporting requirements, but the risk is that by increasing the

economic functions of the agent, the principal could be deemed by the local tax authorities to

have a permanent establishment within the country.

The best solution would be, therefore, to use a reference account structure in the name of the

agent and set up an intraday sweep (avoiding balances and any risk of loan/debt relationship

between principal and agent) from that account into the principal account. The exact modalities

of each setup will naturally require specific advice, but this widely accepted structure means that

customers could benefit from local account conditions. Central bank reporting could be done

remotely by the group treasury using electronic banking software.

Unlike the agent, the commissionaire has a legal relationship with the customer and can,

therefore, execute collections and act as local resident entity on behalf of the principal.

However, it should be noted that neither an agent nor a commissionaire has legal ownership of

the goods and the accounts receivable belongs to the principal. Therefore, it is the task for the

principal to organise the administrative issues related to the local bank account used for

collections. Central bank reporting should also be effected by the principal. However, by using

electronic banking and sweeping structures the company can request the bank to carry out the

reporting on a quasi-automated basis.

The major drawback of agent and commissionaire structures remains the fact that customers

become importers. It is also important to remember that local circumstances differ substantially

and that local legal and fiscal advice is required on a case-by-case basis.

In addition, it should be noted that the organisation of the cash management structure in a

subsidiary, agent or commissionaire structure can only be successful if all the necessary

support and systems are made available by group treasury and HQ administration. The local

affiliate (in any form) needs to have access to these systems in order to play the supportive role

for the principal as efficiently as possible.

Chapter 18 - Efficient account structures

Overview

This chapter builds on the ideas already set out in the chapters on currency accounts, netting

and pooling. It seeks to suggest various models that can be used for international account

structures depending on what the company is trying to achieve. It looks at various structures

that have evolved to meet the operational and liquidity requirements of the organisation. The

main message of this chapter is that there are no universal solutions; it is what is best for each

company and each circumstance that is important.

Learning objectives

A. To understand various approaches to account structures

B. To understand the importance of account structures and how they can impact many

other areas of treasury

C. To be able to differentiate between efficient and inefficient structures as they relate

to certain company types and depending on what they are trying to achieve

D. To be able to identify some of the pitfalls and problems

18.1 Introduction

During the late 1980s and early 1990s many large companies, on advice from their cash

management banks; put in place ‘all or nothing’ account structures. When foreign currency

accounts were discussed in chapter 10, two options were discussed: ‘staying at home’ (keeping

your currency accounts in one location - usually the home country of the treasury); or ‘going

native’ (keeping currency accounts in the home location of the currency).

The ‘all or nothing’ approach to account structures meant that companies employed one of two

strategies:

keeping all currency accounts in the treasury’s home location (or one “treasury friendly”

location) or

keeping all currency accounts in the currency’s home country.

The major cash management banks did much to reinforce these two strategies. Banks with

extensive overseas networks promoted the latter strategy, while those with few or no real

overseas offices promoted the idea of keeping currencies offshore in the company’s home

location or in a tax efficient location for simplicity.

This approach is gradually being abandoned following the general realisation that:

not everything is done best centrally;

not all countries are the same from a regulatory standpoint (significant differences can

arise in tax, law and particularly exchange controls);

not all banking systems are the same;

not all subsidiaries have the same needs and

not all subsidiaries have the same levels of financial expertise.

In response to these factors more pragmatic approaches are emerging.

18.2 The need for efficient regional account structures

Many multinational companies (MNCs) have put in place sophisticated account structures

designed to meet a variety of needs:

pay and receive currency in the normal course of business (ie accounts payable and

receivable activities);

process capital and other flows associated with capital expenditure, dividends,

acquisitions, etc;

settle currency transactions carried out by treasury;

settle inter-company netting, reinvoicing or in-house factoring transactions and

link treasury accounts to local company bank accounts in order to manage group

liquidity.

18.3 Resident and non-resident accounts

Before examining the different scenarios that companies use for their cross-border payments in

more detail, it is important to be aware that in many countries around the world, central banks

insist that resident and non-residents accounts must be segregated. In practice this can mean a

different approach to central bank reporting and different charging structures or lifting fees. An

example of two differing approaches can be seen when comparing the UK and Germany. When

a German company opens an account in the UK, the account charges will be identical to those

paid by a UK company for the same service. However, when a UK company opens an account

in Germany it is designated a non-resident account and becomes subject to a different set of

charges to that of a resident company. In particular, all movements into the account from

residents, or out of the account to residents, are normally subject to an ‘ad valorem’ lifting

charge which, in the case of Germany, is normally based on 1.5 per mille (EUR1.5 per

thousand) with no maximum. It is likely however that, at least inside the EU, it will be difficult to

maintain this distinction in the long-term as it not compatible with a well-functioning single

market. Additionally, in some cases the rules relating to withholding taxes will be different for

residents and non-residents.

18.4 Country–specific regulations on cash pooling and payment of credit interest

Another important aspect to consider are countries' different regulations as regards cash

pooling and the payment of credit interest. For example:

France will not allow banks to pay credit interest to residents on current accounts or

deposits denominated in domestic currency lodged for less than one month, but there

is no prohibition on paying interest to non-residents or on currency deposits. Residents

do not have withholding tax taken at source, but non-residents do. Such arrangements

mean that it is not possible to pool resident and non-resident balances;

currently in Malaysia the monetary authorities will not allow credit interest to be earned

on a corporate current accounts, however, banks will automatically sweep to a deposit

or savings account to achieve the same result. This is limited to resident accounts;

banks in the USA are not allowed to pay credit interest on current accounts, better

known as ‘demand deposit accounts’ or DDAs. However, most banks have the

capacity to sweep cleared balances overnight to offshore credit interest-bearing

accounts. The funds are subsequently swept back at the start of the following working

day;

in Germany banks are not allowed to report their positions to the central bank on a net

basis, so that if they were to pool debit and credit balances for a company, reserve

asset ratios would still be calculated on the gross positions, rather than the net

positions. The resultant cost, when passed back to the company means that it makes

no sense to do notional pooling in Germany, only physical balance sweeping. In

addition, due to central bank reporting requirements and lifting charges, it is not

possible to include resident and non-resident balances in the same sweeping

arrangement and

UK and Danish central banks, on the other hand, will allow banks to report net

balances as long as certain criteria are fulfilled, the most onerous of which are cross-

guarantees between all participants in a pooling scheme. But once these are in place

notional pooling is allowed. Resident and non-resident accounts - and even foreign

currency balances - can be included.

Therefore when looking at account structures companies need to consider that each country

has its own specific regulations for cash pooling, interest earning on credit balances and

withholding taxes.

18.5 Corporate currency account structures

18.5.1 Four basic account structures

Broadly speaking there are four basic bank account structures for the receipt and payment of

foreign currency in the normal course of business. The complexity will increase later in the

chapter when we look at structures that can also be used for liquidity management.

level 1: pass everything through a local currency account;

level 2: currency accounts in the company’s home country;

level 3: currency accounts in the appropriate centres for each currency and

level 4: the pragmatic approach, look at each currency and see what works best.

18.5.2 Level 1: Use of local currency account

This diagram shows a small company or a small subsidiary of a large group. The company

imports raw materials, which are billed in EUR or currency, and exports the finished goods to

buyers, who are billed in EUR. In this case all funds pass through one EUR account. If

purchases are made in a currency other than EUR, then a payment could be made using a

currency draft or an electronic transfer, debiting the EUR account with the equivalent of the

currency amount. By billing overseas buyers outside of the euro-zone in EUR, the company is

passing the foreign exchange issues and risk management problems to their customers. By

quoting prices to a foreign customer in EUR, pricing could also be regarded as less competitive

- particularly when costs of currency purchases are added. Additionally, in some countries funds

received into the account from abroad and payments out of the account abroad could be hit by

lifting charges (a charge made in some countries when funds move between residents and non-

residents).

18.5.3 Level 2: Use of set of currency accounts in company' s home country

The approach in level 2 shows a company that also imports raw materials invoiced in currency.

In order to be more competitive, the company is also prepared to quote/invoice in the currency

of the buyer. As the company has inflows and outflows in currency, currency accounts have

been opened to save conversion costs where the two coincided. However, each of these

accounts is held in Ireland. This means that the paying customer still has to make an overseas

payment, albeit in his or her own currency. The Irish company has taken on the onus of the

currency risks and for any foreign exchange activity that may have been necessary (ie surplus

funds built up on the currency account and converted to EUR as and when required - possibly to

settle foreign exchange contracts). However, all movements into and out of these accounts

could still be subject to lifting charges or beneficiary deductions in some countries.

18.5.4 Level 3: Currency accounts in appropriate currency centres

Level 3 shows a company that is now not only billing its buyers in their own currency, but has

also opened local currency accounts in each market to make it simple for buyers to pay. In fact

buyers in each country can settle with the selling company in exactly the same way as they

would pay a domestic company. The company now has a sales subsidiary in Germany so that

all payments can be made locally without incurring lifting fees or requiring central bank

reporting. The head office accounts (with the exception of the German and Irish subsidiary

accounts) will all be ‘non-resident’ accounts, which may have made them subject to lifting

charges in some countries when a resident pays funds to them. But in all other respects this is a

convenient structure for both receiving local collections from customers and for making local

payments to suppliers. Companies therefore need to consider the convenience factor of in-

country accounts against their costs and the control problems that they often cause. If

companies are running such accounts with one multinational bank and using one electronic

banking system to manage them, the control aspects are already covered. But if each account

is with a different bank in each country, the control aspects are likely to be greater. Companies

using this type of structure may want to consider rationalising banks and bank accounts, using

fewer in-country accounts and persuading some customers to pay cross-border to an account

held in another centre. This would improve the control aspects and, at the very least reduce

administration (and reconciliation) costs. Also the risk aspects of holding currency balances will

of course need to be considered and appropriate hedging strategies adopted.

18.5.5 Level 4: The pragmatic approach

This model looks at each country and considers why the accounts are needed and where the

best location is for them. In this case, the company has sales subsidiaries in three countries with

accounts sweeping into an in-country head office account. These accounts are under the control

of the treasury and may be referred to a treasury control accounts. For CHF, AED, SEK and

USD, where there are no operations on the ground and little sales activity, the company decided

to hold these accounts centrally in Dublin.

This structure also attempts to add a level of liquidity management by sweeping / zero balancing

funds into a head office account that could be used to offset debit and credit balances (where

allowed). Net credit positions could be invested out of this. When the funds move from the

subsidiary’s account to the head office account there will be an inter-company loan. This must

be accounted for in each company’s books. Additionally, the head office account may be able to

earn credit interest. If so this must be apportioned to each participating subsidiary. Surplus

funds can then be sold for EUR and remitted back to Ireland as necessary.

Care needs to be taken when using these four models for analysis - particularly level 4.

Research shows that the level 4 account structure is often seen when a company is moving

from level 2 to level 3, but it will not be a deliberate; just a transitional state. Finally, and even

more confusingly, some companies that are trying to run a level 3 structure with all accounts in

the currency centres, may end up with a level 4 structure by default. This is not because of

deliberate sophistication, but because their chosen cash management bank may not have

branches in Switzerland, United Arab Emirates, Sweden and the USA. So in effect they are

running a sub-optimal level 3 structure.

18.6 Currency swaps and pooling

Before looking at a number of different account structures we need first to revisit the use of

currency swaps for cash management purposes.

Currency swaps are frequently used by treasury for liquidity management purposes and in

particular for moving surpluses in one currency to reduce deficits in another.

In chapter 16 currency swaps are discussed in detail. Here we just need to recognise that

swaps can be used to move funds in different currencies between accounts in a fully hedged

manner, specifically as a method of moving liquidity between deficit and surplus cash pools, in

effect creating inter-company cross-currency loans.

18.7 Using one bank per country

Also before examining more complex account structures, it is worth reviewing the advantages of

moving all subsidiaries’ accounts to one bank and creating a cash pool. The diagram below

shows four subsidiaries, each with unconnected accounts at different banks. Two have average

credit balances and two run average debit balances. Although average debit balances equal

average credit balances, the group will pay GBP8,000 in interest charges. If the companies

were not being paid credit interest on credit balances it would cost the group four times this

amount.

 

By moving these accounts into one bank and setting up a cash pool, the interest cost (in theory)

should be zero. The company is, however, likely to pay an administration fee.

This diagram shows a notional cash pool. The same effect would take place if each account

was zero balanced to a concentration account. The major difference would be that the transfer

to the concentration account would be regarded as an inter-company loan, whereas a notional

pool would not create a loan.

18.8 Account structures and liquidity management

The four models given earlier look at account structures mainly from an operational or trading

aspect. Account structures that have worked best for normal business purposes have not

always been the best structures for liquidity management. There have been many different

configurations used by multinational companies (MNCs) for liquidity management purposes.

Such structures are usually designed to take account of, mitigate or minimise one or more of the

following:

resident and non-resident status;

reducing or eliminating lifting charges;

legal and regulatory considerations;

notional pooling versus physical sweeping of funds;

resident and non-resident status;

reducing or eliminating lifting charges;

legal and regulatory considerations;

notional pooling versus physical sweeping of funds;

ability to link treasury accounts to local operating accounts in the cash pool;

ability to earn credit interest on credit balances;

ability to move funds between pools in different currencies for liquidity

purposes on a same-day value basis;

withholding tax (see chapter 25);

other direct and indirect taxes (see chapter 25);

thin capitalisation (see chapter 25);

minimising costs;

exposure management;

regulatory reporting;

technology (see chapters 20 and 21) and

ease of use.

The rest of this chapter examines a range of account structures which address various of these

issues. The advantages and disadvantages of each account structure are listed.

18.9 Decentralised control – each subsidiary with currency accounts in home

location

The above structure is typical of a fairly unsophisticated decentralised group. Each of four

subsidiaries hold their own currency accounts in their home location, but each uses a different

bank.

Advantages:

can use same bank as for local currency (LCY);

easy to transfer funds to LCY account when required;

easy to pay in currency cheques, albeit with a longer clearing cycle;

easier reporting (getting statements, one local electronic banking system etc);

credit interest normally payable;

no language and communication problems;

drafts easily obtained;

telex/mail transfers easily delivered and

lower cost – should reflect lower commission.

Disadvantages:

no co-ordination possible as each subsidiary is stand-alone;

economies of scale are limited;

no local pooling opportunities;

no foreign exchange matching opportunities;

no group netting possible and

sub-optimisation in terms of bank charges and costs as each subsidiary will be paying

standard or close to standard pricing.

Overall this type of structure has very little to recommend it.

18.10 Decentralised control - each subsidiary with currency accounts at currency

centres

In this structure, the only change from the previous structure is that the currency accounts have

now been moved to the currency centres.

Advantages:

cheques are cleared quickly, albeit with later cut-off times;

18.11 Joint control by central treasury with currency accounts at currency centres

This structure has copied the structure described in diagram 18.8 and overlaid a central treasury

to jointly control the accounts and provide some co-ordination.

The accounts may be held in joint names with the central treasury, or central treasury staff may

have signing powers on the subsidiaries’ accounts.

Advantages:

all the benefits of ‘going native’, as discussed in the previous structure;

local subsidiaries able to use these accounts for operations;

central treasury can use same set of accounts to manage group liquidity;

central treasury should be able to use its influence to move accounts to one bank

and put local cash pools in place (see below);

use of just one bank in each country offers the opportunity to negotiate better

pricing, terms and conditions;

central treasury can establish inter-company loans and deposits using surpluses in

one country/currency to fund deficits in another using currency swaps and

as central treasury provides a centre of excellence, there may be no need for

‘treasury’ staff in each location.

Disadvantages:

complications arise where there is a requirement for non-resident as well as

resident accounts, with the result that two separate pools may be needed in some

countries;

lending between cash pools creates inter-company loans between subsidiaries;

may not be tax efficient and

to be effective, the central treasury must know the liquidity requirements of each

subsidiary in advance, as it is not always possible to swap or move funds between

different countries/currencies same day value.

The advantages of this structure are significant in comparison to those structures

seen in diagrams 18.7 and 18.8.s

18.12 Joint control using pool controllers with currency account at currency centres

The above structure is similar in many ways to the previous one. In this case, however, cash

pools have been set up and each subsidiary, which needs an account in a currency, is obliged

to keep that account in the appropriate cash pool. Each cash pool is run by a pool controller - a

person resident in the country where the pool resides. (Note: some of these cash pools would

be notional and others concentrated)

Advantages:

going native’(as spelt out in section 18.10);

same accounts can be used for operational and liquidity management purposes;

cash pools in place with one bank in each country;

management of all group funds by a person in each currency centre with expertise in

local money markets;

pool controller will normally offer surpluses to central treasury first;

cross-currency funding available between pools using foreign exchange swaps carried

out by central treasury (see chapter 16) and

local investment carried out by pool controller if central treasury does not need the

funds.

Disadvantages:

needs accurate cash forecasting to be effective (see chapter 13);

can only include the ‘core’ cash positions because value can be lost moving funds

cross-border due to differing money transfer system cut-off times and costs can be

high;

complicated by resident and non-resident issues (company may need two pools);

creates inter-company loans between subsidiaries;

may not be tax efficient and

it can be difficult for banks to move money cross-border for same-day value in order to

settle swaps between cash pools and this can be an expensive and time-consuming

process if it is done every day. Therefore, many companies that move funds between

cash pools will seek to identify amounts of cash or core positions that can be

transferred weekly or monthly, based on forecasted positions.

18.13 Centralised control with group currency accounts at currency centres

This account structure using in-house banking principles was made popular by a number of

multinational companies. The concept here is simple. In a previous chapter we looked at the

use of ‘nostro’ accounts by banks. To reiterate, banks can open one currency account for each

currency in the currency centre and enable their customers to open currency accounts in their

(the bank’s) books in another centre. In effect, the companies’ positions are an aggregate of the

bank’s ‘nostro’ account and all entries actually pass across that ‘nostro’ account.

The in-house banking account structure is exactly the same as this. The ‘group’ accounts shown

on the diagram, (one per currency), are the treasury’s ‘nostro’ accounts and all subsidiary

activity (receipts and payments) flow through these. The in-house bank runs memo accounts for

each participating subsidiary in the in-house bank’s books and produces ‘bank statements’ at

regular intervals.

Advantages:

benefits of ‘going native’;

only one decentralised account held in each country. All subsidiaries have access to

this for the receipt or payment of currency in that country;

automatically creates a non-resident currency pool without having the cost of moving

funds between participant accounts;

economies of scale as all volumes pass through this account;

minimises bank charges;

less need for local treasury expertise;

central treasury becomes principal banker to the group and a wholesale purchaser of

bank services from real banks;

the ‘nostro’ account can be used as the netting settlement account or to settle currency

sales and purchases that treasury undertakes with real banks and

the 'nostro' account can be used as the link to the domestic resident cash pools as a

means of managing overall liquidity as illustrated in the following diagram.

Disadvantages:

needs a powerful treasury system or ERP system to run in-house bank accounts;

gives rise to a large amount of accounting and memorandum recording;

needs a large team at the centre and

need to consider tax aspects.

18.14 Concentration to one bank - via treasury accounts

This structure is based on in-country cash pools with surpluses or deficits being centralised in a

set of accounts held in a single tax efficient location (ideally where withholding tax is not

deducted at source).

Advantages:

a structure that gives treasury a set of accounts for liquidity purposes based ‘at home’

(or close to home), as well as allowing subsidiaries to run operational accounts in cash

pools in the currency centres;

structure enables ‘one-country multi-currency pooling’ of treasury accounts or swaps

between surplus and deficit accounts held at the centre. Surpluses can be proactively

managed in the money markets;

easy structure for treasury to manage, particularly if transfers to treasury accounts are

‘core’ positions moved monthly or weekly;

treasury accounts are likely to get better interest rates for balances held outside their

natural currency centre and

no withholding taxes deducted at source, if using tax-efficient location.

Disadvantages:

multiple cross-border money movements (unless based on forecasted core positions)

and hence more cost and possible losses of value;

creates loans between subsidiaries and treasury. In most multinationals, treasury has

been set up specifically to be the common counterparty for all inter-company activity,

so this would not normally be an issue; and

withholding tax may have to be self-imposed by treasury (and later paid to the tax

authorities) when passing interest back to subsidiaries located in countries where

withholding taxes are normally taken from interest payments.

18.15 Concentration of funds to one bank, plus pooling

This structure can be used in groups with fairly autonomous subsidiaries that use different

banks. In this structure there are no domestic cash pools. The features of this structure are as

follows:

each entity maintains a second offshore currency account in its own name in a single

tax efficient location (ie one where there is no withholding tax deducted at source). Eg

account 1 in country 2 in the name Franco Bakers SA. Therefore, account 2 in the

offshore EUR pool is also held in the name of Franco Bakers SA;

these offshore accounts are notionally pooled (single currency pooling);

treasury maintains a dummy account in each offshore currency pool (T a/c). Because

the treasury account may be ‘resident’ and the subsidiaries’ accounts ‘non-resident’, it

is essential that the accounts are located in a jurisdiction that allows the pooling of

resident and non-resident accounts and

there is no co-mingling of funds and no loans are created between participants.

Advantages:

treasury can locate its control accounts at home or in one efficient centre;

as funds move only between accounts in the name of the same entity there are no

inter-company loans created;

offshore pools should earn higher rates of interest than in-country pools;

no withholding taxes deducted at source if correct location is selected;

liquidity can be moved between surplus/deficit pools by means of a currency swap and

debiting/crediting the dummy treasury accounts. Therefore, even on a multi-currency

basis no inter-company loans are created and

the single currency pools could in turn be pooled to create a ‘one-country, multi-

currency pool’ if required (and if the bank used provides this service).

Disadvantages:

different accounts being used for operational and liquidity purposes, thus resulting in a

doubling up of accounts and higher account maintenance fees;

complicates interest apportionment;

cost of multiple funds transfers means that company would not want to transfer funds

on a daily basis

potential losses of value if funds not moved same-day;

only optimal when using accurate forecasted core surpluses/deficits;

need to consider lifting charges on funds movements and

may need to self-impose withholding tax when passing back interest to subsidiaries.

This structure could be used in the euro-zone. It would create one large notional pooling

structure with, in this case, one dummy treasury-controlled EUR account for investment and

borrowing purposes as part of the pool.

18.16 Pooling one bank per country with treasury accounts in the various pools

The above structure is an 'ideal world' for a treasury and its cash manager. It illustrates a

situation where the company has set up in-country cash pools and runs a dummy treasury

account in each. If country 1 has a surplus in its pool and country 2 has a deficit, then the

treasury can carry out a transfer or currency swap (if different currencies) and debit the dummy

account in pool 1 and credit the dummy account in pool 2.

Advantages:

treasury maintains accounts in-country (going native) to match up to the operating

accounts;

one currency cash pool set up for each currency which includes a dummy treasury

account used for funding/lending to other pools;

no funds transfers unless treasury initiates them;

no inter-company loans and

no interest apportionment issues. Interest can accrue on operational accounts as

normal (albeit at a group interest rate).

Disadvantages:

is treasury allowed to operate an account in the pool? In many countries, the treasury

account will be non-resident and will not be allowed to reside in the same pool as the

resident accounts. In some countries, this would not be a problem (UK or Denmark) or

it may only be necessary to report the require movements through the accounts to the

central bank. To date, these rules vary from country to country and due diligence will

be needed before trying to set up such structures.

It is difficult to control accounts and cash pools with different banks in a number of countries.

Using an overlay bank can overcome the problems with this structure.

18.17 Using an overlay bank

As mentioned in the previous section, in an ideal world, treasury would be able to:

keep its dummy accounts in each national pool;

monitor and control these accounts using one electronic banking system;

all funds could be moved cross-border with same-day value;

there would be no lifting fees or beneficiary deductions and

all central bank reporting would be carried out by one bank.

The structure in diagram 18.16 seeks to address these issues and is promoted by a number of

pan-regional and global banks.

The features of an overlay bank are:

treasury manages group liquidity using one bank;

treasury’s accounts in the currency centre;

liquidity moved between pools via treasury accounts;

treasury only needs one bank/system to manage group liquidity;

resident/non-resident issues handled by overlay bank;

reliance on one bank and

creates inter-company loans if "T" account not in local pool.

18.18 Moving liquidity between pools using an overlay bank

This structure needs to be broken down further. How would liquidity move between pools:

I. in countries where the treasury can hold an account in the local pool?

II. in countries where the treasury account cannot be held in the local pool?

18.18.1 Treasury accounts in local pools

The stages of the process are:-

Stage 1. Funds moved to overlay bank by domestic urgent EFT

Stage 2. Treasury carries out swap:

                -   Dr T. account in country 1

                -   Cr proceeds to T account country 2

Stage 3. Move funds from overlay T account to T account in country 2 pool by urgent EFT

18.18.2 Treasury accounts held outside local pool

Stage 1. Funds moved to overlay treasury account by domestic urgent EFT

Stage 2. Treasury carries out swap:

              - Dr T A/c in country 1

                - Cr T A/c in country 3

Stage 3. One subsidiary (3) is designated as 'pool leader' and opens a resident account with the

overlay bank. The non-resident-to-resident movement is carried out within the overlay

bank. (No lifting charges are taken, just a fixed fee, and the overlay bank does any

central bank reporting necessary). The treasury account may not be needed with the

overlay bank in country 3, unless required for other purposes (see below)

Stage 4. Funds move from subsidiary's account with the overlay bank to its account in the

national pool by domestic urgent EFT. This is a simple in-country same-day value

resident-to-resident payment.

Advantages:

treasury holds control accounts in the centre of the currency with the overlay bank and

in the national cash pool where allowed;

treasury can virtually manage all group liquidity using one bank and one electronic

banking system;

all liquidity is moved between pools for same-day value passing through overlay

accounts;

all resident/non-resident and central bank reporting issues handled by the overlay bank

and

overlay accounts can be used for other purposes (netting settlement, receipts of

currency funds for non-resident subsidiaries, payments on behalf of overseas

subsidiaries, etc).

Disadvantages:

high reliance on the overlay bank and

creates an inter-company loan if the treasury cannot hold an account in the national

pool. This may not be a problem.

18.19 Euro account structures and liquidity management

Post Emu some companies are now reviewing the overlay structure in Europe to decide

whether it is still a valid concept. Many of the impediments that the overlay structure was

designed to overcome have either disappeared or are being eroded by Emu.

The resident/non-resident differentiation between member states is discriminatory and it should

only be a matter of time before they are eliminated in a single market. Many companies have

already negotiated away the lifting fees associated with this differentiation. Money can now

move on a same-day value basis without an overlay bank through the TARGET cross-border

payment system, enabling a single, EUR-based cash pool to be set up. Local banks are

generally very efficient at handling central bank reporting in their home countries and they could

be left to do this.

Cross-border pooling in Europe - without an overlay bank features:

resident accounts in each country zero balance each day to a non-resident account

owned by the treasury;

resident and non-resident accounts held with the same national bank;

different national bank used in each country;

national bank carries out central bank reporting;

no lifting fees on transfers between resident and non-resident accounts within the

same bank – just a fixed monthly fee;

cross-border non-resident transfer to centrally-held concentration account may be

‘target balancing’ or may take place at different intervals (ie larger countries daily,

smaller countries weekly) and

inter-company loans take place within national bank. Means treasury will have to carry

out interest apportionment.

18.20 Main cash pool structures used in Europe

18.20.1 Euro concentration account

Features:

in-country accounts in name of operating companies;

zero or target balancing to concentration account via overlay accounts if necessary – or

direct and

concentration account:

- co-mingled funds;

- eliminates deficit positions (as debit accounts are “funded”);

- usually interest-bearing;

- used to invest surpluses in money market;

- could have group overdraft line attached to enable funding of subsidiaries and

- needs location where interest is paid gross and where there is no problem having

resident/non-resident accounts in same pool.

Advantages:

simple structure.

Disadvantages:

co-mingling of funds in concentration account – bank usually cannot do interest

apportionment;

creates inter-company loans between treasury and subsidiaries – lots of bookkeeping;

as treasury responsible for calculating and paying interest (company-to-company) may

create deemed dividends or company-to-company withholding tax (see chapter 25)

treasury must withhold any tax payable on interest when passing it back to subsidiaries;

lifting fees  may be payable on moving funds across border. Overlay accounts could be

set up, with the co-ordinating bank, in name of resident entities to avoid this and central

bank reporting will be necessary when funds move cross-border.

18.20.2 Concentration to notional cash pool

Features:

subsidiary accounts in-country zero or target balance to account in notional pool in

name of same legal entity (via in-country overlay accounts);

deficit accounts in-country funded by debiting same legal entity account in the pool;

dummy account in pool is overdrawn to bring pool to zero and to invest pool surpluses

or fund to finance pool shortages;

dummy account may have credit facility attached to it and

ideally needs location where interest is paid gross.

Advantages:

no co-mingling of funds;

no inter-company loans;

bank can do interest apportionment (so will also handle withholding tax) and

interest is paid by bank to company.

Should avoid lifting fees as cross-border movements are within overlay bank.

Disadvantages:

extra level of accounts/costs;

extra documentation – cross-guarantees – legal set off;

entities from certain countries not able to join (France, Italy);

central bank reporting must be done

18.20.3 Concentration to notional cash pool using 'Re' accounts

Features.

subsidiaries’ accounts are zero balanced to treasury ‘Re’ accounts and

accounts owned by treasury – holding funds as agent for the subsidiaries.

Advantages:

same as for the previous structure (section 18.20.2), but additionally;

no cross guarantees needed as all accounts “owned” by treasury;

most countries can participate and

does movement from subsidiary’s account to ‘Re’ account constitute an inter-company

loan? This is a grey area and contrary tax and legal advice is given on this. (see below)

Disadvantages:

potentially some tax or legal regimes may claim that an inter-company loan has taken

place. This issue should be clarified in advance of setting up the structure; but

will need effective intra-group documentation to specify relationships, ie account owner,

agency relationship, beneficial owner of the funds etc.

18.20.4 Notional pooling with all accounts in one centre

Diagram 18.22: Notional pooling - all accounts one centre

Features:

no in-country accounts;

all accounts held in one centre and notionally pooled;

treasury dummy account used to invest net surpluses or when overdrawn to fund net

deficits and

needs location where interest is paid gross of withholding tax.

Advantages:

no co-mingling of funds;

no inter -company loans;

bank can do interest apportionment and

interest paid bank to companies.

Disadvantages:

all payments cross-border – extra expense to company;

all collections cross-border extra expense to company’s customers;

care resident to non-resident – lifting charges – central bank reporting;

cross-guarantees and set off documentation needed and

entities from certain countries not able to participate.

18.20.5 Cross-border 'notional' pooling provided by network bank

Diagram 18.23: Cross-border ‘notional’ pooling (network bank provider)

Features:

provider – pan-European bank with network;

funds swept from local accounts to resident overlay accounts (no change of ownership);

overlay accounts with same pan-European bank;

overlay accounts ‘notionally concentrated’ to memo accounts (no funds move);

memo accounts are notionally pooled and

bank calculates and pays interest.

