Put simply, a distinction is made between settlement in central bank money and settlement in commercial bank money. In short, this is about who provides the accounts in which the settlement of money takes place, and thus whom the participants in a settlement system take risk against.

Central bank money is money issued by a central bank and can include cash, i.e. physical banknotes and coins, or digital money, such as that held by banks in accounts with the central bank. An alternative to central bank money is commercial bank money. Commercial bank money is best defined as money issued by a commercial bank and held in accounts at that bank. Settlement means that money, securities or both change hands in a transaction by making a transfer between two parties.

CPMI-IOSCO^[3] CPMI is a standard-setting body for central banks and IOSCO is the equivalent for financial supervisory authorities. has published international principles, the Principles for Financial Market Infrastructures (PFMI), ^[4] Principles for Financial Market Infrastructures (bis.org) to provide guidance for maintaining a safe and efficient financial infrastructure. These principles define settlement in central bank money and commercial bank money as follows:

Central bank money is a liability of a central bank, in this case in the form of deposits held at the central bank, which can be used for settlement purposes. Settlement in central bank money typically involves the discharge of settlement obligations on the books of the central bank of issue. Commercial bank money is a liability of a commercial bank, in the form of deposits held at the commercial bank, which can be used for settlement purposes. Settlement in commercial bank money typically occurs on the books of a commercial bank.

To carry out a settlement, money needs to be held in an account with the operator where the settlement takes place, a settlement institution. If the settlement institution is a central bank, the money in the account is central bank money. If it is a private settlement institution, such as a bank or a private financial market infrastructure, it is commercial bank money. By holding money in an account, the account holder has a credit risk towards the provider of the account, as that money ends up on that provider's balance sheet. The same risk may arise if a participant pledges securities to gain access to money for settlement. International principles and guidelines, as well as European legislation, favour the use of central bank money for settlement in financial market infrastructures.

However, it is important to distinguish between credit risk and counterparty risk here. The most efficient and safe way to settle securities is a method known as delivery versus payment (DvP), i.e. securities and money are exchanged between the counterparties in a transaction at the same time. In this way, the counterparty risk in settlement can be eliminated as the payment and the change of ownership are executed at the same time, so there is no risk of any party not receiving its share of the transaction. However, DvP does not eliminate the credit risk that exists between the settlement institution and the participants before the settlement of a transaction takes place.

If a participant has deposited money with a settlement institution and the settlement institution defaults before settlement can take place, this can have major consequences, mainly for the participant itself but also for the financial system as a whole. Participants risk losing the money they have in their accounts with the settlement institution and, in the case of large amounts, there may be spillover effects to the rest of the financial system. Therefore, settlement institutions dealing with large volumes and high values are of particular importance to the financial system. Settlement can take place without credit risk if it is in central bank money. As a central bank cannot go bankrupt, settling in central bank money eliminates credit risk. However, it should be noted that the financial system is based on a combination of, and interaction between, systems settling in central bank money and commercial bank money.

An example of a settlement system in Sweden that settles in central bank money is Euroclear Sweden, the Swedish Central Securities Depository (CSD). Euroclear Sweden's settlement of securities is based on a model in which central bank accounts belonging to the Riksbank are integrated into Euroclear Sweden's system, and settlement of securities can thus take place against money on the same technical platform. As the money is held in accounts provided by the Riksbank, the credit risk is on the Riksbank and not on Euroclear Sweden.

Euroclear Bank is an example of an institution that settles in commercial bank money. Euroclear Bank is a CSD with a banking licence, which means it can give and take credit from its participants. Participants can use securities held in their account with Euroclear Bank as collateral to access money to settle new transactions. This means that participants have a credit risk on Euroclear Bank and vice versa.

An institution that settles in commercial bank money can limit the credit risk of participants by allowing them to deposit money for settlement in an account with the central bank and limiting their settlement capacity to the amount they have deposited with the central bank. This refers to a settlement model in commercial bank money that is backed by central bank money. In the event that the settlement institution does not provide or take credit, no credit risk arises between the settlement institution and its participants.