Payment System Technologies and Functions: Innovations and Developments

Payment System Technologies and Functions: Innovations and Developments Masashi Nakajima Reitaku University, Japan

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Library of Congress Cataloging-in-Publication Data

Nakajima, Masashi, 1958Payment system technologies and functions: innovations and developments / by Masashi Nakajima. p. cm. Includes bibliographical references and index. Summary: “This book analyzes the evolutionary trends, functions and mechanisms of payment systems and presents an in-depth explanation of how these trends led to the reduction of settlement risk and the importance of such mechanisms that have contributed to the evolutionary progress of payment systems”--Provided by publisher. ISBN 978-1-61520-645-2 (hbk.) -- ISBN 978-1-61520-646-9 (ebook) 1. Check collection systems. 2. Electronic funds transfers. 3. Clearinghouses (Banking) 4. Payment. I. Title. HG1692.N35 2011 332.1’78--dc22 2010040558

British Cataloguing in Publication Data A Cataloguing in Publication record for this book is available from the British Library. All work contributed to this book is new, previously-unpublished material. The views expressed in this book are those of the authors, but not necessarily of the publisher.

Table of Contents

Foreword............................................................................................................................................... vii Preface..................................................................................................................................................viii Acknowledgment................................................................................................................................. xiv Section 1 Basic Knowledge about Payment Systems Chapter 1 Basics of Payment Systems.................................................................................................................... 1 Introduction.............................................................................................................................................. 1 Settlement and Payment System............................................................................................................... 2 Importance of Payment System................................................................................................................ 2 Several Aspects of Settlement................................................................................................................... 3 Paper-Based Payment Systems and Elecronic Payment Systems............................................................ 4 Actors in Payment Systems...................................................................................................................... 4 Banks as a Payment System..................................................................................................................... 5 Processes in Payment System.................................................................................................................. 6 Functions of Central Banks..................................................................................................................... 7 Network Externalities of Payment System............................................................................................... 8 Payment System as a Natural Monopoly................................................................................................. 8 Interdependencies of Payment Systems.................................................................................................... 9 References.............................................................................................................................................. 10 Endnote.................................................................................................................................................. 10 Chapter 2 Classifications of Payment System..................................................................................................... 11 Introduction............................................................................................................................................ 11 Operator of Payment System................................................................................................................. 12 Settlement Method.................................................................................................................................. 12 Frequency and Timing of Settlement...................................................................................................... 13

Payment Value........................................................................................................................................ 14 Settlement Date...................................................................................................................................... 14 Settlement Asset..................................................................................................................................... 15 References.............................................................................................................................................. 16 Endnote.................................................................................................................................................. 16 Chapter 3 Settlement Risk..................................................................................................................................... 17 Introduction............................................................................................................................................ 17 Origin of Settlement Risk....................................................................................................................... 18 Settlement Risk and Pre-Settlement Risk............................................................................................... 18 Classification of Settlement Risk............................................................................................................ 19 Magnitude of Loss Caused By Settlement Risk...................................................................................... 20 Actual Examples of Settlement Risk....................................................................................................... 21 Exposure of Settlement Risk................................................................................................................... 23 Reduction Measures of Settlement Amount............................................................................................ 23 Reduction Measures of Time-Lag.......................................................................................................... 25 References.............................................................................................................................................. 27 Endnotes................................................................................................................................................. 28 Section 2 Basic Payment Systems and Advanced Payment Systems Chapter 4 DTNS System and RTGS System....................................................................................................... 30 Introduction............................................................................................................................................ 30 Two Basic Payment Systems.................................................................................................................. 31 Comparisons of Two Basic Payment Systems........................................................................................ 31 Risk Management Measures in DTNS System....................................................................................... 33 Risk Reduction by Introducing RTGS System........................................................................................ 36 Liquidity Management in RTGS System................................................................................................ 36 References.............................................................................................................................................. 41 Endnotes................................................................................................................................................. 41 Chapter 5 Hybrid System and Integrated System.............................................................................................. 42 Introduction............................................................................................................................................ 42 Hybrid System........................................................................................................................................ 43 Integrated System................................................................................................................................... 45 Mechanisms that Support Advanced Payment Systems......................................................................... 49 References.............................................................................................................................................. 54 Endnote.................................................................................................................................................. 54

Section 3 Innovations in Payment Systems Chapter 6 Evolutionary Trends of Payment Systems......................................................................................... 56 Introduction............................................................................................................................................ 57 Transision From DTNS System to RTGS System................................................................................... 57 Introduction of Hybrid Systems.............................................................................................................. 62 Introduction of Integrated Systems........................................................................................................ 63 Evolutionary Process of Payment Systems............................................................................................ 64 Multi-Currency Payment Systems and Offshore Payment Systems....................................................... 65 Linkage With CSD.................................................................................................................................. 70 Financial Edi Capability........................................................................................................................ 72 References.............................................................................................................................................. 73 Endnotes................................................................................................................................................. 73 Chapter 7 Driving Forces for Innovations in Payment Systems........................................................................ 75 Introduction............................................................................................................................................ 76 Rapid Growth of Settlement Values and Settlement Risks...................................................................... 76 Enlightenment by the BIS....................................................................................................................... 76 Competition between Payment Systems................................................................................................. 84 Technological Progress.......................................................................................................................... 86 References.............................................................................................................................................. 87 Endnotes................................................................................................................................................. 88 Chapter 8 Critical Issues on Payment Systems................................................................................................... 89 Introduction............................................................................................................................................ 90 Governance Structure of Payment Systems........................................................................................... 90 Legal Issues on Payment Systems.......................................................................................................... 91 Operational Reliability of Payment Systems.......................................................................................... 92 Efficiency Issues of Payment Systems.................................................................................................... 93 References.............................................................................................................................................. 94 Endnote.................................................................................................................................................. 94 Section 4 Developments of Payment Systems in Selected Countries Chapter 9 Payment Systems in US....................................................................................................................... 96 Introduction............................................................................................................................................ 97 Fedwire.................................................................................................................................................. 97

CHIPS.................................................................................................................................................. 103 ACH..................................................................................................................................................... 118 References............................................................................................................................................ 129 Endnotes............................................................................................................................................... 129 Chapter 10 Payment Systems in EU..................................................................................................................... 130 Introduction.......................................................................................................................................... 131 From TARGET to TARGET2................................................................................................................ 131 TARGET2............................................................................................................................................. 135 Retail Payment Systems In EU............................................................................................................. 151 References............................................................................................................................................ 166 Endnotes............................................................................................................................................... 167 Chapter 11 Payment Systems in Japan................................................................................................................ 168 Introduction.......................................................................................................................................... 169 BOJ-NET.............................................................................................................................................. 169 Transition of BOJ-NET to RTGS System............................................................................................. 171 FXYCS.................................................................................................................................................. 182 Zengin System...................................................................................................................................... 183 References............................................................................................................................................ 189 Endnotes............................................................................................................................................... 189 Chapter 12 CLS Bank............................................................................................................................................ 190 Introduction.......................................................................................................................................... 190 Background of CLS Bank..................................................................................................................... 191 Outline of CLS Bank............................................................................................................................ 193 Funding and Settlement Procedures of CLS Bank............................................................................... 198 Risk Management of CLS Bank............................................................................................................ 204 Liquidity for CLS Settlement................................................................................................................ 206 Counter-Measures for Pay-In Failure................................................................................................. 207 Impact of CLS Bank............................................................................................................................. 208 Extention of Business Areas by CLS Bank........................................................................................... 210 References............................................................................................................................................ 211 Endnotes............................................................................................................................................... 212 About the Author............................................................................................................................... 213 List of Abbreviations.......................................................................................................................... 214 Index.................................................................................................................................................... 219

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Foreword

It is fair to say that payment systems have become one of the most vibrant areas of reform, be it in terms of policy, technology or products. This is shown by the rapid pace of change we observe in national and international payment systems around the world. One of the reasons for this reform process is the realisation – not so long ago – of the importance of the financial market infrastructure, of which payment systems are an important part, for a safe and sound financial system. In fact, robust payment systems are widely considered to be a key requirement in maintaining and promoting financial stability. This was illustrated by the recent financial crisis where many things in the financial markets went wrong, but the payment systems – even at the worst moments when some of the markets froze – turned out to be resilient. The main reason that the financial markets managed to avoid serious problems at the level of the market infrastructure can be found in the substantial efforts made by many stakeholders in the financial system over the past years. More precisely, during the decade preceding the recent crisis, the financial sector as a whole spent a great deal of effort on enhancing the market infrastructure, mainly by removing unnecessary counterparty risk from the financial system, both at the domestic level and at the global level. This book provides an extensive overview of the world of payment systems. It starts by presenting the basic concepts and risks, describes traditional and advanced payment systems, provides useful insights in the trends and innovations in the payments landscape and ends with a description of the developments in a number of important currency areas, including the role played by CLS Bank in the settlement of foreign exchange transactions. The attention paid to innovations in this book is, in my view, very important for a good understanding of the evolution taking place in payment systems. Technological progress contributed substantially to innovations in payment systems. Arguably, technology was the main driver behind the single most important innovation to enhance the soundness of payment systems: the introduction of real-time processing and settling of payments. The rationale behind this was simple: whereas net settlement systems settle at the end of the day, real-time gross settlement systems allow for the final and irrevocable settlement of each payment at the time of it being entered into the system. There is no longer the need to wait until the end of the day to be sure that a payment received that day has successfully settled. In a sense, this conceptually small step made possible a whole series of changes that fundamentally changed the risk profile of payment systems. In this book, the reader will find all the information needed to understand the way payment systems function and will gain a better understanding of the current transformation taking place in this field. Marc Hollanders. Special Adviser on Financial Infrastructure Former Head of Secretariat, . Committee on Payment and Settlement Systems Bank for International Settlements

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Preface

Payment systems are the indispensable infrastructure for financial markets and business activities. A payment system is a mechanism that facilitates the smooth transfer of funds between financial institutions. Every commercial trade and financial transaction is finalized only when the final settlement is made through a payment system. If operational failures were to happen in a payment system, which prevented smooth transfers of funds, national economies and financial markets would be thrown into extreme confusion and seriously damaged. Therefore, the safety and efficiency of payment systems is incredibly important for national economies and financial systems to function effectively.

FEATURES OF THIS BOOK The first feature of this book focuses on the evolutionary trends of payment systems. During the past two decades, payment systems have evolved drastically from simple settlement methods to more highlysophisticated ways of handling payments. One of major factors in causing such an evolution was the progress of information technology (IT). This book analyzes the evolutionary trends of payment systems and presents an in-depth explanation of how these trends led to the reduction of settlement risk and the improvement of settlement efficiency. The background and driving forces for such innovations are also thoroughly discussed. The second feature of this book puts a spotlight on the functions and mechanisms of payment systems. The functions of payment systems have become very sophisticated and complicated with the help of technological progress. Some mechanisms were invented to support such advanced payment systems, which include frequent netting, offsetting, matching facility and advanced queue management. This book tries to cast light on the importance of such mechanisms that contributed to the evolutionary progress of payment systems. The third feature of this book comprehensively covers the basic knowledge about payment systems, which includes some definitions concerning payment and settlement, classifications of payment systems, and origins and reduction measures of settlement risk. In addition, the cases study analyses of payment systems in US, EU and Japan as well as the CLS Bank are provided in the second half of the book. These basic and concrete examples are particularly useful for beginners who want an overview of payment systems. As a whole, this book will hopefully provide a valuable tool for those interested in learning about payment systems (i.e., academics and researchers, graduate and undergraduate students, relevant parties of authority and central banks, and professionals in payment business who need to get a full understanding of payment systems).

