Chapter 12

THE EXCHANGE FUNCTION

Reporters:
Galas, Crystal Joy M.
Enano, Margie
Miogue, Mary Joy

The exchange function of a commercial bank covers the domestic and international levels. As
far as local exchange is concerned, banks handle the clearing and collection of checks, drafts, and
other items. For foreign exchange, banks also clear and collect instruments involved in the
international network and provide the means of payment for international buyers and sellers. It would
do well, at this juncture, to look into the facets of a bank's foreign department.

This chapter discusses the items exchanged, the clearing house of yesteryears, and the clearing
house of the present. Also included are the kinds of exchanges, the collection process, and the foreign
exchange.

Items Exchanged
On the domestic level, checks drawn on banks within the city are the subject of interbank
offsetting of balances. This system of settling balances is known as the clearing process. Hence, when
a depositor deposits his check instead of encashing it, the check has to be cleared. The same happens
when a draft or coupons on bonds are deposited or given to a bank for collection. For banks will
present a number of items against one another and only the balances will eventually be settled.
In international finance, drafts, letters of credit, banker's acceptance, as well as other items
destined for collection become the subject of interbank settlements. Sometimes, the whole procedure
is terminated simply through the credit instruments or memoranda from one bank to another without
physical cash involved in the transactions. At other times, if cash has to be provided, only small sums
are needed for the voluminous exchanges undertaken.

The Clearing House

A clearing house is an association of banks that agree to contribute to the expenses of
interbank settlement of items for exchange or collection to minimize effort and provide safe measures.
It could also connote the place itself where the checks and other items are cleared. By clearing, we
mean that through the process, it will be ascertained whether or not the checks or drafts have funds
to back them up.
The place is usually a one-room affair rather than a whole building. It simply accommodates
the member-banks that grouped together for this purpose. Such banks are represented by the clerks
assigned for this specific job. Each of the banks shares in the expenses to finance the operations of
the clearing house. The expense is distributed on an equitable basis.
In the clearing house, each clerk representing a bank is given his proper place and there are
facilities provided to effect the exchanges such as the boxes where the bunch of checks are
exchanged. There are also calculating machines of the most modern styles and efficiency to further
facilitate the clearing process.
The floor plan of the room is such that there will be facility in handling over the checks between
the clerks. The chairs and other furniture and fixtures are conveniently located to avoid too much
mobility of the persons involved. For the work itself requires concentration and accuracy as the clerks
reflect the exchanges in the forms provided for this purpose. Everything in the clearing house,
therefore, tends to enhance and improve the process to attain the desired degree of safety.

Origin of the Modern-Day Clearing House

In the past, the clearing system was a rather slow and expensive process. Each bank had to
send messengers to different banks to present the checks and ascertain whether they were backed up
by funds. For example, X Bank sent its messenger to Y Bank, and Z Bank and in turn these latter two
would send their messengers to X Bank. Messengers, therefore, met each other on the way every
regular banking day.

At first, they did not know where each was bound to. But, as time went on, these messengers
started to have nodding acquaintance which soon developed to friendship. Then an idea occurred to
them. "What if each messenger just brought the checks drawn against his bank halfway and
exchanged these with the other messengers?" Then they would return to their respective banks with
the checks they exchanged. The next day, they would again exchange the checks, after these shall
have been presented to their respective banks and either cleared or returned for some reason or
another. The messengers tried the system and found the same to be convenient for them.

Soon their superiors learned about these arranged meetings. Equipped with more intellectual
prowess and ingenuity, the upperclassmen implemented the idea in a more systematic way.

The plan which was later translated into action was one whereby instead of sending
messengers to different banks, each bank would merely send one or two messengers each to a
designated place of meeting. And so the modern-day clearing house was born. After which the other
details about the functions and finances of a clearing house were deliberated upon and eventually
implemented. So that today, the process of clearing is a far cry from the days of old.