Advantages:

all funds remain in the country of origin (in the overlay accounts);

no cross-border funds movements; therefore no transfer fees or payment cut-off times

to worry about;

as there is no physical transfer of funds and no transfer of ownership, therefore central

bank reporting is not required;

no inter-company loans and

no cross guarantees and minimal documentation required.

Disadvantages:

some banks do not offer the service because:

o they cannot establish an effective right of set off in law between the accounts;

o their systems cannot handle the calculation and

o as a matter of policy they prefer to offer cross-border zero balancing.

Some banks will only offer this service to blue chip companies for the above reasons,

and may even then require a parent guarantee or comfort letter.

18.20.6 'Notional' pooling provided by a bank without a network

Diagram 18.24: ‘Notional’ pooling (non-network bank provider)

Features:

provider (Bank A) is a non-network bank;

lead bank opens ‘nostro Re account’ with same bank as customer in each country.

These accounts will be interest-bearing;

funds swept internally to ‘nostro Re account’ each day;

lead bank tracks transactions via SWIFT MT940/942 or MT950;

funds ‘notionally swept’ to memo accounts;

memo accounts notionally pooled;

bank calculates and pays interest;

no inter-company loans and

as a ‘nostro account’ – non-resident central bank reporting may be necessary.

Generally, the advantages and disadvantages are the same as in the previous structure (section

18.20.5)

18.21 Account structures summary

There are many ways of structuring accounts, and there is no right or wrong way. Due to

regulatory problems most companies will adapt the structures illustrated in this chapter and may

use several, depending on the country concerned. Due diligence is necessary with all these

structures and the tax ramifications need to be addressed by each company's tax adviser.

Chapter 19 - Selecting banks for cash management purposes

Overview

This chapter discusses some of the criteria used by companies in the selection of banks for

cash management and operational service purposes at various levels, ie locally at subsidiary

level, at country level, and at regional or global levels.

Learning objectives

A. To understand selection criteria for cash management banks at:

   - local subsidiary level;

      - country level and

     - regional or global level.

B. To be able to discuss the different criteria and to apply them to different types of

companies.

19.1 Introduction

There are a number of bank products that may be totally undifferentiated as far as customers

are concerned and generally bought on price alone. Such products include:

credit facilities;

foreign exchange and

derivatives.

For other products, price alone is not the sole buying criteria and other aspects need to be taken

into consideration. These are value-added type services which require that the company assess

the bank in terms of service quality, advice and consulting skills, technology and how well all

these elements are co-ordinated along with the product and service delivery. Cash management

is an example of such a service.

This section will use empirical data, gathered during various research projects, as a foundation

and to illustrate some of the points made.

Most large corporate groups need banking and cash management services at different levels as

diagram 19.1 illustrates. The buying criteria at each level may be different as the roles of the

corporate entities may differ at each of these various levels. Therefore the range and scope of

banking services required will vary.

19.2 Selecting banks for local/domestic cash management purposes

Selecting local banks for operating purposes, although probably the most complex choice

because of the array of retail-type services on offer, is often the most poorly-made decision. Ask

many companies why they bank with a particular bank or branch and the typical response is

likely to be one of the following:

it is the nearest bank to our office (this can be a valid reason, but not when used as the

sole decisive factor);

we have always been with them;

it is where the chief executive keeps a personal account or

the branch manager is a friend of the treasurer.

In an ideal world the response should be:

"We carry out a major review of our banking needs and facilities every three years and offer our

business for tender. Although price is one element on our decision, we look for service quality

and a comprehensive range of other services. Last time X bank came up with the best overall

package of services. That's why we use them."

Companies that use this approach will weight the criteria in their tender document or

negotiations with the bank, giving extra scores for 'must haves' (eg good quality service) as

opposed to 'nice to haves' (eg smart looking electronic or internet banking applications).

19.3 Criteria used to select local banks

Five topics cover the main selection criteria for choosing local banks

19.3.1 Location

Often location is weighted highly in the list of selection criteria and companies will normally seek

to find a bank with a branch network that will match up to their own locations. The branch

network may be needed for paying in or drawing out cash, for depositing cheques, and possibly

for employee banking.

19.3.2 Clearing capability

In each location, it is important that the branch used belongs to a bank that is a member of the

local clearing. This will ensure that collection items (cheques, bank transfers or giros) are

converted to usable cash quickly with minimal cost. Likewise, it will also ensure that payments

to third parties or other group entities are handled with maximum efficiency and lowest cost. A

bank that is not a direct clearing member cannot guarantee this and has to rely on another bank

to provide these services to its customers, adding to cost and complexity and reducing control.

19.3.3 Volume capacity

It is equally necessary that the branch of the chosen bank has the capacity to handle the

volumes required by the customer concerned, or is prepared to lay on extra staff or install extra

equipment to meet demand. One very large, high-volume corporate customer can put a lot of

pressure on a small bank branch.

19.3.4 Service quality

Service standards and quality are equally important. Although quality measures are often

regarded as within the purview of the group treasury, quality measurement techniques

developed by some groups are increasingly being implemented at subsidiary level to monitor

local bank performance. Increasingly, as cash management products, services and pricing

become very similar, companies look to be able to assess banks from the standpoint of their

service quality during a selection process.

19.3.5 Electronic or internet banking

Remote locations should be able to make good use of electronic or internet banking, the main

area of concern being the level of support provided by the bank. Most banks only have support

units based at major branches, in which case the quality of the telephone support becomes of

major significance. Increasingly companies are expecting the type and quality of support that

they might receive from a computer services company. It is no longer possible for banks to

provide 'best efforts' type support. It must be provided by computer professionals who

understand banking.

19.4 Service checklist

The services required at local level will vary from company to company. They may range from

fairly basic to quite comprehensive and might include: 

local currency account;

overdraft facility;

short-term loan;

letter of credit opening;

foreign exchange dealing facility;

cheque issuance and collection facilities;

reconciliation services (tapes, disks, etc);

cash handling, deposit and withdrawal;

payroll preparation;

same-day value transfers and collections;

future value transfers and collections;

credit card processing;

investment services (for surplus cash):

o deposit account and

o CD and

others.

Often the local branch will not be involved with these services, which may be provided from the

nearest “corporate banking centre” or ‘international’ branch. However, local branches may be

tasked with monitoring the exposures that such services create and acting as a ‘post office’

between the customer and the corporate banking/international office.

19.5 Criteria used to select domestic banks

As discussed in chapter 18 (Efficient account structures), some companies will provide a level of

centralisation by use of a country treasury. At the same time, the country treasurer may typically

also be the treasurer of the largest subsidiary operating in that country. Therefore, all the

services set out in 19.4 will be necessary, but it is likely that additional services will be required

at county level such as:

cash pooling, zero balancing/concentration;

ability to monitor other entities' bank accounts electronically;

ability to 'sign' other entities' payments (using remote electronic or internet banking

services);

foreign currency accounts;

more extensive money market and foreign exchange services and

risk management advice and transaction capabilities.

As discussed earlier, tendering local cash management business to obtain a better, or cheaper,

cash management service is a fairly common and reasonably straightforward practice. Some

large corporations look to do this on a country-by-country basis every two or three years.

However, a completely fresh look at your regional or global cash management requires a

completely new approach. Issues such as saving an odd day's float may seem tremendously

important within a national cash management system but can take on a new perspective when

weighed against the many other aspects that need to be considered when dealing with cash

management on a regional or global basis.

19.6 Domestic bank tenders

19.6.1 Overview

It has become increasingly fashionable during the past five years for companies to put their

banking services out to tender. As part of this process, companies periodically review all their

banking arrangements and look at the various products that they are using, to ensure that both

banks and the banking system overall are being used efficiently. The process also includes

comparing terms and conditions offered by banks and making sure that all charges are

transparent. As well as transparency of banking charges, some form of proactive investment, or

at least credit interest on all surplus funds is a goal of most major companies.

19.6.2 Review existing bank arrangements

Prior to going out to tender, the majority of large corporations will examine their banking

arrangements as follows:

collect information on:

o prices;

o commissions;

o interest rates and

o average balances;

look for interest earning opportunities:

o bank accounts

o directly;

o via pooling or concentration and

o links into money market funds;

identify potential hidden charges:

o float and value dating and

analyse payment methods used:

o cheques versus electronic and

o urgent versus non-urgent EFT.

19.6.3 Request for information (RFI)

When a company goes into the market to discuss charges with a new bank, they are often

feeling the temperature of the water. In many cases, they are only comparing the pricing and

service of their existing banks and may find that they are getting a reasonably good deal. If this

is not the case, the company may decide to pre-qualify a set of banks that appear to be able to

deliver a better service. Bearing in mind that not all banks are good at all things, how should a

company establish which banks provide the services closest to their requirements? Some firms

will go through a semi-formal process, collecting information using a request for information

(RFI) to help narrow down the list. Generally speaking, most companies will not go out to

tender, particularly for domestic business, to vast numbers of banks. The RFI (often a letter)

should be designed so that banks respond with service details that enable a company to assess

the strengths and weaknesses of the various banks under consideration. The company will then

draw up a shortlist of suitable banks. It may in fact produce some sort of ranking or weighting of

responses. For example, a local authority that collects large amounts of cash over its counters

from ratepayers may need the facility of a local branch or local cash centre, which can handle

cash. This aspect will be weighted highly on a RFI response. This is not a tender; merely a

quick way of getting information on banks’ services to enable pre-qualification. It should not

normally include too much detail and banks will typically respond with brochures plus a covering

letter.

19.6.4 The tender document or request for proposal (RFP)

Large companies tend to avoid using the standard bank tender document forms that most of the

big banks now offer. Such a document usually avoids asking any sort of embarrassing

questions and will come linked to a set of standard responses. The idea of a tender document

or request for proposal (RFP) is that it allows a company to communicate its unique set of

requirements to the banks and usually the standard bank forms are not flexible enough to do

this. The RFP should contain details of volumes and types of transactions, expected service

levels, electronic banking requirements and any special facilities such as cash collection, cash

drawing, special chequebooks, or cut-off times.

Additionally, of course, the RFP should clearly set out how the corporation is structured and who

the management are. If well produced, it will instruct the responding banks to prepare their

response to the RFP in standard format that allows responses to be fed into a spreadsheet for

easy analysis. The bottom line is that the company should be able to discover from the

responses the true standards and costs of the proposed transactional banking services. The

RFP should be sent to a few banks pre-qualified in the RFI process. Generally speaking, a well-

prepared RFP usually provides the company with a good level of responses that are easy to

evaluate. Bigger corporations will not offer their business to banks for long fixed periods; three

years will usually be the limit. At the top end of the market, linking price to the retail price index

is often not considered attractive, as the general trend in pricing for operational banking is

downwards; linking the cost of banking services to the cost of a dozen eggs is not logical.

Corporations will not necessarily accept the lowest tender either; service quality may be more

important. If the customer is trying to move away from an existing bank, moving costs may be

involved, and some form of compensation may still have to be offered as an incentive to move

from existing bankers that may be offering higher pricing. Finally, having reduced the number of

pre-qualified candidates to a shortlist of two or three banks through the RFP process, large

companies may hold some sort of ‘beauty parade’ or negotiation meeting with a short-list of

banks to decide on the best provider. They will normally expect, particularly if they are

professionally advised, that the bank’s response to the tender is their opening offer and will

often try to persuade the bank to lower pricing in certain areas. For example, a bank may put in

the lowest overall price, but actually have higher charges in some areas, or for certain kinds of

transactions.

In summary, the tender document should be designed for the following purposes:

to communicate a unique set of requirements to the bank, including:

o existing arrangements;

o what the company is trying to achieve;

o volumes of transactions;

o levels of service required;

o needs for electronic services and

o special facilities needed (personalised chequebooks, security levels of

electronic banking products, etc);

to invite the bank to respond in a set way (this aids analysis and comparison between

banks - if the customer does not insist on this, the banks may respond in their own way)

and

to discover the true cost of all services (including those that often go unmentioned, eg

value dating).

19.6.5 Evaluation of responses

This is a difficult area and it can present a minefield for the unwary. Just selecting the response

that appears to have the lowest pricing is not necessarily the best solution. Areas such as value

dating and credit interest also need to be included. In some cases it will work out cheaper in the

long run to pay a little more than rock bottom. Also, of course, how do you know that the

cheapest response is still competitive? It may be that for the volumes involved, competitive

prices should be even lower.

Merely accepting the lowest tender - even if it appears reasonable - is not the end of the story.

Larger buyers will and should use this as the opening offer in a negotiation. Often pricing which

is better than the best response can be obtained during the negotiation stage. However,

companies must remember that service quality is also as important as price. If banks can not

make a reasonable return from providing a service, they have little incentive to invest in service

quality initiatives.

Some companies will use the tender process even if they do not want to change banks. This will

keep the existing bank on its toes and ensure that it remains competitive, offers appropriate

prices and does not take advantage of a long established relationship. Above all, buyers of

services need to remember that after the negotiation meetings have faded into history, the

actual quality of the service will still be of major importance. The hidden costs involved in tracing

payments that have gone astray or have been misallocated, or of information that is inaccurate

and late, can be high.

19.7 Issues with bank tendering

19.7.1 Lack of bank staff knowledge and involvement

Account or relationship managers are traditionally credit-trained bank staff. Although account

managers can analyse balance sheets for credit purposes, in many cases they have never been

trained to analyse a company's cash and treasury management activities. In some banks it will

be these people that are called upon to produce proposals for transactional banking services or

cash management.

In some banks, account officers do not specialise by industry and others have a superficial

knowledge of their customer's business and, in many cases, cash management needs. These

deficiencies are often very apparent in proposals. This approach puts a bank at a disadvantage

when competing against other banks that are structured in a more sophisticated way and where

account officers are supported by cash management professionals.

In many traditional domestic banks, account officers have not been trained to advise on, or sell

cash management and operational service products. As these products are often regarded as

less important by these banks and unexciting by account officers, particularly in comparison to

capital markets and dealing room products, staff generally do not have a good feel for them, nor

the way in which customers use them. Many senior bank staff still think ‘cash management’ is

‘electronic banking’ and that they need to be computer specialists to understand it.

In banks where cash management is a recognised business stream, account officers are

supported by product specialists; each customer will also be assigned a cash management

specialist. The account manager and the designated cash management specialist will be

responsible for generating the leads, making sure that the bank 'pre-qualifies' for the tender list

and for putting together the response to the RFP. In some banks where companies might have

a purely cash management relationship, the cash management specialist may also be

responsible for managing the relationship with the customer and any credit requirement will be

put in place by a central credit analysis area. This saves unnecessary doubling up of staff.

19.7.2 Customisation

Proposals must be customised, rather than created from standard paragraphs. The proposal

should also explain how the customer might use products and services to create the solutions

they are looking for, what they will do in terms of improving efficiency or reducing costs and any

unique features of the providing bank s products that might be particularly appropriate for this

customer.

The leading cash management banks structure a unique response to a RFP, which seeks to

match 'solutions' (rather than offer 'products and features') to customers' problems.

19.7.3 Pricing and costs

Pricing is important in the tender process. Domestically, cash management services are

sometimes regarded by corporates as commodity products and are therefore very price

sensitive. For international and cross-border cash management price remains less important.

However, when looking at the pricing, several things need to be considered:

the cheapest price is not always the right price;

the bank that offers the lowest per item pricing does not necessarily produce the

response with the overall lowest cost, nor exactly the best product offering;

service quality is now regarded as almost as important as price by experienced treasury

staff and some will be prepared to pay a little more for service guarantees;

price is usually only one of the criteria used to decide where business goes. However, it

is generally necessary for banks to be in the lowest price quartile to attract new

business and

pricing that is too cheap can make companies suspicious.

Some banks pricing may appear inconsistent and this is often because it is calculated on a 'cost

plus' formula, with base cost being determined on a fully loaded basis. Some domestic banks do

not use techniques such as marginal costing nor do higher volumes of transactions seem to

attract bulk discounts. Thus a company clearing 100 cheques each year would appear to be

subject to the same per item price as another client clearing one million cheques.

There are several issues here. Firstly, are costs correctly determined and properly understood?

Secondly, are the per-item costs of a small corporate customer the same as those for

multinational customers? The answer to both questions is often 'no'.

Thirdly, cost is only one element in price. Already mentioned there is the generally accepted

market practice of discount for bulk items, but pricing in a vacuum based on cost plus will never

enable a bank to come up with a market price. A bank has to understand the price that the

market will bear (ie, the 'going' price). Some banks seek to be low-cost providers and price for

major corporate business on the margin - seeking in some cases a contribution to overheads

rather than covering fully loaded (and probably already fully covered) fixed costs.

Most banks in Europe are now charging major companies on the basis of product pricing. The

old idea of relationship pricing, with one service subsidising another, is all but gone. This is

because, in the past, large companies have taken advantage of so-called 'relationship pricing'

to 'cherry pick' the cheaper loss-making services, and then buy the dearer (profitable) services

from another source.

Product pricing does allow some cross-subsidies, but only within the payment or cash

management environment. For example, a large company may have a large number of cheques

to clear, but may also make substantial use of automated clearing houses and high-value

clearing systems. The bank may decide to reduce its marginal contribution on cheques

(particularly if it thinks it can move the customer away from cheques), but would make up for

this shortfall by making higher margins on ACH and high-value payment items.

Diagram 19.2: Illustrative pricing

  Marginal

costs

Market price Bank price Marginal

profit

Cheques USD0.03 USD0.06 USD0.04 USD0.01

ACH USD0.03 USD0.05 USD0.05 USD0.02

High-value payments USD3 USD6.5 USD6 USD3

(Note: Pricing quoted is purely designed to illustrate this example).

19.8 Criteria for selecting regional or global cash management banks

The major areas that are considered necessary when selecting suppliers of global cash

management can be categorised under nine major headings.

Diagram 19.3: Global cash management criteria for bank selection

relationship with the group;

branch network;

good payment cut-off times;

reasonable pricing;

a cash management culture;

strong back office capability and quality service;

good credit rating;

adequate delivery systems and other cash management facilities (eg pooling/netting).

Each of these has a different level of significance depending upon the way the company

concerned wishes to structure itself and also, of course, on the level of sophistication of the

banks that are ultimately chosen.

19.8.1 Strong relationship with the group

Cash management is attractive business to banks, The major multinationals will only award this

business to a global or regional bank if they believe that the bank will financially support future

activities of the group eg new debt issues, acquisitions, and provision of working capital facilities

such as overdrafts.

19.8.2 Branch network

Research among major multinationals suggests that one of the most important features of a

regional/global bank is that it has branches on the ground working together as a network rather

than a set of individual 'fiefdoms' . Such a branch network should be connected together

through a telecommunications network and offer a similar service in every country. Use of

branches on the ground means that there will be less use of correspondent banks. In

international money transfer, the majority of mistakes usually occur when one or more additional

banks get involved with a transaction. Use of just one bank group enables one central point of

contact for the company which should be staffed with suitably qualified cash management

specialists who understand international and cross-border cash management. Additionally, of

course, good local arrangements for clearing transactions should be in place. Preferably, the

local branch of the bank selected should be a direct member of the local clearing. It should be

able to offer good value dating on all incoming and outgoing transactions. But the real benefit of

holding an account with a bank that has branches in each country is that those companies

which wish to hold their accounts in a local currency centre are able to do so.

19.8.3 Good payment cut-off times

Whether companies decide to keep their accounts in a local currency centre or to keep them

centrally in one location (ie London, Amsterdam, Brussels, Singapore, New York), cut-off times

for both international payments and receipts are very important. Within a region, it should be

possible for a multinational to manage its cash on a same-day basis, which means its bank

must be able to move money cross-border with same-day value. Early clearing cut-off times in

some countries and poor systems in some banks can make this very difficult. Generally

speaking, multinational companies want the widest possible time windows.

19.8.4 Pricing

While most multinationals are very price sensitive, pricing is not the main driver when selecting

a bank that provides a good cash-management service internationally. Pricing should be

sensible and realistic. Some banks will offer a regional or global price covering all payments and

receipts and other cash management activities. But it should be remembered that value dating

is also part of the overall price (and an aspect particularly prevalent in Europe and South-East

Asia) and therefore requires consideration. Also, the incidence of lifting charges (where a

special charge is made for moving money between resident and non-resident accounts) and the

deduction of beneficiary charges also need to be considered. Ancillary charges may not always

be included in a bank’s pricing proposal to the customer, but can be significantly more than the

payment charge itself. For example, it is fairly common in Europe to be quoted a payment

charge, a telex, cable or SWIFT charge, plus a charge for using a bank’s correspondent. Some

banks charge for their cash management services based on turnover (this is fairly common in

France). Given the option, it is always better to be priced on an item-specific basis rather than

on turnover (it is also easier to estimate banking costs). Finally, any corporate treasurer that

thinks they obtain free banking in any country in Europe or South-East Asia needs to beware. In

reality, such companies may be paying excessive pricing, based on interest-free balances or

value dating if they are led to believe that they are getting free services. Companies need to

ensure that they obtain explicit pricing, credit interest on all credit balances and no surprises.

19.8.5 Cash management culture

As mentioned several times already, cash management is not about electronic banking.

Unfortunately, a large number of banks in less-developed countries in Europe, South-East Asia

and Latin America may tell you otherwise. Cash management banks understand corporate

treasury, they can add some value in the sales process and they have well-trained staff that act

much more like consultants than salesmen. Such staff understand how international banking

works and will normally report to a division head, not a local branch manager. They can offer the

same high-level of service everywhere and supply one set of matched products right across the

region or even globally. Such a set of products will provide one single window into the bank.

Generally, cash managers want to deal with their regional and global cash as professionally as

they do with their domestic cash.

19.8.6 Back office capability and quality service

While many banks provide front-end electronic delivery software that looks very impressive,

what is really important is what happens when the user presses the 'enter' button on his PC.

What actually happens in the bank s back office? How quickly does it happen? How efficiently

does it happen? And to what quality standards does it happen? Back office quality has become

a big issue, particularly in the more sophisticated markets of the USA and Northern Europe. But

it is very apparent in a number of countries in Southern Europe and South-East Asia that

service quality is very low on many banks agendas. Such an approach is not sufficient for any

bank that professes to provide a pan-regional or global cash management service. Not only do

they need to provide common standards, in terms of accuracy and processing standards, but

they also need to give an indication of how they handle any mistakes and how quickly they will

be corrected. Multinationals are looking for a standard high-quality service worldwide and many

are prepared to pay slightly more to obtain it.

19.8.7 Bank credit ratings

Not so many years ago, most companies would never have considered a bank's rating when

looking at cash management services. Nowadays it is becoming almost as important to rate a

cash management bank as it is to rate the bank where deposits are placed. Companies that are

passing many billions of USD through their accounts on a daily basis need to consider, even if

their accounts zero out at the end of the day, the risks attached to using such banks. The

corporate credit policy can often be used as a starting point. There is a need to estimate

average balances on accounts and average volumes and values of electronic funds transfers

put through the banks concerned. Standard risk rating reporting can be useful as well. The

chosen bank needs to have a good short-term credit rating. Companies also need to consider

the country risk. Where is the ultimate country risk to them if something should go wrong? Is it

with the head office or the individual branches? It is also important to look at systemic risk. This

means not only looking at the electronic banking system through which payments will be

processed but also reviewing the bank's links into the clearing and how they link into their

correspondents (very often their weakest area). The management of the bank can also provide

risk. Companies should look to deal with a bank that has an established track record with senior

staff that have been in the business for many years. In the larger, more professional banks, it is

possible to have a career within the cash management division, thus stability of management is

much more of a norm. Finally, of course, customers should be looking to deal with a stable

institution that has a long-term commitment to cash management, not one that moves in and out

of the business when it suits them.

19.8.8 Delivery systems

While it is important that front-end products meet users’ needs, it should be remembered that

electronic or internet banking is only a method of delivering a cash management service. Such a

system should provide one window into the bank, preferably worldwide, which delivers a

matched set of flexible products. One of these products should be cross-border electronic funds

transfer which should incorporate high levels of security (some would argue that international

funds transfers require a greater level of security than domestic funds transfers). As well as

EFT, electronic balance and transaction reporting must also be available. Some banks now

provide intra-day updates or even real-time reporting right across a whole region (even

worldwide). Therefore, access to the complete range to cash management services from one

electronic banking system is the prime requirement of most global cash management

operations.

Increasingly useful to many multibanked companies is a multibanking service from their lead

cash management bank. While many banks can provide their customers with details of

accounts held with other banks through data exchange, few offer the ability for the company to

input payment instructions via their electronic funds transfer systems for onward delivery and

processing at other banks (using MT101 messages). This service is becoming increasingly

useful for moving liquidity around a region.

In Europe, multinationals (MNCs) such as IBM are demanding these types of services and the

more pragmatic banks are beginning to provide them.

19.8.9 Other facilities

If within a MNC there is extensive intra-group trading, a netting system can become an

important part of its cash management structure. There are a number of banks globally that can

provide these services either by supplying software or a service on an outsourced basis (this

can become very cost efficient if set up appropriately). Additionally, cash pooling or cash

concentration using zero balancing can become a very useful part of a global cash management

structure. In certain countries, it is possible to notionally pool balances for interest rate

calculation purposes. Where such a pooling technique is not allowed or not possible, zero

balancing facilities need to be utilised. It should be emphasised that in many countries where

pooling and zero balancing are legally allowed, many local banks do not actually provide the

service. In such circumstances a global bank can be very useful. Balance management takes

on new complexities in a cross-border environment, and areas such as early cut-off times for

same-day value transactions becomes very important. For example, if you are closing out your

MYR book at 11:00 Kuala Lumpur time and a large credit transaction hits your account with

same-day value at 11:30, you will need a mechanism in place to automatically invest those

funds. This is a common area of weakness for banks; one insurance policy could be to

negotiate credit interest on current accounts. However, in many regimes this is either against

banking regulations, policy or custom and it can result in withholding tax being deducted from

credit interest paid. In some countries, the amount of credit interest paid on a current account

would be fairly derisory. Therefore, some form of sweep facility into a higher interest-bearing

deposit account may be necessary for those funds which the corporate treasurer is not able to

manage on a proactive basis. In countries such as France, where interest is not payable on

resident current accounts, treasurers often avail themselves of a facility provided by banks that

will automatically invest surplus funds into overnight money market instruments.

Finally, one additional facility that is particularly useful to multinationals that are looking at cash

management on a global basis, is some form of central billing. This prevents bank statements

being clogged up with many individual bank charges, and thus helps streamline the

reconciliation process, particularly if an automated account reconciliation system is being used.

This may be offered either at group or subsidiary level (which enables easier charging out).

While many domestic banks will actually charge for a payment immediately after the payment

has been made, the large and more sophisticated banks can track the amount of activity across

accounts and then submit a monthly bill, broken down at subsidiary level. This shows each

cash-management service and the volume of transactions that have taken place. These types of

billing services resemble the account analysis statements that are provided by some major

banks in the US. However, they are often much less detailed.

19.9 Reviewing existing arrangements

When considering selecting a cash management bank, it is not necessary or wise to put your

business out to tender in exactly the same manner in which it exists at present. It is preferable

to take a completely fresh look at how the company’s cash management is structured, to review

the instruments used and, in particular, look at the existing account structure to ensure that it is

the most efficient available to you. Look at methods of speeding up collections and at the

appropriate methods for making payments. ‘Appropriate methods’ are not only those that can

slow down the payment process as much as possible. There are different payment standards in

every country and different norms in terms of payment instruments and the amount of payment

float that counterparties will tolerate. For example, the last thing a company would do in Belgium

is to try to pay another company by cheque, as the cheque is not a standard form of payment in

that country (you would normally pay a third party in Belgium by a bank giro transfer). Likewise

in the UK, a bank giro transfer would be one of the last ways you would consider paying a trade

debt. It would be far more appropriate in the UK to pay by cheque, electronically (CHAPS) or

through the automated clearing system (BACS). When looking at existing arrangements, check

the value dating being given on items through bank accounts and ensure that there are no idle

balances sitting there. Account structures also need to be reviewed from time to time in terms of

whether accounts are regarded as being resident or non resident and assess the different

charging structures that relate to both.

19.10 Emu and bank relationship rationalisation

In the discussion on account structures in chapter 18, we suggested that companies will,

probably, need to use fewer banks for cash management purposes in Europe because of Emu.

We now need to look in more detail at how Emu is assisting companies to restructure their bank

relationships, and suggest how companies may choose to do this. In turn, this should identify

those banks that are likely to be 'winners and losers' in the process.

In theory, with one currency covering all Emu countries, companies should only need one bank

account for cash management purposes, and therefore only one bank in the country of its

choice to cover the whole EUR region. As discussed in chapter 18, a one-country corporation

that has most of its business in its home country and which only imports or exports a small

percentage of its purchases and sales to other Emu countries, would find this structure to be

quite feasible. All imports could be paid and all exports settled in EUR using the EBA EURO1 or

the TARGET systems. It is possible that such a company already needs very few banks and

therefore Emu has had little effect on its banking relationships.

Many MNCs had already put in place national cash pools before EMU and use a pan-European

bank in an overlay structure (ie linking domestic cash pools held in each country with a treasury

control account held with the pan-European bank's branch in the same country). Excess funds

in each country can then be concentrated into the control account from where they could be

invested by the regional treasury, or swapped into currencies where deficits were held and lent

to other group entities.

The result of Emu is to leave groups with EUR cash pools in each country. This is not an

optimal situation. As some of these pools are likely to be in surplus and others in deficit, the

ideal situation would be to create one EUR cash pool for the whole region. This requires either

notional pan-European pools to be set up, which few banks can offer, or same-day cross-border

concentration of all EUR funds into one tax efficient location. This latter idea is a real possibility

given the working hours that payment and settlement systems now operate to accommodate

TARGET.

As funds move faster, more efficiently and for less cost within one bank rather than between

banks, it is not surprising that such services have been developed by the pan-European banks.

In terms of payments, banks are attracted by volume, particularly if it is automated. Many banks

are prepared to offer significant price reductions and better terms and conditions for higher

volumes of payments. Prior to Emu, most MNCs would have made local currency payments

from the domestic banks they used in each country. The pan-European banks have now joined

the clearing systems in each country. They have therefore gained access to both local currency

and EUR-clearing facilities from all or any Emu country; a MNC that puts its EU-wide EUR

clearing out to tender is now able to offer all this business to one of the few pan-European

banks. Such a MNC will receive a better deal from that bank than from any of the national banks

that individually would not have EU-wide direct access to the clearings and have to use

correspondents, EBA or the TARGET system.

Most MNCs move to set up regional EUR cash pools with pan-European banks for liquidity

management purposes. They also make EUR payments from this pool of funds. Therefore, it

logically follows that the next step when billing customers in EUR will be to request the payor to

remit funds to the local branch of the pan-European bank as well. Thus all EUR funds are

concentrated with the one pan-European bank.

This being the case, what is left in terms of business for the domestic banks other than services

relating to physical cash handling and paper-based transactions that the pan-European banks

do not want or cannot handle? These are traditionally the services which cost the most to

process, and which, with a few exceptions, are unattractive to all banks.