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It is my hope that this book will make an intellectual contribution to promoting a better understanding of payment systems for a wide range of interested people, and open up the way to make further progress on enhancing the safety and efficiency of payment systems.

ORGANIZATION OF THE BOOK The book is organized into four parts and twelve chapters. A brief description of each chapter follows:

Section 1: Basic Knowledge about Payment Systems Chapter 1 gives an explanation of the basics of “payment systems.” Payment systems are an essential part of financial infrastructure. The chapter sets up the basic knowledge of payment systems to help the reader understand the discussions in the later chapters. The background knowledge includes several aspects of settlements, actors in payment systems, banks as a payment system, the process of payment systems, and the functions of central banks. It also identifies the economic natures of payment systems, such as network externalities, natural monopoly and interdependencies of payment systems. Chapter 2 presents some classifications of payment systems. Classifications are made from the following standpoints. The first point is the operator of a payment system. Some payment systems are managed by central banks and others are operated by private sectors. The second point is the settlement method. Some payment systems make settlements on a net basis and others settle payments on a gross basis. The third point is the frequency and timing of a settlement. Some payment systems execute settlements only at designated times, and other payment systems make in real-time. The fourth point is the payment value. Some payment systems are mainly for large-value payments and others are for smallvalue payments. The fifth point is the settlement date. In some payment systems, payments are settled on the same day the payment orders are submitted to the system. In other payment systems, payment orders are not settled until the next day, where overnight settlement risk resides. The last point is the settlement asset. Some payment systems use “central bank money” as a settlement asset and others make use of “commercial bank money.” These classifications are useful to understand basic payment systems as well as advanced payment systems which are discussed in the later chapters. Needless to say, these classifications are not mutually exclusive. Instead, one can use a combination of these classifications in order to describe a payment system. Chapter 3 discusses “settlement risk.” During the process from trade to its settlement, there is a risk that the settlement will not take place as expected. This is the settlement risk which may cause a liquidity problem and/or loss to the party involved in the settlement. First, the source of settlement risk is identified in two kinds of settlements; simple settlements and exchange-for-value settlements. Second, the differences are clarified between the settlement risk and the pre-settlement risk. Third, it gives the classifications of settlement risk, which includes credit risk, liquidity risk, systemic risk, legal risk and operational risk. Fourth, it makes clear the difference between the principal risk and replacement cost risk. Fifth, it gives actual examples, in which settlement risk turned into reality. They include the Herstatt Bank incident, the BCCI incident and the Bearing incident. Finally, after identifying the exposures of settlement risk, reduction measures of the settlement amount and time-lag are discussed. Several mechanisms, such as netting, Payment versus Payment (PVP), and Delivery versus Payment (DVP) are of significant importance in reducing settlement risk.

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Section 2: Basic Payment Systems and Advanced Payment Systems Chapter 4 provides comparisons between the two basic payment systems, the Designated- Time Net Settlement (DTNS) system and the Real-Time Gross Settlement (RTGS) system. Those comparisons are indicative of the difference between the two systems and highlight the characteristics of each system. The DTNS system and the RTGS system have their own advantages and drawbacks. The RTGS system is far superior to the DTNS system from the viewpoint of the reduction of settlement risk. Conversely, the DTNS system has an advantage on the aspect of liquidity required for a settlement. In sum, this chapter shows that there is a trade-off between the DTNS system and the RTGS system, or more concretely between safety and efficiency in payment system. This is the essential starting point to review the development of the advanced payment systems in the later chapters. Chapter 5 takes an analytical approach to two advanced payment systems; the “Hybrid system” and the “Integrated system.” The Hybrid system is a system which combines the liquidity-savings features of the DTNS system with the immediate finality of the RTGS system. The Hybrid system is characterized by frequent net settlements during the day. The Integrated system is a payment system which has both the RTGS mode and the Hybrid mode. The participants of an Integrated system can use the RTGS mode for urgent payment and utilize the Hybrid mode for non-urgent payment. These advance payment systems are supported by several sophisticated mechanisms achieved through the progress of information technology. The chapter gives an explanation of such mechanisms, which include (i) frequent netting and continuous processing, (ii) partial netting, (iii) offsetting, (iv) searching and matching facility, (v) queue management function, (vi) pre-funding account, and (vii) multiple functions in a single payment system.

Section 3: Innovations in Payment Systems Chapter 6 presents an analysis about the evolutionary process of payment systems. Payment systems showed remarkable changes in the past two decades. The first evolutionary trend was the transition from the traditional DTNS systems to the RTGS system. A technology diffusion analysis of the RTGS technology across the world is also presented. The next step in the evolution of payment systems was the introduction of the Hybrid system. Several Hybrid systems in Europe and the US are discussed in detail. The third trend was the introduction of Integrated system. Emergence of some Integrated systems are discussed, which include the LVTS in Canada, the PIS in France, the MEPS+ in Singapore, the TARGET2 in EU and the Next Generation BOJ-NET in Japan. And then, a hypothesis on the typical evolutionary pattern from the simple DTNS system to a more sophisticated system is proposed. The chapter also reviews another line of evolutionary trends, including “Multi-Currency Payment Systems” and “Offshore Payment Systems,” and the linkage between a payment system and a Securities Settlement System (SSS). It also gives an explanation about the adoption of Financial EDI capability, which is the scheme that enables the processing of the remittance information with payment instructions in the payment system. Chapter 7 makes an analysis of the driving forces leading to the evolutionary progress of payment systems, as mentioned above. The first driving force was the growing recognition of settlement risk. As the values of payments over payment systems increased dramatically in the past two decades, the central banks worried about the substantially-increased settlement risk. It was one of the biggest motivations in improving payment systems in each country. Second, several reports by the Bank for International Settlements (BIS) triggered the reforms on payment systems in each country. Such reports include the “Core

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Principles Report,” the “RTGS Report,” and the “Lamfalussy Report.” Third, the competition between payment systems played a role. The competition between the CHIPS and the Fedwire in US was typical case. Lastly, the progress of IT played a critical role. Enhanced computer capacity, improved communication networks and reduced technology costs contributed greatly to the innovation in payment systems. Chapter 8 discusses the public policy matters which should be considered in designing and evaluating the payment systems. First, the governance structures of payment systems are discussed. Governing approaches essentially affect the way payment systems are managed, including participation rules, risk management schemes and the efficiency of the system. Second, the legal issues with payment systems are reviewed. It goes without saying that a payment system should have a well founded legal basis. The third point of public policy matters is operational reliability of payment systems. As payment systems become increasingly dependent on computers and networks, the operational reliability of the system is a key element in preventing operational risk. The last point discussed is the efficiency of payment systems. As payment systems enjoy a monopoly situation in many countries, there are no market forces urging payment systems to achieve the cost-efficiency. Therefore, it is important for payment system operators to make the cost-efficiency of a system their own initiative.

Section 4: Developments of Payment Systems in Selected Countries Chapter 9 provides a case study on the payment systems in the US. The Fedwire and the CHIPS are the Large-value payment systems in US which handle interbank payments for the money market, government bond market, and FX market. The Fedwire is a central bank payment system, owned and operated by the Federal Reserve. The CHIPS is a private payment system, owned and operated by TCH Payments Co. The Fedwire is operated as a RTGS system. The CHIPS belongs to the Hybrid system, where net settlements are made continuously during the day. The new settlement method of the CHIPS (i.e., the “CHIPS Finality”) is scrutinized closely in the chapter. The chapter also describes the Retail payment system in the US, the Automated Clearing House (ACH). The ACH is a nationwide electronic file transfer mechanism that processes retail transfers between customer accounts. The functions of FedGlobal ACH and Financial EDI in the ACH network are also discussed. Chapter 10 provides detail on the payment systems in the EU. The landscape of payment systems in the EU was changed drastically by the introduction of a single currency, the “Euro” in January 1999. As for the Large-value payment system, the TARGET was introduced in 1999, which was a distributed system that linked the national RTGS systems with an interlinking network. The TARGET2 was introduced in 2007-2008 to replace the first-generation TARGET. The TARGET2 is a centralized system with a single platform and has a series of sophisticated mechanisms. The EURO1 is another Large-value payment system operated by the EBA CLEARING. The Retail payment systems in EU are still fragmented, which means that each country has its own Retail payment system. In order to overcome such a situation, the European Central Bank (ECB) and European Commission have promoted the Single Euro Payment Area (SEPA) project. The detail of the SEPA project is described in this chapter. Chapter 11 takes a close look at the payment systems in Japan. There are three payment systems in Japan: the BOJ-NET, the FXYCS and the Zengin System. The BOJ-NET is the equivalent of the Fedwire in the US, and the TARGET2 in Europe. It was operated as a RTGS system and then enhanced into an Integrated system in 2008. The Next-Generation RTGS (RTGS-XG) project is described in detail in this chapter.

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The FXYCS is a payment system that handles the JPY-leg payments for FX transactions. In this sense, the FXYCS is the equivalent of the CHIPS in the US. The Zengin System is a national fund transfer network for retail payments, which is the equivalent of the ACH in the US. The Zengin System is planned to be upgraded to a sixth generation system in 2011. The details of the new mechanisms of the six generation system are described in the chapter. Chapter 12 focuses on the CLS Bank. CLS Bank was established in 1999 to eliminate settlement risk associated with settling FX transactions in different time zones. Although CLS Bank was established as a private bank in the US, its function is dedicated to providing a multi-currency settlement service. Thus, CLS BANK should be regarded as one of the payment systems. This chapter elaborates on the mechanism of CLS Bank, which includes the organization, the shareholders, the eligible currencies, and the accounts used for CLS settlements. The funding and settlement procedures and risk management schemes of CLS Bank are discussed in greater detail. In addition, the impact of CLS Bank on FX settlements and the FX market is also analyzed.