Advantages. The modern system of clearing has some advantages on the part of the bank as
well as the customers. They are the following:

1. A greater amount of work could be accomplished in less time. At the clearing house
each representative is required to come on time so that the operations could start at the signal
of the manager. Hence, if everyone is at his post at the designated time, the whole process will
be finished in less than one hour. This enables the clerks to devote their time to other tasks.
2. A lesser number of employees is necessary to accomplish clearing. At the most, only
two clerks are necessary-the delivery clerk and the settling clerk. However, in the Philippines,
only one clerk doubles up as delivery and settling clerk. This, therefore, eliminates the
employment of several messengers as in the old system.
3. Less amount of money, if at all, is needed to effect the clearing. There is hardly any
cash that changes hands among banks. If there be any, then this would only represent the
balances. For example, if X Bank has P600.00 claims against Y Bank and Y Bank has P500.00
claims against X, only the balance of P100.00 in favor of X Bank will be settled.
4. It is a safer way of settling balances. While it is true that the items are stamped "Non-
negotiable" before they are brought for clearing, nevertheless, the present system is safer than
what it used to be in the past. For any misdemeanor on the part of the representatives could be
checked in no time as there is a designated place of meeting. Responsibility is also pinpointed.

Operation. The process of clearing checks begins from the time the banks' representatives
leave their respective banks up to their return after having exchanged the checks and the proper
entries are made in their books. Sometimes, it involves the next day when some of the items are
returned due to some defect or insufficiency of funds.

Before leaving the bank, the clerk assigned for clearing prepares the checks to be cleared as
well as the settling statement. In assorting the checks, each bank upon which they are to be
presented for clearing and eventual settlement, is assigned a number. An envelope to contain these
checks is then labeled as to the bank's number, name, and the total number and amount of checks.
Accompanying the checks will be a list of each one of them where their numbers and amounts are
detailed. The envelope with the list and the checks is sealed. The items shall have already been
stamped "Non-negotiable."

The settling statement which contains a list of all the banks, excepting the one preparing the
statement, is then made. The bank preparing it will reflect the totals of the items drawn against the
other banks as claims against them and the grand total as claims against the clearing house. This total
is also reflected in the "credit card."

Upon arrival at the clearing house, the bank representatives present the credit card to the
clearing house's settling clerk. The latter enters the amount in his settling statement. The
representatives then enter the room and take their respective seats. At the signal from the manager of
the clearing house, they start exchanging the envelopes containing the checks. Then the amounts
appearing on the exchanged envelopes are reflected in the settling statement. When the signal to stop
is given, all the representatives heed the order.

In the meantime, some of the clerks shall have gone back to their banks to bring the
exchanged packages of checks for final disposal. Or, they may all wait until the clearing period is over
before they go back to their respective banks.
 Upon going out, each clerk presents the debit card to be filled out in by the clearing house
settling clerk as to the amount. The balance will then appear to be either "Due To" or "Due From" as
the case may be. If the bank represented has more claims than payments to the other banks, then it
has a credit balance or "Due From." It is then said that it gains from the clearing process. But if the
reverse situation happens, the bank loses.

If there are two clearing periods, the checks not cleared in the first clearing will be taken
up in the next clearing."

Collection of Proceeds. In a sense, the clearing process is also the collection of checks, although
collection may partake of a somewhat different nature in other cases. The procedure of entering the
transaction in the bank's books, however, follows similar patterns.

When an item is either for deposit or collection, the person expecting the proceeds is
immediately credited in the bank's books on a deferred basis. Before these proceeds are realized,
however, the item is sent for clearing, as has already been described. So that if the instrument is
dishonored, then the bank will have to make reversing entries to cancel out the original entries. If the
items are honored, that is, they are not returned in the next clearing period then the entries become
final in favor of the recipient of the proceeds.

If the collection item requires a service charge, as is the normal procedure in most banks, then
the expense is either deducted from the depositor's account or the person requesting the collection is
charged separately. In either case, the bank earns a service charge from collections effected through
it.

In the collection of checks or other items, another aspect to consider would be the type of
exchange encountered. Hence, the different exchanges might be well looked into.

Kinds of Exchanges
To fully grasp the significance of the clearing and collecting processes, the following kinds of
exchanges may bring to light the deviations from the simplest to the more complicated types.