The current argument that says local subsidiaries of a MNC need local banks for their branch

network is also diminishing as more and more paper-based transactions are being replaced by

electronic funds transfers, giros and credit cards which do not require a branch network.

19.11  Opportunities for non-EU banks in the corporate payment area

Emu makes it possible for European banks to compete across borders with each other.

However, it also opens up the market for banks headquartered outside the European Union.

The main non-EU banks that can demonstrate a strong capability in the areas of corporate

payments and cash management services in Europe today are unlikely to change their

strategies much post-Emu. In fact, evidence suggests that several of them are consolidating

their positions through product and service differentiation. At the top end of the market (‘Fortune

500’ and ‘Times 1000’ companies) the pan-European cash management market is dominated

by three large US and two European banks. A number of secondary US banks are entering the

market using combinations of branches, strategic alliances and super-correspondent banking

arrangements. Some of the other major European banks have less-developed strategies and

incomplete product offerings, but nevertheless strong ambitions in this field. There are also

some banks originating in some of the smaller European markets and non-US that have

ambitions in the region. Such banks tend to emanate from:

Australia;

Switzerland;

Central and Eastern Europe and Benelux (Belgium and the Netherlands).

19.12 Bank alliances

From a bank's point of view building alliances with other banks is an alternative to branch

expansion. From the point of view of multinational corporations (MNCs) it offers an arrangement

that can deliver an international network with the potential for savings.

What is the difference between this and correspondent banking?

an active rather than passive approach to the market;

active contacts, at all levels within the member banks and

identifying each other's strengths and weaknesses' even to the point of exiting certain

areas of the business.

Complementary strengths might be identified in respective customer bases, market branch

systems, product and services. Weaknesses in a small branch network might mean low market

penetration, low returns on assets and equity, overwhelming competition and disproportionate

management time allocation. To make alliances work better, members need to make available:

secondments and shared training and

free access to each other’s products and customers.

Fundamentally, the alliance must be for mutual benefit without requiring equity investment.

Investment can be part of the deal, but it is not a prerequisite.

In Europe the increase in cross-border trade brought about by the single market and the EUR

has increased demand for international banking services. A number of bank alliances have

been formed to assist internationally active companies to rationalise their European cash

management. These alliances have linked their payment systems so local banks can become

the gateway to an international network.

Typical benefits include:

receivables available more quickly;

electronic bank statements for all foreign accounts;

cheaper and more efficient cross-border payments and

concentration of EUR funds centrally. Liquidity can be managed on a pan-European

level.

There are three major alliances operating in Europe: IBOS, Connector and UniCash.

19.13 How is Emu changing things for banks in the cash management business?

Emu has made things easier for cash management banks in Europe and may provide one more

step towards harmonisation and creating a true single market, but there is still much to change

before there is a true level playing field where Europe looks like the US (ie one country). Many

regulations have not changed with Emu (tax, central bank reporting) and outdated ideas of

discriminating between residents and non-residents, withholding value on cross-border

transactions and old fashioned ideas on pricing will not change overnight. This is probably an

area where the European Commission or the European Central Bank have to take the lead.

However, the US banks in Europe (and a very few European network banks) have already

overcome all of these issues very successfully. They do not need TARGET for same-day cross-

border money movement. They can move funds cheaply, efficiently and in a few minutes

through their own systems and branch networks. They also have direct links into the local

clearings in most countries. Like all European banks, they will also benefit from initiatives such

as the EBA cross-border service for non-urgent EUR payments. The US banks in Europe are

not only members, but also represented on the committees of many of the major European

clearing systems. They will be able to add EUR-based products to their already wide range of

products. They are already offering services such as creating one single EUR cash pool for

same-day investment, that many local banks will not be able to offer for many years.

It would appear these five or six network banks will be able to consolidate their lead in this area,

making it even more difficult for other later entrants to catch up. The barriers for entry to the top

end of the market will be raised still further for new entrants to the cash management business.

Meanwhile, some domestic banks will start to feel the pinch as customers, already enjoying high

levels of service for pan-European business, start to use the same providers for local EUR

transactions as well.

19.14 Conclusion

When selecting a global cash management bank it is often best to adopt a formal approach by

producing a tender document. This should be a detailed document which is meant to

communicate a company's unique set of requirements to the banks. It will have to include

details of the volumes, service levels required, types of electronic banking services and any

special facilities that might be needed. For example, special electronic banking security,

chequebooks in certain countries and so on. Banks should be requested to respond in a

standardised way, which will aid evaluation.

With a regional or global tender, it might be best to ask banks to respond on a country-by-

country basis. Remember that the aim of a tender document is to discover the true cost of the

services required and to identify some differentiation between the various service providers.

Generally speaking, a well-prepared tender document usually initiates a set of well thought out

and easy to understand responses from the banks. When the responses come back from the

banks, the main points should be input into some sort of matrix to compare them. Is the lowest

price the best bank to go with? Is the lowest price the most competitive? At the end of the day,

with tendering all the banks have given is their opening offer in terms of the services and prices

they are prepared to offer. Everything is negotiable, particularly in global cash management.

In summary, companies need to determine their treasury and accounting structure. They should

work out in advance how they want to manage banking internationally, pre-qualify the banks

and service providers that might be used and produce a detailed request for a proposal or

tender document. If a couple of banks are offering very similar terms, then put them through a

'beauty parade' process where they are interviewed in depth and then visit their back offices to

see how everything works. Once the supplier is chosen, companies should negotiate with them

on the finer points and then set up an action group to work actively with the bank to implement

the solution that both parties are agreed on. Once up and running after six-to-12 months, review

and fine tune your structure.

Technology and Systems for Treasury

Chapter 20 - Electronic delivery systems : technical and security overview

Overview

Sometimes the term 'electronic banking' is used to describe both the delivery systems and the

services themselves. But as proprietary technology gives way to a more 'open' communications

environment, and as internal systems are increasingly integrated with systems outside the

company/organisation, it is more accurate and practical to distinguish between the delivery

system(s) and the products/services themselves.

Part A – Electronic delivery systems

This part of the chapter describes the various types of electronic delivery systems required by

treasury and the technology choices facing those selecting and using systems today.

Part B – Systems security

Included in the second part of the chapter is an overview of the all-important issue of security of

systems used in the corporate treasury, including the particular security issues when using such

systems over the public internet. It provides some anecdotal examples of security breaches

connected with the use of electronic funds transfers. Finally, it considers the security of the

SWIFT system, used by the major banks both for their own and their customers' transactions.

The banking services that are delivered electronically are described in the next chapter (chapter

21), which also looks at the functionality of treasury management systems.

Learning objectives – part A – electronic delivery systems

To understand:

A. The different electronic systems and services required by treasury

B. The importance of systems integration

C. A typical systems architecture for treasury

D. The technology choices for the treasurer

Learning objectives – part B – systems security

To understand:

A. How message authentication works and what is secured

B. Symmetric and asymmetric authentication techniques

C. Digital signatures and PKI

D. How multinational banks cope with different security standards

E. Minimum EFT security standards

F. The security system used by SWIFT

G. Identrus

PART A – ELECTRONIC DELIVERY SYSTEMS

20.1 Information

20.1.1 Treasury's needs

In the first chapter, we discussed the treasurer’s role in terms of the major functions undertaken

by treasury.

To be able to manage these functions the treasurer needs ‘information’ about:

positions;

interest/exchange rates and

market activity.

Back in the 1970s Walter Wriston, then Chairman of Citibank, said: “Information about money

will become more important than the money itself.” In the 21st century, this statement no longer

gives us pause for thought. In our personal lives, most major purchases we make are on the

basis of information about our creditworthiness, without any cash transaction involved. In

business, we routinely speak of ‘value’ (instead of cash).

Modern treasury departments need to:

access internal data (accounts payable and receivable, cash flow forecasts);

access market data (foreign exchange and money market rates, credit databases); 

collect information on and be able to monitor positions ( bank accounts, dealing activity

etc);

analyse the information collected;

make fast decisions;

action those decisions quickly;

record actions and update positions and

identify exposures.

To do these things well, the treasurer requires systems and automation. Some of the systems

needed are supplied by banks, others by third party software houses (or they may be developed

in-house) and others come from data feeds from market information providers. The need for

information systems can be looked at as an iterative process.

20.1.2 Information sources

Information comes from various sources such as:

electronic balance and transaction reporting systems from banks;

market information systems (Reuters/Telerate, etc);

custody systems;

accounting systems and

business systems.

20.1.3 Decision support

These functions may be performed by one system, or a combination of systems and

spreadsheets. Typically, a large corporate treasury will use a treasury management system

(TMS), normally supplied by a specialist software house, although some companies do develop

their own. (Treasury management systems are dealt with in detail in chapter 21).

Using an analysis produced by the TMS, the treasurer will make a series of decisions, which he

or she will need to action.

20.1.4 Transaction initiation

The treasurer may decide to pay away funds, invest or borrow funds, open a letter of credit, etc.

Typically the systems used for this are supplied by banks.

These actions need to be recorded quickly so that they are reflected in the corporate position. A

second iteration can then be undertaken.

20.1.5 Updating internal records

Each transaction needs to be documented in the internal records for accounting purposes. Most

TMSs automatically update the internal records following each transaction, either via a built-in

accounting system, or by producing a file and link to update an accounting or enterprise

resource planning (ERP) system.

(We cover ERP systems in more detail in section 21.19)

20.2 The treasury’s systems architecture: integrating diverse systems

20.2.1 System architecture

Diagram 20.1 describes the systems requirements of a corporate treasury from the perspective

of a typical treasury workflow: information – analysis – transaction – accounting. But, as we said

in section 20.1, treasury needs a number of services from different sources. Selecting the right

services is, of course, important. Some of the choices involved are considered in more detail in

chapter 21 .

But achieving a systems architecture that works well for your treasury is every bit as critical. By

systems architecture, we mean the master plan of how different services integrate with each

other inside the treasury department and communicate with the services outside. The aim is to

ensure the company always has the information it needs and that systems are responsive to

business needs, rather than the other way round.

Designing and implementing systems architecture requires expert IT input. But, because of the

specialised nature of treasury, treasury professionals often find themselves deeply involved in

such projects.

20.2.2 Six key areas for treasury

From a treasurer's perspective, there are six key areas to consider:

20.2.2.1 The treasury system:

This is the decision support system at the heart of treasury. It might be no more than a series of

spreadsheets; more likely these days it will be an expensive piece of software purchased from

one of the many specialist treasury systems providers and integrated with external systems.

20.2.2.2 The banking services:

This will be ensured by one or more systems from one or more banks, depending on the

company’s needs.

20.2.2.3 The technology infrastructure approach:

How will the treasury systems communicate with both internal systems and with external

partners and subsidiaries? Does the company want to use PC-based applications, or access

applications on a server via a browser? Systems strategy needs to find a balance between

flexibility to accommodate new requirements and simply letting the systems environment

develop randomly.

20.2.2.4 The security environment:

How can the systems environment be made secure? What is the trade-off between security and

usability?

20.2.2.5 Other internal systems:

For example, they may wish to receive data from the company accounts payable/receivable

systems, cash forecasting reports from subsidiaries and so on.

20.2.2.6 Other third party systems:

In addition, treasury might want to receive external information feeds of market information.

Diagram 20.2 shows a possible systems architecture for a centralised corporate treasury with

overseas subsidiaries and a shared service centre for centralised processing of such tasks as

accounts payable/receivable, payroll, etc. This is just one possible scenario – there are many

others. But it does show how complex the systems integration requirements can become for the

treasury department.

20.3 Technology infrastructure

20.3.1 The choices

We need to consider the main technology infrastructure choices facing treasurers today,

including the security challenges. These are the fundamentals of an effective treasury systems

architecture.

In chapter 21, we will consider electronic delivery of banking services and the treasury

management system itself. Specific security requirements will be covered there with regard to

the services themselves. The final chapter in this section looks outside the treasury at e-

business and tries to suggest how these current developments will come to impact the

corporate treasury department.

Most treasury departments have some degree of choice when it comes to selecting the systems

to be used in the treasury. However, their choice may be limited by their organisation’s overall

IT policy in terms of operating systems supported by the company, security around connection

to the public internet, and so on.

20.3.2 Client/server approach

In practice, the majority of treasury, bank and third party services used in treasuries today

require the installation of application software on the user’s desktop. This application software

on the ‘client’ PC accesses data (eg account details or files of counterparty information) from a

remote database server and processes it on the user’s PC.

This approach, although it has been phenomenally successful, has the drawbacks that installing

and maintaining software is expensive, and users can only access applications from computers

that have the necessary software set up.

20.3.3 Browser approach

Perhaps the most obvious choice when selecting new banking and third party services today is

between PC-based client/server applications and server-based applications accessed from a

browser.

It is now possible for any PC or network computer (and a range of other computing devices) to

access data, files – and have the applications to process that data - from a central server, using

just a standard piece of software.

A browser is a piece of software that ‘renders’ (displays as text) pages of data that have been

prepared using hypertext mark-up language(html). Preparing data for access from a browser is

fast (and, therefore, cheap) using html, allowing more people access to more data. The

drawback of html is that it treats data as pages – and this limits flexibility of data presentation

and manipulation. eXtensible mark-up language (XML) offers a potential solution to this problem

as its flexible open-standard format allows interoperability and facilitates integration of different

data types.

20.4 Intranets for treasury

Mention the browser and we immediately think of the internet. But, whether or not they allow

their employees to access the internet, most companies today operate intranets – closed, local

or wide-area networks that link employees to central servers of data and applications that can

be accessed using a browser, as described in 20.5.

Intranets allow much wider access to data than was previously possible when data was locked

in departmental systems. For example, an intranet can give employees direct access to benefits

and pensions data without the help of the personnel department. Of course, access profiles

ensure employees can only access the files that are appropriate to them, allowing confidential

information to remain secure.

Within treasury, applications that require input from a range of different departments or locations

may be suitable for this approach. For example, some treasuries have moved their monthly

netting procedures onto the intranet. Subsidiaries can input their payment data and access

reports without specialised software, while the treasury is released from the burden of sending

out multiple faxes or email reports at each stage.

20.5 The internet and treasury

Whether or not to use the public internet for treasury applications is a more complex question.

The benefits are obvious - the browser + access via the internet + server-based centralised

applications is a low cost and effective way to communicate with subsidiaries, banks and a host

of other counterparties and business partners.

But the public internet does introduce new and considerable risks to such activities, in addition

to the security considerations that apply to any computerised data. In particular, on the internet

we need to worry about:

accidental or malicious release of sensitive information to public view and

virus or denial of service attacks.

There have been a number of well-publicised examples of financial services providers suffering

these problems.

On the other hand, the coming explosion of e-business, including hosted services from

application service providers (ASPs), suggests that simply ignoring the public internet is no

longer a possibility for the treasurer. (See chapters 17 and 21 for ASP treasury systems).

20.6 Data exchange standards

Every treasurer selecting a new system or service will quickly come up against issues of data

exchange. Getting computers to talk sensibly to each other is still a considerable preoccupation.

There are two principal challenges:

message formats – can structured data from one application be read and applied

accurately by another? and

message content – do the messages allow for all the information to be included that will

be needed at each stage of a multi-stage process?

Many systems are still proprietary and require special interfaces to be built to enable the kind of

systems integration illustrated in diagram 20.2. Although software companies increasingly offer

standard interfaces - for example, between treasury systems and the major enterprise resource

planning systems (ERP) - systems integration can be a time and budget-consuming task.

Banks use SWIFT standard messages to exchange data between themselves in a standard

format. For example, SWIFT defines standard message formats for balance reporting (SWIFT

940) and the SWIFT 100 series of messages defines different payment types. These standard

messages are used by banks worldwide. Some companies also use SWIFT message formats to

communicate with their banks and other financial institutions.

Another set of financial message standards has been defined by EDIFACT (under the auspices

of the United Nations). These message formats are often used by companies to make supplier

payments electronically, because they can include quite detailed remittance advice along with

the payment instructions themselves. This is called financial EDI (FEDI) and is dealt with in

more detail in chapter 21. EDIFACT is also increasingly used by corporations to communicate

with their banking partners.

20.7 Summary – electronic delivery systems

The treasury management system is the key recording and analysis system at the heart of

treasury. Electronic banking systems provide direct communication between the treasury and its

banking partners. Other systems, such as market data, may also be required.

The degree to which these systems are integrated will depend on the size, scope and budget of

the individual treasury. A fully integrated treasury systems architecture is the goal, since this will

increase internal efficiency (eg., by avoiding rekeying of data), improve the timeliness of

information about the business’s cash flows (for example, by taking cash flow forecasts directly

into the treasury system) and improve treasury responsiveness.

The gradual introduction of browser and internet technologies is broadening the choice of

systems architectures, communications and functionality. Implementing such technologies

should be considered in the context of the e-business revolution.

PART B – SYSTEMS SECURITY

20.8 Systems security

Security should be a high priority for treasury professionals, who need to ensure that the

financial procedures, processes and systems used in the treasury are not vulnerable to misuse

or failure from any internal or external cause, whether deliberate or accidental.

Of course, 100% security is probably impossible to achieve. Rather, physical and systems

security require a risk management policy that includes a disaster recovery plan alongside a

rigorous audit procedure, to ensure that if things do go wrong, errors/problems are detected

early and dealt with efficiently.

There is something of a taboo around security failures – many organisations will simply not

admit to them. But independent research in the UK suggests that approximately 20% of major

companies have suffered some direct loss as a result of a security failure. Another 10% have

suffered consequential losses and a further 35% have suffered from both. If this trend is

indicative of all computer users, then 65% of UK computer installations have suffered some

financial loss in recent years.*

Recently, a series of well-publicised security breaches on services delivered over the internet

has brought the issue of computer security firmly into the public consciousness. These problems

have included the accidental publishing of individual names and credit card details on public

websites, deliberate attempts to defraud online banks as well as denial of service attacks on

online retailers as well as the now-notorious 'love bug' virus.

By its nature as an open, unpoliced system, the internet presents a new set of risks to be

managed. But while much attention is focused on these (and they will be covered in this section

of the chapter) it is important to recognise that all systems – including paper-based, manual

procedures – can be subverted or can fail.

The particular problems of the internet aside, systems security is a mature science. Procedures

and tools exist to ensure a good level of protection for both systems that deliver sensitive data

and systems used to execute payments.

Our purpose here is to give an overview of the security required for the information and payment

systems used in the corporate treasury, as well as examining the security required for business

via the internet. We also look at the security around SWIFT, the interbank communications

network.

Further observations on security are made alongside the descriptions of the treasury

management system and various bank services in chapter 21.

*PricewaterhouseCoopers

20.9 Knowing the risks

In order to ensure systems are adequately protected, you need to be aware of the nature and

variety of risks by undertaking, or asking a security expert to undertake, a risk assessment.

Some of the areas to be considered include:

20.9.1 Physical security

The data you wish to protect should be physically secure. Considerations here include:

restricting access to buildings or departments;

restricting the number of people allowed to access a particular system or application;

ensuring a protective environment for business-critical hardware;

ensuring passwords are never kept in physical form and

considering the risks, including possible theft, associated with data held on portable

computers.

20.9.2 Systems access security

Considerations here include:

ensuring systems are protected at every access level. For example, ensuring automatic

log-off if an application is interrupted and left unused for more than a few seconds;

ensuring clearly documented access profiles, separation of duties and administrator

responsibilities;

ensuring passwords are de-activated quickly when staff leave and considering the risks

associated with remote access (eg dial-up from portable computers).

20.10 Security procedures and tools

As discussed in section 20.9, there are recognised procedures and tools to protect systems

from known risks. Many of these are implemented as standard, for example, on payment

systems supplied by banks. The basics are described below and should be explicitly considered

when drawing up a treasury security policy or installing any new system.

20.10.1 Access controls

An access profile details the particular applications and procedures available to each user. A

user's personal access will be secured by a user name and password. Additionally, a user might

be required to use a smart card or other device to control access to a particular application.

Passwords should be changed regularly and should not be memorable names, date of birth, etc

as these are subject to educated guessing by potential hackers or fraudsters.

The management of individual access to systems and of their passwords is called 'access

management'.

20.10.2 Confidentiality of data

In order to ensure that confidential information is protected during transmission (eg, to prevent

eavesdropping by someone tapping into a phone line) data may be scrambled before

transmission and unscrambled on receipt. This procedure is called 'encryption'.

Many banks currently use the triple data encryption standard (DES) to provide strong encryption

for payment messages.

20.10.3 Authentication and integrity

System suppliers and users need to be able to demonstrate that messages sent over systems

are genuine and that the person sending them was authorised to do so. (Hopefully, they will

never be faced with having to demonstrate that a message sent was not genuine or from an

impostor.) This is called 'message authentication'. Additionally, there is a need to ensure that

the message sent arrived in a complete and unaltered state, and that this message could only

have been dispatched by an authorised person. This part of the security process is called 'non-

repudiation'.

Some funds transfer systems use electronic hand-held key pads which combine passwords and

personal identification numbers with an algorithm to produce a form of test key which is then

keyed in for each payment or at the end of each batch of payments. On receipt at the bank, the

algorithm is decrypted and checked for accuracy.

Clearing systems, such as CHAPS in the UK, use 'black box' technology to protect users. At the

transmitting end of CHAPS, user banks' black boxes add message authentication codes

(MACs) and scramble or encrypt information. At the receiving end, the reverse process occurs.

The boxes themselves are tamper-resistant, and the whole system is so secure that there are

no known instances of security breaches or frauds involving CHAPS. MACS are described in

detail in section 20.12.

Protection of data during transmission through networks is also important. The incidence of data

corruption between the customer and the banks, which has been a problem in the past, can be

substantially reduced if both parties are using error-correcting modems.

20.10.4 Network and internet security

Any message sent over any network (a leased or private line, a value-added network or the

internet) is vulnerable to interception and/or alteration. If the message contains sensitive

information, and in particular if it is an instruction to move funds, it must be protected through

the procedures outlined above.

The internet has made it possible for a single computer to access many millions of servers

through one standard piece of software (the browser) via a modem and an internet service

provider. And, as discussed above, this introduces a new set of risks. The risks of malicious

hacking and interception are greatly increased and the potential for virus infection becomes a

serious concern.

Corporate systems connected to open networks should always be protected by firewall

software. PCs connected to the internet should be equipped with virus protection software to

ensure that at least those known viruses are detected and prevented from infecting the machine

and sending infected files to others. These days, corporations also need to be proactive about

viruses and ensure a reliable source of up-to-date virus intelligence is available to them.

20.11 Securing the treasury environment

Today, most treasuries use PCs. In many large treasuries, all the primary systems are PC-

based. However, the importance of controlling access to these PCs is often overlooked or taken

for granted.

As a basic requirement, each PC should have a physical lock and a series of logical locks once

the system is powered up, so that, if necessary, individual programs and files can be protected.

These precautions should be put in place even if only non-sensitive data is on the machine.

PCs that will be used as personal workstations and are connected to communication networks

for use in transaction initiation (funds transfers, electronic mail, online foreign exchange dealing,

etc) need to be particularly well protected. In some organisations one PC is set aside purely for

this purpose. However, this PC is often centrally situated, left switched on all day, available to

just about everybody, with the various systems software applications sitting on an unprotected

fixed disk. It is not uncommon for treasuries to share the same passwords among several staff

and for those passwords to be written on ‘post-it’ slips and stuck to the side of the PC (very

useful information for the entrepreneurial cleaner).

Apart from obvious security precautions such as locks, additional physical devices can be

installed. A number of banks install encryption and authentication black box devices (similar to

those described for CHAPS) which either stand alone by the customer's PC or are incorporated

into their modem to give added protection.

20.12  Message authentication codes

Message authentication codes (MACs) can be applied to individual payments or to batches of

payments or both. A MAC is a unique number that is generated by a mathematical algorithm

that combines the cryptographic 'key' with the total content of the payment or message that it

authenticates. Therefore it will change with every message that is sent.

As every character within the message is involved in this process, any changes to the message

in transmission would prevent the authentication code being verified by the recipient. The use of

an authentication code therefore not only identifies the originator, but also shows that the

message has not been modified during transmission.

Certain banks use physical devices to apply MACs. Others use software authentication and

encryption techniques. Whichever method is used, the basic process is similar. A complicated

code is constructed from a payment sequence number, the characters making up the message

(including the amount) and usually a code which is unique to the customer (such as their PIN

number). This code will then be encrypted while travelling through the network to be decrypted

at the receiving bank.

This level of security should be able to ensure that:

there are no missing or duplicated messages (replay or loss);

the messages have not been tampered with or amended (modification);

the message has not been copied during transmission (pipelining or leakage);

the message (with encryption) cannot be read by a third party (privacy);

a third party could not pretend to be an authorised customer (masquerade) and

neither party to a payment can claim that it was not sent or received (non-repudiation).

Ideally, companies should look for 'end-to-end' security; however, any 'end-to-end' security

system has to be matched by appropriate security within each organisation itself. An

organisation that uses EFT or EDI will still need to put in place:

effective administration and control processes;

secure access control to systems;

an authorisation process;

secure hardware and communications systems that are fully backed-up and

strong audit procedures.

Failure to address these points could compromise the overall security of the process.

20.13 Security using symmetric keys

There are currently two main approaches to producing authentication codes, each with different

advantages. The first of these uses 'symmetric' keys (ie the same key is used both to generate

the authentication code and to verify it when received). This is a useful approach when security

is being managed between two specific organisations such as a bank and its customer. It allows

the security system to be managed entirely by a bank, which becomes the 'trusted' organisation

in the process.

A bank can provide its customer with a cryptographic key on smart cards, which can be issued

to authorised individuals within the organisation or as part of the software used for EFT or EDI

payment initiation. Thus, the smart card becomes a physical token that can be held by an

individual which can only be used with a personal identification number (PIN) that has to be

entered by the individual each time the smart card is used. Use of the smart card will verify to

the bank that the message has been submitted by an authorised user. In this way, the MAC is

never known to anyone, neither the sender, not the receiver. Its use is solely a computer-to-

computer matter.

Verification of the authentication code also confirms to the bank that the message has not been

altered during transmission. Use of message sequence numbers within the message (which

cannot be modified en route) guards against subsequent duplication of the message using the

same authentication code and also enables the receiving computer to identify that a message

has been lost.

Symmetric keys therefore guard against masquerade, modification, duplication and loss of a

message. They also allow the bank to identify that an authorised user was involved. However,

as both parties hold the same key, they could both generate a valid authentication code for a

message, therefore non-repudiation is not possible unless the security hardware itself restricts

the recipient's use of his key 'only' to verification of the authentication code.

20.14 Security using asymmetric keys

An alternative approach is to use an algorithm in which different, but related, keys are used to

generate and verify the messages. This will effectively guard against threats associated with

repudiation as only the originator can generate the authentication code with their own key. The

receiver has a different key that will only allow them to verify that the authentication code

received is valid. The authentication code generated by asymmetric keys is often referred to as

a 'digital signature'.

The use of asymmetric keys allows one of the keys to be advised to all users as a 'public key'.

The other, related, key is held as a 'private key' which is confidential to the originating

organisation or individual. This 'private key' is used to generate the authentication code, or

digital signature, which is attached to the message. The code can be verified by any recipient

using the 'public key', which is always in the public domain.

This process using asymmetric keys is also known as public key infrastructure (PKI). It is now

starting to be applied to facilitate transactions over the internet as well as via EDI.

PKI is useful for communicating with multiple trading partners/banks. Each organisation (or

individual) has a private key to authorise all its messages. All potential recipients can be made

aware of the public key, because it can only be used to verify the authentication code and not to

generate it. One private key is therefore sufficient to send 'signed' messages to all a company's

banks (and in the case of EDI or e-commerce via the internet, to all its trading partners). If

symmetric keys were used in this environment, each new banking or trading relationship would

need an additional unique key and this would increase the complexity of key management and

control.

As different (asymmetric) keys are used to generate and verify each authentication code, this

approach uniquely identifies the originator and gives proof to the recipient of the sender's

identity. This prevents repudiation of the message by the sender, which will be of growing

importance as multiple banks' and trading partners' computer applications talk directly to each

other.

To be an effective facilitator of trade, a digital signature must be backed-up by a third party

willing and able to certify the identity of the holder of the private key. This third party 'certification

authority' – which might be a bank, a post office or other reputable organisation – checks

identity documents before issuing a 'digital certificate' (a piece of software containing the private

key).

Banks see the role of certification authorities as a potential new line of business for them in the

future internet-enabled environment. As highly regulated organisations they are trusted by their

customers and have wide brand recognition. A group of banks is co-operating to achieve this

and has set up ‘Identrus’, which will offer a globally interoperable PKI, with each bank issuing

‘Identrus’ digital certificates on behalf of its customers. ‘Identrus’ is just one of many PKI

initiatives currently being developed. See 20.27 for further coverage of Identrus. As national

governments roll out legislation making digital signatures legally acceptable, we can expect to

see a rapid expansion in the use of PKI, especially for business-to-business transactions. 

20.15 Smart cards and digital signatures

Smart cards are starting to be introduced in conjunction with PIN numbers to provide better

access control to systems as well as authentication of payments. The user must be in

possession of the right smart card and password to be able to access the system. In some

systems, the card reader can write back information to the card, thus, enabling 'session' or 'one-

time' passwords to be used. Smart cards can also be used in conjunction with message

authentication techniques (asymmetric keys) to apply digital signatures to payments. One

problem with smart cards is that they require a card reader to be fitted to the computer used to

access the service. Since readers are still relatively expensive, and since this requirement limits

access from remote computers and portables, this has impeded the large-scale acceptance of

smart card-based access control and message authentication.

20.16 Other standards

Some countries have implemented national security standards for payments. These present the

banks that operate cross-border with additional problems. In Europe for instance, France,

Belgium and Germany have all implemented national standards. As Europe becomes more of a

single banking market with the EUR, more national security standards may be announced as

local banks look for ways to construct new barriers. The major payment banks have already

developed the ability to import a payment in one format and to one level of security, process it

and to export it into a local clearing system in another format and to another level of security

using advanced reformatting techniques.

In the US there are various laws that impose standards on banks. The Uniform Commercial

Code Section 4, Subsection A (normally referred to as UCC4A) states that banks must offer

systems that include 'commercially reasonable standards'. Such standards now tend to include

authentication and encryption.

In general, the banks believe their EFT systems to be very secure. Any additional levels of

security will be expensive to provide, and may affect systems' user friendliness. However,

security and price are not the only things stopping treasurers using EFT products.

20.17  Things to consider for the future

Security experts have long hoped for low-cost, practical ways to uniquely identify individuals for

systems access management. Biometric techniques such as finger-printing, retina scanning,

face/voice-recognition have benefited from considerable research budgets and great progress

has been made over recent years in discovering not only what works, but also what is

acceptable to individuals. For the time being, finger-printing and voice-recognition appear to

offer the most potential and both of these are beginning to be incorporated into commercially

available software and hardware.