REFERENCES Allsopp, P., Summers, B., & Veale, J. (2009, February). The Evolution of Real-Time Gross Settlement: Access, Liquidity and Credit, and Pricing. Financial Infrastructure Series: the World Bank. Bank for International Settlements. (2001, July). A Glossary of Terms Used in Payments and Settlement Systems. Bank for International Settlements. (2003, April). Payment and Settlement Systems in Selected Countries (the Red Book). Bank for International Settlements. (2009, March). Statistics on Payment and Settlement Systems in Selected Countries: Figures for 2007. Fry, M. (1999). Payment Systems in Global Perspective. Routledge International Studies in Money & Banking. doi:10.4324/9780203279991 Haldane, A., Millard, S., & Saporta, V. (2008). The Future of Payment Systems. Routledge. Hollanders, M. (2007). Issues Shaping the Future of Payment Systems. SPEED, 1(3), Winter. Humphrey, D. B. (1995). Payment Systems – Principles, Practice, and Improvements. The International Bank for Reconstruction and Development. Khiaonarong, T., & Liebenau, J. (2009). Banking on Innovation: Modernisation of Payment Systems. Physica-Verlag Heidelberg. Manning, M., Nier, E., & Schanz, J. (2009). The Economics of Large-value Payments and Settlement: Theory and Policy Issues for Central Banks. Oxford University Press. Nakajima, M. (2009). All about SWIFT. Toyo Keizai Inc.(in Japanese) Nakajima, M., & Shukuwa, J. (2005). All about Payment Systems (2nd ed.). Toyo Keizai Inc.in Japanese

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Nakajima, M., & Shukuwa, J. (2008). All about Securities Settlement Systems (2nd ed.). Toyo Keizai Inc.in Japanese Pringle, R., & Robinson, M. (2002). E-money and Payment Systems Review. Central Banking Publications Ltd. Rambure, D., & Nacamuli, A. (2008). Payment Systems: From the Salt Mines to the Board Room. Palgrave Macmillan. Summers, B. (Ed.). (1994). The Payment System: Design, Management, and Supervision. International Monetary Fund.

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Acknowledgment

This book was mostly inspired by the experiences when I worked in the Bank of Japan (BOJ) for more than two decades. For much of that period, I was involved in the financial stability side rather than in the monetary policy side. There, the payment system was one of the main issues of concern. My superiors and colleagues guided me in the right direction. From 2003 to 2005, I had the chance to work for the Bank for International Settlements (BIS), my colleagues at the Committee on Payment and Settlement Systems (CPSS) gave me some invaluable advice and innovative ideas. As a member of Secretariat of CPSS, I met several CPSS members who were directors of central banks in charge of payment system. Through the discussion with these thoughtful central bankers, I could get several new perspectives on payment systems. The following is the list of people whom I am particularly grateful to. Without their direct and indirect effect and contributions, this book would not come out. Alan Taylor, EBA Clearing Daniela Russo, European Central Bank Dieter Becker, European Central Bank Esmond Lee, Hong Kong Monetary Authority Hansjörg Nymphius, Deutsche Bank Hans-Jürgen Friederich, Deutsche Bundesbank Iwao Kuroda, Chuo University (former BOJ) Jean-Michel Godeffroy, European Central Bank Jeffrey Marquardt, FRB Jochen Metzger, Deutsche Bundesbank John Trundle, Bank of England Jonathan Butterfield, CLS Group Lawrence Radecki, Federal Reserve Bank of New York

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Lawrence Sweet, FRB Marc Hollanders, BIS Patrick Parkinson, FRB Robert Lindley, BIS Tommaso Padoa-Schioppa, European Central Bank Vincent De Santis, CHIPS Yoshiharu Oritani, Meiji University (former BOJ) Yvon Lucas, Bank of France Finally, I am grateful to Ms. Julia Mosemann of IGI Global for her continuing and professional support.

Section 1

Basic Knowledge about Payment Systems

1

Chapter 1

Basics of Payment Systems

ABSTRACT This chapter gives an explanation of the basics of “payment systems.” To begin with, it is necessary to know what a payment is and what a payment system is. A “payment” usually describes a transfer of monetary value between two parties, (e.g., the seller and the buyer). Thus any organized arrangement for transferring monetary value between parties can be defined as a “payment system.” Payment systems are an essential part of the financial infrastructure and their importance cannot be overstated. This chapter sets up the basic knowledge of payment systems to help the reader understand the discussions in the later chapters. The background knowledge includes the several aspects of settlement, actors in payment systems, banks as a payment system, process of payment systems, and functions of central banks. The economic natures of payment systems, such as the network externalities, natural monopoly and interdependencies of payment systems are also discussed in this chapter.

INTRODUCTION When a trade of goods or services is made, the buyer should pay “money” to the seller in exchange for them. In some cases, the money would take the form of banknotes and coins, and in other cases, the deposit money is used. This process is usually called “payment.” When a payment is successfully made, the obligation between the buyer and the DOI: 10.4018/978-1-61520-645-2.ch001

seller is discharged. This act of discharging obligations is described as “settlement.” “Payment system” is a mechanism that enables such kind of settlement or a smooth transfer of funds between buyers and sellers, and/or between banks. In the modern society, no economic activities are possible without payments and settlements. In this sense, it could probably be said that payment systems are one of the most imperative and significant social infrastructures.

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Basics of Payment Systems

As payment systems are directly supported by only a limited number of professionals in central banks and commercial banks, the general public seldom or never notices the role and importance of payment systems. For this reason, the management of payment systems has sometimes been regarded as the “behind-the-scenes activities”, which are actually not seen by many people. Similarly, payment systems are even compared to the plumbing. That is to say, payment systems are extremely important, but their operation is carried out underground and out of sight. But the times have changed, and a lot of attention is currently focused on payment systems. The background of the attention is threefold. First, the volume of fund transfers handled through payment systems has increased dramatically. That means “settlement risk” which arises when a payment is not made as expected, has also increased. Large risk is always a cause of concern for the authorities and central banks. Second, a remarkable evolution of the payment system continues due to the development of Information Technology (IT). The progress of IT has enabled the advancement of payment processing and created some enhanced payment systems. Third, the business aspects of payment have received greater recognition. Payment related businesses, like clearing businesses and custody businesses are becoming more and more attractive for financial institutions.

SETTLEMENT AND PAYMENT SYSTEM Definition of Settlement “Settlement” is defined as “an act that discharges obligations in respect of funds between two or more parties” (BIS, 2001). More plainly, settlement is an act to make payments in compensation for purchases of goods or services, and complete the business process.

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Any economic activities, including the mailorder, B2B transactions, internet auctions, trading of equities and government bonds, and foreign exchange trading, ultimately require a settlement. In other words, settlement is indispensable to credit-based business transactions in the modern world.

Definition of Payment System “Payment System” is a mechanism that enables such kind of settlement or funds transfer smoothly between the buyer and seller, and/or between the banks. According to the definition of the Bank for International Settlements (BIS), “a payment system consists of a set of instruments, banking procedures and, typically, interbank funds transfer systems that ensure the circulation of money” (BIS, 2001).

IMPORTANCE OF PAYMENT SYSTEM Payment System as an Infrastructure A payment system plays a pivotal role in circulating funds all over the economy. If some malfunctions were to happen to a payment system and hinder the flow of funds, the impact would be extraordinary and disruptive. The economic activities and functions of financial markets would become completely paralyzed. You can easily imagine such a disastrous situation where no one can make payments and no one can receive money from others, and that all the flow of funds between banks stopped dead. Therefore, we can conclude that payment systems are social infrastructures that support all economic activities, including the commercial activities and transactions in financial markets. A safe and efficient payment system is an important mechanism that props up the functions of financial markets and the financial system.

Basics of Payment Systems

Greenspan’s Concern

Bank-Related Settlement

An episode involving Alan Greenspan highlights the importance of payment system. When the chairman of the Federal Reserve Board (at that point) heard of the September 11 attack in 2001, his immediate concern was not the inflation rate or the industrial production of the US economy, but the “Fedwire,” the electronic payment system in the US. He worried that a shutdown of the Fedwire would lead to the collapse of financial markets and financial systems not only in the US but across the globe.

On the other hand, settlements are often made with the involvement of banks. Settlements with banks include the paper instruments like the checks and bill payable, bank transfer of deposits, and direct debit. As for a bank-related settlement, if the payer and payee have their own bank accounts at the same bank, the settlement is completed with an account transfer within one bank. This process on the book of a single bank is referred to as “internal settlement” (see Figure 1a). However, in the case that the payer and payee use different banks, the involved banks need to exchange the payment order and fund settlement through a payment system (see Figure 1b). The settlement of commercial trade is usually dealt with through a “retail payment system.” That is the exact reason why a payment system is required. Supposing a case where only one bank exists in a country like the “monobank system” in socialist countries, there is no need for a payment system, as the internal settlement can handle all the domestic payments. A settlement encompasses the fund transfer of much larger amounts between banks. A “LargeValue Payment System” (LVPS) handles this kind of settlement. Payment system is also inevitable for interbank settlement.

The possible economic crises were all too evident. The worst, which I thought highly unlikely, would be a collapse of the financial system. The Federal Reserve is in charge of the electronic payment systems that transfer more than $4 trillion a day in money and securities between banks all over the country and much of the rest of the world. We’d always thought that if you wanted to cripple the U.S. economy, you’d take out the payment systems. Banks would be forced to fall back on inefficient physical transfer of money. Business would resort to barter and IOUs, the level of economic activity across the country could drop like a rock. (Greenspan, 2007)

SEVERAL ASPECTS OF SETTLEMENT An act of a “settlement” takes various forms.

Cash Settlement For instance, individuals and corporates can make settlements directly without the involvement of banks. In these cases, the banknotes are widely used, and this process is called “cash settlement.”

FX Settlement When foreign currency is involved in the fund settlement, which is referred to as a “foreign exchange (FX) settlement.” Delivering of the USD and euro after the USD/euro deal is the typical case of foreign exchange settlement.

Securities Settlement In addition, the concept of settlement includes “securities settlement,” which means the transfer of securities after a trade of equities, government

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Basics of Payment Systems

Figure 1. Internal settlement and settlement through payment system

bonds, or corporate bonds. However, the securities settlement is nearly out of the scope of this book. This book concentrates on the schemes of fund settlement. Payment system plays an essential role in this arena and is sometimes referred to as “interbank funds transfer system.”

PAPER-BASED PAYMENT SYSTEMS AND ELECRONIC PAYMENT SYSTEMS Paper-Based Payment Systems In the early days, the payments among the banks used to be made by exchanging the paper payment instructions. But, as the number of payments increased substantially, it became quite difficult to transfer funds smoothly with the paper instructions and manual handling. Therefore, people tried to utilize Information Technology (IT) in the payment system. This endeavor resulted in developing the “electronic payment systems” which were equipped with the computer systems and networks.

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Electronic Payment Systems In an electronic payment system, the host computers of payment system are linked to the terminals or computers of the participants via networks. These systems originally used to be called “electronic payment systems,” but the name became obsolete soon. Then, these systems came to be called simply as “payment systems,” that was because most major payment systems became electronic and there was no need to add the word to distinguish.

ACTORS IN PAYMENT SYSTEMS The main actors of interbank funds transfer include the payment systems, central banks, and commercial banks. The division of roles among these actors is as follows.

Payment Systems A payment system is a system or an organization which conducts the funds transfer. Some payment systems are managed by private companies and called a “private payment system,” and others

Basics of Payment Systems

are managed by central banks and referred to as a “central bank payment system.” In many countries, those two payment systems co-exist and share the roles. Usually, a payment system covers one jurisdiction (or country) and one currency. In several cases, however, a payment system covers more than one country or more than one currency. There is also a case with several payment systems interlinked with each other. Payment systems take on a public nature, as they handle a huge amount of payments from many individuals, corporations and banks all over the country. Thus some conditions are required for a payment system. First, a payment system should be managed efficiently by a sound business method. Second, the operator of payment system should manage settlement risk strictly in order to minimize the effect when defaults happen.

