Explainer: The Settlement Finality directive opens its doors to payment and e-money institutions

Ivan Mangatchev explains how the EU’s Settlement Finality Directive ensures payment finality and protects financial systems, now including payment and e-money institutions.

The world of settlement finality

From an outsider’s perspective, the world of settlement finality might seem somewhat obscure and mystic. In practice, it is indirectly related to our everyday life, as it concerns financial stability. In general, the purpose of settlement finality is to mitigate the so-called „systemic risk“or the risk that the illiquidity or failure of one institution and its inability to meet its obligations when due will lead to the illiquidity or failure of other institutions.[1] The result could be financial crisis that affects society as whole.

The European Union (EU) Directive 98/26/EC (Settlement Finality Directive, SFD) governs settlement finality in payment and securities settlement systems. The SFD has been transposed into the national law of EU Member States.[2] It is surprising that the SFD does not explicitly define “finality,” but only references it twice in the context of reducing systemic risk, and ensuring the enforceability of collateral and netting, specifically in Recital 9 and Recital 12. It is important to note that, finality, based on the SFD`s title, applies only within the scope of “payment and securities settlement systems”.

1. What does “settlement system” mean?

Before analysing the nature of settlement finality, it is important to first clarify what constitutes a settlement system. Article 2(a) of the SFD establishes three positive and two negative criteria that an arrangement must satisfy to qualify as a system under the SFD.

Positive criteria:

• The system must be a formal arrangement involving three participants (or two as an exception), governed by common rules and standardised arrangements for clearing or executing transfer orders between participants, whether through a central counterparty (CCP) or not.
• The system must be governed by the law of a Member State chosen by the participants; however, the chosen law can only be that of a Member State in which at least one participant has its head office, and
• The system must be officially designated as such and notified to the European Securities and Markets Authority by the Member State whose law applies.

Negative criteria:

• The system operator, settlement agent, CCP, clearing house, or indirect participants are not considered participants within the system, as their role is to operate it; and
• Arrangements between interoperable systems, meaning between two or more system operators involving cross-system execution of transfer orders, do not qualify as a system under the SFD.

2. Who can be a participant in the settlement system?

There are two categories of participation in the settlement system – direct and indirect – Art. 2 (f) and (g) SFD.

A “direct” participant can be an institution, CCP, settlement agent, clearing house, system operator or clearing member of a CCP authorised pursuant to Article 17 of Regulation (EU) No 648/2012. The “indirect” participant is an institution, CCP, settlement agent, clearing house, or system operator with a contractual relationship with a participant in a system executing transfer orders. This relationship enables the indirect participant to pass transfer orders through the system, provided that the indirect participant is known to the system operator. It relies on a direct system participant to carry out transfer orders on its behalf, either because it does not meet the system's admission criteria or because direct participation in a system would be too costly.[3]

3. The newcomers in the system – payment institution and electronic money institution

As it has already been mentioned above, institutions are in the scope of direct and indirect participants. Such institution can be credit one, investment firms, public authorities, publicly guaranteed undertakings or any undertaking whose head office is outside the EU and whose functions correspond to those of the EU credit institutions or investment firms – Art. 2 (b) SFD.

These institutions were included in the SFD by virtue of Art. 4 Regulation (EU) 2024/886 in 2024.  The reason for such a step has been explained as an effort in removing obstacle for payment institution and electronic money institutions from providing instant credit transfers in euro efficiently and competitively – Recital 15 Regulation (EU) 2024/886.

It is important to note that an “instant credit transfer” means a credit transfer which is executed immediately, 24 hours a day and on any calendar day – Art. 2 (1a) Regulation (EU) No 260/2012. Such transfers can be initiated via online banking, mobile banking applications, an automated teller machines, or in any other way on the premises of the payment services provider (PSP). Both payment institution and electronic money institutions are PSPs – Art. 4 (11) Directive (EU) 2015/2366 (PSD 2). Furthermore, Art. 5a (1) Regulation (EU) No 260/2012 requires all PSPs offering payment services for sending and receiving credit transfers to also provide instant credit transfers services.

4. Execution of transfer orders in the settlement systems

As mentioned above in the discussion of the first positive criterion, the main purpose of the settlement system is to clear or execute transfer orders between participants.