20.18 SWIFT standards for bank-to-bank security

No review of security on electronic banking products would be complete without looking at

SWIFT, the telecommunications and standards organisation owned by 7,000 of the world’s

largest banks. The vast majority of international interbank telecommunications use the SWIFT

network and, daily, several million messages - many of them funds transfer messages - are

exchanged between SWIFT members. SWIFT’s success as an organisation has largely been as

a result of five things:

the reliability of its network;

its scope in terms of geographical coverage, membership and transaction types;

the development of worldwide standards for financial messages;

its fair pricing policy and

its strong security.

SWIFT's goal is to provide reliable, secure and rapid communication between its members.

Financial messages are transmitted immediately with all verification and authentication

procedures being carried out automatically. There are currently about 150 standard messages

categorised into nine message types. Arguably the payment messages (the MT100 and MT200

series) are the most important.

The network is controlled from two operating centres, which in turn control regional processors

based in most of the countries where member banks operate. These processors act as

concentration points in each country. The operating centres provide message validations,

acknowledge receipt, store copies and control message receipt and delivery. In each country,

member banks are connected to their regional processor via public switched or private leased

lines.

It is a measure of the serious way security is viewed at SWIFT that their security administrator

reports to each board meeting on the status of security and control of the company' s systems

and services, as well as any matters relating to responsibility and liability including claims,

disputes and investigations.

SWIFT' s security policy sets out to achieve five things:

integrity - the authorised use of the network and the accountability of the messages

and the underlying transactions;

confidentiality - restricting the exposure of data during transmission, processing and

storage;

availability - to prevent and detect unavailability to users for any reason;

reliability - both in terms of the service conforming to users' needs and the physical

security of the assets necessary to keep the system operations and

accountability - informing users of any compromises to any of the above and to

assume liability where appropriate.

SWIFT security consists of a series of controls. These are technical, procedural, organisational

and contractual. These controls are a means to prevent or deter risks from occurring and to

detect, correct or recover from them when and if they do.

The controls cover four main areas:

the network itself;

the data transmitted through the network;

the control systems in the operating centres and

the environment in which those systems reside.

A chart summarising the controls, areas of coverage, security objectives and the applications is

shown in diagram 20.7:

20.19 SWIFT security and control policy

The SWIFT system has several levels of security built around 4 main functions: 

access controls. These are provided at three levels: system log-in; terminal access via

passwords; and physical access to the site;

authentication. This is regarded by SWIFT as the most important control for integrity

and legitimacy of financial messages. It guarantees that the message was sent by the

party identified in the message header and that it has been received correctly. This is

done through the use of one-time passwords based on message authentication rather

than direct exchange. As asymmetric keys are used, the authenticator can be

considered as a digital signature which authorises the transaction. This means that the

authentication keys exchanged between members should receive the highest level of

protection possible. In addition, end-to-end integrity ensures that messages are

received complete and correct, using message authentication to spot any transfer of

information that may have occurred during transmission;

encryption. End-to-end encryption software encrypts sensitive information before it is

stored. This means that users’ messages are, in fact, double encrypted (once by

hardware and once by software). Further optional layers of encryption can be requested

using bilateral ‘keys’ known only by the sender and receiver. As well as providing

privacy it helps protect check sums and authentication as well as traffic sequencing,

log-in functions and passwords. It also helps data integrity by failing to decrypt

corrupted data and

reconciliation. The system provides full reconciliation of messages sent and received

using sequencing features, end-to-end confirmation, status messages and online audit

controls.

SWIFT has automated the bilateral exchange of keys between members, which takes place

over the SWIFT network rather than using paper-based methods and makes use of asymmetric

algorithms. As discussed in section 20.14, these involve the use of a pair of keys, a public key

and a secret or private key. First, this enables data enciphered by a correspondent using a

counterparty’s public key to only be deciphered by the counterparty on receipt, by use of private

key. Secondly, the sender, in effect, signs the message using a secret key that only the correct

receiving banks can decrypt and verify. Such an algorithm is simple to use, provides

confidentiality, data integrity (because it is applied to the whole message) and non-repudiation.

Additionally, it does not require the exchange of a master key and is the only method which

totally precludes a network carrier from deciphering data.

RSA (named after its inventors, Rivest, Shamir and Adleman) is regarded as the state of the art

system in public key cryptography and this is the system SWIFT has chosen to use. This makes

SWIFT security standards similar to those used by the military and secret service organisations.

SWIFT also makes use of smart cards (or ICC’s - integral circuit cards - as they prefer to call

them) and secure card readers (SCRs) at user interfaces to the SWIFT network. Each card has

a programmable memory enclosed in a silicone chip embedded in the card. The card works

when it is inserted into a secure card reader. The SCRs used by SWIFT also have a simple

keyboard attached. Access to ICC functions is effected by keying in a secret personal

identification number (PIN) known only to the cardholder. Additionally, cards and the card

readers are tamper-proof. Access to the system is, therefore, only available to an authorised

user with a valid card and matching PIN number. SCRs can both store and generate secret

keys and SWIFT uses these secrets for authentication, certification, digital signatures and

encryption of data.

ICCs and SCRs are used for two primary purposes by SWIFT: for bilateral exchanges of keys

and for log-in facilities. This eliminates the disclosure of secret information to humans (it is all

machine-to-machine) and provides good security management at user installations at a cost-

effective price.

20.20 Security case studies [Non-examinable]

Hearing the worries expressed by some corporate treasurers about the security of electronic

banking services, it is interesting to recount how electronic banking helped prevent two

manually-initiated frauds. For obvious reasons, neither the bank nor the companies concerned

wish to be identified.

20.20.1 Case 1

The customer was an oil company that took an electronic balance and transaction reporting

system but, due to concerns about security, did not use the bank's EFT system, as it

erroneously thought this to be less secure than using manual instructions. An employee, using a

piece of headed note paper, instructed the bank to pay away funds to an account opened by

them for the currency equivalent of GBP1m. The letter appeared to the bank to bear the

signature of the usual officer authorised to give such instructions, so they made the payment.

20.20.2 Case 2

The customer was a pharmaceutical company. Although, for most of the year the bank account

had low credit or even debit balances, a large credit balance built up once a year. In past years,

an instruction was received to remit the balance overseas (presumably a remittance back to the

parent). Like the oil company, this customer took an electronic balance and transaction

reporting system and similarly gave written instructions to the bank on standard corporate

letterhead to make payments and transfers.

As in past years, an instruction was received by the bank to transfer the balance (some

GBP11m) overseas, but this year, the instruction was to an account opened by the fraudster.

On the face of it the bank had received a good instruction and made the payment.

20.20.3 The outcome

In both cases, the companies concerned not only took a real-time transaction reporting service,

but they also looked at the transactions across their accounts several times a day. Both

payments were spotted by vigilant treasury staff and the bank was telephoned and asked to

explain the debits to the accounts. It was then that both frauds were discovered.

Fortunately, both payments were made overseas on a spot basis (ie settlement two working-

days forward) so the bank was able to put the receiving bank on notice of the frauds and both

payments were returned.

20.20.4 The moral of the stories:

manual payments are often more insecure than electronic ones;

if you are using a balance and transaction reporting system perhaps you should get one

that gives current-day information;

if you take a current-day information service, look at it before the close of business each

day and

keep signatory lists in a secure cabinet.

20.20.5 Food for thought

If both payments had been made and not spotted until after the funds had been withdrawn by

the fraudsters, who would have been held responsible?

20.20.6 Case 3 'The lethal combination'

The Computer Crime Unit of the Metropolitan Police received a call from the managing director

of a well-known merchant bank. He was in possession of an anonymous letter stating that the

bank's computer manager (Mr X) had been stealing funds for some time through the money

transfer system and was using the SWIFT network to get the funds away. The letter finished

with a warning that the funds would not be traceable.

The police visited the bank and looked at the background of Mr X, who had worked for the bank

for many years and was married with a family. Looking at the controls to the bank's major

systems, it was apparent that there were few dual controls. As Mr X was at the top of the

hierarchy, he was able to gain access to any part of the system. The directors were largely

computer illiterate and had no access to, nor control of, any of the bank's systems. The bank

dealt extensively in eurobonds and most transactions were fairly large. The investigators

established that transactions below GBP25,000 were not subject to close scrutiny. They

therefore decided to investigate all payment transactions between GBP24,000 and GBP25,000

over the previous few weeks. As they needed access to the computer for this, Mr X was

requested to visit another building by the managing director on some pretext. The investigation

found three transfers between these figures each paid away via SWIFT, but which had to be

approved by the SWIFT supervisor. On making enquiries, the office gossip told one of the

investigators that it was rumoured that the attractive female SWIFT supervisor was having an

affair with Mr X.

The police decided to trace each payment through the SWIFT network. Each payment took the

same route: to a bank account in Belgium and then through various correspondents, eventually

ending up at a branch of a UK clearing bank situated 100 yards away from the merchant bank.

A bank account had even been opened there in Mr X's own name.

Within four hours of being called in, the police were able to confront Mr X with his crimes. He

admitted everything and was arrested. He said the reason for the crime was his relationship with

the SWIFT supervisor: she had expensive tastes in jewellery and lifestyle and all the money had

been spent on her. When the police went to interview the woman, despite being many floors up

in a high-rise office, she attempted to throw herself out of the window. The computer manager

was sentenced to three years in prison and the woman, who was found to be mentally

disturbed, was committed for treatment.

The money had come from the bank's nostro' accounts, which had not been properly reconciled

since an audit six months earlier. With such large amounts passing through the accounts each

day, relatively small discrepancies such as the amounts defrauded were not investigated by the

bank.

One last piece of advice from a senior police officer is well worth remembering: "Never put one

person in a position of total responsibility where nobody else understands what he is doing."

20.20.7 Case 4

A computer hacker, Vladimir Levin, from St Petersburg, Russia has been charged with hacking

into Citibank's EFT system and stealing amounts reported as being as high as USD13m.

According to the bank, they detected a first amount of USD400,000, and monitored the system

as further amounts were taken. The monitoring enabled them to report the fraud to the FBI and

trace Levin as the perpetrator. The fraud was committed by gaining access to the bank's

standard cash management system and by extracting funds from a number of financial

institutional customers' accounts. The level of knowledge that Levin appeared to have of

Citibank's systems raises speculation that there was some inside help. This, however has been

denied by Levin and his accomplices.

Access to Citibank's system was effected via a set of fixed passwords, rather than access via

one-time or variable passwords controlled from a device such as a Smart card. Using 'sniffer'

programs, hackers can monitor transmissions between customers and banks and pick up

unencrypted or poorly encrypted passwords and security codes which they can then use

themselves. This seems to be what Levin did.

20.21 The banker’s actions

Faced with the problems cited in these case studies, banks have three options:

tighten up internal and external security features;

tighter documentation which puts more responsibility onto customers and

insurance against fraud.

The second point is important, as banks seek to limit their liability to areas directly under their

control with their cash management documentation. However, some of the agreements if tested

might not stand up in court. As publicity of computer crimes is bad for both companies and

banks, such cases rarely reach the courts and some compromise on sharing losses is usually

struck where direct responsibility cannot be assigned to one particular party. In such cases, both

the bank and the company need to be insured against computer-related crime.

20.22 Insurance

The London insurance market, via Lloyd's, has several thousand banks that insure against

computer crime. A specialist underwriter in computer-crime insurance estimates that over 80%

of banks and financial institutions have a computer-crime policy.

Crimes committed by identifiable employees are covered by an overall policy known as a

banker's blanket bond, but crimes committed by unknown or third parties have to be covered

separately. Most banks buy a combined policy that adds a computer crime policy to the blanket

bond; without this 'add on' banks are only partly covered. However, the biggest risk that

underwriters perceive is that of infidelity by employees. Infidelity can mean anything from

handing the strong room keys to a burglar to committing a fraud through the use of a computer.

In the late 1970s, underwriters became concerned about computer developments in banks and,

in particular, electronic funds transfer systems. They therefore restricted cover for third party

crimes to the National Clearing House Association's payment systems in the US. This produced

a demand from banks for wider coverage, which resulted in the first Lloyd's computer crime

policy in 1981. The policy now has sections relating to:

third party manipulation of data;

computer instructions – ie coverage for deliberate programming-based frauds, the most

common known as the 'salami technique'; where each transaction has a few cents

'sliced off' which are posted to a secret account operated by the fraudster;

transmission - where the bank is passing funds transfer instructions through a network

or a clearing house;

erasure or loss of bank data. This area would cover virus attacks; and

electronic customer cash management products. The cover available under this clause

is related to a message being received and acted on by a bank that did not in fact come

from the customer, resulting in a loss to the bank.

Under the cash management clauses, banks are covered for fraudulent input, modification or

destruction of electronic data, where the perpetrator intended to cause loss to the bank or to

"obtain a financial gain for himself or another". Cover is also extended to banks arising from

electronic communications outside of their own systems. This would cover interbank

communications such as SWIFT, items originating from an automated clearing house or

fraudulent instructions received via telex or similar means which interfaced directly with the

bank's computer system.

Cover is currently available for up to USD200m. Although this seems high in comparison to

individual claims, if a criminal gains access to a branch of one bank, it is possible that he may

try the same at other branches. Some banks will assume a level of risk themselves, say the first

USD2m of any loss, with only larger amounts therefore recoverable under the policy. This

obviously reduces premiums, while protecting a bank's balance sheet from the larger potential

losses.

Banks wishing to take out such cover will be subjected to an independent appraisal of their

systems and their security procedures. Those that do not match up to the required standards

will not receive cover. So, in practice, it is the banks with the most secure systems that are best

covered.

20.23 Insurance for the company

Because the exposures that companies face are different to those of a financial institution,

Lloyd's has produced a similar, though less complicated, policy for companies. Such a policy

would typically cover:

the programming risk - where a systems developer commits a crime by deliberately

programming fraudulent instructions into the computer code;

malicious destruction of data - areas such as viruses are covered and

crime risks associated with the entry, storage and transmission of data within the

corporation and for links with banks (ie electronic cash management systems).

The company will need to cover internal crimes by employees as well as external attacks and

will need to consider an employee fidelity insurance policy as well as one for computer crime.

20.24  Enforcement

In the UK for instance, a National Hi-tech Crime Unit will become operational during 2001 to

provide law enforcement with the vision it needs to plan for the hi-tech future. According to an

article in Nexus, the magazine of the UK-based National Criminal Intelligence Service, the new

unit will work closely with the computer industry, research new technologies and trends in

criminal activity, provide intelligence via an intranet and play a role in developing national policy

on international issues.

20.25 Identrus

Created in 1999 by a group of commercial institutions, Identrus provides infrastructure for global

E-commerce. Identrus offers certainty about a trading partner’s identity in electronic business-

to-business transactions. Through a relationship with participating financial institutions,

companies are able to use the internet to conclusively identify trading partners and conduct

trusted business-to-business e-commerce with any other participant in the Identrus system.

Identrus provides authentication, non-repudiation, confidentiality and integrity. There are

currently sixty plus financial institutions acting as certifying authorities. Together they cover

more than 113 countries and millions of businesses. Identrus uses crypto-secured digital

identities (based on PKI technology), which are interoperable across a wide variety of vendor

technology, and real-time validation of those identities (ie authentication). In addition, Identrus

offers: 

assurance of digital identities through warranties (ie integrity); 

globally enforceable contracts binding all participants and

an auditable electronic information trail for dispute resolution (ie non- repudiation).

20.26 Eleanor Initiative

With the Eleanor project, Identrus aims to offer a global e-payments solution. Eleanor aims to

provide banks and their customers with secure domestic and cross-border e-payments, through

creating e-commerce equivalents of well established existing payment tools such as cheques,

letters of credit etc. It uses the underlying Identrus infrastructure to provide security of payments

to both parties executing a trade transaction via the internet. While Identrus provides the trust, ie

trading partners are certain that they are dealing with bona fide partners in a secure, confidential

and transparent environment, Eleanor confirms if a payment is going to be made as well as the

modalities and the timing of the payment. Eleanor fits in with existing bank and other providers’

e-commerce solutions. Eleanor offers providers and their corporate clients:

common standards and legally enforceable rules and resolution procedures that

guarantee certainty of payment across the globe;

open specifications (XML, PKI etc) that allow multiple but interoperable solutions;

different payment processing options enabling differentiation in the treatment of the

buyers in function of their credit standing, existing relationship, etc. This includes banks

providing, if required, payment assurance. Payments can also be made revocable or

conditional upon release of certain documents etc. There are currently six payment

options, mostly based on traditional payment instruments:

o payment orders (giro transfer/ACH credit);

o payment obligations (draft, promissory note, bill of exchange, trade

acceptance);

o certified payment obligations (bank-accepted bill, endorsed promissory

note, payment guarantee);

o conditional payment orders (payment subject to certain conditions, eg

delivery versus payment)

o conditional payment obligations (escrow payment, documentary

collection) and

o certified conditional payment obligations (letter of credit);

use of a trusted third-party, ie the participating banks, which certify identity and

creditworthiness of trading partner; 

enhanced straight through processing. Trading partners have pre-established

instructions with their banks for payment authorisation, routing and settlement; these

instructions are carried out in a transparent manner and

complete audit trail of all communications and transactions.

From a buyer’s perspective, the main advantages are:

access to a variety of payment options to satisfy any seller’s requirements;

improved cash management as payments can be timed precisely by the buyers;

improved trade risk management and dispute resolution via the use of conditional

payment facility and

payment and purchasing data can be bundled improving overall efficiency.

From a seller’s perspective, the main advantages are:

ability to diversify payment requirements to suit the buyer;

reduced credit risk through payment assurance;

ability to finance operations through the sale of payment obligations and increased

efficiency by bundling payment and purchasing data.

20.27  Summary – systems security

Although treasurers do need to consider security seriously, it needs to be put into perspective

alongside the other aspects that need to be considered. What could be less secure than a blank

chequebook lying around the treasury department, for example? Most of the current range of

treasury products and systems have very strong security features built in and to put them into

good effect only requires sensible precautions on the part of users.

Chapter 21 - Treasury and cash management systems

Overview

Against the background of the technical and security overview given in chapter 20, this chapter

covers the functionality of typical treasury management and cash management system (TMS)

as well as the electronic delivery of banking services. It makes some observations on the

process of selecting a treasury management system and describes the various banking services

required by a corporate treasury.

As discussed in chapter 20, the extent to which these various discrete systems are integrated

will depend on the overall systems architecture selected by the treasury itself.

In addition to the general overview of security in chapter 20, this chapter outlines security

considerations specific to the services under discussion.

Learning objectives

To understand:

A. The role of the treasury management system

B. Selection process for a TMS

C. Standard banking infrastructure for electronic banking

D. The banking services required

E. The different types of balance and transaction reporting

F. Different types of electronic funds transfer systems, including financial EDI

G. Other services which are delivered electronically

H. Enterprise resource planning systems

I. Foreign exchange portals

J. Electronic bill presentment and payment

21.1 The treasury management system

If you were lucky enough to be designing a treasury' s systems architecture from scratch, you

would almost certainly start by selecting a treasury management system (TMS). The treasury

management system would become the core system for recording transactions, monitoring

positions, analysing data and providing possible outcomes through decision support tools. It

would also link directly to other key systems, taking in bank account and financial markets data

from outside the organisation, and accounts payable and cash flow forecasting data from

internal entreprise resource planning (ERP) and other systems. It would keep track of your debt

and investment commitments, prompting decisions at rollover dates. It would generate deal

confirmations and pass funds transfer requirements to the payments system. And it would

generate all your treasury accounting data and other management reporting requirements

automatically and perfectly.

But, just as treasury departments reflect the very different requirements and cultures of the

businesses they serve, so too, there is considerable variation in the way that different off-the-

shelf treasury management systems handle and process data and the functionality they offer.

Often this will be a result of their provenance – a system that started its development in the

banking industry, for example, might place a heavier emphasis on the front office functions of

deal input and risk management. Another system, developed for the needs of an international

company, might offer stronger cash management capabilities. Some systems are rather basic,

while others require extensive tailoring ahead of actual implementation. And there is a large

variation in cost – in fact, when treasurers come to select treasury systems, they soon find that

the seemingly large number of available systems is quickly narrowed down as the market

segments into low, middle and high price tags! Of course, some treasuries still build their own

TMS in-house, though the cost of skilled IT professionals and the frequent requirements for

changes makes this a less popular option than it once was. And some smaller treasuries

continue to use a simple series of spreadsheets to record and monitor their transactions.

In the real world, your treasury management system will, inevitably, demand some

compromises to any grand plan drawn on a blank sheet of paper. There will be legacy systems

and less than perfect, pre-existing processes that have to be accommodated, trade-offs to be

made between efficiency and security and corporate IT policies and budget constraints to take

into account.

All this suggests that selecting a treasury management system is a complex and business-

critical decision.

In this section through to section 21.4 we suggest some of the choices that those selecting a

treasury management system will face, as well as a methodology for project managing the

selection process. Many of these observations also apply to the selection of electronically

delivered banking services, which are described in the second half of this chapter.

21.2 Why a new system

Usually, a decision to purchase a new treasury system will be the result of some major market

change. For example, some companies preferred to buy a new system rather than try to ensure

that their old one would operate properly after the 2000 date change. For US-based treasurers,

the need to comply with FAS 133 requirements has prompted a rash of new TMS purchases.

Other factors that can motivate companies to invest in a new TMS are restructuring, (this might

involve the setting up of a centralised treasury unit servicing all subsidiaries) mergers or

acquisitions or even the arrival of a new finance director or treasurer.

Whatever the reason, it is worth thinking carefully before making a change, not only because of

the cost involved but also because of the potential disruption caused by a lengthy

implementation process.

21.3 Technology choices

Hopefully, the choice of system will not be dictated by the technology platform, but it will still be

important to give some thought to this at the outset. Two vital questions are:

with which existing systems (outside as well as inside the treasury) will the TMS need to

integrate and

do standard interfaces exist?

The selection of a new system allows an opportunity to take advantage of technology

developments, which may improve functionality or make communications cheaper and easier.

The obvious development here is the potential to provide browser-based access to the

functionality required by subsidiaries and others. Treasurers might also want to consider

whether or not to implement remote access from mobile phones or laptops for deal input or

reporting purposes.

Another important technology consideration is the developing application service provider (ASP)

market. ASPs host services that can be accessed remotely (usually via a browser and the

internet) as an alternative to licensing software for internal use. These services are particularly

suited to smaller companies, which may not have access to the capital required to licence

software. Another advantage of ASPs is that the technical requirements of running a TMS such

as systems maintenance, back-up and upgrades are effectively outsourced. That said, the

treasury needs to ensure that service level agreements are in place that provide at least the

level of reliability and responsiveness that could be achieved by licensing the software.

Treasury systems providers and some third party service companies are making a strong play in

the ASP arena but their solutions are, at time of writing, rather new and unproven.

(These choices, as well as some of the resulting security implications, are also covered in

chapters 17 and 20).

As a rule, a TMS should provide the following benefits:

eliminate as much manual processing as possible and thereby minimise the risk of

errors;

optimise cash management;

record all treasury activity;

improve risk management and

provide seamless integration with other systems such as accounting, ERP and payment

netting systems.

If necessary, a TMS should also be able to generate separate data for subsidiaries using the

group treasury centre.

21.4 Cost of TMS system

Buying, implementing and maintaining a TMS represents a major investment for a treasury,

whatever its size. However, despite the high level of investment required, it often remains

difficult to establish the true cost of a TMS system or compare pricing. There are various

reasons that prevent transparent pricing:

functionality can differ substantially from one system to another, even within the same

price bracket; 

some TMSs adopt a modular approach, whereby modules are added to match the

client’s requirements, making it difficult to compare with TMSs that provide the main

functionalities from the outset and 

given the size of the investment, there is scope for price negotiation, with the extent of

discount on offer varying from supplier to supplier.

In addition to obtaining a true estimate of the cost of implementing a TMS, treasurers need to

cover all components of the process. This includes not only the licensing fee for the system, but

also the maintenance cost charged by the supplier for ongoing maintenance and support. The

other main cost is selection and implementation of the TMS system. Selecting a system, be it

effected in-house or with the help of external consultants, is time and resource-consuming. The

implementation cost can also be significant, depending on the degree of customisation.

To complete the picture, prospective buyers need also to compare the cost of buying a TMS

with the cost of using an ASP provider. Again, there are considerable difficulties in comparing

functionalities and pricing, but, whatever the final outcome, there will have to be a trade-off

between on the one hand functionality and customisation and pricing on the other.

21.5 Managing a system selection

21.5.1 The project team

Selecting a treasury system requires detailed project management and the attention of a

dedicated project team, which should be:

representative of all the eventual users/beneficiaries of the system; 

led by a project manager and

given the authority needed to get the job done.

21.5.2 The selection process

Although the company’s ‘big picture’ will inevitably be compromised, it is a good idea to have an

ideal goal in mind. To make sure the ideal really is that, the project team needs to look at the

company’s treasury activity from a long-term perspective in order to accommodate future as well

as current needs. This should cover items such as treasury structure, banking arrangements,

cash and liquidity management, risk management etc. It is also important to canvass the

opinions of other stakeholder areas (accounting, IT, compliance etc.) within the organisation,

both at group and subsidiary level. The project team should also seize the opportunity to review

existing working methods and, where necessary, propose improvements that can be integrated

into the new system. This kind of brainstorming may provide some good ideas, which turn out to

be perfectly achievable!

21.5.2.1 Requirements definition

The initial brainstorming will be followed by a detailed evaluation of requirements. The project

team will find that they need to ask questions of all the different players involved – the treasuries

front, middle and back office functions, subsidiaries, senior financial management, accounts

payable and receivable and possibly even the company’s banking partners – to get a clear and

complete view of the business needs.

21.5.2.2 Pre-qualifying round

Once the exact requirements have been identified and documented, it is preferable to preview

the market to narrow down the number of suppliers that need to be approached. It might be

feasible to do this through desk research, although some first round demonstrations are

advisable. Visiting an exhibition or conference is a good way to pick up a lot of information (and

brochures!) in a short time and the web allows anonymous research of the individual

companies. One aspect treasurers need to consider now and later is the ‘staying power’ of

potential vendors. Do they have a track record in the business? What level of investment are

they making in research and development? Who are their major clients? What is their financial

standing? How do their fees compare, taking into account the different pricing elements as

defined in section 21.4.

21.5.2.3 Request for proposal (RFP)

The request for proposal is a formal document to which those approached should respond by a

given date. It needs to be carefully designed to ensure responses contain sufficient detail to

allow a useful analysis so that the company can start to distinguish between the different

offerings. It is important that responses should be tailored to specific questions instead of

inviting large quantities of generalised or insufficient data. Questions should cover, among

others, all aspects of pricing (both start-up, maintenance and update/add-on costs), degree of

support and training on offer during and after installation, technical questions on the systems

and the way they operate. It is of course essential to provide respondents with a precise

description of your needs and the existing system environment with which the TMS will have to

interact. A number of targeted questions should ascertain the extent to which a supplier is able

to answer each of your needs, including the supplier’s ability to link in seamlessly with your

existing accounting and other systems.

21.5.2.4 Analysis

Analysing the responses will usually be carried out using a score-card to determine which

vendors meet which requirements most closely. At this stage, the company should also be

starting to further prioritise its requirements and distinguishing between ‘essential’ and ‘nice to

have’ attributes.

21.5.2.5 Shortlist

Once a shortlist has been determined, the selection process will become intense. To get a real

sense of what a system can do, it is of course vital to have live demonstrations of the system’s

capabilities. As a first step, the project team and some of the end-users might want to see the

different systems operating on a stand-alone basis without allowing suppliers time to prepare or

customise the system. In case the RFP responses are not in themselves sufficient to determine

the shortlist, the project team might decide to hold this ‘impromptu’ demonstration round prior to

drawing up the shortlist. However, only the shortlisted suppliers should be asked to provide full

and detailed demonstrations of the systems working with the company’s own data. Setting this

up will require a little work. The team will need to decide on the tasks it wants to see

demonstrated, design a standard script that can be used with each vendor (to ensure fairness

and a comparable result) and send them the data, reports, etc to be processed in good time

before the demonstration date.

The team will have to set aside a full day to see and appraise each demonstration. Remember

also to consider integration issues and future plans as well as ease and speed of use. In this

context, the project team might want to ask suppliers to put them in touch with existing users.

21.5.2.6 Selection

As well as the technical requirements, the team will now need to negotiate all the contract

details, including the vital issues of support during implementation and beyond. By this time

implementation itself should be discussed both internally and externally with the vendors. The

following questions should be addressed during those discussions:

what will be required;

which and how many people will be needed;

how long will it take and

what is a reasonable testing and parallel running schedule?

Prior to signing a contract, the project team will also need to check that all required

documentation is in place. Most of the documents will already have been provided by suppliers

during the RFP and tender process, but the project team, with input from the legal department,

will have to ascertain that issues such as warranties, accurate description of the system and its

functionalities in light of the proposed activities, consequences of failure or delay, liability issues,

conditions of payment, contract termination procedures, damages etc. are documented in a

satisfactory manner.

21.6 Implementation

As with the selection process, implementation will require dedicated project management skills

and very careful planning to ensure not only a successful system installation but also seamless

interconnectivity with existing systems, including accounting and electronic banking systems. All

existing data need to be migrated and, where appropriate, new templates have to be set up. It is

also important to provide the necessary backup in case of failure. Last but not least, special

attention should be paid to the security implications of installing a TMS (see section 21.7). Once

implemented, the TMS system needs to be tested thoroughly before going live. Staff needs to

be trained and all procedures throughout the implementation process need to be documented

so as to provide staff with clear and up-to-date user guidelines.

The implementation process should, of course, not be allowed to interfere with the normal day-

to-day running of the treasury and subsidiary operations. It is, therefore, important not to have

over-ambitious targets for the implementation or to make excessive demands on valuable

members of staff. Periodic reviews against a detailed project plan with clear objectives should

ensure the implementation process is finalised within the agreed timescale and budget.

21.7 Treasury management systems: security considerations 

Although most treasury professionals would undoubtedly agree the need for stringent security

on transaction initiation systems, few would regard security as a major issue when it comes to

treasury management systems (except where the software incorporates a transmission or

communications module). Treasury management systems are in essence a database of

treasury transactions and positions. These systems range from no more than a few simple

spreadsheets to sophisticated integrated packages costing several hundred thousands (or even

millions) of USD and residing on large mini or mainframe computers.

Although obvious protection such as physical keys and logical passwords can be put in place to

stop the trainee from reformatting the PC' s fixed disk and destroying the database, other areas,

such as the segregation of functions, need to be considered.

It should be possible to separate functions such as transaction input, settlement instructions,

printing standard reports, production of special reports, system maintenance and audit reports.

Although such separation is available on most of the systems currently on the market, it is fair to

say that such features are often badly-used by companies and generally access-control

procedures to treasury management systems are weak. It is still possible, on the cheaper

systems, for a programmer or hacker to break the security of the database and to be able to

ascertain the names of all the users to the system and all their passwords.

Why is the control of access to treasury management systems generally weak? There appear to

be three reasons:

firstly, as users are not able to commit actual fraud on treasury management systems,

(unlike transaction initiation systems) security has never been considered a high

priority. Customers and suppliers alike have discounted the problems that a rogue

member of staff could damage the database if he set his mind to it;

secondly, both suppliers and customers have always given speed of access to the

information on the database as a priority. Security precautions can only reduce speed

of access and

thirdly, and probably most basically, many companies access the TMS via PCs or

terminals; continually having to log-on and off is considered an unnecessary burden in

a busy treasury department.