Central Banks Historically, central banks have played an active role in payment system. Central banks inherently have the function as “the bank for banks,” where almost all banks hold accounts. Central banks can provide the settlement assets with finality, which is called the “central bank money.” Therefore, as a part of their function, central banks operate a payment system and provide settlement service for financial institutions, typically banks. Central banks are also the active participants in payment systems for conducting open market operations. It means that the central bank uses its payment system to implement monetary policy. Hence, it is widely recognized that a sound payment system is a precondition for the successful conduct of monetary policy (Bech, 2008). The extent to which central bank is involved in the payment system varies from country to country. It is generally the case that central banks tend to support the interbank payment system, which handles large-value payments. Some other central banks are also involved in the operation

of retail payment systems. The typical case is the Federal Reserve in the US. Some central banks also offer a settlement service for the private payment systems. More concretely, a private payment system calculates the positions to be settled among the participants, and then the actual transfers of funds take place in the central bank system. Another important role of central banks is to provide the liquidity to the participants of a payment system. The payment system requires a certain amount of intraday liquidity for a smooth settlement. As a provider of central bank money, only a central bank can carry out this responsibility (discussed in more detail later).

Banks Banks are major participants of payment systems. They use payment systems to settle their own obligations in the money market, securities market and FX market. They also use payment systems on behalf of their customers, e.g. individuals and corporations.

BANKS AS A PAYMENT SYSTEM Internal Settlement As mentioned above, banks can execute “internal settlement,” when the payer and the payee have their bank accounts at the same bank. This kind of transaction is referred to as an “on-us” transaction or “book transfer.” In this sense, a bank can be regarded as a kind of payment system itself. That is because they can make settlements with their books, even in a small scale. The more they make internal settlements, the more they take on the nature of payment system. When it comes to the transfer of funds between accounts held at different banks, the payment system comes into play and handles the settlement between the two banks.

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Basics of Payment Systems

Tiered Structure of Payment System As is often the case, the operators of payment systems admit indirect participants as well as direct participants as a participation method. “Direct participant” has an account with the settlement agent and can directly exchange payment orders with other participants in the system. On the other hand, “Indirect participant” usually does not have an account, cannot send payment order directly to the payment system, and has to make settlements through direct participants. Indirect participant (the second-tier participant) makes arrangement with direct participant (the first-tier participant) who make settlements on behalf of the indirect participant. This kind of approach is called a “tiered structure” or “tiered membership” in a payment system. Some payment systems adopt the tiered structure with indirect participants and others allow only the direct participants. For example, the CHAPS in the UK is famous for a highly tiered structure, with only 18 direct participants out of around 350 commercial banks in the UK. On the contrary, the BOJ-NET admits only the direct participants.

Clearing Bank and Quasi Payment System In the tiered structure, the direct participant who widely accepts the responsibility of settlement for indirect participants is referred to as “Clearing Figure 2. Processes of payment system

6

Bank.” A Clearing Bank can internalize many settlements in its own books. This process is called the “internalization” of payment. This is a situation where payments are settled between the accounts of the same Clearing Bank internally, without being processed through the payment system. If the internalization advances, one Clearing Bank can settle a substantial amount of payments in-house. In this case, the bank starts to have a public nature like payment system, and is sometimes referred to as a “Quasi Payment System.” A Clearing Bank or Quasi Payment System is required to secure higher level of risk management than the ordinary participants of payment systems.

PROCESSES IN PAYMENT SYSTEM The stage of processing in payment system can be conceptually divided into three processes: payment, clearing and settlement (see Figure 2).

Payment The first process is called “payment.” In the process of payment, the participants of a payment system send payment orders to the system, and receive them from the system. A “payment order” is a message to the payment system requesting the transfer of funds to the payee, and is also called “payment instruction” or “payment message.”

Basics of Payment Systems

There are two kinds of payment orders. One is the “credit transfer order,” which requests the funds to be moved from the payer’s (originator’s) account to the payee’s (beneficiary’s) account. The other is the “debit transfer order,” which is the debit collection orders made or authorized by the payer to move funds from (the bank of) the payee to (the bank of) the payer and result in a charge (debit) to the account of the payer. Most large-value payment systems are only for the credit transfer orders, and most of retail payment systems support both the credit transfer and debit transfer orders.

Clearing The second process is called “clearing.” The clearing process is to aggregate all the payment orders and calculate the “net credit/debit position” of each participant. The net position is the sum of the value of all the transfers it has received less the value of all transfers it has sent. If the difference is positive, the participant has a “net credit position” and will receive the net amount. If the difference is negative, the participant is in a “net debit position” and obliged to pay the net amount.

Settlement The third process is “settlement.” In this process, each participant should pay the net debit position and receive the net credit position. An actual funds transfer is made at this stage, and the settlement becomes final. When a system is dedicated to facilitate the settlement of the transfer of funds, it is sometimes called a “settlement system.” However, the term of “payment system” is more commonly used to indicate an overall funds transfer system, including a settlement system. To be precise, “payment and settlement system” would be an all-round expression including both systems. As described later, a “net payment system” has all three of these processes. In contrast, a Real-

Time Gross Settlement (RTGS) system does not have the clearing process, and the payment process is directly connected to the settlement process.

FUNCTIONS OF CENTRAL BANKS Central banks have the multiple functions in payment systems. First, central banks provide the settlement asset with finality. Second, central banks can provide the liquidity to the participant of a payment system necessary for a smooth settlement. Third, central banks conduct the oversight for private payment systems. Simply put, central banks play a very significant role for payment systems.

Providing Finality The first function of central bank is to provide the finality to the payment system. “Finality” or “settlement finality” is an important concept for payment systems. Finality means that a transfer of funds becomes irrevocable and unconditional. In a condition the finality is not confirmed, the business process is not completed and there is still a risk of it not being settled. Accordingly, it is quite important to affirm when the settlement become final. There are only two payment instruments with finality in the world. One is the banknotes. When paying with the banknotes, the obligation is discharged at the moment of handover. On the contrary, if payment is made by check, there is still a risk of dishonor in the later stage and the situation cannot be regarded as final. The other payment instrument with finality is the deposit balance with central bank, which is often referred to as the “central bank money.” When a fund transfer is made between the two accounts at a central bank, it becomes final and irrevocable immediately after the transfer is made. Even when a payment system is a private one, the

7

Basics of Payment Systems

settlement has finality if the final settlement is made at the accounts of a central bank.

Providing Liquidity “Liquidity” is a synonym for funds, and frequently used when discussing a payment system. Providing liquidity to the participants of a payment system is another function of central bank. This liquidity is usually lent to the participant during the daytime in order to facilitate the early payment and smooth progress of settlement. These funds are called “intraday liquidity” and participants should repay the funds by the end of the day. Especially, the RTGS system requires large liquidity to carry out the settlements, many central banks provide the intraday liquidity to the participants by the method of the intraday overdraft or intraday repo transaction (to be discussed below).

Conducting Oversight In addition to trying to enhance the safety and effectiveness of their own payment systems, central banks conduct the oversight on private payment systems. This oversight is made from the perspective of financial stability. If a private payment system contains some risks, any defaults could have disruptive influence on many banks as well as financial market. That is the background rationale that central banks should conduct the oversight on payment systems.

NETWORK EXTERNALITIES OF PAYMENT SYSTEM “Network Externalities” are defined as a change in the benefit that a user derives from a service when the number of other users of the same service changes. This is also known as a “network effect.” “Positive network externalities” exist if the benefit of a user increases when the number of other users increases.

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As with a telephone network or fax network, payment system has the strong positive network externalities. The more participants (i.e. financial institutions) that join a payment system, the more value the system has, since a participant can send payments to more participants and more customers of the new participants.

PAYMENT SYSTEM AS A NATURAL MONOPOLY A payment system tends to be a natural monopoly in a single currency area. A “natural monopoly” occurs when the economies of scale predominate in an industry and the maximum efficiency of production and distribution is achieved through a single supplier. Natural monopoly tends to arise where the fixed costs are enormous but the marginal (variable) costs of supplying to additional users are very small. This holds true with payment system, since it requires a huge investment when building a new system but the additional costs for new participants are marginal. Therefore, a certain type of payment system (e.g. large-value payment system or retail payment system) tends to be a monopoly in a country by its nature. It is unlikely that more than one payment system for the same kind of payments compete against each other in a single currency zone. It is a well-known fact that a monopoly tends to entail several problems. The most classic problem of monopoly is inefficiency. The monopoly institution tends to set a higher price than the marginal cost of payment service. Another problem is the abuse of political power. The monopoly institution could use its profit and power to influence the arbitrary management of payment system. If a payment system is mutually-owned by its users, the monopoly problems could be mitigated to some extent. However, the regulators and overseers of payment systems should pay much attention to prevent the abuse of a monopoly in

Basics of Payment Systems

setting the usage fee and criteria for participation, especially in the case of a privately-owned payment system.

INTERDEPENDENCIES OF PAYMENT SYSTEMS Each payment and settlement system does not always exist completely independently. They are growing more interconnected with each other and becoming more interdependent. As a result, the smooth functioning of an individual payment system often depends on the smooth functioning of other related systems. This fact requires the system operators, financial institutions, service providers and regulators to have adequate understanding of the nature of risk and appropriate risk management under an interdependent situation. There are several forms of interdependencies among payment and settlement systems (see Figure 3).

System-Based Interdependencies In some cases, the interdependencies arise from the direct relationships among payment and settlement systems. For example, Large-Value Payment Systems (LVPSs) and Central Securities Depository (CSD) may have technical links1 or an account relationship to provide Delivery versus

Payment (DVP) settlement of funds and securities. Another example is CLS Bank, which depends on the account relationship that CLS Bank holds at each central bank of eligible currencies to provide the Payment versus Payment (PVP) settlement of FX trades (see Chapter 12 for more details). These kinds of direct cross-system relationships are called “System-based Interdependencies” (BIS, 2008).

Institution-Based Interdependencies The interdependencies can take the form of more indirect ways. Large financial institutions may have multiple relationships with many payment and settlement systems. In this case, common participation of a financial institution in two or more systems creates indirect interdependencies among the systems. In some cases, large financial institutions are not just the common participants, but also serving as the liquidity providers, settlement banks or custody banks. If such a financial institution makes a liquidity trouble in one system, the disruption may have a direct impact on another system. These kinds of interdependencies arising from the activities of one financial institution in two or more systems are called “Institution-based Interdependencies” (BIS, 2008).

Figure 3. Forms of interdependencies (Source: BIS (2008))

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Basics of Payment Systems

Environmental Interdependencies

REFERENCES

Interdependencies can arise from the indirect relationships between multiple systems, which depend on a common reliance on the same service provider. Such common reliance includes the IT providers, network providers, and common elements of physical infrastructure (power, water, etc). A typical example is the reliance of the financial industry on the “Society for Worldwide Interbank Financial Telecommunication” (SWIFT). SWIFT provides the financial messaging services more than 9,500 financial institutions as well as offers the network services for more than 100 payment and settlement systems. If by any chance, the SWIFT network would have disturbance, many payment and settlement systems would be affected. These kinds of interdependencies arising from common factors, including the use of a common service provider are referred to as “Environmental Interdependencies”(BIS, 2008).