Transfer order is an instruction by a participant to place at the disposal of a recipient an amount of money by means of a book entry on the accounts, an instruction that results in the assumption or discharge of a payment obligation as defined by the rules of the system, or to transfer the title or interest in securities via a book entry on a register – Art. 2 (i) SFD. It represents the intention of the participants to “settle” their intended transactions.

Clearing is a process for establishing positions, including the calculation of net obligations and ensuring that financial instruments, cash, or both, are available to secure the exposures arising from those positions – Art. 2 (3) Regulation (EU) № 648/2012 (EMIR). Typically, it precedes the settlement. In the context of securities, “settlement” means the completion of a securities transaction, where obligations between the parties are discharged through the transfer of cash, securities, or both (Art. 2(1)(7), Regulation (EU) No 909/2014 – CSDR). Settlement requires participants to have a settlement account held with central bank, settlement agent, or CCP. This account is used for holding funds or securities and to facilitate the settlement of transactions between participants.

In other words, “clearing” refers to the calculation of the settlement position of all parties in relation to each other, while “settlement” is the transfer of value based on those calculations, caried out by a clearing house or by a settlement agent.[4]

5. Netting

Settlement systems can be classified as Real Time Gross Settlement (RTGS) and Deferred Net Settlement (DNS) systems. In an RTGS environment, every transfer order is settled individually, on a transaction-by-transaction basis. In DNS systems, transfer orders are settled on a net basis, meaning that the participant’s settlement position is calculated on bilateral or multilateral basis, as the sum of the value of all the transfers.[5] From a legal point of view, netting is defined as the process of converting multiple claims and obligations arising from transfer orders – issued or received by a participant or participants to or from one or more other participants – into a single net claim or a single net obligation, so that only the net claim may be demanded or the net obligation must be fulfilled (Art. 2(k), SFD).

Settlement finality of transfer orders and netting

In order to mitigate systemic risk and potential disruption of settlement systems in the event of insolvency proceedings against a participant, the SFD provides protection for transfer orders and netting.

If insolvency proceedings are opened against a participant, transfer orders and netting are legally enforceable and binding on third parties as of the moment prior to the opening of such proceedings – Art. 3 (1), first paragraph, SFD. Even more, these proceedings do not have retroactive effects on the rights and obligations of the participant arising from, or in connection with, its participation in the system before the opening of such proceedings.

The so-called “suspect period” – the rules under which certain transactions performed during a specified period before the opening of insolvency proceedings can generally be challenged by the insolvency administrator as void – will not apply – Art. 7 SFD.

The second scenario is when transfer orders are entered into a system after the opening of insolvency proceedings and are carried out within the business day (as defined by the rules of the system) of the opening of such proceedings. They will be legally enforceable and binding on third parties only if the system operator can prove that, at the time such transfer orders became irrevocable, it was neither aware nor should have been aware of the opening of the proceedings – Art. 3 (1), second paragraph, SFD. It is important to be mentioned that insolvency proceedings against a participant will not prevent funds or securities available in the settlement account of that participant from being used to fulfil that participant’s obligations in the system on the business day of the opening of the insolvency proceedings – Art. 4 SFD.

Thus, in both scenarios, the SFD recognises irrevocability of transfer orders and the finality of netting, both before and after the opening of insolvency proceedings against a participant.

Why the inclusion of payment institution and electronic money institution in the SFD matters

Most people use online banking and mobile banking applications in order to access their payment account and initiate payment transactions. That is why it is very important for them to be sure that their payment transaction will be executed safely and reach the intended recipient of funds, even in the event of insolvency proceedings against their own or the payee’s payment or electronic money institution. Art. 10 (1) of PSD2 provides two safeguards for funds received from payment service users or through another PSP for the execution of payment transactions:

• funds should not be commingled with other funds held with the same PSP and they are protected against claims from other creditors of the payment institution or electronic money institution, in particular in the event of insolvency; or
• funds should be covered by an insurance policy or other comparable guarantee in the event that the payment institution or electronic money institution is unable to meet its financial obligations.

The amended SFD enhances the safeguards provided by Art. 10 (1) PSD2 by extending protection to payment institution and electronic money institutions at the level of their settlement accounts. This protection is crucial not only for these institutions but also for their payment services users. It represents a significant step toward a safer and more stable financial environment.