Adequate back-up and a contingency plan for systems failure or other disasters are also

advisable.

21.8 Impact of browser technology on treasury management system

Most suppliers are now able to provide web-enabled treasury management systems. These are

particularly suited for companies that maintain a decentralised treasury structure at subsidiary

level as well for global companies with regional treasury centres. However, even companies that

have a centralised treasury approach are increasingly looking for web-based features that allow

subsidiaries access to a limited number of functions, such as cash forecasting or multilateral

netting. In combination with eXtensible markup language (XML), which allows for overall system

interconnectivity, web-enabled TMSs should help treasurers to achieve greater straight-through

processing throughout their company network. (In section 21.20, we provide two case studies of

major companies that have implemented a web-based treasury management system).

21.9 Banking services

21.9.1 Customer access

Diagram 21.2 illustrates the range of banking services that a corporate treasury service may

choose to receive from one or more banks. In this part of the chapter, we will focus on cash

management services including payments.

Banks do not allow customers direct access to their application system but put another system

in between, usually referred to as the ‘electronic banking platform’. For account data, customers

access copy records. For payments initiation, (discussed below) the electronic banking

computer/platform provides authentication (see chapter 20) and reformats and routes

transactions to the correct application system.

Diagram 21.3 shows a typical connection via a dial-up line from a user’s PC. The vast majority

of corporate users access banking services from a PC loaded with bank-supplied, Windows-

based software via a dial-up or leased line. However, web-enabled corporate banking services

are now becoming available. These enable an authorised user to access services from a

standard browser, via the public internet (or sometimes, via a dial-up or leased connection) as

illustrated by diagram 21.4. In some cases it is still necessary to load a bank-supplied program

onto the user’s PC, such as an additional security application.

21.9.2  Balance and transaction reporting

Balance and transaction reporting is a key cash management service offered by banks. It can

be delivered to various levels of timeliness:

intra-day information and

start of current day information;

intra-day information and

real-time information.

21.9.2.1  Previous-day information

This is the basic service available from most banks. It provides details of activity across the

account and balances for the previous working day. Some banks that can offer better standards

domestically may still report information from overseas locations on a previous-day basis.

Many larger companies with active accounts regard this level of reporting to be inadequate for

their needs.

21.9.2.2  Start of current day reporting

Care needs to be taken with this standard. It will normally provide full details of the previous-day

activity and information on items that will be debited or credited to the account today via the

early sessions of the automated clearing. This service can cause confusion because it only

reports items passing through the automated clearings that were processed the previous

evening for posting value date the current day. Such reporting will not include:

items that failed auto-clearing (cheques and credit transfers);

manual items which could not clear automatically;

returned/unpaid items (cheques, direct debits) that will be debited to the account during

the day;

any items paid in at other banks/branches on previous days but failed in the course of

clearing and

items passed across accounts during the current day (eg items processed across the

counter).

21.9.2.3  Intra-day reporting

This will provide details of activity posted to the account during the current day, updated at pre-

arranged intervals throughout the working day.

21.9.2.4  Real-time reporting

This is offered by more advanced banks with real-time accounting systems or journals where

each item across the account is automatically reported to the electronic banking computer and

is immediately available to customers.

Although real-time reporting sounds attractive it needs to be put into context:

does it cover all items that might be posted to an account during the day?

does it cost more?

does the company really need real-time reporting from non-domestic locations?

does it add confusion in terms of internal corporate cut-off times for daily positioning

and investment/borrowing decisions? and

does it really add value to the treasury?

21.9.2.5  Bank information reporting systems: security considerations

The main requirement for these systems is not security but privacy. However, most banks

transmit information in plain form (not scrambled) and rely on error-correcting modems to

ensure that there is no data corruption. Access to such systems is normally granted at 'two

password level', ie the user inputs the identification for the organisation, a personal ID and

password to enter the system and, in some cases, a further password linked to the service

required within the system.

On some systems, users can be restricted by codes to view only certain accounts or to retrieve

only certain levels of information. Newer systems transmit encrypted files to users' PCs and the

bank-supplied software decrypts the data for reporting on users' PCs.

21.9.2.6  Coverage

Balance and transaction reporting may only be available from accounts held with the bank

supplying the system, although increasingly banks can report their accounts into other banks'

systems using data exchange networks or SWIFT. In the latter scenario banks will use the

SWIFT message standard case MT940 (as discussed in chapter 7.10)

Likewise, some bank systems will provide details of domestic, international or cross-border

activity via the same system. With others it may be necessary to take two systems (one

domestic and one international).

21.10 Collecting bank account data globally

21.10.1 Glossary of data exchange terminology

Before discussing multibank reporting it would be useful to recapitulate or introduce

the definitions of some of the terms used:

BAI Bank Administration Institute. A US-based institution that provides standards for

financial transactions.

SWIFT Society for Worldwide Interbank Financial Telecommunications. Organisation

owned by over 4,000 banks that provides a communications network and message

standards for interbank transaction or customer transactions passing bank-to-bank.

MT940 A SWIFT message type used to transmit a customer statement from one bank to

another.

MT950 Message type designed to send a bank brief details of its own account with the

sending bank (less detailed than a 940).

MT 100 Customer to customer payment sent between two banks where the sending bank’s

account with the receiving bank is debited. The MT100 message is currently being

phased out in favour of the new MT103 message type;

MT101 Customer to customer payment where an account owned by the customer with the

receiving bank is debited.

MT103 MT103 is an extended and structured version of the MT100, which it will replace by

November 2003;

MT210 Advice to receive message. Informs a bank that it will receive funds from another

bank to be credited to a customer’s account.

EDIFAC

T

International standard for EDI (electronic data interchange) developed under the

aegis of the United Nations.

ASC X12 US domestic standard for financial EDI messages.

VAN  Value-added network. A telecommunications network provider that can also

provide some processing or additional services (eg data exchange or reformatting).

21.10.2 Multibank reporting

Data collection lies at the heart of a company’s cash management system. The main differences

between companies’ cash management systems and procedures largely depend on the sources

and timeliness of their information. Some independent-minded treasurers believe that all the

information needed to manage their cash effectively already resides within their own systems

and that, by optimising the use of that data little or no use needs to be made of bank provided

data. However, these treasurers are in the minority. Most feel that to be able to manage their

cash on a global basis, up-to-date and accurate details of bank account balances and account

activity is a must. As few banks, even those with a reputation for cash management, can

provide a full banking service competitively in all countries, most major companies use several

banks. Whilst this may make sense in theory, in practice it can cause difficulties when it comes

to the collection of account data. The multibanked company has four options available to it:

buy an electronic reporting system from each bank it uses;

buy a software package known as ‘poll/parser’ (see section 21.10.4);

take a reporting service from a lead bank and get other banks to report into it or

take a data feed direct from a data exchange vendor and request all banks to report into

it.

The choice depends much on the company’s requirements and its banks’ capabilities. At

present, many banks can only provide account information as at the close of business the

previous day. Some can provide an early morning list of items that are due to hit the account

from the clearings during the day and a few can provide intra-day updates, where information is

refreshed two or three times during the day. Bearing in mind that many banks post transactions

to customers’ accounts on a batch basis, such facilities are often of limited value. A few of the

major banks offer real-time reporting globally where the information database is updated

seconds after a transaction has taken place.

Those companies that need either real-time or intra-day information would be best advised to

take a direct service from their major banks, possibly using a poll parser (see section 21.10.4),

as real-time or intra-day data exchange is not a current option. Current-day data exchange is

well established in the US but not elsewhere.

For those companies that only require end-of-day reporting, an electronic reporting service from

each bank should not really be necessary. A system supplied by a lead bank, or a data

exchange service (discussed in sections 21.10.5 and 21.10.6) that all banks report into (usually

by the intermediary of a SWIFT MT940 message), would be a more suitable solution.

21.10.3 Use of several electronic banking systems

A multibanked company which decides to take several banks' reporting systems often finds that

a member of staff is doing little else other than logging-on to the banks concerned, down-

loading information and (probably) printing it out. Because each bank provides its data in a

different format, standardisation requires manual intervention or feeding the information into a

spreadsheet package. This method of data collection is people-intensive and time-consuming. It

may often be quite late in the day before the treasurer is able to ascertain his complete position

across the region: often too late to act on any surpluses or deficits on a same-day basis.

21.10.4 Use of multibank poll/parser or cash management workstation

Many multibanked corporations continue to buy a separate balance reporting system from each

of their banks, but use a software package known as a multibank poll/parser to access the

service. This software will call each bank in turn, log-on to its cash management service and

automatically retrieve account data (polling). The data collected will be written to a file and then

‘parsed’ into a standard format for reporting purposes. These packages are available from

specialist software houses and some banks. A number of treasury systems also have modules

that provide this function. Some products also have the facility to take a file from the customer’s

own accounting system and to provide auto-reconciliation. The most widely known multibank

workstation in Europe is ‘Multicash’. Developed for banks by an independent German software

house, ‘Multicash’ is available from banks or software houses and now provides the standard for

all bank-reporting services in Germany and some Eastern European countries with similar

banking systems. Additionally, GEIS, GPS (formerly NDC), Fides and Banklink, the principal

cross-border data exchange companies, have built links to enable non-German banks to

provide data to ‘Multicash’ users.

21.10.5 Using a lead cash management bank for data collection

As the leading providers of cash management services in Europe, the major US banks tend to

be the major deliverers of other banks’ data to those companies where they are the lead cash

management banks. Many hundreds of banks report account data into these banks each day;

this is then delivered (with information on their own accounts) to a large number of companies

across the region. Most banks will report into the lead banks through the SWIFT network using

MT940 standard messages. However, they will accept the less detailed MT950 standard or take

information via the data exchange vendors. At present, most reporting into the lead banks from

other banks is done on an overnight basis. Meanwhile, as mentioned in section 21.10.1, the US

banks themselves offer real-time account updates on their own accounts.

Some banks may be reluctant to report their client activity to another bank. However, when

faced with the risk of losing a valuable customer, most are prepared to set aside their

reservations on data exchange (DX). The main worry of less sophisticated banks is that the

receiving banks will have access to the data that has been sent. Most banks have strict security

procedures to prevent staff looking at customer data - even data from its own branches - and

such areas are regularly checked by bank internal audit teams. Some banks are reluctant to

data exchange (DX) because they do not have the automated capability to do it and the less

sophisticated ones fear that providing such information will encourage customers to draw off

funds. Some banks have also had bad experiences.

21.10.6 Using VANs for data exchange

The main value-added networks involved with bank data exchange are General Electric

Information Services (GEIS), Global Payment Services (GPS, formerly NDC), Banklink and

Fides. Information from international banks can be sent to the data exchange companies in BAI

(see section 21.10.1) or SWIFT format. Additionally, Fides can handle the French format -

ETEBAC. In addition, EDIFACT now provides a basic standard for both account reporting as

well as transaction initiation, which all DX providers will have to add to their services. DX

companies use a variety of VANs. For example, GPS is now network-independent and uses a

variety of networks. Banklink uses GEIS, others use BT Tymnet and SWIFT. Fides, the Swiss

financial information services company which provides similar capabilities, joined forces with

Scitor, the airline-owned telecommunications network and can deliver a whole range of treasury

services including foreign exchange and interest rates. GEIS itself provides the network for

much data exchange activity in Europe, as well as providing private networks for electronic

banking services. Increasingly, major corporate treasuries need to use a network themselves for

the receipt and delivery of information from and to subsidiaries. Thus, they are turning to private

networks to provide reliable and secure services to the treasury sector both for information

transmission and transaction delivery (and are looking to the same companies that the banks

use).

In the past, companies have always had to buy their data exchange services via banks, which

delivered the information through their proprietary electronic banking systems (in the same

manner as direct bank-to-bank data exchange). Now, most DX providers can deliver data

directly to the end user. This benefits the large corporate user in several ways. DX companies

can provide companies with a multibank file that they can take straight into their systems.

Intermediate banks provide little additional value in delivering other banks’ data and in some

cases, where a bank’s own reporting systems are rudimentary, information from other banks

could be truncated. Moreover, delivery via an additional party can potentially add expense,

delay in availability and constitutes one extra link in the information chain that could go wrong.

On the other hand, using a lead bank’s electronic reporting system and obtaining data from

other banks via a data exchange vendor also makes major companies ‘bank-independent’ to a

large extent.

More sophisticated banks no longer compete with each other in providing balance and

transaction reporting services. They compete in terms of the quality of the information provided,

its level of detail and its timeliness. Without doubt time is money: there is real value to a

company in knowing that EUR100m has arrived in their Brussels account at 11:00. This enables

the company to invest those funds a day earlier than if they had had to rely on a close of

business reporting service. Few banks can provide intra-day updates to other banks, even

though DX services are available 24 hours a day, 365 days a year and can take as many

updates as the banks are prepared to send. Potentially, updates could be available to

subscribers virtually instantaneously. Moreover, incoming data is usually free to deposit - the

client pays when they collect it from the database.

The next logical step would be to add multibank, multi-country payment initiation to DX services,

subject to suitable security arrangements. Some vendors and banks are offering this service

and companies that want to use such facilities will need to make specific arrangements with

their banks. Some banks will be less than enthusiastic about the idea. This will allow the

corporate treasurer true one-stop shopping for multibank data collection and payment initiation -

something many large companies have been asking for since electronic banking was introduced

into Europe in early 1980s.

21.10.7 Via the internet?

In the very near future it seems likely that treasurers will be able to access multibank data via

the internet using browser-based services. A number of so-called ‘portals’ already exist where

companies can access different providers through a single, internet-enabled window and some

of these portals are actively exploring the potential to make cash management services

available by the same route.

21.10.8 Other data available

Details about current account activity can be complemented by a range of other data including:

deposit and loan account details (with accrued interest);

outstanding foreign exchange contracts, letters of credit and bills;

custody portfolio and other reporting;

exchange and interest rates;

pooling data and calculations and

central billing or account analysis (ie, bank charge calculations).

21.10.9 File export facilities

File export facilities increasingly enable a routine to be set up so that data can be exported

(some automatically and directly) into spreadsheets, treasury management systems or

database systems for use in further analysis.

21.11 Electronic funds transfer

21.11.1 Types of payment

There are a number of different types of payments that can be initiated remotely via a bank

service. These are the main types of transaction initiation products available:

advice to receive messages (not available from all banks);

inter-account transfer (same entity, also known as a book transfer);

same-bank transfer (third party);

domestic fund transfers (urgent or non-urgent);

international funds transfers (urgent or non-urgent);

draft issuance;

direct debit initiation;

issue of advice to receive messages and

remittance advices.

21.11.2 Advice to receive

Advice to receive messages have traditionally been used by banks and financial institutions to

advise other banks of the pending receipt of funds to enable the receiving bank to do two things:

position the funds - so that value dates are respected and interest can start to be paid

from the value date and

to put the bank on notice that a payment is to be received (via MT103) so that, if it is not

received, the bank can advise the beneficiary of non-receipt.

Large companies are now using advice to receive messages (MT210) in a similar way and

triggering them using the EFT modules of the major banks.

21.11.3 Payments system data capture

Payments systems can be of three generic types usually referred to as:

online interactive;

offline batch and

browser-based.

The online interactive payment system data capture is now regarded by many as old fashioned

and involves using a PC or terminal to conduct an interactive online session with a bank’s

mainframe. This process requires long sessions connected to the bank, resulting in high

communications system costs for the company and a need to install larger banks of modems to

cope with access requirements for the bank. Consequently, this method is seldom used

nowadays.

The offline batch method enables all processing, including authorisation, to be carried out via a

PC. Only when the payment is to be transmitted to the bank is a communications link

established. This means shorter communications sessions with high-speed exchanges of files

and, therefore, lower cost. This is the main method used by banks at present.

Few companies are currently using browser-based systems for more than occasional payment

instructions, although files of formatted instructions could be sent via the internet, with the

necessary security in place (see chapter 20). However, the development of XML will make it

easier to send structured messages over the internet. As a result of these technological

advances, online interactive processing could again become the major communication method.

21.11.4 Repetitive or predefined beneficiaries

21.11.4.1 Predefined

Many systems enable users to establish a set of predefined beneficiaries in a library and to

restrict usage of this library. The library is always installed on the user's system in the case of

the offline version, but may reside either on the customer’s or the bank's system for online

interactive or browser-based systems.

Once set up, a user calls up a template and only needs to input the non-static data: currency,

amount, value date and references. The approval and release of payments from such systems

must be treated in much the same manner as for one-off payments (see section 21.11.5).

21.11.4.2 Security considerations

This type of facility restricts the user to initiating payments to pre-authorised beneficiaries.

Details of the beneficiaries and their banks have been pre-advised and reside on the bank’s

mainframe computer. After entering all relevant passwords, the operator merely calls up the

detail on his PC screen and is only able to enter the amount, currency and value date of the

payment and references. Beneficiary information, bank account details, etc cannot be altered.

A second check, either by sight verification (visual check on amount, reference etc) or by key

verification (where the authorising person cannot see the amount, must key it in again ‘blind’

and the system checks that both inputs match), is usually available if required.

Repetitive offline systems are not necessarily designed with security in mind, but ease of use (ie

to input and approve a large number of payments as quickly as possible). In many systems of

this type, all information is changeable and the ability to set up new repetitives can be made

available to any user by the system administrator.

21.11.5 Random or one-off payments

This module enables users to authorise a beneficiary and immediately trigger an EFT to his

account in one process.

Some users may be denied access to this facility by their user profile. Often only senior staff will

be allowed access. Increased signing powers or extra staff may be required to trigger such

payments as they represent more of a threat to security.

The ability to make one-off payments is usually made available by the system administrator to a

few senior treasury personnel for convenience and often as an additional function to the

repetitive function, (ie the same system performs both functions). The level of security should, at

the very least, separate the input and verification between different staff and possibly delegate

authorisation and the release to the bank to a third person.

Often funds transfer systems also have the ability to import payments from other systems used

in the treasury or accounting department (eg accounts payable, netting system, treasury

management system for settlements) and the import function can also be specifically assigned

to certain individuals.

Importing payment data, possibly from systems operating in a less secure environment,

demands an additional security feature to ensure the secure transfer of data from the exporting

system into the payment system. Some systems have established formal links (ie bank and

treasury or accounting system suppliers co-operate), in others the links may be self-built.

Systems using ‘Windows’-based technology make this very easy.

21.11.6 Inter-account transfers

The level of security for inter-account transfers does not have to be so stringent as for third

party payments. Many bank payment systems have special functions or transaction codes

relating to account-to-account transfers and a set of parameters that enable internal functions to

be separated from the external transfer of funds. Inter-account transfers are usually delegated

to fairly junior members of staff, but a secondary approval mechanism is usually also available

to prevent mistakes rather than lapses of security.

21.11.7 Payment system configurations

Old payment initiation systems gave little thought to user-friendliness and it was not unusual for

a bank to offer either a series of payment initiation systems or several modules, one for each

type of payment (usually because of system constraints in the supplying banks). Diagram 21.5

shows the architecture used by more proactive banks. Through a single payment module, a

user can make a decision on the input screen as to which method of payment will be used. A

billing system sits behind this system as each payment method will be charged differently.

Users find this style very convenient and user-friendly.

21.11.8 Multibank payments

Some bank systems enable users to trigger payment instructions to other banks. These are

converted on receipt at the lead bank into SWIFT messages (using a MT101 message

standard) and pass through the SWIFT network to the account holding bank. The account

holding bank will hold a standard instruction from its customer authorising it to action such a

payment, and on receipt of the payment message will debit the instructing customer’s account

and make the payment on their behalf.

21.11.9 Payments system security

All types of electronic payments systems discussed in section 21.11 should also have the

following further characteristics in common:

a unique ID and password for each user;

message/transaction authentication facility and

an audit trail that details exactly who did what and when and is capable of being

available only to a specified user.

After transmission, an acknowledgement of good receipt by the bank must be received back by

the customer, preferably including a unique reference attached to the payment for tracing. This

reference should appear as part of the debit transaction reference on the debit party’s

transaction details, be they reported via paper statement or electronically, to aid reconciliation.

21.12 Financial EDI

21.12.1  What is financial EDI?

EDI is the exchange of business related data between trading parties. This does not involve

banks and may relate to the purchase and sale of goods. Financial EDI involves banks and

companies working together to make payments and deliver financial data relating to such

payments via a value-added network (VAN) in a standardised format, usually EDIFACT in

Europe or ASC in the USA.

Most banks regard an EDI payment order as being different to an EFT payment. They are in fact

virtually identical except that the EDI payment order has more remittance detail than is allowed

with a standard EFT. Consequently the banks have separate 'products and services' for

financial EDI.

There are two approaches:

bank provides stand alone PC-based software and

company uses its own software and bank merely provides ‘hand shaking’ and

authentication facilities. The company then transmits EDI payments and advicces direct

to the bank’s computer.

In the US, most financial EDI transactions move through the banking system like standard

payments with the remittance details attached. In most European countries, due to old clearing

system technology, the payment and data elements are separated by the banks and are

delivered separately, usually through the intermediary of a VAN:

In diagram 21.6, the sender sends a file of payment orders to the bank. The bank separates the

payment and the remittance detail. The payment is processed through the clearing system

(usually the ACH – low-value clearing) and the remittance detail is sent to the receiver through a

value-added network. The receiving bank will advise the receiver of the payment and they will

reconcile this against the remittance detail received via the VAN. Non-EDI capable receivers

can normally persuade the bank to send remittance details in hard copy format through the post

for manual reconciliation.

EDI has been adopted mainly by large corporations, which have been able to impose their

preferred trading method on smaller companies. Some of these large corporations have made

considerable investments in EDI and look set to continue using these systems for some time to

come.

Smaller companies, unable or unwilling to invest in the software necessary for EDI, are now

looking to e-commerce (using a browser and the internet) to achieve the same and even greater

efficiencies for their businesses.

21.12.2  EDI payments: security considerations

Interestingly, EDI has proved the testing ground for the security processes and tools critical to

the development of ‘safe commerce’ via the internet. The major threats that have been identified

for EDI primarily relate to message security of ‘application-to-application’ transmission between

trading partners. This concept of security between applications is very important as it gives the

ultimate recipient of a message confidence that it was sent from the stated originator without

modification, even though it may have been handled by third parties during transmission. The

development of public key infrastructure using digital signatures (see chapter 20) has helped to

secure both financial EDI messages and orders and payment instructions via the internet.

21.13 Reconciliation

Two types of reconciliation systems are available from banks:

cheque reconciliation and

full account reconciliation

21.13.1 Cheque reconciliation

Diagram 21.7 illustrates the cheque reconciliation process :

Step 1import of a file from automated cheque runs or manual keying-in of data from cheques

issued;

Step 2 automatic matching of cheques issued data against cheques presented data (from

electronic balance reporting);

Step 3 production of reports highlighting:

- cheques paid;

- cheques yet to be presented and

- mismatch report. This is the most important as this would highlight

possible encoding errors or, worse still, attempts to alter cheques

fraudulently and

Step 4 file export for use in MIS or accounting systems or for archiving purposes.

While useful to a company issuing a lot of cheques, non-cheque items are not covered at all by

this service.

 21.13.2 Full account reconciliation

This service is much more sophisticated than cheque reconciliation and can reconcile any type

of item (i.e not just cheques issued). It can be set up to pull down files from the customer' s

accounting systems and to reconcile any item. With such systems, matches can be made

against:

exact amounts;

close amounts;

value dates;

reference fields and

combinations of the above.

Tolerances can be set by users as appropriate. In some cases the systems can also handle (as

well as one to one matches) one to many, many to one and even many to many. This type of

service can usually handle data from any bank and may be offered as an ‘add on’ module to the

multibank poll/parser (as discussed in section 21.10.4) or can be supplied as an additional

module to a treasury management system.

21.14 Other transactional facilities delivered by electronic banking

21.14.1 Trade services initiation

This provides customers with the ability to issue and amend import letters of credit. Most banks

have offered electronic trade facilities via proprietary PC-based services for sometime and such

services are now also offered via the browser and the internet.

21.14.2 Foreign exchange dealing

Proprietary dealing services are available from a number of banks either via a PC-based

Windows system, or increasingly, via the browser and the internet.

In addition, many banks are now participating in one or more of the internet-based portals which

provide companies with a single, one-stop route to all their foreign exchange providers. Of

course, it is still necessary to enter into a credit agreement ahead of trading, but companies are

able to notify their foreign exchange requirements simultaneously to their chosen foreign

exchange banks for pricing. Thus they can deal online at the preferred rate with the preferred

institution. (For a more in-depth discussion on foreign exchange portals see section - 21.20 ).

21.14.3 Custody initiation

Where a bank holds securities for a company as its custodian, both reporting and transaction

initiation are increasingly performed via electronic banking. Some banks’ electronic banking

systems will have a separate custody module.

This service will enable the customer to send instructions to ‘receive’ and ‘deliver’ securities

electronically to their custodian and to accept rights/bonus issues, etc.

Reporting will cover areas such as portfolio valuation, information on dividend payments and

other corporate actions.

As with other services, custody services are increasingly available via browser and internet

technology.

21.14.4 Netting

This service provides access for netting participants to banks’ mainframe-based netting systems

(discussed in chapter 11) for the purposes of inputting transactions and receiving netting

reports. Netting can be efficiently moved onto a corporate intranet. This possibility is discussed

in more detail in the technology overview in chapter 20.

21.14.5 Other transaction initiation services: security considerations

Other types of electronically initiated transactions also need in-built security. The issue of a

letter of credit or a foreign exchange transaction performed electronically should be treated from

a security standpoint in exactly the same manner as a normal payment as the risks to the

customer can be just as great.

 

21.15 Trends that are emerging

The following are now becoming common among newer electronic banking systems:

one delivery platform for all bank services;

matched set of application programs - all programs have the same standards;

close to/real-time processing and reporting at the bank;

extensive use of file transfers from bank to customer and to bank from customer;

minimal manual input - ability to import/export files at customer location;

EB systems which easily integrate each other, with other packages and customer

systems;

multibank facilities (reporting and EFT);

report generator - to enable user to customise their own report;

user-friendly security (see chapter 20);

unattended sessions – PC automatically logs-on at pre-set times to collect data;

selection of payment types - customer decides how payment is made - not the bank;

browser-based delivery options and

portals – banks are increasingly open to partnerships with other banks and software companies

to make services available online via ‘portals’ – one-stop sites where users can access a range

of information and services. As an example, one Scandinavian bank has set up its own portal

for companies to access its services, but it will also be offering links via the portal to an ASP

treasury system. The multibank portal for foreign exchange and capital market trading are

further examples.

21.16 Trends in cash management services

Trends are moving towards a single workstation offering:

multibank balance and transaction reporting (any account, any currency, any bank) with

same-day data;

multibank payments - domestic and international;

reconciliations;

standard reporting and report generator for customisation;

deposit lodging / withdrawal facilities;

netting - input / reporting;

pooling - analysis / interest apportionment;

total liquidity management, including end-of-day automated investment options and

small-value dating – foreign exchange and money market.

secure e-payments as exemplified by the Eleanor initiative (see section 20.27).

21.17 Documentation for electronic banking services

21.17.1 The agreement

The documentation that a company is expected to sign prior to a bank's supplying an electronic

banking service varies widely from bank to bank and from country to country. Likewise, the level

of flexibility, in terms of areas that might be amended in some of the document clauses, varies

between banks.

Some banks require very large and complicated documents to be completed which attempt to

cover any type of eventuality, whilst other banks’ forms are shorter, but not necessarily more

user-friendly.

Documentation normally includes the following:

definitions;

supply of services, covering:

o customer' s agreement to follow procedures set out in the user manual and

o customer' s agreement to pay the bank's tariff or charges and to agree to

changes to them with appropriate notice;

equipment and software:

o customer agrees to run bank software on appropriate equipment and bank has

no liability if incorrect equipment is used and

o bank agrees to provide appropriate software, but does not warrant that it is

error free;

software licence:

o bank grants non-transferable software licence to customer and

o customer undertakes not to copy, sell or publish details about the software;

security:

o customer agrees to abide by security provisions set out in user guide;

o customer's liability for any loss to the bank from misuse or loss of security

provisions (devices or passwords) - whether loss attributable to an employee or

not and

o bank assumes no liability for fraudulent use of security provisions;

customer instructions:

o customer’s liability for accuracy and correctness of instructions;

o bank and customer's liability to keep instructions secure;

o customer authorises bank to act on any instructions it receives through the

system without having to check manual instructions or authorities;

o bank’s ability to refuse certain instructions;

o bank has no obligation to amend or cancel an instruction received electronically

and

o customers do not have the right to use electronic banking to create

unauthorised overdrafts;

confidentiality:

o bank’s obligation to keep customer information confidential, save in respect of

some legal obligation to have to divulge it.

limitation of bank’s liability:

o bank’s only liability is in respect of default, negligence or misconduct of bank

employees and

o bank’s financial liability is limited - sometimes to the value of any item lost or

defrauded, sometimes to the amount paid by the customer for the service;

termination:

o usually either party can terminate the agreement subject to a number of days’

notice and

o all rights cease to exist on termination;

other provisions relating to:

o amendments to tariffs and user guides superseding earlier ones;

o newer documentation taking precedence over older documentation and

o bank’s right to change terms and conditions subject to notice;

legal jurisdiction:

o each provider will tend to use its home country jurisdiction and

o customer also agrees to be bound by any local laws if using the system

internationally and

authorisation:

o from a legal entity to have its accounts reported to another entity or to authorise

another entity (eg group treasurer) to initiate payments from its accounts.

21.17.2 Set-up forms

Set up forms are set out as follows:

accounts to be included - from service supplier bank or other banks;

connection times that company will want to access system;

local area networks used;

details of equipment - PCs, modems - customer proposing to use;

request to take optional extra services:

o intra-day updates;

o currency and interest rates;

o foreign exchange dealing;

o custody and

o trade services and

authority to debit account for the service fees.

21.18 Security considerations for systems in the treasury

Here we provide a checklist of the security requirements for systems used in the corporate

treasury.

21.18.1 Standards for electronic funds transfer systems:

dual authorisation by system administrators setting up access rights;

unique user ID and password for each user;

passwords must be at least six characters long - ideally alpha numeric;

passwords must not be displayed;

if residing in the PC, passwords must be encrypted;

a limited number of log-on attempts after which disablement should occur;

time-out facility or auto log-off after period of inactivity;

ability to limit users to making payments to predefined beneficiaries;

separation of input, verification and release processes between several users;

sight or key verification - key verification enables verifier to rekey some basic data eg

currency and amount and for the computer to match this against the original data input;

daily audit trail checking with violations reporting;

message authentication codes added to each payment message and to each batch;

password changed regularly and prompted by the system;

providing a predefined beneficiary library with encryption and MACs to avoid tampering;

passwords should not be capable of being recycled;

encryption of all passwords residing on the system;

tiered levels of authorisation based on payment amounts;

extra levels of authority for making one-off (non-repetitive) payments;option to use

smart card technology to authorise and release payments and

menu customised to users rights. If you're not authorised to do it - you cannot see it on

the menu.