Bank for International Settlements. (2008, June). The Interdependencies of Payment and settlement Systems. Bech, M. (2008). The Diffusion of Real-time Gross Settlement. In Haldane, A., Millard, S., & Saporta, V. (Eds.), The Future of Payment Systems. Routledge. Greenspan, A. (2007). The Age of Turbulence. The Penguin Press. Nakajima, M., & Shukuwa, J. (2005). All about Payment Systems (2nd ed.). Toyo Keizai Inc.in Japanese Nakajima, M., & Shukuwa, J. (2008). All about Securities Settlement Systems (2nd ed.). Toyo Keizai Inc.in Japanese

ENDNOTE 1

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Payment systems and securities settlement systems which have technical links with central bank-owned payment systems are sometimes called “ancillary systems.”

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Chapter 2

Classifications of Payment System

ABSTRACT This chapter presents some classifications of payment systems. Classifications can be made from various standpoints, such as the following. Some payment systems are administered by central banks and others are operated by private sectors. Some payment systems make settlements on a net basis and others settle payments on a gross basis. Some payment systems are mainly for large-value payments and others are for small-value payments. Some payment systems execute the settlements at designated times, and the settlements take place in real-time in other payment systems. Some payment systems use the central bank money as a settlement asset and others make use of the commercial bank money. These classifications are not mutually exclusive. Rather, one can use a combination of these classifications in order to describe the feature of a payment system. For example, a payment system may be managed by a central bank, make settlements on a gross and real-time basis, and be mainly used for large-value payments.

INTRODUCTION Taxonomy is the practice and science of classification. In many cases, taxonomy is somewhat tedious. It could lead beginners to a labyrinth of DOI: 10.4018/978-1-61520-645-2.ch002

learning. However, taxonomy is sometimes very useful. It can be a very powerful tool to understand the whole picture. When classifying the whole thing into the separate parts according to the several standpoints, it brings out the reality of things.

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Classifications of Payment System

In what follows is the classification of payment systems made by the operator, settlement method, frequency and timing, payment value, settlement date and settlement asset.

OPERATOR OF PAYMENT SYSTEM Payment systems can be classified into the “central bank payment system” and “private payment system” on the basis of the operator of the system. In many countries, these two payment systems co-exist and share the roles.

Central Bank Payment System The “Central bank payment system” is a payment system which central bank owns and operates. The Fedwire in the US, TARGET2 in EU, and BOJ-NET in Japan are the examples of this category. Generally, the central bank payment system consists of deposit accounts at a central bank and a funds transfer system. The degree of involvement of each central bank in payment systems is different from country to country. For instance, the US is a typical example of deep involvement. To be more precise, the Federal Reserve System (Fed) operates the Fedwire for large-value funds settlement and government bond settlement as well as operates the Automated Clearing House (ACH) for retail payments. In the UK and Canada, on the other hand, payment systems are mainly owned and operated by the private sector and the involvement of central banks is rather limited.

Private Payment System The “Private payment system” is a payment system owned and operated by private sector. Typically, the operator is an association of banks or a userowned company, which is sometimes called “clearing house”. Though, due to the public nature of payment system, it is fairly rare that the operator

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is a pure business corporation for profit-taking. In many cases, the private sector operator tries to take on a public nature by adopting various measures in ownership and decision-making structure. Such measures include admitting membership to the central bank, giving a seat on the board of directors to the public sector, and making the central bank the shareholder. The CHIPS in the US, EURO1 in EU, and Zengin System in Japan are the examples of private payment systems.

Clearing System and Settlement System According to the three stages of processes in payment systems mentioned in Chapter 1, the private payment systems are sometimes called the“clearing systems,” and the central bank systems are referred to as the “settlement systems.” This is because the private payment systems cover the clearing process and the settlement process is carried out by the central bank payment systems in many cases.

SETTLEMENT METHOD Payment systems can be classified into the “net settlement system” and “gross settlement system” on the basis of settlement method. In the former system, settlement is made based on a “net position”, which is calculated by the sum of the received amount less the sum of the paying amount. In the latter system, settlement is made on the gross amount of the individual payment order.

Net Settlement System “Net Settlement System” is a payment system in which payment orders are settled on a net basis. In this system, a net credit or net debit position for each participant is calculated. “Net position” is the sum of the value of all the payments received

Classifications of Payment System

less the value of all payments sent. If the difference is positive, the participant is in a “net credit position,” and will receive the net amount. If the difference is negative, the participant is in a “net debit position” and should pay the net amount. An arrangement, in which a net position is calculated between two parties, is called “bilateral netting.” Meanwhile, an arrangement, in which a net position is calculated between a participant and the rest of the participants in the payment system, is called “multilateral netting.” The net credit or debit position at the settlement time is called the “net settlement position.”

Gross Settlement System “Gross Settlement System” is a payment system in which the settlement of funds occurs individually on a gross basis. In this system, no netting is made and settlement is made on the instruction value (gross value) of each payment instruction in the order of arrival.

FREQUENCY AND TIMING OF SETTLEMENT Payment systems fall into three categories on the basis of frequency and timing of settlement: the “designated-time settlement system,” “real-time settlement system” and “continuous settlement system”. In the first system, settlement is made only at a certain time. In the second system, settlement is made in real-time when the system receives the payment order. In the third system, settlement is made continuously when a payment order meets the condition for settlement.

Designated-Time Settlement System “Designated-Time Settlement System” is a payment system in which settlement is made only at a designated-time, one time or several times in a day.

A classic example of this system is to make a settlement only one time at the end of the business day. This is called the “end-of-day settlement system.” In the end-of-day settlement system, the net settlement positions are settled from the net debtors to the net creditors. This is to say, the end-of-day settlement system is usually operated in conjunction with the net settlement system.

Real-Time Settlement System “Real-Time Settlement System” is a payment system in which settlement is made immediately in real-time. This means that the processing of payment order is carried out at the time when the system receives it rather than at some later time. In a Real-time Settlement System, settlement is made individually at real-time during the operating hours of the system.

Continuous Settlement System “Continuous Settlement System” is a payment system in which settlement is made continuously when a payment order meets the condition for settlement. Different from a Real-Time Payment System, payment orders go into the checking process before the settlement process. When and only when a payment order satisfies the settlement condition, the payment order is processed for settlement. To take one example of a settlement condition, the balance of the related accounts should be positive (above zero) and below the upper limit after the processing of the payment order. The processing could be gross settlement or net settlement, depending on the settlement mechanism. The Continuous Settlement System falls into an intermediate category between the Designated-Time Settlement System and Real-Time Settlement System. If a payment order passes the settlement condition immediately, the order is processed in no time. In this case, the continuous settlement system is more like the Real-Time

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Classifications of Payment System

Settlement System. But if not the case, there is a possibility that the payment order may have to wait in the queue possibly for hours.

PAYMENT VALUE Payment systems can be classified into the “LargeValue Payment System” and the “Retail Payment System” on the basis of payment value. The former system is mainly for large-value payments, of which a typical example is an interbank fund transfer. The latter system is mainly for small-value payments, which are made up of the payments of individuals and corporations.

Large-Value Payment System “Large-Value Payment System” (LVPS) is a payment system mainly for the large-value payments. It is also called “large-value funds transfer system.” Usually, no floor limit (minimum amount) is set, and participants can send a payment order of any amount. Therefore, this naming does not mean that this system is exclusive for large-value payments, but suggests that this system handles mainly payment orders with large values. A major target of the Large-value payment system is the transactions in financial markets, including the money markets, government bond markets, and foreign exchange markets. The BIS (2005) pointed out the characteristics of payments processed through a Large-value payment system as follows. •

• •

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They are exchanged among financial market participants (so-called wholesale payments); They are usually urgent and require timely settlement (time-sensitive); They are related to important financial market activities such as money markets

or foreign exchange transactions as well as many commercial transactions. Hence, payments processed in a Large-value payment system include important payment orders both for financial institutions and financial markets as just described, and are usually regarded as a “Systemically Important Payment System11” (SIPS). To give actual examples, the Fedwire and CHIPS in the US, TARGET2 and EURO1 in EU, CHAPS in the UK, and BOJ-NET in Japan fall within this category.

Retail Payment System “Retail Payment System” is a payment system mainly for small-value payments, which are primarily made by individuals and corporations. Payments for the mail-orders, internet shopping, salary payments, or utility bill payments are the typical examples of this payment system. Since a Retail payment system handles a vast range of trading, it processes a huge number of payments in a day. Payments for the business-tobusiness (B2B) transactions, business-to-consumer (B2C) transactions, and consumer-to-consumer (C2C) transactions go to a Retail payment system for settlement. To cite the concrete examples, the ACH in the US, STEP1 and STEP2 in EU, BACS in the UK, and Zengin System in Japan fall within this category.

SETTLEMENT DATE Payment systems can be classified into the “sameday payment system” and “next-day payment system” on the basis of settlement date. In the former system, payments are settled on the same day when payment orders are submitted to the system. In the latter system, payment orders are

Classifications of Payment System

not settled until the next day of submitting payment and so the overnight settlement risk resides.

Same-Day Payment System All Large-value payment systems in major industrialized countries are the same-day payment systems. That is to prevent the emergence of overnight settlement risk. Needless to say, the RTGS system and the continuous settlement system are included in the same-day payment system by definition. Many of the Retail payment systems have become the same-day payment systems to reduce settlement risk. Such systems include the STEP1 in EU and Zengin System in Japan.

Next-Day Payment System In some payment systems, the submitting payment orders (payment process) and calculating net positions (clearing process) are performed on the same day. But the actual settlement of the net settlement position (settlement process) is carried out on the next day. In this case, settlement risk exists overnight. To name a few, the ACH in the US and STEP2 in EU fall within this category.

SETTLEMENT ASSET In a settlement system, the settlement is performed by exchanging “settlement asset” at the settlement institution. Settlement asset is defined as “an asset used for the discharge of settlement obligation” (BIS, 2001) and more concretely, it indicates a deposit balance at the central bank or a commercial bank. A settlement institution is the organization which keeps the records of participants’ accounts in order to achieve settlement within the settlement system. Generally, the settlement institution is a commercial bank or a central bank. Settlement asset is an asset for the

participants of the system, and at the same time, it is a liability for the settlement institution. Payment systems can be classified into the “payment system with central bank money” and “payment system with commercial bank money” on the basis of a settlement asset. It should be noted that a settlement asset is a different criteria from the operator of a payment system. Some private payment systems operated by the private sector use the central bank money as a settlement asset. Thus, it means that those two criteria are not mutually-exclusive.

Payment System with Central Bank Money When a payment system uses the deposits at a central bank as settlement asset, it is called the “payment system with central bank money.” In this system, funds are transferred between the participants’ accounts at a central bank. Central bank money has superiority in the safety, liquidity and finality; because a central bank never goes bankrupt and never faces a lack of liquidity because of its money creation power. This is the reason why many Large-value payment systems use central bank money as settlement asset. It is also worth noting that global standards recommend that the Systemically Important Payment Systems (SIPSs) should use the central bank money as settlement asset.

