What is a central clearing bank and how does it work? And please explain like I am literally 5 years old. I understand nothing about finance.

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What is a central clearing bank and how does it work? And please explain like I am literally 5 years old. I understand nothing about finance.

In: 35

You know that bank on Main Street with the Bank of America sign, that’s not the Bank of America. It’s a branch, one of many. There is a BofA central clearing bank, in LA I think. That’s where the interbank transaction you did at the local branch really happen.

A transfer of funds from an account at bank A to an account at bank B requires a coordinated transfer between different accounts.

When Alice sends $100 to Bob, bank A must somehow transfer the money to bank B, adjust Alice’s balance and tell bank B that there is money which needs to go to Bob’s account.

One way of doing that is for Bank B to have an account at bank A. Bank A just transfers the money from Alice’s account to Bank B’s account and then messages bank B to tell them there is money incoming for Bob.

This works fine if there are 2 banks. If there are 100 banks, then each bank needs 99 accounts with the other banks. Things start getting complicated. Worse, what if bank C gets into financial trouble and runs out of money – every bank with an account at bank C might lose money.

The other way is to use a central clearing bank. There is one central bank which acts as middleman. Every other bank has an account with the central bank.

When Alice sends $100 to Bob, bankA messages the central bank. The central bank transfers $100 from Bank A’s account into bank B’s account, and forwards the message to bank B telling them that the money is for Bob.

This makes it much simpler, each bank only needs one account with the central bank. Also the central bank guarantees each transaction. It doesn’t do anything which can get it into financial trouble so it won’t lose the banks’ money. This makes risk management easier for the other banks.