21.18.2 Standards which companies should consider implementing themselves for EFT

systems

appoint system administrators/security officers who should not be users themselves;

insist that passwords and PINs are not written down and never shared;

consider putting EFT terminal/PC in a secure area;

document authorities, policies and procedures and

do not trust anyone.

21.18.3 Security standards for treasury management systems (and other systems used in

the treasury department):

a documented security policy should set out roles and responsibilities;

a security co-ordinator or system auditor should be appointed - preferably a non-user;

implement a regular review of access control procedures to ensure level of access and

personnel involved are still relevant;

consider restricting access to the treasury department;

security should be considered when purchasing any new package or system;

will internal or external auditors be happy with security standards?

all systems should have:

o  audit trail

o access control procedures;

o back-up and recovery procedures;

o contingency plan which has been tested;

o unique user IDs set up and approved by senior managers  and

o access violation reports;

when testing new systems, use different environments from live systems and

when using a network, controls should be in place to protect against unauthorised

access, eavesdropping, monitoring or uncorrected error transmission.

21.19  Enterprise resource planning (ERP) systems

Enterprise resource planning or ERP aims to integrate all departments and functions across a

company onto a single computer system that can serve all those different departments'

particular needs. ERP solutions are now widely used by MNCs as it provides them with an

overview of their whole network. Implementing ERP solutions is notoriously difficult and requires

a complete reorganisation of the company structure. To obtain the maximum benefits of ERP it

is also necessary to adapt the company’s culture and ensure staff buy-in across the

organisation. Given these huge challenges, companies often prefer an incremental approach

whereby different ERP modules are introduced per department (finance, HR, warehousing etc).

These different modules can be linked together subsequently. ERP is particularly useful in areas

such as finance as it can provide companies with an overall picture of their financial situation

and generate data for their cash forecasts. Internal ERP systems can be linked to the

company’s treasury management systems as well as to third parties such as banks. However, in

practice, development and usage of ERP modules specifically aimed at treasury remains

limited. Historically, ERP has tended to focus on areas such as inventory management and

accounting. As a result, even the most ERP-enabled companies are often unable to provide

senior management with easily accessible cash flow data through their ERP systems. The

advent of web-based solutions and XML should however facilitate the interlinking of ERP

systems with stand-alone systems. The arrival of web technology and XML is also putting

pressure on banks to provide solutions that allow seamless interfacing between their bank

systems and corporate ERP systems. Several of the larger banks are now able to integrate

corporate ERP systems into their banking systems through a single gateway. In addition,

several e-procurement software specialists have teamed up with banks to create business-to-

business solutions that leverage existing ERP systems. Furthermore, a growing number of

banks play an active part in e-procurement portals or net market places. However, there are, as

yet, no comprehensive solutions that cover all aspects of the financial value chain.

21.20  Foreign exchange dealing and multibank portals

One of the most tangible results of the development of web-based technology has been the

emergence of internet-based trading platforms. Among the most significant trading platforms are

the foreign exchange portals. The majority of these platforms are single bank-based but there

are also a number of multibank portals as well as some trading platforms linked to system

suppliers. At present, the most significant multibank portals are FX Connect, Currenex and

Centradia. Corporate usage of foreign exchange portals is growing albeit at a slower pace than

was initially expected. A sizeable number of treasurers remain reluctant to abandon the familiar

phone channel in favour of depersonalised online trading. Issues of trust and the perceived

need to obtain traders’ views have so far limited the take-up of online trading. However, as the

number of banks providing liquidity via online portals grows, the pressure on treasurers to follow

suit is rising. As a result, low-value trades in the more widely traded currencies, where human

contact is less vital, are increasingly conducted online.

The main advantage of online trading is not so much the pricing - indeed the price quotation for

larger trades where human contact is important often remains manual - but the ease of use, the

creation of a clear audit trail and above all the increased straight through potential for trade

execution and post-trade settlement. This potential for increased trade and post-trade efficiency

is likely to grow as rationalisation pressures in the online foreign exchange market forces portal

providers to further improve their interconnectivity and straight through processing capabilities.

Ultimately, portals should be able to achieve complete automation of the trading cycle from pre-

trade to settlement for bulk trades.

Companies can also use online portals, in particular multibank portals, as an opportunity to

impose uniform policies, reduce the risk of human error and improve their overall risk

management. Portals, in particular multibank portals, also offer a considerable amount of

research and information to treasurers in a single location.

Given the wide array of foreign exchange online trading options available, the task of selecting

the appropriate portal can be daunting. The expected consolidation in the online foreign

exchange trading market is further complicating the task. There are, however, a number of

criteria that can facilitate the search and ensure the selected online portal (s) are reliable and in

line with the company’s business needs:

given that this is a relatively new marketplace, it is essential to check the status of the

provider in the market. This should include obtaining information on the organisations

backing the venture and their commitment to the foreign exchange market. Single bank

portals linked to one of the larger banks are probably better placed to survive future

consolidation than some of the smaller players. In the case of the multibanking portals it

is also important to remember that the greater the membership and support, the better

the liquidity and the pricing. In this context it is also worthwhile establishing the names

of the institutions that act as marketmakers. This will also allow you to establish if they

include some of your traditional foreign exchange providers;

service levels, including available support functions, and reliability are another important

factor. In this context it is worthwhile to talk to current portal users;

the range of products that can be traded on the portal should also be an important

consideration. Ideally, companies should be looking for a provider that can offer a wide

range of foreign exchange instruments (including derivatives) as well as other financial

products. Generally single bank portals score the best on this criterion;

security should of course be a major concern and it is important to ensure that the portal

has adequate encryption and state-of-the-art technology;

the availability of the necessary risk management tools (including adequate reporting

and audit trail) is also an aspect that needs to be considered;

as is the straight through processing and interconnectivity capabilities of the provider.

The pre-trade, transaction and settlement cycles should ideally be conducted via a

single window and the site should provide interfaces with TMS, ERP and other in-house

applications;

ease of use of the portal is also relevant;

restrictions in terms of currencies, size etc should also be explored;

any costs involved should also be part of the equation, as is establishing the overall

competitiveness of pricing offered on the site ;

finally, the ease and cost of membership procedures and

future strategy and plans of the portal are some of the other factors to consider when

selecting an online foreign exchange portal.

21.21   Electronic bill presentment and payment

 

Electronic bill presentment and payment (EBPP) and electronic invoicing presentment and

payment (EIPP) provides major opportunities and challenges to companies and banks alike.

Most industrialised countries have now put in place the necessary legal framework, including

electronic signature legislation while security concerns have been addressed through the use of

PKI infrastructure and initiatives such as Identrus and Eleanor (see sections 20.27 and 20.28).

As a result, e-commerce, in particular business-to-business e-commerce, has the potential to

grow substantially over the coming years. All the major banks now provide EBPP (business-to-

consumer) and EIPP (business-to-business) solutions, often in alliance with other banks and

consolidators, including payment and collections outsourcing solutions. Alternatively, instead of

going through a consolidator, companies can set up EIPP and EBPP solutions either for their

collections or payables processes, which are directly available either via their own or third-party

host websites. The introduction of EBPP and EIPP presupposes a reengineering of the whole

business cycle; marketing, procurement, production and customer service all need to be

reengineered and integrated with EBPP and EIPP applications. EBPP and EIPP also require a

robust underlying database, efficient and flexible data transmission mechanisms as well as

review, approval and rescheduling functionalities. In addition, the EBPP and EIPP solutions

need to be integrated with accounts payable, accounts receivable and general ledger systems

as well as with other internal systems such as ERP, supply chain and customer relationship

management (CRM) systems. The ability to provide in-depth reporting and analysis should also

be an essential feature of any efficient solution. Once all this is achieved the advantages are

numerous:

 

increased transaction speed;

increased number of counterparties;

reduced costs both internally and externally (banking and transaction costs);

less risk of errors;

faster dispute resolution;

better relationship management;

improved reporting;

improved reconciliation and

better risk management.

While EBPP and EIPP have the potential to revolutionise corporate payment and

collection processes, there remain still considerable hurdles to overcome. These

challenges are twofold:

 

despite some uniformisation, differences in national legal and regulatory frameworks

continue to hamper efficient cross-border electronic invoicing, particularly in Europe and

lack of open standards. Despite attempts by a number of market participants to develop

open XML-based standards, there are as yet not fully interoperable standards.

21.22  Case Studies of  browser-based treasury (non examinable)

Merck & Co

As a one of the world’s largest pharmaceutical groups, Merck & Co Inc, has a very significant

international presence; in Europe alone, where the company is known as MSD, Merck has 45

subsidiaries. The company has large foreign exchange exposures as well as a considerable

amount of liquidity and liabilities to manage. In its home market, the US, treasury is run on a

centralised basis. In Europe, a central treasury unit acts as an in-house bank providing cash

management, netting, foreign exchange and cross-border payments. It also offers international

treasury services in terms of setting up foreign entities and helping them with their financing as

well as capital structure.

As a global company, Merck was looking to centralise its treasury operations on a global basis,

whilst maintaining local input through the use of web-based technology. Merck also wanted to

achieve the following objectives:

establish uniform and simple business processes and rules;

have a single source of information;

facilitate data access;

provide value-added features and increase speed and reduce costs.

To this end, Merck selected Alterna’s AUROS, an intranet-based global treasury workstation.

Auros is linked to the in-house bank and the centralised accounts payable and receivable

functions as well as the centralised general ledger.

Auros provides the following functions: 

inter-company netting (96 participants as at 2001);

processing of centralised cross-border payments;

management of cash centralisation and pooling activities;

recording, reporting and accounting for all in-house bank transactions;

registering inter-company loans;

providing information on foreign exchange activity;

delivering cash flow forecasting information and 

giving subsidiaries a ‘free’ basic treasury workstation.

All foreign payments are routed through Auros, so that payments can be made out of the

nearest Merck resident account in the currency of the transaction, thereby avoiding foreign

exchange and cross-border charges.

In terms of cash management, Auros allows:

local entities to directly enter required funding;

restricted access for each local entity to its own information;

centralised funding authorisation without manual intervention;

the possibility to integrate funding flows with other flows going through the treasury

system, eg flows linked to foreign payments and netting and 

full transparency to local entities which are able to monitor progress of funding requests.

CISCO Systems

Internet network specialist Cisco has achieved e-enabled treasury by building its own e-enabled

treasury solutions.

The rationale behind the migration to an e-enabled treasury consisted of the following factors:

time and hence cost savings in terms of executing a particular function;

standardisation/scalability;

increased control (audit trail);

reduction in errors;

value-added decision making;

improved execution;

increasing employee morale and productivity and

state-of-the-art e-treasury.

To achieve this goal treasury defined its exact needs in conjunction with the IT department. The

IT department provided the exact scope of the project which was then signed off by treasury

based on its requirements. IT subsequently finalised the technical requirements and started

development. Upon completion, IT released the system for user testing. Once treasury was

satisfied, sign-off was given and system went live.

Cisco adopted a step-by-step approach and designed specific modules for cash management,

investment, foreign exchange (including link with foreign exchange portals), exposure analysis

and cash flow forecasting.

Links with working capital management

Chapter 22 - The concept of Float

Overview

Float is often only considered to be something that banks are responsible for. As treasurers

start to become more involved in working capital management, it becomes apparent that float is

incurred in many of the areas in the supply chain. This chapter highlights some of these.

Learning objectives

A. To be able to analyse the supply chain process in terms of its effect on the corporate

cash flow

B. To understand why float occurs

C. To be able to identify methods of reducing float

22.1 Introduction to float

Speak to any corporate treasurer about 'float' and they will probably describe to you one small

area of 'float' that we have already looked at - bank float. Float was narrowly described in

chapter 3 as "the time lost between a payor making a payment and a beneficiary receiving

value". Often, quite incorrectly, this is the only area of float that the treasurer considers. So

much emphasis has been placed on bank float, particularly in the US, over recent years that it is

now measured in hours rather than days.

As treasurers' responsibilities widen to encompass the management of working capital, it

becomes increasingly obvious that bank float is the tip of the iceberg and that many other

aspects and different kinds of float need to be considered.

Consider a normal transaction between two companies. A company is ordering goods from

another company. The chain of events from the supplier's standpoint might be as follows:

orders received;

goods dispatched;

invoice sent;

payment due;

payment made;

payment received;

payment banked;

funds available;

funds moved to correct account and

advice of funds availability.

An analysis of this flow in more detail enables the float and cash flow aspects to be identified.

Each of the above is analysed below.

22.2 Orders received

When the company orders its goods, the supplying company can fulfil orders under various

circumstances, such as:

Scenario I the goods are in stock - so they can be immediately dispatched;

Scenario II the goods need to be manufactured. The following are all available:

raw materials;

machinery to produce goods and

labour and

Scenario III the goods need to be manufactured and

raw materials may need to be ordered;

machinery to produce goods may be fully occupied and

labour may be fully occupied.

Therefore, the time between receiving the order and dispatching the goods could be significantly

different for each scenario. This time is known as 'production float'.

It is also apparent that each scenario has different working capital management implications.

Scenario I necessitates storing finished goods, the production costs of which have already been

incurred and may have been paid for (ie production staff, salaries, machines, premises, lighting,

heating, etc). The cash has already been paid out awaiting a cash inflow in respect of sales.

Having the goods in stock results in a quick response and the ability to generate an incoming

cash flow faster than having to manufacture to order.

Scenario II means that, although raw materials have been purchased, no manufacturing costs

have been incurred so there has been less of an outlay of cash to date. If the goods can be

manufactured quickly, the time between order and dispatch can be minimised and the difference

between cash paid out and cash received can likewise be minimised.

Scenario III is much more complicated. Although the company may have incurred no costs at all

as far as the order is concerned, the time between order and dispatch could be considerable.

Naturally, different industries have different policies in this respect. If you need a battery for a

delivery lorry, your customer expects it immediately. If you are ordering a generator set costing

EUR500,000 then you might expect production float to be several weeks.

22.3 Invoice issuance

Whichever scenario characteristics order fulfilment, we shall assume that the goods are finally

dispatched. What needs to be done to generate a cash flow inwards (ie to get paid)?

Firstly an invoice needs to be issued. The exact mechanism that triggers production of an

invoice varies from company to company, but the time between dispatch of goods and the issue

of an invoice is known as 'system float'. In this case, it will be the supplying company's systems

that are causing the delay. The delay between dispatch of goods and invoice production is

totally under the control of the supplying company. In practice, some companies have invoicing

policies such as:

"We invoice once per week on a Thursday." This means goods dispatched on a

Thursday will not be invoiced for seven days and/or

"we invoice once per month on or near to the 8th" This means that goods dispatched on

8 January will not be invoiced until 8 February.

22.4 Credit period

Once the invoice has been sent, what is stopping the supplying company being paid now (the

efficacy of the local postal service notwithstanding)? First, there is a credit period. Credit periods

often start from the invoice date, not the dispatch date, so there is further delay. Who has

agreed the credit period? Is credit given to companies that do not need it? Can the period be

shortened to speed up payment? Also, does the invoice give sufficient details to facilitate

payment by the most efficient methods?

The delay between the issue of an invoice and the payment-due date is the 'credit period'.

One way to speed up receipt of payment, other than to shorten the credit period is to offer a

discount for early payment. The rate of discount needs to be considered carefully both by the

buyer and the seller.

22.5 Payment due

Payment becomes due when the credit period has expired, but the buying company might not

necessarily pay on time. It is possible that the buying company has ignored the payment date

because of its own payment policy. For example, it might only have two cheque runs per month

on the 15th and the 30th. If the payment due date is the 8th, the company is effectively taking

one extra week's credit. This is known as 'customer float'.

22.6 Payment dispatched

Finally, the payment will be dispatched. If a cheque is put into the post in the UK, even if it was

sent by second class mail, postage would only add a maximum of two days to the process. In

countries such as Greece or Italy it could add nine days to the process and in others it might

take weeks or may be 'lost in the post'. So 'postal float' can be a major problem.

22.7 Payment received

Once received, the time between receipt and depositing the cheque in the bank is totally under

the control of the supplier. Some companies are very poor at banking payments and may only

go to the bank weekly. Others may deposit by post (incurring more postal float) or process the

internal bookkeeping entries before banking the payment. This is also referred to as 'system

float'.

22.8 Payment banked

At this point, we return to bank float. 'Bank float' relates to the period an item takes to clear once

it enters the banking system. Domestically, this may be quite quick, two or three days, but

domestic clearing in some Asian countries might take 14 days. However, collecting a foreign

currency cheque (see chapter 9, section 9.2) would take much longer and would incur

substantially more float (and costs).

22.9 Funds available

If the supplying company were paid by cheque in SGD, and the cheque was sent for deposit to

an account in Singapore, how will the company know when funds become available? The

answer is that it would have to await receipt of an advice. If all the company's expenses are in

USD, having funds available in Singapore is of little use to them. It will need to sell the SGD and

remit the equivalent amount in USD to its account in the USA. This is known as 'concentration

float'.

22.10  Funds moved to the correct account

Once the funds are moved to the correct account, the supplier still cannot use them until it is

advised of their receipt. This is known as 'information float'. Systems such as electronic account

reporting can be used to reduce this.

22.11  Advice of funds availability

Finally, only when the advice arrives does the supplier have use of cleared funds in its bank

account.

This long chain of events can be summarised as follows:

Therefore, float is 'inefficiency' in a business sense. This inefficiency can be

calculated as a cost to a supplier as follows:

Cost of Float = principal amount due x no. of days x cost of funds

360 or 365

22.12 Why does float occur?

Float occurs for two reasons; normal business practices and processes and company's

slackness or inefficiency. Many things can be done to reduce float once it has been recognised.

Recognition of sub-optimal float management should be a major part of any cash management

review.

Concentrating on the financial aspects, float may be caused:

deliberately:

o late payment or

o wrong instrument issued (eg USD cheque drawn on UK bank sent to US

o beneficiary - often called a  'triangular cheque' );

by inefficiency:

o late submission of invoices;

o processing internal transactions before banking payment;

o incorrect or incomplete payment instructions;

o invoicing in wrong currency or

o using wrong collection methods;

logistical situations:

o clearing process;

o postal process;

o standard practice to take float (eg, Spain/Italy);

o foreign exchange regulations (eg, Malaysia) and

o banks not passing on value;

compensation mechanism:

o taken in lieu of a specific charge or

o taken as a hidden extra charge.

22.13 Possible actions to reduce float

Change own systems:

o invoice immediately on dispatch of goods;

o renegotiate/reduce credit periods;

o invoice in correct currency and

o try to encourage electronic payment by quoting bank account details on invoice.

(including, where appropriate, IBAN and BIC details, see section 8.6.2)

Educate customers:

o offer discounts for prompt settlement;

o introduce direct debiting (becoming very common in certain countries in

Europe) and

o provide clear payment details - bank code, account number, transfer method

preferred and value date that you expect.

Include float costs in price:

o possible in some countries/industries, but may impact competitive position.

Negotiate float with banks:

o seek to replace compensation by float with a fixed fee and

o restructure bank accounts (eg if receiving EUR denominated cheques drawn on

banks in France it is advisable to open an account in Paris).

22.14 Banking services designed to control float

There are a number of bank services designed to reduce or control float. The rest of this chapter

explains how they can be used to improve float management.

22.14.1 Lockbox

The lockbox has been discussed already in chapter 9, but when used in conjunction with a

currency account held in the same centre, this service can reduce expensive cross-border

collections to low-cost local collections, as well as reducing float considerably (see chapter 9).

22.14.2 Intervention accounts

Intervention accounts are used widely in Europe, the US and Asia. The idea of an intervention

account is for the supplier of goods to open an account with the same bank and branch as his

customer. Goods may be delivered to a local warehouse (often to the order of the bank) and the

document of title to the goods is sent to the bank. On receipt, the bank will have authority to

debit the buyer's account, credit the supplier's account and to release the title to the goods to

the buyer. The movement of funds will be immediate; same-day, no float. Normally, such

accounts are linked to a zero balancing arrangement to move funds to the supplier's

concentration account.

Intervention accounts are usually used in the following situations:

amounts involved are large;

buyer not considered creditworthy;

inefficient banking system (ie, used to speed funds availability);

seller wants to exchange title of goods for cash and

seller wants to avoid postal and bank float.

22.14.3 Remote disbursement

This is a technique for creating float by issuing cheques drawn on a bank in a poor clearing area

so that items take as long as possible to clear. Many companies regard this practice as

unethical and it has not been legal in the US since 1984. However, it is well known that some

UK companies use these techniques and issue GBP cheques drawn on banks based in

Scotland or Northern Ireland where cheque clearing can take one day longer than in England.

22.14.4 Controlled disbursement account

This is a zero balance account on which cheques are drawn by a payor. This account is only

funded to clear the cheques as they are presented. This 'funding' may be a zero balance facility

or by means of a same-day value payment. To work properly, users must be able to get same-

day notification of transactions hitting their account. This type of account enables a cash

manager to keep his funds fully invested, even after cheques have been issued, until such time

as they are presented.

22.14.5 Direct collections

In this case, cheques drawn on one area or country are sent by mail or courier direct to a bank

in the area of country on which they are drawn.

22.14.6 Efficient collections structure

All the techniques discussed in section 22.14 are widely used in the USA, but are also used by

some companies in other countries. Diagram 22.2 is fairly typical of the collections (receivables)

banking structure of a US company.

This company is based in New York and its main bank is bank A. On the East and West Coasts,

the company operates lockboxes. All remittances from the East Coast are directed to bank B, all

remittances collected in the West of the US are sent to bank C. Both banks move cleared funds

at the close of business each day to bank A for next-day value. In the Midwest, the company

has a strong relationship with bank D; its Midwest lockbox at bank E zero balances into bank D.

At bank F, the company runs an intervention account to service one major customer and again

this zero balances to bank D. At bank D, the company keeps a minimum balance of

USD500,000 and all funds in excess of this amount are target balanced (see section 12.25) to

bank A at the end of the business each day for next-day value.

Chapter 23 - Receivables and payables management

Overview

This chapter explores, in further detail, the link between corporate cash management and the

business as a whole. It is necessary, for liquidity and profit reasons, to make sure that monies

due in (receivables or debtors) are received as early as possible, and monies due out (payables

or creditors) are paid as late as possible. Nonetheless, the cash management aspects have to

be managed in a wide business context. The cash manager has to take into account the

commercial relationship, the economic environment, the business environment, whether

domestic or international, the banking environment and also the company's own corporate

culture and organisation.

Learning objectives

A. How to evaluate the cost to the company of poor cash management

B. The importance of clear terms of trade

C. How to evaluate an alternative course of action

D. How to integrate the various techniques covered earlier

E. How to evaluate the taking of discounts

F. The importance of controlling the payment cycle

23.1 Introduction

The main source of funds for a company are those produced from its ongoing business. While

large one-off investments can be funded through raising new finance from the debt and equity

markets, it is still the funds from ongoing operations that will service the debt, repay the

principal, pay the dividends and pay for labour, goods and services. This makes the control of

receivables and payables critical to the liquidity and health of the company.

23.2 Domestic receivables

23.2.1 Responsibility

Responsibility for managing the receivables ledger will vary from company to company. 48% of

cash managers and treasurers in Europe participating in a survey said that they had

responsibility for managing receivables and payables. Others with responsibility in this area

might include the financial controller, sales and marketing and the credit manager. Either way, it

is the cash manager who has to manage the 'fall out' from poor credit management and so has

a vested interest in ensuring that control is as tight as possible.

23.2.2 Costs of outstanding receivables

It is best practice to collect debts as quickly as possible. The cost to the company of outstanding

debtors can be calculated from an aged debtors analysis. Identifying a receivables problem

should not be too difficult as the sales aging ledger will give a regular update of overdue

accounts. The following table shows an example of a sales aging ledger or schedule.

The figure for 'debtor days' gives a feel for the overall control that a company is exercising over

its receivables, but additional analysis is needed to pinpoint specific problem areas. The 'debtor

days' or 'days' receivables' is a standard ratio which is derived from balance sheet figures. It is

calculated by dividing the debtors figure by the turnover and then multiplying by 365 to give a

number of days figure. If debtors equals GBP360,554 and turnover equals GBP2,392,768, then

debtor days is calculated as follows:

360,554/2,392,768 x 365 = 55 days

Somewhat contrarily, a good payment record can hide other problems. Suppose one of your

major customers pays early to take advantage of the discount you offer. This will bring down the

debtor days (which is good) but:

a) why are they taking the discount? Maybe the company is offering too good a deal; and

b) if the company's average is 30 days and the biggest customer is paying in ten days, it follows

that the other customers must be taking excessive credit.

How serious the problem is will depend on the amount of money that it is costing the company.

Chapter 22 introduced the basic float equation and this can be used to gain a feel for the impact

on a company's results.

Averages are not always useful, especially when applied across many industries with a

multitude of credit terms. However, in the UK, the average days' receivables is in the order of 65

days. Suppose a company offers credit terms of payment due at the end of the month following

the invoice month (ie the invoice is dated 14 February, payment is due by 31 March). On the

books, this should give rise to an average of 45 days' receivables. Suppose again that the

actual days' receivables are 65 days. This means that either the company has to fund the extra

20 days or will not be able to earn interest on those funds.

For a company with a turnover of GBP100m the float equation gives us the cost (assuming a

cost of funds to the company of 7.5%):

Cost = GBP100m x 20/365 x 0.075 = GBP410,959

The company now knows the cost of extended credit terms. The next decision is whether to do

anything about the problem, and if so, what? Bear in mind at this stage that only the opportunity

cost has been considered. There are additional costs such as those involved in the follow-up

process of employee time, legal costs and so on. Also, the longer a debt is outstanding the

greater the chance that it will turn into a bad debt.

The first important point is that while there are many actions that are theoretically possible, it is

necessary to keep an eye on what is commercially feasible and cost effective. If, on further

analysis, the extra 20 days can be seen to be due to one major customer it may be better and

cheaper in the long run not to do anything, except ask politely for prompt payment. Losing such

a customer by insisting on prompt payment and following that through with solicitor's letters may

well cost more than the opportunity cost of the float. Co-operation with the sales and marketing

department will help decide on the best approach. They will know how important a supplier you

are to the customer and hence what bargaining power you may have. They should also know

whether it is a profitable relationship overall.

23.3 Cross-border collections

Particular issues arise where payments are being made cross-border, especially where the

payment is being made by cheque drawn on an account in the country of origin (ie a cheque

sent to a company in the Netherlands from Japan drawn on an account in Japan). The Dutch

company can simply open an account in Japan, and instruct the Japanese customers to send

their cheques to that address. The mail times are shorter as will be the clearing times. In

addition, the costs should be reduced as sending cheques and drafts on international collection

can be an expensive business. An extra benefit may arise because the payment is now a

domestic payment so that the Japanese company may make it by credit transfer rather than by

cheque.

The next decision to be made is how to handle the funds accumulating in the Japanese

account. This subject has been covered in more detail in chapter 10, but briefly, interest rates,

exchange rates, transfer charges, local payment needs, domestic or other funding needs and

tax will influence the decision as to when, and if, to repatriate funds.

All the good practice that applies to domestic receivables' control applies to international

receivables as well, but there are a few additional points to watch. Letters of credit (L/Cs),

described in chapter 9, are a credit guarantee although there is a spin-off in terms of funding.

It should not be forgotten that the L/C also has benefits from a cash management perspective,

since the date of the cash flow (assuming all requirements are complied with) is fixed. As

foreign currency flows are often involved, this has the benefit of fixing the exposure date as well

thus making the foreign exchange risk manager's job slightly easier as well. This is an important

area for companies and one that is often overlooked because of the rather mundane nature of

processing trade documentation. Figures from the Simpler Trade Procedures Board (SITPRO) -

the UK trade agency - estimate that many millions of GBP are lost to UK exporters every year

through delays caused by poor documentation.

Care must be taken to ensure that the start of the payment process is controlled by the

receiving company. Terms such as '60 days from acceptance date' should be avoided since this

means that the customer decides when the payment period starts. If the customer has no urgent

need for the goods and dockside and warehousing costs are not prohibitive, they may not wish

to collect them. If they do not wish to collect them, they do not need title documents; if they do

not need title documents, then they do not need to accept the draft. Use terms such as '60 days

bill of lading date' or 'invoice date', which should be under your control.

23.4 Possible actions

Analysis of the receivables ledger and related information will tell you the nature of the

problems. For instance, who are the offending parties? Are they large or small customers?

Where does the problem lie? Is it in the time taken to pay or the method of payment?

Discussions with your colleagues in sales and marketing will help fill in some market

information. What is the industry norm? Is the market really price-sensitive or not? With these

factors in mind, possible actions could include:

ensure that legally binding terms of trade are in place,specify payment terms;

extend the responsibility for debt collection beyond the credit controller (eg include

salesmen);

link bonus systems to working capital performance;

ensure that payment instructions are clear on the invoice, stating method of payment,

account to which funds should be sent giving account name, account number, bank

name, address and sort code and the IBAN and BIC. All this is obvious, but it is

surprising how often the obvious is overlooked. With the best will in the world, it is

difficult for a bank to apply funds in a timely manner when they arrive addressed to

Smith – London;

include the extra cost of credit in the price? This obviously depends on how price-

sensitive the market is, but where a customer is a consistently bad payor it can be

effective;

make sales conditional on payment in advance or post-dated cheque (a cheque with a

date on it after the date it is drawn) Very often, customers are just bad payors rather

then being poor credit risks so that once you have received the cheque there should be

no further problems. In some countries, it is illegal to issue post-dated cheques;

is it possible to impose penalty clauses such that interest can be added for late

payment? Even where such clauses can be imposed legally they may be practically

unenforceable (although they often have a beneficial psychological effect);

where not agreed in advance, stating your prefered method of payment clearly on the

invoice can often work well if the staff making the payment (often clerks) literally follow

instructions without thinking through the implications for float. Remember that it may

well be beneficial to absorb the higher costs of some forms of payment where the

saving of float outweighs the additional cost;

be aware of industry payment practices. It may, for instance, be common practice to

pay against statement rather than against individual invoices. If this is so, the accent

could be shifted from the invoice to making sure that all relevant items are included in

the monthly statement and that this is sent out in good time;

do you know when your customers have their cheque runs? Very often companies have

cheque runs once or twice per month. It is important to have this information, since

missing a cheque run could involve a month or a fortnight's delay;

does the size of the payment warrant special treatment? Where large sums are being

paid by cheque it may be cost effective to physically pick up a cheque and send it for

special clearance or open an account at the same bank branch that the cheque is

drawn on and deposit it straight away and

offer discounts for early payment. Discounts may be standard in the industry, in which

case you have little choice as to the size of the discount offered. Many companies

forget that discounts become more or less attractive as interest rates in the market

change and so the policy on discounts should be reviewed from time to time.