Payment System with Commercial Bank Money When a payment system uses the deposits at a commercial bank as settlement asset, it is called the “payment system with commercial bank money.” In this system, the settlement institution is a private company, which is not completely safe from bankruptcy. If by any chance the settlement institution runs into default, the settlement would fall into chaos. Therefore, some protection measures should be taken to avoid such confu-

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Classifications of Payment System

sion. And participants of such a system should pay adequate attention to the credit risk of the settlement institution.

REFERENCES Bank for International Settlements. (1989, February). Report on Netting Schemes (the Angell Report). Bank for International Settlements. (1997, March). Real-Time Gross Settlement Systems (the RTGS Report). Bank for International Settlements. (2001, January). Core Principles for Systemically Important Payment Systems.

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Bank for International Settlements. (2003, August). The Role of Central Bank Money in Payment Systems. Bank for International Settlements. (2005, May). New Developments in Large-Value Payment Systems.

ENDNOTE 1



A Systemically Important Payment System (SIPS) is a payment system where, if the system were insufficiently protected against risk, disruption within it could trigger or transmit further disruptions amongst participants or systemic disruptions in the financial area more widely (BIS, 2001).

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Chapter 3

Settlement Risk

ABSTRACT This chapter discusses the issues concerning “settlement risk.” During the process from a trade to its settlement, there is a settlement risk, which is the risk that settlement would not take place as expected. Settlement risk may cause a liquidity problem and loss to the party who was supposed to receive the fund. First, the source of settlement risk is identified in two kinds of settlements; the “simple settlement” and “exchange-for-value settlement.” Second, the differences are clarified between “settlement risk” and “pre-settlement risk.” Third, the classifications of settlement risk is explained, which include “credit risk,” “liquidity risk,” “systemic risk,” “legal risk” and “operational risk.” Fourth, the differences are made clear between “principal risk” and “replacement cost risk.” Fifth, the actual examples are described, in which settlement risk turned into reality. They include the famous “Herstatt Bank incident,” “BCCI incident” and “Bearing incident.” Finally, the measures how to reduce settlement risk are discussed after identifying the exposures of settlement risk. Several mechanisms to reduce the risk, such as the netting, Payment versus Payment (PVP), and Delivery versus Payment (DVP), are described in detail.

INTRODUCTION “Settlement risk” is the risk that a settlement does not take place as expected, which may cause a liquidity problem and/or loss to the party involved in the settlement. If this risk becomes reality in the interbank fund transfer system, the bank which DOI: 10.4018/978-1-61520-645-2.ch003

was supposed to receive the funds from the other banks would suffer serious troubles. When designing or analyzing payment systems, how to reduce settlement risk is the most important point. In order to reduce settlement risk, as a first step, you should know its origin, and its various types and nature. Then, you can examine some tools and measures to reduce or eliminate it.

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Settlement Risk

ORIGIN OF SETTLEMENT RISK A settlement is classified into two types. The first one is the “simple settlement,” in which funds are simply transferred from the payer to the payee. The second type is called the “exchange-for-value settlement,” in which funds are exchanged with other financial assets, such as foreign currencies or securities. The origin of settlement risk differs according to the type.

Simple Settlement “Simple Settlement” is a settlement in which funds are simply transferred from the payer to the payee. In this settlement, the delivery of equivalent value of the transferred funds, such as goods or services, are conducted in a different dimension from payment system. More simply put, if you order a shirt on the internet, the shirt will be delivered by a delivery service, like DHL. Then you will make a payment to the internet company using a payment system. At that time, the delivery service and payment system bear no relation. In this simple settlement, the payment lag is the origin of settlement risk. “Payment lag” is a time-lag between the initiation of the payment order and its final settlement. In order to reduce settlement risk in this context, the time-lag should be shortened as much as possible.

Exchange-for-Value Settlement “Exchange-for-Value Settlement” is a settlement in which funds are exchanged with other financial assets, such as foreign currencies or securities. In this settlement, both a transfer of funds and delivery of assets take place. For example, the delivery of currency A and Currency B occurs in a foreign exchange (FX) settlement, and the transfer of funds and delivery of securities are executed in the securities settlement.

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In the exchange-for-value settlement, a settlement lag is the origin of settlement risk. “Settlement lag” is a time-lag between a funds settlement and delivery of a financial asset. Such a situation could happen, in which a transfer of funds are made but cannot receive the counter financial asset, and vice versa. A mechanism in which the transfer of funds and delivery of assets are conducted simultaneously is quite useful in order to prevent such an awkward situation. These mechanisms are called “Delivery versus Payment” (DVP) for securities settlement and “Payment versus Payment” (PVP) for FX settlement (both will be discussed later).

SETTLEMENT RISK AND PRE-SETTLEMENT RISK Settlement Risk Usually, “settlement risk” is a general term to designate the risk that a settlement will not take place as expected. Meanwhile, this term is sometimes used in a narrow sense. This usage means that a party cannot fulfill the settlement obligations on the due date. When the term of “settlement risk” is used in this narrow sense, the point is that the default will take place on the settlement date. As the settlement process is the final stage, the payment instructions are executed on the settlement date. In the case of an interbank payment, if the payer bank cannot transfer the funds as expected by the deadline of a payment system, the recipient bank will not receive the expected funds, which causes a liquidity shortage and unreasonable loss.

Pre-Settlement Risk “Pre-settlement risk” is a contrary term in respect to settlement risk. This term is frequently used in the exchange-for-value settlement, such as FX settlement or securities settlement. This is the risk that the counterparty of such a trade will be

Settlement Risk

unable to settle the obligation on the future due date. In short, a feature of the pre-settlement risk is that it takes place before the settlement date. Another feature of this risk is that the resulting loss is limited to the cost of replacing the original transaction at current market prices, which is known as “replacement cost risk” (discussed later in this chapter). In other words, if the counterparty of a trade goes into bankruptcy before the settlement date, the buyer cannot receive the required foreign currency or securities.

CLASSIFICATION OF SETTLEMENT RISK “Settlement risk” (as a general term) is classified into several categories as follows on the basis of the cause and nature of the risk.

Credit Risk “Credit risk” is defined as “the risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter” (BIS, 2001). For example, suppose that Bank A made a trade with Bank B in a financial market such as money market, FX market, or government bond market. If Bank A becomes bankrupt before/on the settlement date, Bank B, the counterparty of the trade, cannot receive the funds, foreign currencies or government bonds. In this case, Bank B cannot receive the obligation on the settlement date or even at a future date, because Bank A already became insolvent. If Bank B can receive anything in the liquidation proceedings, it is not the full value of the trade. This is the typical case when a credit risk breaks out.

Liquidity Risk “Liquidity Risk” is defined as “the risk that a counterparty will not settle an obligation for full value when due” (BIS, 2001). In the case of

liquidity risk, the settlement of debt obligation is temporarily unable to be executed and will be fulfilled at a future date. There is a big difference between credit risk and liquidity risk in this respect. Liquidity risk does not imply that the counterparty becomes insolvent; it occurs when a mistake in cash position management or computer trouble causes a temporary lack of funds at a solvent institution. The loss is limited because a bank can receive the obligation in the future, but even so, the bank suffers if it cannot receive the funds in a timely manner. In other words, it would cause a shortage of funds for itself.

Systemic Risk “Systemic risk” is the risk that the failure of one participant in a financial market to settle its required obligation will cause a chain-reaction of settlement failures, which could cause a serious turmoil in the financial market. Such a chain of failures may cause a broad range of significant credit and liquidity problems and, as a result, might threaten the stability of the financial market. Since payment system is a network which links a lot of participants in a financial market, it could be a transmission channel for such chain-reaction failures and cause systemic risk. Systemic risk is the risk that the failure of one participant spills over to other participants in the payment system through debtor-creditor relationships in the process of payment and settlement and, as a result, might paralyze the payment system as a whole. Central banks, who are responsible for financial stability, give their full attention to prevent such risk.

Legal Risk “Legal risk” is defined as “the risk of loss because of the unexpected application of a law or regulation or because a contract cannot be enforced” (BIS, 2001). To give an example, when the default of a bank takes place, and the counterparty regards

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its obligation as protected legally, but in fact, it is not the case. In this case, the couterparty suffers a loss because of legal uncertainty. Each country’s legal system is closely related to this risk, which includes the collateral law, bankruptcy law and contract law. Especially, the “zero hour rule1” in the insolvency law might be a cause of concern for payment system participants.

Operational Risk “Operational Risk” is “the risk of human error or a breakdown of some component of the hardware, software or communications system that are crucial to settlement” (BIS, 2001). A bank facing a shortage of funds due to a mismanagement of a cash position manager is the typical case of operational risk. A breakdown of a computer system preventing a bank from sending/receiving payment orders to/ from the payment system is another example of operational risk. Financial crimes, illicit activities, natural disasters, and terrorist attacks also might be the cause of operational risk. In recent years, payment systems depend heavily on computer and network systems, so the countermeasure for system failure is becoming more and more important. After the September 11 terrorist attack in 2001, the importance of “business contingency plan” (BCP) gained a lot of attention, and many payment systems implemented appropriate measures, including developing the crisis scenarios, identifying the priority operations, and strengthening backup systems.

MAGNITUDE OF LOSS CAUSED BY SETTLEMENT RISK Settlement risk can be classified into two types on the basis of the magnitude of loss arising from settlement risk. The first one is the “principal risk,” in which the loss is the full value of the financial transaction. The second one is the “replacement cost risk,” in which the loss is a fraction of the

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full value of the transaction, namely the difference between the original transaction price and current market price.

Principal Risk “Principal Risk” is “the credit risk that a party will lose the full value in a transaction” (BIS, 2001). This term is typically used with the exchange-forvalue settlement when there is a time-lag between the fund-leg and another leg (e.g. securities-leg or foreign currency-leg). Principal risk occurs when the settlement process starts and one party of the transaction delivers the funds, securities or foreign currency. In this case, this party has the risk that it cannot receive the counter value, even if it delivers the leg of one-side. In the case of a securities settlement, the risk is that the seller of the securities delivers the securities but cannot receive the funds, or that the buyer of the securities makes payment but cannot receive the securities.

