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 210178

numbers
Value date 060600
Random code from bank test 172611
code sheet
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 - These additional charges can include stopped cheques,
taken 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 beneficiary Loss of value toWho initiates

payor
MANUAL Immediate Immediate Payor
Cash 2-3 days 2-3 days Payor
Cheques 2-3 days Immediate Payor
Giros/bank
transfers
AUTOMATED Value date (3 days afterValue date Payor's bank
Standing order * initiation) Value date Beneficiary
Direct debit * Value date (3 days after1-2 days Payor
Debit cards initiation) Up to 6 weeks Payor
Credit cards 1-2 days
2-3 days (average)
ELECTRONIC Same day Same day Payor or payor's bank
CHAPS
BACS Value date (3 days afterValue date Debits - beneficiary
initiation) 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 - cumbersome and old fashioned
- Fax - strong security risks
- Cross-border EFT - 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 Postal system slows receipt

(Manual)
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 The management of cross-border payments resulting in a net

netting 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 Week 2 Week 3

(EUR000) (EUR000) (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 % of value Day % effect
cheques issued expected to clear

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 75

(payables)
Receivables 450 Equity 900
(debtors)
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 200.0 *
loans
Stock 330 (10% of sales)Preference 225.0
shares
Net assets 525 (600-75 Equity 1,110.0
depreciation)
Total 1,515 Total 1,617.5
assets liabilities

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 .10 180 = 5.25

x
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 Liquidity Tax Interest Quoted Current
of support status price form
Commercial 1 to 270 Obligation of Liquidity Interest Normally Yield to Book entry
paper days issuers; varies with subject sold at a maturity
 some are quality of to discount
credit issuer, federal but can
enhanced by though and be
a letter of generally state interest-
credit or held to income bearing,
guarantee maturity taxes with face
value
paid at
maturity
Bankers’s 1 to 180 Obligation of Liquidity Interest Sold at Discount Evidenced
acceptances days accepting varies with subject discount rate by written
bank type and to with face confirmation
quality of federal value
(Bank has accepting and paid at
recourse to bank state maturity
borrower) income
taxes
Repurchase 1 to 90 Securities None Interest At Yield to Evidenced
agreements days held as subject maturity maturity by written
collateral to confirmation
federal
and
state
income
taxes
Negotiable usually 7 Obligation of Liquidity Interest Paid at Yield to Bearer or
certificates days to 5 issuing bank varies with subject maturity maturity registered
of deposit years plus quality of to or semi- form
USD100,000 issuer federal annually
deposit and if
insurance per state maturity
depositor income is over
when FDIC taxes one year
insured
Treasury 3 months Obligation of International Interest Sold at a Discount Book entry
bills to 1 year US market: very subject discount rate
(usually government liquid to with face
3, 6 or federal value
12 income paid at
months tax; maturity
value exempt
paid) from
state
and
local
taxes
Treasury Notes: 2 Obligation of International Interest Semi- In 32nds Book entry
notes and to 10 US market: very subject annually of USD1 and
bonds years. government liquid to per registered or
federal USD100 bearer if
Bonds: income (eg 102 dated prior to
10 to 30 tax; 3/32) 1983
years exempt
from
 state
and
local
taxes
Treasury 3 months Obligation of International Interest Sold at a Bond Book entry
STRIPS to 30 US market: very subject discount equivalent
years government liquid to with face yield
federal value
income paid at
tax; maturity
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 1½
500,000 - 999,999 1¼ 3 2
1,000,000 and over 1¾ 4½ 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 Market price Bank price Marginal

costs 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.
EDIFACT 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 1 import 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.