All the above ideas must be considered within the specific business context such that an

approach that is taken is the best from an overall business perspective, not one that merely

makes life easier for the cash manager or makes it less awkward for the customer's relationship

manager. To this end your own company's reward and reporting systems should be promoting a

common goal. It is often all too easy for the sales manager to say that a company is too

important to press for earlier payment or to threaten with cessation of supplies, when the costs

of the relationship are effectively being borne by the treasury department. While not always

easy to do, a system that allocates the costs of credit to the sales department might concentrate

their minds on what is truly important and what is not. In one instance, one company actually

paid the sales staff a bonus based on sales outstanding at the month end. This story may be

apocryphal but it does illustrate the point.

23.5 Payables

If the main aim of receivables management is to obtain payment as swiftly as possible then the

opposite is true for payables management since the longer you delay payment, the lower your

funding needs or the more you are able to invest.

23.6 Commercial balance

Once again, common sense dictates that you are careful how you set about payables

management. Simply not paying suppliers certainly keeps your cash balances healthy, but may

result in an empty goods inwards area or higher purchase prices in the long run. As always, the

cash manager is looking for the right commercial balance in conjunction with the production and

purchasing departments.

It is difficult to lay down rules for others, but you should develop a policy on payment that you,

as a company, can live with. There has been much coverage of the difficulties faced by

businesses, especially small ones, due to the late payment practices of many companies (and

in particular the larger ones) and there are certainly some ethical considerations to be taken into

account. What can be said is that whatever your policies, payments should always be

controlled. This means knowing when they are due, knowing what is due (after all discounts and

credit notes are taken into account), where and how the payment should be sent, that you have

the funds to cover the payment and that the payment is properly authorised.

23.7 Method of payment

The method of payment is an important consideration. There are country norms for payment

methods as discussed in chapter 3 section 3.4. Some countries are still very much cheque-

based, although the use of Electronic Funds Transfer (EFT) is growing and will presumably

continue to grow. The decision that the cash manager has to make concerns the acceptability of

the methods to the recipient, the costs involved (both direct and indirect) and the existing

systems within the company. All the methods have their advantages and disadvantages.

Processes such ‘as remote disbursement’ (see chapter 22), must be used with care. Issuing a

cheque denominated in GBP to a English supplier which is drawn on an account in Buenos

Aires could cause considerable aggravation between your company and its supplier, whereas

drawing it on a bank in Scotland, where it only takes one extra day to clear, may perfectly

acceptable.

23.8 Discounts

The taking of discounts is also an area that needs consideration. Some companies have

systems that automatically take discounts without evaluating whether they are in fact the best

use of funds. In others, the systems set-up discourage effective use of discounts. By the time

goods have been processed through 'goods inwards' , checked against a purchase order and

been evaluated by the quality control department, the approval process for payment can mean

that discounts which should be taken are lost.

The decision on whether to take a discount or not is dependent again on the 'opportunity

cost/use of funds' argument. Take the case of the supplier who offers terms of '2/10 net 30' or,

in plain English, 30 days to pay, and if paid within ten days, you may take a discount of 2% flat

(2% of the invoice value). What is the discount worth versus taking the extra 20 days? Suppose

again that the company's cost of short-term funds is 15%.

The effective annualised interest rate being offered on the discount can be derived using the

following equation:

discount                   x                   365 or 360*

100 - discount                 no.days - days credit

so that given the figures above:

2   x    360    x    100    =    36.7% per anum

98          20

*transactions in most currencies are calculated on a 360 days, except in the case of a

transactions using GBP where 365 days is the norm).

In this case, the company should take the discount since it is effectively earning 36.7% per

annum by using funds borrowed from the bank at 15%.

Looked at another way, the underlying transaction is for USD100,000. The discount is therefore

worth USD2,000 and the actual payment at the start of the 20-day period will be USD98,000.

This translates to an earning in per annum terms of (not compounded):

2,000   x    360    x    100    =    36.7%

98,000          20

The cost of funding this will be 15% or in monetary terms:

USD 98,000    x      15    x      20   =      USD 816.67

                             100          360

Clearly the company gains from taking the discount in this case. The worse payor that the

company normally is, the more finely balanced the decision becomes, as taking the discount

means giving up more days of 'free credit'. To illustrate, suppose the company normally gets

away with taking 80 days without incurring a penalty, then:

2,000   x    360    x    100    =    10.5%

98,000          70

The longer the "free credit period" the lower the advantage of taking a discount.

23.9 Summary

The main aim of receivables and payables management is to minimise the amount of funding

needed or to maximise the amount of funds on deposit. Good management in this area also

aids cash flow forecasting and allows better long-term funding and investment decisions, a

reduced risk of bad debts, stronger liquidity and hence balance sheet ratios (and from this,

increased credit worthiness). A balance sheet that appears to be under control also sends

important messages to any third parties (banks, suppliers, shareholders, etc) about the ability of

the company's management. It helps develop a positive sentiment towards the company and its

prospects.

Legal, Tax and Regulatory Issues

Chapter 24 - International funds transfer laws

Overview

Funds transfers are subject to local legal regulations and conventions. Some of these laws are

in the form of statutes, based on legal precedents or codes of conduct. In this chapter, we look

at an existing law (UCC4A) a model law (UNCITRAL) and a European Union Directive, all of

which affect national and international developments now and in the future. 

Learning objectives

A. To understand the basic concepts of the two laws and the EU Directive concerned

B. To understand the legally recognised parties to a funds transfer

C. To understand the roles, responsibilities and obligations of each party

D. To understand the new EU cross-border payment regulation

E. To understand anti-money laundering legislation

 

This chapter has been adapted from "Electronic Banking and Security", an Association of

Corporate Treasurers book edited by Brian Welch.

24.1 Introduction

Over recent years, various bodies and authorities have drawn up codes of practice for handling

funds transfers. Most have covered bank-to-bank relationships, such as SWIFT, or bank-to-

clearing system relationships. The relationship between the banks and the parties to funds

transfers (the originator and the beneficiary) have largely been left to individual banks to

negotiate and document with their customers. However, this is often a source of much wrangling

between legal specialists at banks and companies, often ending in an unsatisfactory position for

either or both parties.

This unsatisfactory state of affairs has not remained unnoticed and three bodies have taken

action:

the United Nations;

the European Commission and

the US government.

The United Nations produced the UNCITRAL model law for international credit transfers which

has been used in a vastly watered-down version to draft the EU's Cross-Border Payments

Directive. The US has made most progress by developing a version of UNCITRAL and has

incorporated this as an amendment to the existing Uniform Commercial Code known as UCC4A

which has been widely adopted by individual states and the main clearing systems (CHIPS,

Fedwire and the automated clearing house).

24.2 UCC4A funds transfer law

The Uniform Commercial Code, Article 4, Sub-section A (UCC4A) has turned out to be a

milestone in the development of US cash management services. The Uniform Commercial

Code is a federal code which has been gradually accepted into state laws. Articles 3 and 4 of

the Code set out rules and common practices for issuing, processing and clearing cheques

(checks) and other negotiable instruments. However, until amended with Section 4A, funds

transfers were not covered.

Despite the maturity of the US market, there has been much uncertainty about the law, rules,

regulations and common practices in relation to funds transfers. With the development of

electronic funds transfer (EFT) systems, another layer of complexity was added. Banks have

sought to draw up agreements between themselves and their customers to clarify roles and

responsibilities. In practice, these have tended to be rather one-sided documents (in the banks’

favour) and have only dealt with the relationship between the sender of a funds transfer and his

bank. Many processes through which a funds transfer (and, more particularly, an electronic

funds transfer) passes were not covered adequately or, in many cases, at all. Some companies

refused to sign the banks’ documentation or insisted on it being modified. On a nationwide

basis, this meant that different banks worked to different rules in different states. The party liable

for any problems that might occur in the payment process could, therefore, vary. As a result of a

confusing body of law, those cases that did come to court had contradictory outcomes,

providing little guidance for future cases. Both companies and banks realised that it was in

nobody’s interest for this situation to continue and work began on drawing up a legal code that

could be applied on a national basis.

Input was gathered from interested parties. The Association for Financial Professionals, then

known as the Treasury Management Association, represented the views of corporations in the

process. The banks and other financial institutions engaged in money transfer activities were

represented by bodies such as the National Automated Clearing House Association (NACHA)

and the Federal Reserve Bank as the major providers of national funds transfer systems.

24.2.1 The purpose of UCC4A

UCC4A is a comprehensive law relating to wholesale funds transfers. It excludes consumer

funds transfers, which are covered by a separate law (the Electronic Funds Transfer Act). In

effect, it covers almost all corporate funds transfers that take place within the US (ie where an

originator or payor instructs a bank to make a payment by wire transfer which will be cleared

through a system such as the Clearing House Interbank Payments System (CHIPS) or Fedwire.

Originally, UCC4A was not meant to cover payments through the automated clearing house

(ACH) and direct debits - where a beneficiary initiates the payment - are still not covered.

However, most bank agreements cover all credit transfers, so in signing a bank agreement

drawn up under UCC4A, a company may agree to the same rules and regulations for its ACH

payments. Such an agreement sets out the obligations, responsibilities and relationships

between the various parties to a payment.

The law applies to any payment order passing through CHIPS or a bank that is located in a

state that has adopted UCC4A into its laws. Additionally, any payment that passes through

Fedwire is governed by the law, even for those parts of the process that take part or pass

through other systems or states that do not recognise the law. This is because Fedwire

payments are subject to regulation under Federal Reserve Regulation J, which has incorporated

Article 4A.

The law has been adopted in most states. The two major ones in terms of volume, New York

and California, brought the law into force in January 1991.

Parts of UCC4A can be varied by mutual agreement between the bank and its customers. Other

sections are not allowed to be varied from the standard text.

24.2.2 Terminology

The terms that the law uses are defined as follows:

originator - the party that initiates the instructions to make a

payment;

originating bank - the bank receiving the originator’s instruction;

beneficiary - the party that is due to receive the payment;

beneficiary’s bank - the bank at which the payment is to be received;

payment order - the set of instructions issued by the originator;

acceptance - a bank accepts the payment order when it issues a

payment in accordance with the originator’s

instructions;

intermediary bank - where the originating bank is not able to make a direct

payment to the beneficiary’s bank, payment may be

made through third party correspondent banks and

completion - the funds transfer is completed when the beneficiary’s

bank accepts the payment and pays the funds to the

beneficiary.

24.2.3 The process

The originator issues a payment order to the originating bank, instructing it to make a payment

to a beneficiary at the beneficiary’s bank. On acceptance by the originating bank, it is bound by

the instructions in the payment order and must comply with them by issuing a payment. Once

accepted, the originating bank cannot later change its mind and decline to make the payment.

When there is not a direct banking relationship between the originating bank and the

beneficiary’s bank, one or more intermediary banks may be used by the originating bank. Any

intermediary is similarly bound on receipt and acceptance of the instructions from its

correspondent to carry out the transaction as instructed. The transaction is completed when the

beneficiary bank advises receipt to the beneficiary and either credits it to his account or pays out

the required amount of cash.

24.2.4 Cut-off times

Banks have the right to set cut-off times for payments or processes attendant to payments, such

as cancellation and amendments. Such cut-off times may vary for different types of payment,

different geographical locations or different types of originator. For example, cut-off times for

CHIPS payments may be different to times for Fedwire payments. Customers based in New

York will have different cut-off times to those based in California and a government department

or multinational company might be allowed different times to a middle market company.

24.2.5 Security

As a way of reducing potential funds transfer fraud, UCC4A lays down that the banks, clearing

houses and other systems used to process payments must have developed security

mechanisms to a standard that is ‘commercially reasonable’. The Article does not, however, say

what ‘commercially reasonable’ means. The practical effects of this have been that:

banks have improved the security features of their products, particularly their computer-based

EFT products. A de facto standard has emerged and all the banks’ EFT products have to some

extent become standardised as far as security is concerned. Features such as ‘message

authentication’ and ‘encryption’ of, at least, passwords are now regarded as the norm and

acceptance of telephone or faxed instructions to make payments has now become even more of

a problem for banks; prices of such services are likely to reflect the banks’ strategy to

encourage customers to move to the more secure EFT method.

Originating banks have the right to debit their customer for a payment order that they receive,

whether or not it was duly authorised by a responsible person working for the customer:

as long as ‘commercially reasonable’ security was in place, ie that it contains the

necessary passwords or test keys and that it passes the message authentication

process or

in the event that the customer rejected the use of a reasonable security device or

procedures offered by the bank, having agreed to be bound by any payment order

issued in its name.

If either of these situations has not occurred and the bank accepts and processes an

unauthorised payment, the bank will be liable and will not be able to force its customer to

reimburse it. In such a case the bank will also have no legal recourse to obtain a refund from the

beneficiary, although, in the instance of a mistake rather than a fraud, a request for return of the

payment from the beneficiary might be a sensible first step.

What constitutes ‘commercially reasonable’ security is a much-debated subject. What might be

deemed reasonable for a small company sending a batch of low-value pension payments may

not be considered adequate for a multinational sending a batch of high-value payments issued

to settle securities transactions.

24.2.6 Errors

The general principle of UCC4A is that each party is responsible for its own errors. However,

banks will seek to shift responsibility to customers in their EFT agreements by using

disclaimers. These need to be negotiated, as they are not part of the ‘non-variable’ part of the

Article. Terms covering negligence need particular attention.

24.2.7 The issue of unauthorised payment orders

If a payment order was received by a bank and the person issuing the order was not authorised

to do so, or a valid order was fraudulently altered prior to receipt by the bank, the liability for the

payment will rest on the security procedures that were put in place and how they were used.

The general rule is that where no ‘commercially reasonable’ security procedures are in place,

the bank will be held liable. This will be the case unless the customer has rejected the bank’s

security procedures and there is an agreement between the bank and the customer that the

customer will be liable for any payments issued in its name, whether or not they were properly

authorised. In circumstances where the bank provided reasonable security procedures, then the

liability for the payment will be with the customer unless it can prove that the fraudster did not

obtain information to commit the fraud from an internal source, such as a customer, employee,

former employee or a source controlled by the customer. This means that a fraud committed by

an unconnected third party (eg someone breaching the bank’s security and breaking into the

systems to trigger a payment from a customer’s account) would be the bank’s liability. Article 4A

additionally allows liability to be altered by written agreement between the bank and the

customer.

Liability for unauthorised payments does have some caveats. The customer must notify the

bank of an unauthorised payment within a reasonable time. This will be deemed to be 90 days

unless an agreement to a shorter period has been reached between the parties. If the bank is

held liable, it must not only re-credit its customer’s account with the amount of the payment, but

must also pay interest to the customer. The liability for unauthorised payments covering most

combinations of circumstances is given in the following diagram.

Diagram 24.1: Liability for unauthorised payment order

24.2.8 Payments made in error

The following types of payment errors are covered:

payment to the wrong beneficiary;

payment of a larger amount and

payments that were duplicated (but only if some security device or procedure was in

place designed to detect duplicates).

Under Article 4A, banks’ security procedures do not have to be able to detect such errors to be

commercially reasonable. Security that is designed to confirm that a payment is from a specified

customer will probably be held to be sufficient. However, if some procedure, process or device

was put in place to detect errors and the customer complied with all aspects of these

procedures, then the bank would be held liable; it will be the bank’s responsibility to obtain a

refund from the beneficiary. If the customer does not provide notification to the bank in a

reasonable time and, in consequence, the bank suffers a loss, the bank will be due

compensation from its customer.

The liabilities of the parties may be altered under this section by mutual agreement. Diagram

24.2 summarises the situations and liabilities relating to erroneous payments.

Diagram 24.2: Liability for sender’s erroneous payment order

24.2.9 Communication networks and clearing systems

When payments pass through a third party telecommunications network, such as General

Electric Information Services (GEIS), BT Tymnet or SWIFT, or through a clearing or settlement

system such as CHIPS, the network or clearing system is regarded under 4A as acting as the

agent for the originating bank. Even if that network or system is responsible for the mistake, the

originating bank is held responsible for the payment error. In practice, compensation for

payment errors resulting from the actions of the networks or clearing systems will be detailed in

an operating agreement contained in - or a side-letter to - a contract between the bank and the

network or clearing system.

24.2.10 Identification of the beneficiary

If, on receipt by the beneficiary bank, a payment order cannot be applied because the bank

account number, account name, etc does not exist, completion of the payment cannot occur. In

such a case, the beneficiary bank would be expected to return the payment to the originating

bank the same or next day.

If a payment order includes the beneficiary’s name and account number, but the two appear to

refer to different beneficiaries, the bank can rely on the account number.

24.2.11 Identification of intermediaries and beneficiary bank

If a payment order merely quotes the name of the intermediary or beneficiary bank, without its

appropriate sort code, the receiving bank may act on that name.

24.2.12 Acceptance of payments

A bank receiving a payment order is only said to have accepted the order on execution of the

payment. But if the originating bank and beneficiary bank are the same, the order cannot be

considered to be accepted until the payment date on which the beneficiary or his account

received the funds.

Acceptance by the beneficiary bank generally takes place when one of the following occurs:

the bank pays the funds to, or notifies, the beneficiary that a payment has been

received or credited to their account;

the bank receives settlement in full for the amount of the payment and 

if, within one hour of the start of the next business day, the payment has not been

rejected for any reason by the beneficiary bank or recalled by the originating bank.

In general, once a settlement has been made by the banks involved in the process, acceptance

will be deemed to have taken place. Once accepted, a payment may not be rejected later.

24.2.13 Rejection of payments

Payment orders may be rejected by an originating bank by notifying the sender. Notification may

be by telephone, by letter or through some electronic method. The method used to notify

rejections must be ‘reasonable’ and any agreement that suits a bank and its customer will be

deemed to be reasonable. Payment orders can be rejected because:

they contain ambiguous instructions;

there are insufficient funds in the originator’s account;

there is some credit limitation on the receiving (ie the beneficiary’or intermediary) bank

or the receiving (beneficiary’s or its intermediary) bank is operationally unable to carry

out the instructions.

24.2.14 Cancellation or amendment of the payment order

The sender of a payment order may amend or cancel a payment and such an instruction can be

notified by telephone, in writing or by electronic methods. In circumstances where security

procedures are in place, such procedures must be adhered to. A notification to amend or cancel

a payment must reach the originating bank prior to its published cut-off time, and in a manner

which gives the bank reasonable time to act on the instruction.

24.2.15 The obligations of an originating bank

An originating bank, having accepted a payment order, is obliged to issue a payment on the day

of receipt in accordance with the sender’s order. Intermediary banks are similarly obligated to

follow those instructions. Where the sender specified the use of a particular method of

transmission (eg Fedwire or ACH), it should be respected unless the bank knows of some good

reason why another method might be better, such as a system failure. Where no method is

specified, the receiving bank (be it the beneficiary’s or the intermediary bank) has to use the

most efficient method of transmission and instruct any intermediary to do likewise. Where a

value or payment date is specified, a method must be used that will get the payment to the

beneficiary on the due date.

An intermediary bank, unless specifically instructed to in the payment order, may not reimburse

its expenses or charges by deducting them from the amount of the payment order. It will have to

seek reimbursement from its (instructing) correspondent bank.

24.2.16 Late or improper execution

Where the payment is completed, but some delay occurs before payment is made to the

beneficiary or credited to his account, the receiving bank is in breach of its obligation under

Article 4A. It will, therefore, be obliged to pay interest to the beneficiary or the originator in

respect of the number of late days. Delays caused by a bank, be it the originating, the

intermediary or the beneficiary’s bank, that result in the payment not being made, being

delayed, passing through an incorrect intermediary or not complying with any of the originator’s

instructions, will be the responsibility of the offending bank. It will have to bear any subsequent

expenses and interest, but UCC4A specifically excludes bank liability for consequential

damages.

24.2.17 Obligations of an originator to an originating bank

Apart from situations where a receiving bank makes errors in the execution of the payment, the

originator is obliged to pay the originating bank once the order has been accepted. If the

payment is not accepted, the originator has no obligation to settle with the originating bank. If

the originator has already paid for a payment that is not accepted then he is entitled to a refund

of the amount plus interest. In effect, this provides the originator with a money-back guarantee if

the payment fails. In cases where a specified bank in the transaction could not complete the

transfer for some reason such as the bank’s ceasing trading or insolvency, the originator would

have to pay the originating bank, which would have to pay any intermediaries specified in the

transfer. The originator’s remedy for reimbursement would have to be through the courts under

the bankruptcy laws.

24.2.18 Obligations of the beneficiary bank to the beneficiary

When a beneficiary bank accepts a payment on behalf of a beneficiary, that bank is liable to pay

the beneficiary on the payment date. If acceptance occurs after the bank’s cut-off time, the

funds should be available to the beneficiary the next working day. If the bank refuses to pay the

beneficiary, it may be liable for consequential damages unless it can prove that non-payment

was due to some doubt on its part that the beneficiary had a right to the payment.

Where the beneficiary bank credits the beneficiary’s account in its books, payment occurs when:

the beneficiary is advised that the funds are available;

the beneficiary bank applies the credit in reduction of a debt in the beneficiary’s name,

such as a loan and

actual cash or funds are made available to the beneficiary.

In circumstances where the beneficiary bank releases funds to the beneficiary before it receives

settlement (such as CHIPS transactions prior to settlement) it assumes the credit liability and

the risk of non-settlement (unless it delays acceptance until settlement). A payment made to the

beneficiary on a conditional basis or with recourse will not be permitted, unless the underlying

funds transfer systems allow for it.

24.2.19 Variations by agreement

UCC4A enables some flexibility and certain provisions can be altered by agreement between

parties. Variable areas include:

the time period for a customer to report an unauthorised payment;

the time period for a customer to report errors;

the obligation of a receiving bank to accept a payment order;

the obligation of the beneficiary bank to notify a payment receipt to the beneficiary and

the rate of interest to be paid for losses or late payment.

A number of areas of the Article cannot be altered by agreement. These include:

the bank’s obligation to provide and comply with adequate security procedures;

the bank’s obligation to refund the originator for unauthorised payments initiated from

outside the customer’s area of control;

the bank’s liability for late or improper execution of a payment;

the bank’s obligation to refund the originator for payments made in error;

the sender’s (either the originating or the intermediary bank) obligation to pay a

beneficiary’s bank;

the obligation of the beneficiary’s bank to pay the beneficiary and

the completion of a payment to a beneficiary by the beneficiary’s bank.

Although the US funds transfer systems have amended their rules to bring them in line with

UCC4A, in some cases the regulations of the Federal Reserve Bank and bank operating

circulars may overrule UCC4A.

Other clauses in UCC4A cover:

bankruptcy proceedings and

court intervention.

24.2.20 The impact of UCC4A on US-based companies

Most companies making funds transfers domestically in the US have completed new funds

transfer agreements with their banks within the last few years. These agreements will be in line

with UCC4A but, generally, the banks are seeking to vary those clauses that can be altered in

their favour. Therefore, corporations need to understand the Article and the possible effect of

alteration to variable clauses. Those customers that have not signed funds transfer agreements

with their banks or who refuse to sign the new forms will be bound by the UCC4A as it stands.

24.2.21 The impact of UCC4A on companies based outside the US

UCC4A, although a US law, will affect any company based outside the US that makes USD

payments, whether they have an account in the US or not. For a company that has an account

in the US and uses an electronic funds transfer system supplied by a US bank but in another

country, the chances are that the account documentation is already subject to US law. If this is

not the case, the company may be requested to complete a new agreement. If the system is

taken from a non-US bank or a US bank that uses an agreement based on the laws of another

agreement, it will be subject to US regulations. Once a payment enters the US jurisdiction,

UCC4A is almost certain to apply to the payment because it is, in effect, a domestic transaction

triggered through an international EFT system. When a company banking with a non-US bank

requests that bank to make a USD payment from a currency account, the originator will have a

relationship with that bank and this will be subject to the laws of that bank’s domicile. The bank

however, will need to use a US-based correspondent (or its own US branch) to effect the

payment on its behalf. It will probably do this using SWIFT and, while in transit through that

network, both the sending and receiving bank will be bound by SWIFT rules. On acceptance by

the US correspondent or US branch (if situated in a state that has adopted it) Article 4A will start

to apply. The problem with a situation like this is how to determine which party is liable in the

event of errors or mistakes, as three sets of rules apply to the transaction. The relationship

between the originator and the originating bank will be subject to home country law and the

signed agreement between the bank and its customer. The relationship between the bank and

its US correspondent (or branch) will be governed by SWIFT rules and, from then on, all further

relationships and obligations will be governed by UCC4A. Companies that send large volumes

of payments to the US from offshore would do well to examine the funds transfer agreements

that they have with their banks and examine how they would be affected by problems with large

payments. Likewise, bankers need to consider the implications of UCC4A, not just in terms of

handling remittances for customers but also with respect to the impact of the law on bank-to-

bank transfers for transactions such as foreign exchange settlements. There could be

unpleasant surprises for the unwary.

24.3  UNCITRAL model law on international credit transfers

24.3.1 The model law’s background

The United Nations Commission on International Trade Law (UNCITRAL) designed this model

law on international funds transfers following a study into electronic funds transfers. The

publication of the study in 1986 resulted in the publication of a ‘Legal Guide to EFT’ and

between November 1987 and December 1990 the Commission undertook the task of drafting a

model law of international credit transfers. The model law contains 18 clauses and is designed

to cope with all types of credit transfers, including cross-border electronic payments, and will

apply to banks and other institutions engaged in the funds transfer business. Some message

carriers, such as SWIFT, may remain outside the jurisdiction of the law. The law may be

adopted by any country and, at the same time, an adopting country would be expected to bring

its domestic credit transfer regulations into line with it. Unlike UCC4A, it is designed to cover

both wholesale and consumer payments. This may cause difficulties in some countries where

the two sectors may use different payment networks or work to different standards.

The terminology used in the law is similar to that used in UCC4A - in fact, many of the clauses

and areas of responsibility also bear a remarkable resemblance to the US Article.

The model law recommends the use of message authentication to verify the authenticity of

payments and has similar rules to its US cousin on acceptance and rejection.

24.3.2 The advantages of the law

The advantages to those companies making regular overseas transfers would be:

a reduction of uncertainty due to the absence of statute law covering credit transfer;

uniform rules for all countries adopting the law;

comprehensive coverage of all aspects of the relationships and procedures in a funds

transfer and

a framework of law in the event of there being no formal agreements between the

parties to a transfer.

24.3.3 The disadvantages of the law

Having been produced by 36 countries and taking into account the views of banks, corporations

and consumers, the law has, in some respects, been a series of compromises. Critics say that

some of the provisions do not address the realities of the markets in some countries, nor areas

such as high-volume automated payment systems where account numbers and figures are

more important in straight through processing than account names and amounts described in

words. Unlike UCC4A, the draft law does not address these issues adequately. The law as it

stands is a disincentive to automation and enables substantial damages to be claimed against

automated banks that process payments against numbers alone.

24.4 The EU Cross-Border Payments Directive (EC Directive 97/5)

This much-hyped EU initiative (implemented on 1 January 1999) was, during its discussion and

drafting periods, much reduced in substance and while it covers low-value corporate payments,

it has primarily been designed to cover payments made by and to individuals and small

businesses cross-border in Europe. The banking lobby in Europe is very strong and what

started as an “all” payments directive has in fact ended up as a “small” payments directive. The

size of payments to be covered by the Directive was subject to continued debate, but it was

finally agreed to cover transfers up to EUR50,000. Thus, it only covers credit transfers, not

direct debits, cheques or card-based transactions and only those in the currencies of member

states of the EU. In response, there have been a number of bank initiatives to provide small

value cross-border transfers in accordance with the provisions of early drafts of the Directive

including Eurogiro, Relay, Tipanet, etc.

In practice, most small companies will have service levels with their banks imposed on them;

unlike UCC4A and the UNCITRAL draft model law, the Directive has been designed to protect

the consumer against the large banks. There is little in the Directive about the originator’s

responsibilities. The Directive was approved in November 1996.

The essence of the Directive is:

to speed up the movement of funds;

to stop the practice of double charging by the banks (originator and beneficiary banks)

and to make pricing transparent and

to quantify to some extent the responsibilities of the parties involved in the movement of

funds.

The EU Cross-Border Payments Directive has been enacted to put an end to problems seen

with cross-border payments over many years and to speed up the movement of funds. These

problems can be summarised as:

lack of information available prior to a transaction being undertaken, particularly

regarding charges and

the inefficiency of current practices using correspondent banks which leads to:

o charges being taken by several banks and lack of price transparency; 

o double charging (ie where both the remitter and the beneficiary pay);

o hidden charges being taken by value dating adjustments;

o unreliability of the service in terms of time taken to move the funds between the

remitter and the beneficiary and

o lack of responsibility for errors and mistakes.

The Directive aims to ensure that there is adequate information available to remitters prior to a

transaction being undertaken and that pricing is transparent, ie that there will be no hidden or

double charges or significant losses of value.

The EU has intervened because it regards present cross-border payments circuits as being an

impediment to the completion of the European Single Market. The Commission, over the years,

has repeatedly sought to persuade the banks to put their own house in order with industry-led

initiatives. Unfortunately, despite a number of payment club initiatives such as Eurogiro,

Tipanet, IBOS, etc., many banks and some countries have generally had little interest in

reviewing practices which for years have enabled them to make a good return for what they

regard as nuisance transactions. The Commission, therefore, decided to act.

While designed to protect the consumer and small businesses, the Directive covers all cross-

border transactions made below the EUR50,000 limit. This, therefore, affects corporate

transactions made using both manual and electronic banking methods. Many banks offer a

special electronic service for low-value cross-border payments and companies need to ensure

that the terms and conditions they sign up for will be at least as good as those in the Directive.

In practice, the terms of the Directive are not particularly stringent and most large companies

are likely to be able to obtain far better terms from the major banks.

Given below is comment and, where appropriate, the thinking of the Commission and the

European Parliament is discussed.

Article 1 sets out the scope of the Directive in terms of the institutions involved, the

types of payments covered and the currencies (as discussed above);

Article 2 sets out the definitions of the terminology used in the other articles;

Article 3 defines information that should be available to remitters prior to the payment

being made. This will be a detailed description of the service, including time-scales,

pricing and other relevant details;

Article 4 relates to information that should be available to a remitter after a transaction

has taken place. In particular, within a reasonable period, the remitter should be able to

ascertain a reference number. This should enable the remitter to identify the payment,

the exact amount of the transfer and charges to be paid by the remitter (and the

beneficiary, if appropriate) and the expected date that the beneficiary will receive good

value. Exchange rates used should also be available;

Article 5 sets out bank obligations to execute the payment in good time. This sets out

the responsibilities of all banks involved in the transaction (ie originating, pay through or

correspondents and beneficiary banks). The standard is that a bank must process an

item received by the end of the business day following receipt. Additionally, the

originating bank is held responsible for the whole end-to-end process being completed

within five business days, unless there is an agreement to the contrary. Beneficiary

banks must make the payment proceeds available to the beneficiary within one day of

receipt. Failure of a bank to meet these obligations will make it liable to pay

compensation to the parties involved;

Article 6 is designed to ensure that all banks execute the payment in accordance with

the payment order. It covers the transparency of charging and effectively puts an end to

the age-old process of double charging (ie the remitter paying on origination and the

beneficiary paying by having amounts deducted from the principal amount by each bank

handling the transfer);

Article 7 sets out the originating bank’s obligation to refund funds to the remitter or to re-

credit their account, if the payment is not received 20 days after the expected value

date. The only way out for banks would be ‘force majeure’. This clause has also been

subject to much debate and the banks wanted some form of opt out clause. All charges,

fees and interest are to be reimbursed by the originating bank to the remitter within 14

days of the remitter’s request.