Simple exchange occurs when the parties involved are depositors of the same bank in the same
locality, or between the main office and its branches flence, the process of clearing and collection is
simplified. The only thing to do is to offset the entries by debiting the account of the check's issuer
and by crediting the account of the party depositing the check. The check itself is not sent to the
clearing house. The reason for this lies in the fact that the bank is in a position to ascertain right
away, except in branches outside the locality, whether the check is backed up by funds or not since it
has the subsidiary ledgers of both parties to the exchange.

Local exchanges take, lace when the parties are depositors of two different banks but in the
same locality. In this case, the check is sent to the clearing house, where it will be among the checks
exchanged and finally presented to the bank on which it is drawn. Upon deposit, the person depositing
the check is credited on a deferred basis, subject to clearance. If the check is good, that is, it is
backed up with funds, the credit entry stays. But if the check is returned for insufficiency of funds or
other reasons, then a reversing entry is made. These would be the entries in the individual bank's
books.

However, since the banks belong to the clearing house, entries reflecting gains or losses in the
clearing and collection process will also be entered in the clearing house's books. Such balances fall
under the category of interbank deposits which form part of the banks' reserves.

Domestic intercommunication is a little more complicated, and occurs when the parties to the
exchange belong to different banks situated in different localities. As in local exchange, entries will be
made when the recipient of a check deposits the same or request the collection of the same. But,
because there is no clearing house in other places, the process of clearing will be done at the Bangko
Sentral.

International exchange resembles domestic intercommunication, except that exchange and

collection is effected between parties living inter different countries and depositing different banks.
The items will be cleared at the international clearing house. Another at feature added would be the
conversion of one kind of money to another. Hence, exchange rates are involved in the process. For
example, the dollars will be converted to pesos or vice versa.

It must be said, at this point, that not only depositors are privileged to make use of the bank's
exchange function but also customers who request banks to collect items for them. The only possible
advantage of a depositor would be the lesser charge for collection or perhaps even to the extent of
collection gratis et amore as an added service of the bank in an effort to win more depositors and to
maintain cordial relations with the old ones.

Communication Breakthroughs
One of the major services offered by multinational banks is the movement of funds across
national boundaries. Nonetheless, the service was not developed adequately until the early 1970s.
Prior to that, transfer of funds among countries could take several days to several weeks, even when
cable transfers were used. This necessitated the development of fast and efficient ways of
communicating.

In the effort to eliminate the time lag in carrying out international money transfer by mail or
telex, a number of banks organized the Society for Worldwide Inter-bank Financial Telecommunication
(SWIFT) in 1973. The SWIFT has grown from an initial membership of 239 banks in fifteen countries
to over 1,200 banks in more than fifty countries. The SWIFT services primarily involve processing
transactions such as customer transfers, foreign exchange confirmations, bank transfers, and
documentary credits. A special message text language allows banks to 'talk' to each other by
computer in common language. This added capability serves to greatly facilitate information transfers.

Another important institution is the Clearing House Interbank Payment System (CHIPS), an
international electronic check transfer system that moves money between major US banks, branches
of foreign banks, and Edge Act subsidiaries of out-of-state banks. The system handles a large volume
of transactions per day and most of the foreign exchange trade and Eurodollar transactions. The
CHIPS has speeded up the settling of its transactions to the close of each business day rather than the
next business day as was the custom.

In the Philippines, there is the Philippine Clearing House Corporation (PCHC) which is co-equally
owned by the members of the Bankers Association of the Philippines (BAP). It is a corporation with 11
board of directors. The direct participants to the PCHC are the commercial banking institutions. The
non-commercial banks are the indirect participants through a Conduit Clearing Agreement with direct
clearing participants. All participants to the PCHC must be banking institutions that operate under a
charter, or certificate of authority granted by the Bangko Sentral. All commercial and universal banks
both foreign and local that are members of the Bankers Association of the Philippines (BAP), were
required to own equity holdings with the PCHC. Eventually, PCHC admitted the thrift banks into its
membership.
The PCHC was born for the purpose of automating the clearing system of checks and
checking transactions. Hence, clearing of checks is now done through the Electronic Clearing System
(ECS). The system enhances the timing, prioritizing, and updating of bank accounts. It provides online
communication linkage between the clearing banks and the PCHC. This results in the on-the-spot
transmission of electronic check data to a host computer within time limits to fully expedite clearing
transactions. Banks have access to the host for the retrieval of clearing information immediately after
the netting process, which takes two hours after bank cut-off time.