Replacement Cost Risk “Replacement cost risk” is the risk arising from price fluctuations. If the seller of the securities becomes bankrupt before the settlement date, the buyer of the securities becomes unable to receive the securities. If the buyer still needs the securities, it should go into the market and buy the same securities. On this occasion, there is a risk that the market price is higher than the original contract price. In the case of the seller, it suffers a loss when the market price is lower than the original transaction price. In this situation, the risk arising from the difference between the current market price and the original contract price is called “replacement cost risk.” This risk only pertains to the case where the solvent party does not yet make payment or delivery to the bankrupt party. Thus, this is the risk

Settlement Risk

before the settlement process starts and is also called “pre-settlement risk.” Once the solvent party conducts a payment or delivery and is unable to cancel it, the pre-settlement risk is transformed into the principal risk. Replacement cost risk is a kind of “market risk,” arising from the fluctuation of market price. Therefore, the larger the market volatility, the larger this risk becomes. And the longer the time-lag between the trade date and settlement date, the higher this risk grows. The magnitude of replacement cost risk is rather limited compared to that of principal risk. If the price movement between an original trade and a replacement trade is just 1% of the securities price, the replacement cost is a matter of 1% of a trade. As the loss of principal risk is 100% of securities price, the magnitude of the principal risk is 100 times that of the replacement cost risk in this case. Usually, the replacement cost is just a small percentage of the principal. However, if the market price fluctuates dramatically, the risk might become quite considerable. For instance, it is reported that during the financial crisis of Black Monday in 1987, the stock prices of the NY stock exchange dropped around 25 to 35 percent between the trade date and the settlement date.

and ordered the liquidation of the Bank. The order was issued at 3:30 p.m. on 26 July 1974 in Frankfurt when the interbank payments system finished the settlement in Germany. Prior to the closure order of Herstatt Bank, several of its counterparties had paid Deutsche Marks to the Bank on that day through the German payment system. These counterparties anticipated to receive the counter value in the US dollars later on the same day in New York. Against those expectations, as the closure order was issued at 10:30 a.m. in New York, the correspondent bank of Herstatt Bank suspended the outgoing US dollar payments from the account of the Bank. Because of this, the counterparties could not receive the counter value in the US dollars. As the Bank was an active player in the FX market, the default amount of the Bank was beyond $200 million as a whole, which caused a large number of banks to suffer a loss and there was a big disruption in the international financial market. As a consequence of this incident, the FX settlement risk caused by the international time differences was named “Herstatt risk.” Ironically, the Herstatt Bank was reduced to dust, but the name of the Bank remains in the payment system terminology today.

ACTUAL EXAMPLES OF SETTLEMENT RISK

The Bank of New York (BONY) was one of two clearing banks for government bonds in the US, which offered clearing and settlement services for a large number of securities dealers. One day in November 1985, the BONY became unable to send the delivery orders of government bonds to the Fedwire in the daytime due to computer trouble. This resulted in one-sided transactions of receiving of huge amounts of government bond, coupled with the payment of a large amount of funds to other participants of the Fedwire. This situation led the BONY to incur an immense overdraft from the Federal Reserve Bank of New York.

There were several incidents, in which settlement risk turned into reality. Here are some examples of such incidents.

Herstatt Bank Incident (1974) In 1974, Herstatt Bank (Bankhaus Herstatt in German), which was a small bank in Germany, suffered an excessive loss by a series of failures in FX trade. Becoming aware of that, German banking authorities withdrew its banking license

Bank of New York Incident (1985)

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As a result, the BONY borrowed $3 billion in intraday overdraft and $2.3 billion in overnight lending. With the vast amount of overdraft and lending, the BONY managed to get through the day and was able to avoid the crisis of default.

New York’s Blackout Incident (1990) In August 1990, there was a huge blackout in New York City including the downtown centers. This caused the malfunctions of computers of financial institutions as well as the disruptions in the financial markets and payment systems for a few days. Some financial institutions suffered shut downs of the computer systems, which obstructed the payment business. The market rate showed terrible ups and downs because some major participants could not take part in the market. The Federal Reserve Bank of New York managed to continue the operation of the Fedwire with a private electronic generator.

BCCI Incident (1991) On July 5th 1991, the banking supervisors in Europe ordered the closure of the Bank of Credit and Commerce International (BCCI). The BCCI was a major international bank of Arab origin, registered in Luxembourg, and was suspected of committing fraud on a massive scale. This closure order was issued at 1:00 p.m. London time on that day (8:00 a.m. in New York). The UK and Japanese banks suffered a principal loss by this closure. They were the counterparties of the BCCI in FX trades which were due to settle on July 5th. As for a USD/sterling FX transaction, the sterling payment was made through the Clearing House Automated Payments System (CHAPS) in the morning of that day, but the USD payment was cancelled before its processing in the Clearing House Interbank Payments System (CHIPS). Therefore, the BCCI’s counterparty lost

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the principal amount of the FX deal, which was not a small amount. A major Japanese bank also suffered a principal loss for the USD/yen deal. The yen payment was duly made through the Foreign Exchange Yen Clearing System (FXYCS) on July 5th of Japan Standard Time. However, the assets of the BCCI in New York were frozen before the settlement of the USD leg of the transaction took place. This is another example of Herstatt risk, caused by the time differences.

Bearings Incident (1995) Baring Brothers was the oldest merchant bank in London, until it collapsed at the end of February 1995 due to the unauthorized trading by its derivatives trader in Singapore, Nick Leeson. This collapse caused a crisis of making the end-of-day settlement in the ECU clearing nearly unable to be completed. The ECU clearing was the clearing system of the European Currency Unit2 (ECU) operated by the ECU Banking Association (the current Euro Banking Association). Concretely, on Friday, February 24th, one clearing bank sent an ECU payment to Baring Brothers due on Monday, February 27th. On Sunday, February 26th, the bank recognized the appointment of administrator in bankruptcy to Barings and tried to cancel the payment instruction. But the rules of the ECU clearing did not permit this kind of cancellation. The net position of the bank on Monday happened to be negative and the bank had to pay the net debit amount, which included the payment to Barings, at the end of the day. Fortunately, the bank finally agreed to pay the net position and the settlement between the 45 clearing banks was duly completed in the timely manner. However if, the sending bank had not eventually agreed to pay the net debit position, the end-ofday settlement would have failed, which had led to the unwinding of all the payments. The failure of final settlement could have had very serious

Settlement Risk

consequences with the systemic impact on all the banks as well as the ECU market.

EXPOSURE OF SETTLEMENT RISK There are two factors that decide the scale of settlement risk, namely, the settlement amount and time-lag. The exposure of settlement risk, which means the amount at risk, is defined as a product of the settlement amount and time-lag. In other words, the larger the settlement amount becomes and the longer the time-lag becomes, the higher settlement risk grows (see Figure 1).

Settlement Amount In a gross settlement system, the settlement amount is the principal amount of a transaction. Meantime, the net positions are the object of concern in a net settlement system.

Time-Lag Time-Lag in a Simple Settlement In a simple settlement, settlement risk is the risk for the receiver of the funds. It arises when a trade is executed, and disappears when the receiver confirms the receipt of the funds. The time-lag between the execution of the transaction and the completion of confirmation is of concern.

Figure 1. Exposure of settlement risk (conceptual diagram)

Time-Lag in a FX Settlement Foreign exchange (FX) settlement is a sort of exchange-for-value settlement, in which one currency is exchanged with another currency. A time-lag between the completion of the two legs of the transaction (i.e. one currency leg and another currency leg) is of particular concern. This risk disappears when the counterparty confirms the receipt of the currency purchased. The difference from a simple settlement is the timing when the risk arises. The FX settlement risk starts when a payment instruction for the currency sold can no longer be cancelled. At this stage, the bought amount is clearly at risk. Until the payment instruction becomes unable to cancel, the bank does not face the settlement risk exposure, even though it faces a possible pre-settlement risk.

REDUCTION MEASURES OF SETTLEMENT AMOUNT As mentioned above, settlement risk represents the products of settlement amount and time-lag. In order to reduce settlement risk, either settlement amount or time-lag, or both of them should be reduced. “Netting” is often used as a measure in order to reduce the settlement amount. Netting is defined as “an agreed offsetting of positions or obligations by trading partners or participants” (BIS, 1992). Netting reduces a large number of individual positions or obligations to a smaller number of positions. Netting can be classified into the several categories on the basis of a number of concerned parties and legal grounds.

Classification of Netting According to the Number of Concerned Party The netting can be classified into two major categories; “bilateral netting” and “multilateral netting.” This classification depends on whether

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Figure 2. Bilateral netting and multilateral netting

eral netting is often conducted through a central counterparty (CCP) that is legally substituted as the buyer to every seller and the seller to every buyer. Although the relation between the CCP and each participant is bilateral, the netting effect is similar to that of multilateral netting.

Classification of Netting According to the Legal Notion The netting can also be classified into three categories; “payment netting,” “obligation netting” and “close-out netting.” This classification is on the basis of a legal view point.

Payment Netting

the netting is made between two parties or among more than two parties (See Figure 2).

Bilateral Netting “Bilateral netting” is an arrangement between two parties to net out their bilateral obligations. In other words, two parties offset their credit obligations and debt obligations for a certain period of transactions in a one-to-one relationship, and the amount of difference, which is often called “net position,” is settled.

Multilateral Netting “Multilateral netting” is an arrangement among three or more parties to net out their obligations, where the netting is arithmetically achieved by summing each participant’s bilateral net positions with the other participants to make a multilateral net position. The multilateral netting of payment obligations normally takes place in the context of a multilateral net settlement system. Multilat-

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“Payment netting” is a method of settling all gross obligations due on the same date in the same currency by the payment of net amount. In this netting, as the subject of netting is only the payment instructions, the credit obligations and debt obligations still exist on a gross basis. In other words, the netting has no impact on the obligation of the original contract. The payment netting only brings about a reduction in the number of payment instructions and settlement amount. It should be noted, however, if the settlement of net position is not executed in this netting for any reason, there is still a possibility that the settlement of gross obligation might be required.

Obligation Netting “Obligation netting” is a method to offset obligations due on the same future value date in the same currency and replace them by new obligations, i.e. net positions. In this netting, the original obligation on a gross basis no longer exists and is replaced by a new net position. “Novation” is the legal term which means the replacement of obligation with agreement from the concerned parties. Thus, this netting is also called “netting by novation.”

Settlement Risk

In this netting, the magnitude of risk is reduced to the net amount when the netting is made. It is the merit of this netting that there is no return of obligation on a gross basis, even if the settlement of net position is not executed for any reason.

Close-Out Netting While the two netting schemes noted above are the netting that are conducted under normal circumstances, “close-out netting” is a special form of netting which comes into effect when some predefined events, such as a default, occurs. More concretely, when a predefined event occurs, such as the appointment of liquidator or the commencement of bankruptcy procedures, all the existing contracts of concerned parties are offset and a net position is calculated by computing the present value of the future obligations. The close-out netting looks similar to the obligation netting in respect that obligations are novated into a new obligation. However, the closeout netting is different from the obligation netting in several respects. First, the novation is put into motion only by special events, such as default or bankruptcy. Second, the novation covers not only the obligations due on the same value date in the same currency, but also the obligations due on the different value date and/or in the different currency. Third, all the obligations of the default counterparty are considered due when the netting is executed. In short, the close-out netting is the netting scheme for the very special cases and has much stronger power than the obligation netting.

Setting Transaction Limits To set transaction limits is also a useful tool for each financial institution to put restrictions on settlement amounts. Some payment systems impose a “debit cap” or “credit limit” to each participant of the system to limit the risk exposure of a participant vis-à-vis another participant or the risk exposure to the payment system as a whole.

As a self-imposed risk management tool, some financial institutions set limits on the unsettled amount with other financial institutions. These limits are set separately for each of counterparty depending on the risk-based evaluation. The limit is sometimes called “Daily Settlement Limit” (DSL).

