The 137 banks that are members of the Clearing House Interbank Payments System pass and receive electronic funds transfers in their own name all day long.
But unlike Fedwire, where the Federal Reserve guarantees the payment once it notifies a bank the funds are in its Fed account, payments made on CHIPS are provisional and are not made final until settlement -- which occurs around 5:45 p.m. each business day.
There are 21 settling participants and 116 nonsettling participants that make and receive payments in their own name during the day but must use a settling participant for the actual transfer of funds at the end of the business day.
Settlement on CHIPS is done on what is called a net basis. At the end of the day, CHIPS tells each bank what its position is with respect every other CHIPS bank and what its overall net position is.
So Citibank, for example, might be told it has received $1 billion in payments from Chase Manhattan Bank and sent $1.1 billion in payments to Chase. On a net basis, Citibank owes Chase $100 million. Totalling up all the bilateral net positions, Citibank may have received $15 billion in payments and sent out $16 billion. In the aggregate, Citibank owes $1 billion net.
Because the banks deal only with each other, the net amount banks owe must equal the net amount banks are due.
The settling banks review all their positions plus the positions of the nonsettling banks that use them as agents -- in part to make sure the nonsettling banks have enough funds to cover their net position.
If all banks indicate they are willing to settle, those that owe funds on a net basis transfer those funds from their Federal Reserve accounts via Fedwire to the CHIPS settlement account at the New York Federal Reserve Bank.
Once all the payments are in, the CHIPS settlement account then sends funds via Fedwire to the Federal Reserve accounts of CHIPS banks that are due funds.
A settling bank can refuse to settle, either on its own account or if a nonsettling participant does not cover its position. Non-CHIPS members use CHIPS banks as agents. If a non-CHIPS bank does not cover its position, however, a CHIPS bank still is required to settle.
If a bank refuses to settle, CHIPS wipes out all transactions for that bank for the day. It is as if the bank never made a payment or received one. Then the remaining 136 banks try to settle. If the bank that cannot settle has a large net debit -- or daylight overdraft position -- it is possible that the default will spread throughout the entire CHIPS system.