In addition to the PCHC, there is the Bangko Sentral Regional Clearing System that caters to
the regional banks.

The Collection Process

The collection process involves the clearing of checks or drafts. The collection items may be
classified as to how the payment will be effected, and they are known as the clean and documented
items. The differences between them are briefly cited below:

1. Clean items. When the check, drafts, or other items given for collection is free of any
documents or conditions relating to its final payment, it is termed as clean collection.
2. Documented items. When the payment of the items for collection is predicated on certain
conditions contained in the contract of credit, such as the term "sight draft with bill of lading"
(SD/BL) or where the other documents must be presented before payment is effected, the
 process is known as documented collection. In such a case, the bank assigned to collect the
item should strictly follow the conditions set forth in order to avoid liability or loss on its part.

So that the bank may be guided accordingly upon payment of the documented collection item,
it prepares a tickler which is used as some sort of filing system to determine the maturities of drafts.
The tickler is referred to when a maturing item is presented for payment. Among the important
aspects of the preparation of this filing system is the entry of the conditions to be followed regarding
the collection. This becomes very important in case of time drafts or collection items maturing after a
certain period of time.

The collection procedure may also be effected by and time drafts, as follows: the use of
demand or sight drafts

1. Demand items. These are collection items which are payable on demand upon presentation.
If dishonored, they should be immediately referred to the issuing party so that the necessary
correction on the instrument may be made to facilitate payment. Or the necessary protest could
be likewise presented verbally or in writing according to law, as mentioned in the chapter on
bank credit instruments.
2. Time items. Time items are those whose payment is effected after a certain period of time
upon presentation. Such items are presented first for acceptance and then at maturity for
payment. The time items are also usually documented and therefore require the setting up of a
tickler to keep track of the maturities and the instructions for payment.

As in the case of demand items, they are to be protested when dishonored either for
acceptance or for payment. Or they may just be referred to the parties issuing them for correction
or any other remedy to facilitate their negotiation and final payment.

Foreign Exchange
Foreign exchange may include several interpretations. It could mean the exchange of goods
and services between international buyers and sellers. Or it may refer to the means of payment in
international trading.

The banks deal mostly in the transfer of funds without the physical use of cash from the
simplest to the most complicated type of exchange. It is, therefore, fit for the discussion on foreign
exchange in this chapter to focus on the bank's foreign exchange function relating to the means of
payment and the instruments used therein.

Exchange Rates. Exchange rates are prices and are, therefore, determined by supply of and
demand for foreign exchange. The date of payment is of utmost importance in determining these
rates. Hence, it becomes evident that the method of transferring the funds would be a matter of
importance. Payment transmitted by cable rather than by mail would spell a significant difference in
the rate of exchange.

In the matter of the instruments themselves, a demand draft would be more advantageous
than a time draft. For although a duly accepted draft could be easily negotiated, it requires the
discounting process. The bank, however, earns more in discounting time drafts.

In quoting prices, either the "rate of the day" or some other price prevailing in the money
markets, the cost of transmission is usually excluded since such cost may vary according to the
method of transmission-either by cable or by mail. In case of by cable, for instance, the night letter
(NLT) would be the least expensive.

The Balance of Payments. The balance of payments (BOP) would reflect the economic a
statistical transactions one country has with other nations of the world. It is a that summarizes, for a
specific period (typically a year or quarter), the economic transactions of an economy with the rest of
the world. It covers all the goods, services, factor income and current transfers an economy receives
from or provides to the rest of the world, and capital transfers and changes in an economy's external
financial claims and liabilities. Transactions are generally between residents and non-residents. The
exceptions are the exchange of transferable foreign financial assets between residents and
transferable foreign financial liabilities between non-residents. For purposes of the BOP, residency
relates to the economic territory of a country, not nationality. An international unit is a resident unit
when it has a center of economic interest in the economic territory of a country.