Article 8 covers complaints and redress. This sets out a timetable to enable companies’

problems to be handled rapidly and specifies that each country should have a

complaints body or ombudsman. Again the banks are seeking to get any rulings by the

complaints bodies or ombudsman as ‘not binding’ and

Article 9 deals with implementation - originally expected to be December 1995 and later

December 1996, the Directive finally became law at the beginning of 1999.

24.5 The EU Regulation on Low-Value Cross-border EUR Payments (EC Regulation

2560/2001)

Adopted on 19 December 2001, the Regulation on Cross-border Payments in Euro (EC

Regulation 2560/2001) came into force on 31 December 2001. As a regulation it is directly

applicable in all Member States, including the countries outside the euro-zone, for all low-value

cross-border payments denominated in euro as defined in the regulation, and does not need

transposing into the respective Member States’ Law.

The regulation came about as a direct result of the continuing high costs associated with low-

value cross-border payments for consumers and small and medium-sized enterprises. The

issue was highlighted by the results of the European Commission Survey released in December

2001, which indicated that despite pressure from European authorities, cross-border payment

charges were in many cases as high as in 1993, the date of the previous survey. Coinciding

with the abolition of the legacy currencies within the euro-zone, the new regulation aims to make

the concept of the euro-zone as a single domestic payment zone tangible to the citizens of the

countries participating in Emu.

At present this Regulation only applies to electronically processed cross-border payments as

this is the area where the most improvements have been made in terms of efficiency,

particularly through the creation of cross-border networks and alliances such as Eurogiro, IBOS

as well as the EBA’s STEP1 and STEP2 initiatives. Furthermore, the regulation seeks to

promote further efficiency gains through the obligatory use of the International Bank Account

Number (IBAN) and the Bank Identifier Code (BIC) (See Section 8.6.2). In addition, all member

states that still apply central bank reporting requirements for balance of payment purposes

agreed to abolish reporting requirements for payments that fall under the new Regulation, so as

to facilitate automation.

The key guidelines of the Regulation are: 

as of 1 July 2002, electronic cross-border payments (ie all ATM withdrawals and POS

transactions, regardless of the type of payment card used as well as the loading of an

electronic wallet) within the EU denominated in EUR, other than credit transfers, below

the EUR12,500 threshold will attract the same charges as domestic transfers;

as of 1 July 2003, the Regulation will also apply to euro-denominated cross-border

credit transfers within the EU below the EUR12,500 threshold;

the obligatory communication of IBANs and BICs by institutions and suppliers to their

customers;

the Commission will present an evaluation report on the Regulation’s application by no

later than the 1st July 2004 and

the minimum threshold for payments to which this Regulation applies will be raised to

EUR 50,000 by 1 January 2006.

(For the implications of the Regulation see Section 8.6.1).

It should be noted that in the case of the non-euro-zone countries, Denmark, Sweden and the

UK, the Regulation only applies to cross-border credit transfers initiated in euro. In practice, this

means that British, Danish and Swedish consumers withdrawing money from an ATM or making

a payment by card in another Member State will still pay a foreign exchange-related charge.

Vice-versa euro-zone customers will have to pay charges on any card payment or ATM

withdrawal in any of the non-euro-zone member countries. Equally, a GBP, DKK or SEK

denominated cross-border transfer will not fall under the new Regulation.

Article 1 sets out the scope of the Directive in terms of the institutions involved, the

types of payments covered and the currencies (as discussed above);

Article 2 defines the different concepts; 

Article 3 stipulates that the charges levied by an institution for electronic cross-border

payments in euro within the EU below EUR12,500 (up to 31 December 2005, and below

EUR50,000 thereafter) are the same as the charges levied by that institution for

corresponding domestic payments in euro. This Article takes effect from 1 July 2002 in

relation to cross-border electronic payment transactions. This covers, for example,

credit card and debit card payments, ATM cash withdrawals and payments using cards

that store credit. Article 3 is also effective from 1 July 2003 in relation to cross-border

credit transfers.

Paper cheques are excluded from the Regulation’s requirement for non-discrimination

between domestic and cross-border charges. However, the charges applied to cheque

transactions must still be transparent.

In addition, the Regulation allows non-euro area Member States to opt to extend the

Regulation’s application to cover payments denominated in their own currencies;

Article 4 deals with the obligation of the institutions to ensure full transparency of the

charges. Institutions must make available to their customers, in written and

understandable form, information on the charges levied for cross-border payments in

euro as well as for domestic payments in euro and this prior to the transaction. This can

be done electronically, if appropriate, provided that is in accordance with national rules.

Institutions may also be required to provide a written warning to customers of the

charges that are applied to the cross-border use of cheques in the cheque books

themselves. The enforcement of this stipulation, is, however, left to the discretion of the

individual Member States. Modifications to any charges have to be communicated, in

writing, to customers prior to application. Equally, information has to be provided on

exchange charges for changing currencies into and from euro prior to the transaction as

well as specific information on the charges that have actually been applied;

Article 5 deals with the use of International Bank Account Numbers (IBANs) and

institutions’ Bank Identifier Codes (BICs). Institutions have to communicate to their

customers, upon request, the customer’s IBAN and their BIC. Additionally, from 1 July

2003, institutions have to indicate on customers’ account statements, or in an annex

thereto, their IBAN and the institution’s BIC. Customers also have to be notified of the

charges that will be levied by the institution if, when making a cross-border payment,

they do not communicate the International Bank Account Number (IBAN) of the

intended beneficiary and the Bank Identifier Code (BIC) of the beneficiary’s institution to

their own institution. In the context of cross-border invoicing for goods and services in

the Community, suppliers who accept payment by transfer in euro have to communicate

their IBAN and the BIC of their institution to their customers. Likewise, customers must

communicate to the institution carrying out a cross-border euro transfer both the IBAN

of the beneficiary and the BIC of the beneficiary’s institution, if they are to benefit from

the Regulation;

Article 6 deals with the obligations of the Member States, requiring them to remove by 1

July 2002 any national reporting requirements for balance of payment purposes for

amounts below EUR12,500. Member States are also required to remove by the same

date any national minimum requirements for the identification of the beneficiary that

may prevent automation of payment execution;

Article 7 covers compliance issues and stipulates the nature of the sanctions in case of

non-compliance;

Article 8 offers a review clause and stipulates that by 4 July 2002 the Commission shall

submit to the European Parliament and Council of Ministers a report on the application

of the regulation. This report shall review the impact of the Regulation, examine the

advisability of changes and, where appropriate, propose amendments to the existing

Regulation and

Article 9 deals with the implementation of the Regulation.

24.6 Anti-money laundering legislation

The Financial Action Task Force (FATF), the dedicated intergovernmental body set up by the

G7 countries in 1997 to combat money laundering, defines money laundering as ‘the processing

of criminal proceeds to disguise their illegal origin’.

Although going back far in history, money laundering came to the fore and probably received its

name in the United States during the period of the Prohibition; when criminals tried to hide the

provenance of the small denomination cash obtained from bootlegging and other criminal

activities through the establishment of, among others, laundries with coin slot machines.

Since then, money laundering has become far more widespread and has caused profound

social and political damage. The International Monetary Fund, for example, has stated that the

aggregate size of money laundering in the world could be somewhere between two and five

percent of the world’s gross domestic product.

Recognising the fact that money laundering is a global issue requiring a co-ordinated

international response, the G7 set up an intergovernmental body, the FATF in 1989 which now

covers 29 countries and jurisdictions including the major financial centre countries of Europe,

North and South America, and Asia as well as the Gulf Co-operation Council.

In addition, FATF works closely with other international bodies involved in combating money

laundering such as the United Nations, The Bank for International Settlements, the European

Union, the Council of Europe, the Organization of American States, dedicated regional task

groups such as the Caribbean Financial Action Task Force, the Asia Pacific Group on Money

Laundering etc, and private bodies such as the Wolfsberg group, which regroups the world’s

largest private banks.

24.6.1 The 40 FATF Recommendations

To help governments worldwide tackle money laundering more effectively, FATF outlined 40

recommendations which constitute a comprehensive blueprint for action against money

laundering. FATF’s 40 Recommendations cover the criminal justice system and law

enforcement; the financial system and its regulation; and international co-operation. Each FATF

member has made a firm political commitment to combat money laundering based on these

guidelines.

FATF monitors members' progress in implementing anti-money laundering measures based on

its 40 Recommendations; reviews and reports on laundering trends, techniques and counter-

measures; and promotes the adoption and implementation of FATF anti-money laundering

standards globally.

FATF also maintains a list of countries or territories that refuse to co-operate or implement

adequate anti-money laundering legislation. Currently, the NCCTs (Non-Co-operative Countries

and Territories) list includes the following countries and territories[1]:

1. Cook Islands

2. Egypt

3. Grenada

4. Guatemala

5. Indonesia

6. Myanmar

7. Nauru

8. Nigeria

9. Philippines

10. St. Vincent and the Grenadines

11. Ukraine

Since the Financial system is the pivotal in any money laundering activity, the 40

Recommendations contain several measures financial institutions need to take to prevent

money laundering (recommendations 8 to 18):

Recommendation 8 and 9 define the scope of institutions covered by the

Recommendations. FATF recommends that in addition to banks it also includes non-

bank financial institutions as well as organisations that do not fall under any prudential

supervision such as “agents de change”;

Recommendation 10 and 11 deal with customer identification and the need for financial

institutions to take reasonable measures to ascertain the true identity of the persons on

whose behalf an account is opened or a transaction conducted if there are any doubts

as to whether these clients or customers are acting on their own behalf;

Recommendation 12 sets out the need for financial institutions to undertake adequate

record keeping of transactions and customer identification. Institutions should be able to

provide competent authorities swiftly with transactions records and customer

identification (even after account closure) for a minimum period of five years;

Recommendation 13 states that the supervisory authorities should pay special attention

to money laundering threats inherent in new or developing technologies that might

favour anonymity, and take measures, if needed, to prevent their use in money

laundering schemes;

Recommendation 14 asks for financial institutions to monitor complex, unusual large

transactions, and all unusual patterns of transactions, which have no apparent

economic or visible lawful purpose. The background and purpose of such transactions

should, as far as possible, be examined, the findings established in writing, and be

available to help supervisors, auditors and law enforcement agencies. The transactions

to be monitored include interbank transactions and even transactions within financial

institutions;

Recommendation 15 deals with the obligation for financial institutions to report promptly

any suspicious transactions, including tax related transactions, to the competent

authorities;

Recommendation 16 asks for financial institutions and directors, officers and employees

of these financial institutions to be protected by legal provisions from criminal or civil

liability for breach of any restriction on disclosure of information imposed by contract or

by any legislative, regulatory or administrative provision, if they report their suspicions in

good faith to the competent authorities, even if they did not know precisely what the

underlying criminal activity was, and regardless of whether illegal activity actually

occurred;

Recommendation 17 states that financial institutions, their directors, officers and

employees, should not, or, where appropriate, should not be allowed to, warn their

customers when information relating to them is being reported to the competent

authorities;

Recommendation 18 stipulates that financial institutions reporting their suspicions

should comply with instructions from the competent authorities; and

Recommendation 19 demands that financial institutions develop programmes against

money laundering. These programmes should include, as a minimum: 

o The development of internal policies, procedures and controls, including the

designation of compliance officers at management level, and adequate

screening procedures to ensure high standards when hiring employees; 

o an ongoing employee training programme and

o an audit function to test the system.

In 2001, FATF issued a consultation paper to all interested parties about a review of the 40

Recommendations in the light of the latest developments in money laundering. The FATF has

identified 3 areas of main concern: 

Customer identification, suspicious transaction reporting and supervision;

Identification of the eventual ownership of corporate vehicles and

Non-financial businesses and professions that are targeted by money launderers.

24.6.2 Anti-terrorist guidelines

Since September 11, FATF has also been charged with following up terrorist financing and has

since formulated a number of specific recommendations to help governments and the financial

sector to cope with this new challenge.

From the financial sector point of view, the most important recommendations are

recommendations IV, VI and VII:

Recommendation IV requires financial institutions, or other businesses or entities subject to

anti-money laundering obligations to report promptly to the competent authorities any suspicion

of terrorism related funds;

Recommendation VI urges countries to take measures to ensure that persons or legal entities,

including agents, that provide a service for the transmission of money or value, including

transmission through an informal money or value transfer system or network, should be licensed

or registered and subject to all the FATF recommendations that apply to banks and non-bank

financial institutions and Recommendation VII asks countries to oblige financial institutions,

including money remitters, to include accurate and meaningful originator information (name,

address and account number) on funds transfers and related messages that are sent. This

information should remain with the transfer or related message through the payment chain and

in the case of incomplete originator information, countries should ensure that financial

institutions, including money remitters, conduct enhanced scrutiny or monitoring of these

transfers.

24.6.3 Implementation

Numerous countries have now implemented the FATF recommendations into their legislation.

These include the USA (2001 USA Patriot Act), Japan (most notably, the Anti-Organized Crime

Law) and the European Union (EC Directives 91/308/EEC and 2001/97/EC (to be implemented

by Member States by June 2003) as well as the proposed regulation on the control of cross-

border cash and cash-related instruments to and from the EU of June 2002) and other FATF-

members such as Mexico, New Zealand, Australia and Argentina.

Most European countries also have ratified the Council of Europe ‘Convention on Laundering,

Search, Seizure and Confiscation of the Proceeds from Crime of 1990’, the so-called

Strasbourg Convention.

The UK has ratified the Strasbourg convention and implemented the European Directive

91/308/EEC via primary legislation (including the amended 1988 Criminal Justice Act, the 1994

Drug Trafficking Act, the amended 2001 Terrorism Act and the 2002 Proceeds of Crime Act)

and the 1993 Money Laundering Regulations, which were amended in 2001 and 2002. An

updated version of the Regulations, incorporating the changes required by the second money

laundering directive (Directive2001/97/EC) will be enacted in 2003. This will extend the scope of

areas for which providing of suspicious transaction reports (STRs) either directly or via a

dedicated Money Laundering Reporting Officer (MLRO) to the competent authorities becomes

obligatory. It also widens the regulated sector to include certain aspects of the legal,

accountancy and tax advice professions as well as real estate agents, solicitors, casinos and

dealers in high-value goods.

As part of their anti-money laundering programme, several countries (including all EU and

OECD countries) have established specialised agencies, so-called Financial Intelligence Units

(FIUs), which are regrouped internationally in the ‘Egmont Group’. Among the more well known

FIUs are the American Financial Crimes Enforcement Network (FINCEN), the UK’s National

Criminal Intelligence Service (NCIS) and Japan’s JAFIO (Japan Financial Intelligence Office).

In a separate development, the Wolfsberg Group, a dedicated association of several of the

world’s leading private banks, has issued a set of global guidelines (‘The Wolfsberg Anti-Money

Laundering Principles for Correspondent Banking’) on anti-money laundering controls in the

settlement process between banks.

(For more details on the ‘mechanics’ of money laundering and the practical implications of anti-

money laundering legislation, see section 9.11)

[1] As at 24 October 2002.

Chapter 25 - Tax and regulatory implications

Overview

Like any other business transaction, cash management will have tax aspects and the cash

manager has to be aware of them. The tax consequences of any transaction will not only

depend on the nature of the transaction, but also on the specific circumstances of the company

or companies involved as well as the country of residence of the parties. Consequently, this

chapter is not designed to deal with all tax aspects in any detail. Rather it is intended as a

general introduction to taxation issues, to make the cash manager tax aware. Although, as a

general rule, cash management is not the driving factor behind tax planning, any and all cash

management activities will have either positive or negative tax consequences. These need to be

taken into account when deciding on an appropriate cash management structure.

The cash management team should always consult the in-house or external tax specialists in

advance. Often consultation after the implementation of a certain transaction will lead to

additional tax and other costs when changes are required. The tax advisers should also be kept

informed of changes in cash management transactions or other circumstances in the company’s

business. Regular review of the cash management strategy with the tax team is strongly

advised, since changes may not only affect the cash management policy, but also the overall

tax position of the company or its affiliates. A change in the ownership of a company may have

particularly far-reaching consequences for the tax treatment of certain treasury operations.

Learning objectives

The learning objectives of this chapter are to gain a general understanding of taxation issues

that impact on cash management decisions, in particular:

A. The different taxes that affect cash management

B. The tax implications of pooling arrangements

C. The notion of permanent establishment

D. The tax implications of treasury centre location

25.1 Introduction

In this course we do not intend to teach corporate tax as a subject; instead we hope to make

participants 'tax aware' and help them to understand the basic tax concepts as they relate to

cash management.

As well as standard corporation taxes there are others that the cash and treasury manager

needs to be aware of.

25.2 Tax treaties

These are usually a set of bilateral agreements between countries that will recognise and give

allowance for taxes paid in each other‘s jurisdictions. Sometimes this will result in no, or lower,

taxes being paid in the home country.

25.3 Withholding taxes

Internationally and under most domestic rules, withholding taxes are levied on interest,

dividends and royalties and, in certain cases, on income from employment and for certain

(intangible) services.

For the treasurer, withholding tax issues will generally be limited to withholding tax on interest

and dividends. However, in certain cases withholding taxes may apply to payments that are

considered ‘in lieu of interest’ such as guarantees and arrangement fees.

In some countries the rules relating to withholding tax (WHT) are different for resident and non-

residents (eg France)

There are essentially four types of withholding tax that treasurers need to consider:

tax on dividends;

tax deducted at source – usually by a bank on interest;

tax deducted by the corporate treasury in respect of bank interest and

tax deducted by the corporate treasury in respect of interest on inter-company loans.

WHT on dividends is relatively straightforward. WHT is often deducted by banks at source from

interest paid to depositors. In this respect the company loses those funds immediately, and the

bank has use of them until they are paid over to the relevant tax authority.

In some countries such as the UK and the Netherlands banks pay corporate interest gross, ie

without deduction of WHT. This is one of the reasons why such countries are popular as cash

pool centres. However, if affiliates are participating in the pool that would normally be subject to

WHT in their country of domicile, the corporate treasury will have to withhold the tax before

paying interest to such affiliates. In this case the corporate (treasury) has use of the funds until

they need to be paid over to the tax authorities.

In other countries, a WHT or stamp duty may have to be paid on inter-company loans (eg

Portugal, Poland) which makes this type of funding unattractive. In some countries the rules can

be further complicated. In the UK, for example, a company paying interest to another company

is subject to WHT whereas payments to a bank are not.

The amount deducted by the payer and paid over to the local tax authority may, in some cases,

be reduced under the provisions of double taxation treaties between the payer’s and the

recipients’ countries of residence.

As there are considerable differences between WHT rules, corporates need to carry out due

diligence at country level first and then look at the tax treaties that are available to it before

obtaining a full appreciation of the impact of WHT on their activities.

25.4 Transfer pricing

Transfer pricing relates to the prices charged by associated entities for transactions between

them.

The basic rule in all transfer pricing regulations is that related parties are required to deal with

each other as if they were third parties. This principle is referred to as ‘arm’s length’ pricing.

Failure to apply this principle may lead to adjustments of the pricing and to denial of tax

deductions or imputation of extra income to the taxpayor.

Failure to have contemporaneous documentation in place to support the transfer pricing system

used will reverse the burden of proof. As a result, an intention to shift profits abroad may be

deemed present unless proven differently.

In the field of financial transactions, and in particular, interest rates, foreign exchange spreads,

guarantee charges and fees for the various transactions are subject to arm’s length pricing

requirements. Areas such as in-house re-invoicing and factoring centres usually receive

particular scrutiny from the tax authorities of all countries where participating group members

are based. Also where an in-house treasury vehicle is based in a jurisdiction that is a

recognised tax haven, tax inspectors will become particularly suspicious and will need proof of

market pricing.

Under tax treaties, often a corresponding adjustment will be possible in theory and information

can generally be exchanged with the tax administration of the treaty partner(s) to combat

alleged wrong pricing.

It is, therefore, important that the basis of pricing financial transactions is not only at market

prices, but that there is documentation in place to evidence it. Where there is a central treasury

operation or an in-house bank pricing, arrangements should be formalised in the same manner

that they would be with an external commercial bank. Therefore, loan agreements stating

borrowing rates and other terms and conditions should be signed between parties and spreads

agreed for taking deposits or buying or selling currencies. Fees for services such as netting, re-

invoicing or factoring must be fully documented.

The same applies where a parent company is obliged to guarantee a subsidiary as a means of

securing the subsidiary a lower borrowing rate. In such a scenario, the parent should charge the

subsidiary for the value of the guarantee. If the guarantee is merely for bank comfort, and does

not enable cheaper financing, then the parent should not charge.

The introduction of concepts such as “shared service centres” where a centralised group

resource provides services to affiliates will attract particular attention from tax inspectors. Again

the arm’s length rule must apply, and the pricing and service levels must be fully documented

and close to those that might be offered by a third party provider.

25.5 Value-added taxes and stamp duty

Treasury managers should be aware that under certain circumstances value-added tax (VAT)

and stamp duties may be due in connection with financial instruments. Where intra-EU financial

transactions are concerned, such VAT will generally not be recoverable.

As far as stamp duties are concerned, it should be noted that the execution of certain

documents of a financial nature could lead to the levy of stamp duties. Examples are a 0.8%

stamp duty in Austria on any written loan document and a stamp duty of 1% on loan documents

executed in Greece.

Stamp duties are generally quite formal taxes and the simple fact that a document is not

executed in the country that levies the tax may be sufficient to avoid the duty becoming due.

However, the tax still can become due if the document is ‘repatriated’ for legal or other reasons.

25.6 Banking taxes

Some countries have introduced taxes on banking transactions. In Italy this tax is known as the

‘Amato Law’, after the minister who introduced it. In Australia there is the ‘Bank Administration

Duty’, aptly referred to locally as the ‘BAD Tax’.

25.7 Tax implications of pooling arrangements

Pooling arrangements have of late become a more and more important financial instrument.

Certainly, the introduction of the EUR has substantially increased the demand for cross-border

pooling arrangements between companies in various countries in the euro-zone.

A clear distinction must be made between:

notional pooling and 

zero balancing.

Notional pooling means that credit and debit balances of various companies are notionally

aggregated, without actual transfer of ownership of the funds. Notional pooling will also require

a legal right of offset to secure the position of creditors.

Under ‘zero balancing’, no legal right of offset is required and funds will actually change hands.

The debit and credit positions become positions of the pool leader.

From a tax point of view, pooling - be it notional pooling or zero balancing – can be seen as a

set of inter-company loans. However, the tax treatment of both types of cash pools is quite

different.

In the case of zero balancing, where no legal right of offset exists, the arrangement will

generally pass the arm’s length pricing test. Provided that the various parties to the scheme will

neither receive less interest income on their credit balances nor pay more interest on their

debits than they would have in relation to a third-party transaction. Any additional benefit could

thus be credited to the pool leader of the zero balance operation. However, in practice part of

the savings will be (required to be) passed on to the members of the pool in the form of reduced

debit interest rates and increased credit interest. In almost all cases tax authorities will regard

zero balancing schemes as creating inter-company loans and will, therefore, tax them

accordingly as inter-company interest.

In a notional pooling arrangement, the legal right of offset will mean that credit positions of one

company may be at risk in view of debit positions of other companies in the pool. This would,

between unrelated parties, normally require some form of guarantee payments by the

companies that are in a debit position. Computing this ‘fee’ is a complicated business. Interest

paid on notional pools is usually regarded as bank interest.

Furthermore, many countries will not allow or will not have the legal provisions in place to allow

cross-border legal rights of offset, making notional pooling virtually impossible in cross-border

situations.

Under some circumstances cross-border zero balancing may be a tool to avoid withholding

taxes. In the UK under pre-April 2001 rules, domestic withholding tax is due at the rate of 20%

on interest paid on long-term loans between two companies that are not members of the same

tax group. Pooling arrangements may lead to the existence of a long-term loan, which may not

always be predictable at the outset. However, if the pool was managed by a non-resident

company in a country with a withholding tax treaty, the domestic withholding tax would be

avoided. It would be necessary to make sure that treaty relief provisions are complied with,

which generally will mean that a certificate of residence of the pool leader will be required. The

same system will solve a similar issue in Spain, where the domestic withholding tax on interest

between non-consolidated companies (90% or more ownership) is 18%, but interest payments

to EU resident companies are exempt.

Both notional pooling and zero balancing will generally be structured through banks. However,

this does not necessarily mean that any interest payments or receipts qualify as bank interest.

In essence, the tax authorities may regard the debit and credit positions as inter-company

transactions; with the bank merely acting as a facilitator. If the leader of the pool is a group

company and not a bank, one will have to look at the relationship (eg residence/tax treaties)

between the leader of the pool and the various members.

25.8 Permanent establishment

The technical term for an overseas branch of a domestic company is permanent establishment.

Under UK rules a company is taxed on its worldwide income, including income from foreign

branches, whether such income is remitted or not. However, generally, the host country of the

permanent establishment will also tax the income of the permanent establishment. Thus, double

taxation could arise in theory. The UK will avoid double taxation by allowing as a credit against

the UK tax the amount of tax paid in the host country, with a maximum of the attributable UK

tax. The effective tax burden of a foreign permanent establishment will consequently always be

the amount due in excess of the foreign tax or the UK tax, provided there is a tax treaty between

the countries involved.

Certain forms of a foreign presence may not lead to the existence of a permanent establishment

in the foreign country. Tax treaties define what constitutes a permanent establishment. Most

treaties will follow the definition set forth in the OECD model tax treaty, which determines that a

permanent establishment is deemed present in the case of at least:

a branch;

an office;

a factory;

a workshop;

a mine or other form of extraction of natural resources or

a construction site with a duration of 12 months.

The model treaty also specifically excludes certain forms of foreign presence from the notion of

permanent establishment such as, but not limited to:

use of storage facility;

an office purely to provide information or gather information;

an independent agent;

maintenance of stock purely for processing by another enterprise;

maintenance of stock purely for delivery and

pure purchasing activities.

When choosing between a permanent establishment and a foreign subsidiary, one would need

to take into consideration the effective tax rates of the two forms as well as the timing of

inclusion of the foreign income in the home country. In the case of subsidiaries, such inclusion

will generally only arise upon repatriation of the after tax profits by way of dividends.

In the case of financial transactions in particular, the following should be noted:

permanent establishments are generally not treated as separate bodies for tax

purposes. As a rule only the tax treaty between the head-office country and the country

where the permanent establishment is located will apply, especially in order to

determine which part of the overall profit of the head office may be taxed in the foreign

country;

where a branch receives interest income from a party other than its head office, the

applicable tax treaty and, therefore, the withholding tax rate, will be the one between the

country where the other party is located and the country where the head office is

resident. Thus interest payments made by a Belgian company to the French branch of a

UK company will be subject to the Belgium/UK tax treaty and not the Belgium/France

tax treaty. This is referred to as ‘triangular situations’;

in some countries just holding a bank account could mean the owner of the account is

deemed to have a permanent establishment (eg Thailand) and its income taxed

accordingly.

conversely, where the source of the interest is the country where the branch is located,

a different situation arises. The levy of withholding tax is generally reserved to the

country where the interest is sourced (ie in general the country that also allows a

deduction for the interest expense). Interest paid by the French branch of a UK

company to a Belgian company will, therefore, be governed by French domestic rules

and the France/Belgium treaty (which would in this case lead to no withholding tax,

provided the loan is properly documented) and

finally, it should be noted that in general, interest paid by a branch to its head office will

not be allowed as a deduction since it is a payment within the same entity.

25.9 Foreign tax credits

In some regimes credit is given for foreign taxes already paid by allowing these payments to be

offset against any tax levied on qualified income in the home regime.

25.10 Thin capitalisation

This principle is applied in some countries where the tax authorities feel that a company has too

much debt (usually borrowings from another group member) in comparison to its equity. Some

countries have defined rules or benchmarks on this (such as the UK, Germany and France)

while others leave their tax authorities to decide on a case-by-case basis. If a tax authority feels

that there is thin capitalisation, it may treat the interest on the excess borrowing as a dividend

and tax it accordingly (rather than allowing the interest to be tax deductible). This concept can

also be applied to liquidity management structures, particularly zero balancing which by its very

nature creates inter-company loans. In some jurisdiction tax authorities may regard a subsidiary

with a debit account in a notional cash pool as in effect “borrowing” from the group for the

purposes of calculating thin capitalisation ratios.

25.11 Deemed dividends

In some regimes (even where thin capitalisation is not an issue) payment of interest from a

company to its parent may be regarded as a dividend and taxed accordingly by the parent’s tax

authority.

25.12  Financial instruments

The taxation of gains or losses on financial instruments may be applied on a realised or accrued

basis.

25.13 Implications of treasury centre location

Tax is a major issue in the selection of a treasury centre location. Areas set up specifically to

attract treasury may be located in low-tax environments, where local taxes are low and where

there is special treatment of foreign earnings. Such centres usually have practical tax rules

designed specifically for financial activities. They will be located in countries with extensive tax

treaties and there will be no withholding taxes on interest earned or paid, or income from

dividends. These locations should also enable the repatriation of profits without tax deductions.

(In section 17.10, we examine in more detail all aspects of selecting a treasury centre location)

25.14 Tax on foreign exchange gains and losses

Tax on foreign exchange gains and losses is very complicated, and unlike many areas

discussed above, there is little consistency between jurisdictions on how these are taxed.

Additionally, there are special regimes such as Belgian Co-ordination Centres, Dutch Financial

Centres etc where the rules are very different for corporates operating under these regimes

compared to domestic companies.

There are basically two approaches:

taxing foreign exchange gains (allowing losses) on a realised basis – ie profit/loss is

only deemed to have occurred on liquidation of the asset or liability concerned and

taxing foreign gains (allowing losses) as they are accounted for in the profit and loss

account, even though they have not been realised.

Again, in some jurisdictions losses may be carried forward into future years and offset against

future gains. Other regimes may restrict carry forwards or not allow them at all.

25.15 Other types of tax to consider

As this is a cash management course, not a tax course, other areas that need to be considered

by treasurers will merely be covered briefly below, and will need to be further researched by

corporates with their tax advisers.

A distinction is made between passive and active income in many tax regimes. This is

particularly relevant to corporates that are US owned, but will impact others as well. In some

cases the level of taxes (usually WHT) will be different on the two types of income.

The concept of a “controlled foreign company” is also important. CFC legislation is designed to

prevent foreign subsidiaries of corporations that pay lower rates of tax than the parent having a

tax advantage. This usually means the tax rate is topped up on the CFC to the same level as

the parent by the authorities in the parent country.