In the Philippines, our balance of payments would be the statement of transactions entered into
between our country and the other foreign countries with which we trade at a given point of time.
This, therefore, would necessitate foreign exchange to supply the means of payment. The demand for
and the supply of foreign exchange would then become doubly significant considering the items
entering into the balance of payments transaction. The items are:

1. Visible items. These consist of the merchandise exports and imports recorded in the customs
for ascertaining the duties on them. In effect, exchange of visible items would be barter and
only the balance would be actually settled. The need, therefore, to measure the monetary value
requires a unit of account and also the exchange rate.
2. Invisible items. These consist of the money payments used in international transactions such
as the salaries of diplomatic representatives, expenses of tourists, students' pension, and other
such payments which are hard to keep track due to their nature. Some of these payments may
not be recorded accurately. Included here would also be the balancing item which is used to
settle the deficit in the balance of international payments.

Besides the above mentioned items, there are also the unilateral transfers which do not require
cash, but by international accounting procedure, must be entered on both sides of the balance of
payments.

When a deficit exists at the end of the period, such is settled either by means of physical gold
or silver transfers or by foreign exchange. The deficits are usually settled in dollars which might be
covered by foreign balances the Philippines holds abroad or may be sent by any of the methods of
transfer. This latter alternative is availed of if our dollar holdings abroad are not enough to meet the
deficit. It is for this very reason that our Bangko Sentral maintains a sizable amount of dollar reserves
both locally and abroad.

It would be noticed, therefore, that in some instances, clearing processes would suffice in the
settlement of the balance of international payments. For when a country enjoys a surplus position, it is
credited with the amount in foreign exchange. So that when the same country needs this surplus to
pay off merchandise or other items, then the account representing the surplus will merely be debited
to effect payment. Only when the deficit payment cannot be absorbed by foreign balances does the
country suffering a deficit send the actual payment in physical cash, in the form of foreign exchange.
This rarely happen as the common usage is merely the offsetting of entries among correspondent
banks in the international network.

BOP Major Accounts. There are three major accounts in the BOP, namely, current, capital, and
official reserves. Current account records net flow of goods, services, and unilateral transfers. Capital
account records public and private investment and lending. Transactions here are classified as
portfolio, direct, and short term. Official reserves account measures changes in international reserves
owned by central banks and reflects surplus/ deficit of current account and capital account; and these
reserves consist of gold and convertible securities.

Methods of Transfer. Foreign exchange may be transferred from one country to another by the
following methods of transmission:

1. Wire or cable transfer. This is accomplished by one party (a local bank) ordering another party
(a bank in another country) through cable or telephone to pay a sum certain in money to a
specified beneficiary. The cost of transmission is included in the payment.

The cable sent is usually coded and in such a type of transfer, the party receiving the
order may not receive any credit instrument but merely a confirmation of the transaction,
depending upon the wordings of the cable.

In availing of the cable transfer, it may therefore be either an order to pay or simply for
the purpose of informing payment. Hence, the tenor of the cable may be "cable proceeds" or
"advice by cable." In the first case, the proceeds or payment is effected upon receipt of the
 message. In the latter case, information to pay is relayed by cable but the proceeds may be
sent by mail in the form of a draft or some other credit instrument.

2. Mail transfer. This is also an order to pay from one party to another, except that it is sent through
the mail-most often, if not always, by airmail. It is resorted to in order to minimize the expenses since
cable rates vary according to the time element. An instrument representing the order to pay is sent by
mail with a covering letter.

Whether the method of transmission is by cable or by mail, there is necessity for presentment
to effect final payment. If the instrument is a time item, then it must be, as in the regular course of
clearing and collection, presented for acceptance first and later on for payment.

Sometimes, payments are made by offsetting of book entries and, therefore, only credit or
debit memoranda are sent through the mail for confirmation. Or the message to confirm may be
cabled and the confirming memoranda are sent by mail for record purposes.