REDUCTION MEASURES OF TIME-LAG Moving Up Settlement Time One approach to reduce the time-lag on a settlement is to move up the day and time of the settlement. In the Designated-time settlement system, if the settlement time is moved up from the next day to the same day when payment instructions are submitted to the system, the overnight settlement risk is diminished. Moreover, if the End-of-day settlement system is changed to the Continuous settlement system, in which settlement is made continuously during the day, the time-lag between the submission of payment instructions and the execution of settlement, would shorten further. The ultimate form of this approach is to adopt the Real-Time Gross Settlement (RTGS) system. In this system, once the payment order is sent to the payment system, the instructions are processed in real-time and the settlement is made immediately. The time-lag is practically nil in the RTGS system, which means the settlement risk arising from the time-lag is completely eliminated. That is the reason why the RTGS system has been introduced in many countries.

Early Reconciliation Settlement risk for each financial institution extinguish when the “reconciliation” is made. Reconciliation means to confirm the outcome of settlement, including the status of payment

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instructions and the balance of account. Individual institutions can reduce the time-lag between the sending out of payment instructions and reconciliation by moving up the reconciliation time. In order to achieve the early reconciliation, it is necessary to improve the operational procedures as well as to reform the internal system. In the case the settlement process is outsourced, it is also required to develop a close relationship with the outsourcing partner, such as a correspondent bank or settlement agent, to obtain early notices and advice.

Transition to a Synchronous Settlement As mentioned above, the time-lag between one payment leg and another delivery leg is the origin of settlement risk in the exchange-for-value settlement. It is quite useful to adopt “Synchronous Settlement” in order to accommodate this risk. Synchronous settlement is a mechanism in which the settlement of one payment leg and another delivery leg is executed simultaneously. By executing the settlement of two legs at the same time, the time-lag becomes nil and the settlement risk arising from the time-lag is eliminated.

“Payment versus Payment” (PVP) in FX settlement and “Delivery versus Payment” (DVP) in securities settlement are two typical examples of synchronous settlement.

Payment versus Payment (PVP) “Payment versus Payment” (PVP) is a scheme to prevent such situations as “euro delivered, but the US dollars not received” or “the US dollars paid, but Japanese Yen not received” in the settlement of FX trade. To be more precise, PVP is a mechanism which ensures that a final transfer of one currency occurs if and only if a final transfer of the other currency takes place (see Figure 3). In this scheme, the payment of one currency always goes hand-inhand with the payment of another currency, and there is no principal risk caused by the time-lag of the two legs.

Delivery versus Payment (DVP) “Delivery versus Payment” (DVP) is a scheme that links a Delivery, i.e. a securities transfer and a Payment, i.e. a funds transfer. By this linkage, DVP ensures that delivery of securities occurs if, and only if, a funds transfer occurs (see Figure 4).

Figure 3. The concept of payment versus payment (PVP)

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Figure 4. The concept of delivery versus payment (DVP)

DVP can prevent such situations as “the securities delivered, but no counter value received” or “the payment made, but the securities not received.” That is the reason why global standards on securities settlement such as the Group of Thirty (G30) or International Securities Services Association (ISSA) recommended adopting the DVP mechanism for all the securities settlement.

Three Models of DVP There are three DVP models, which were identified in the “DVP report” of BIS (BIS, 1992). This classification is based on whether the fund transfer and the delivery of securities are made on a gross basis or on a net basis.

DVP Model 1 DVP Model 1 is a mechanism that makes a settlement of both securities and funds on a gross (trade-by-trade) basis. DVP Model 1 conducts the simultaneous settlement of an individual securities transfer and an associated funds transfer. By its nature, DVP Model 1 is also called “Gross-Gross Type DVP.”

DVP Model 2 DVP Model 2 is a mechanism where the delivery of securities is executed on a gross basis, but the funds transfer is executed on a net basis. Usually, in DVP Model 2, securities transfers are settled on a trade-for-trade (gross) basis during the day, while funds transfers are settled on a net basis at the end of the day. Focusing on its nature, DVP Model 2 is also called “Gross-Net Type DVP.”

DVP Model 3 DVP Model 3 is a mechanism that makes a settlement of both securities and funds on a net basis. Settlements may occur once a day or at several times during the day. DVP Model 3 is also called “Net-Net Type DVP.”

REFERENCES Bank for International Settlements. (1992, September). Delivery versus Payment in Securities Settlement Systems.

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Bank for International Settlements. (1993, September). Central Bank Payment and Settlement Services with Respect to Cross-Border and MultiCurrency Transaction (the Noël Report).

ENDNOTES 1



2



Bank for International Settlements. (1996, March). Settlement Risk in Foreign Exchange Transactions (the Allsopp Report). Bank for International Settlements. (1997, March). Real-Time Gross Settlement Systems (the RTGS Report). Bank for International Settlements. (1998, July). Reducing Foreign Exchange Settlement Risk: A Progress Report. Bank for International Settlements. (2001, January). Core Principles for Systemically Important Payment Systems. Bank for International Settlements. (2007, July). Progress in Reducing Foreign Exchange Settlement Risk. Goodhart, C. (2008, February). Liquidity Risk Management. Financial Stability Review. Banque de France. Harrison, S., Lasaosa, A., & Tudela, M. (2005, December). Tiering in UK Payment Systems: Credit Risk Implications. Financial Stability Report, Bank of England. Manning, M., Nier, E., & Schanz, J. (2008a). System Design and Sources of Credit Risk in Large-value Payment and Settlement Systems. In Manning, M. (Eds.), The Economics of Largevalue Payments and Settlement. Oxford University Press. Manning, M., Nier, E., & Schanz, J. (2008b). Liquidity Risk in Large-value Payment Systems. In Manning, M. (Eds.), The Economics of Large-value Payments and Settlement. Oxford University Press The Payments Risk Committee. (2000, April). Intraday Liquidity Management in the Evolving Payment System.

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“Zero hour rule” is a provision in the bankruptcy law whereby the transactions of a closed institution that have taken place after midnight on the date when the institution is ordered closed may be retroactively rendered ineffective. If this rule is applied to a payment system, all the settlements that the closed institution made after 12:00 a.m. of the closing day, which were regarded to have settlement finality, become invalid. In this case, all the settlements are cancelled and the net positions should be recalculated, which might cause systemic risk. In the European Union (EU), the Settlement Finality Directive (98/26/EC) was introduced in 1998 in order to keep away zero hour rules from payment systems. It ensures that “transfer orders cannot be revoked after a moment defined by the rules of the system.” Moreover, it clearly states that “transfer orders and netting shall be legally enforceable and, even in the event of insolvency proceeding against a participant, it shall be binding on third parties, provided that such transfer orders were entered into the system before the start of such insolvency proceedings.” In addition, there are no zero hour rules in Japan. The European Currency Unit (ECU) was a basket of the currencies of the European Community member states, used as the unit of account for the European Community as well as in international financial transactions before being replaced by the euro in January 1999.

Section 2

Basic Payment Systems and Advanced Payment Systems

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Chapter 4

DTNS System and RTGS System

ABSTRACT This chapter provides comparisons between the “Designated-Time Net Settlement” (DTNS) system and “Real-Time Gross Settlement” (RTGS) system. Those comparisons clarify the differences between the two systems and highlight the features of each system. The DTNS system and RTGS system have their own advantages and drawbacks. The RTGS system is superior in reducing settlement risk. On the other hand, the DTNS system has an advantage on the level of liquidity required for settlement. This means that there is a trade-off between the two systems in terms of risk and efficiency. With knowledge of the pros and cons of the two systems, the most appropriate system should be adopted according to the feature of payments which are processed in the system.

INTRODUCTION There are two types of basic and traditional payment systems. One is the “Designated-Time Net Settlement” (DTNS) system, and the other is the “Real-Time Gross Settlement” (RTGS) system. In the early days when payment systems became computerized, most payment systems were the DTNS systems. That was because it was rather DOI: 10.4018/978-1-61520-645-2.ch004

easy to develop the DTNS systems and difficult to implement the RTGS functions with the level of Information Technology (IT) at that time. In the course of the 1990s, the RTGS systems became widely used in many countries. Since the RTGS system has the decisive advantage in mitigation of settlement risk, many central banks introduced the RTGS system. As the DTNS and RTGS system have their own merits and demerits, these two systems are used in parallel in many countries.

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DTNS System and RTGS System

TWO BASIC PAYMENT SYSTEMS Designated-Time Net Settlement (DTNS) System In a DTNS system, payment orders which participants submit over the course of a day are accumulated in the system. At the end of the day, the “netting” takes place and the “net position” of each participant is calculated. The net positions are informed to each participant and then, the settlements of the net positions are executed, typically once, at the end of the day. To be more precise, the net debtors are required to pay-in the net debt amount to the system account, and upon receipt of all these funds, the system makes pay-outs the net credit amount to the net creditors. The netting brings about the reduction of the number and overall value of payments. However, the finality of settlement is only achieved at the end of the day. The DTNS system is also called “Deferred Net Settlement” (DNS) system, emphasizing the late settlement. According to the classifications in Chapter 2, the DTNS system is “Net settlement system” and “Designated-Time settlement system.” It is often adopted in “Private payment system.” Some DTNS systems may be “Large-value payment systems” and others may be “Retail payment systems.” Some of DTNS systems are “Sameday payment systems” and others are “Next-day payment systems.”

Real-Time Gross Settlement (RTGS) System In a RTGS system, each payment order is settled individually in the full amount of the payment order (i.e. on a gross basis). If the payer has sufficient balances (or credit availability) in its account, each payment order is settled immediately on arrival in the system (i.e. on a real-time basis). When the payer’s account balance is insufficient to process the payment order, the order

is typically queued in the system, or sent back to the payer as an error order. The RTGS system has the advantage that payments become final as soon as the order is sent to the system, so that the intraday risk exposure does not build up. On the other hand, the downside of the RTGS system is that it requires a higher level of liquidity for settlement compared to the DTNS system. According to the classification in Chapter 2, the RTGS system is “Gross settlement system” and “Real-Time settlement system.” It is often adopted in “Central bank payment system” and “Payment system with central bank money.” Usually, it is “Large-value payment system” and “Same-day payment system” by definition.

COMPARISONS OF TWO BASIC PAYMENT SYSTEMS With these features of the DTNS and RTGS system in mind, the comparisons of two systems can be made as follows, from the aspects of (i) settlement risk, (ii) required liquidity and (iii) operational burden.

Comparison from the Perspective of Settlement Risk In a RTGS system, payment orders are settled individually at the account of the central bank. Accordingly, a payment order becomes final and settlement risk disappears when the payment order is processed on a real-time basis. On the other hand, in a DTNS system, there is a long gap of time between when the payment order is sent to the system and when the net position is finally settled. Until the final settlement, the unsettled amounts accumulate further and further during the day. The finality of settlement is only achieved at the end of the day and thus there is no certainty of settlement until then. If one of the participants fails to meet its payment obligation at the settlement time, there is a possibility that

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DTNS System and RTGS System

all the payment orders could be unwound1. This would lead to a disturbance on the liquidity situation of other participants and possibly bring on another resulting default. Therefore, the RTGS system is far superior to the DTNS system from the viewpoint of reducing settlement risk. The RTGS system achieves finality earlier, which reduces credit and liquidity risk. On top of this, there is no systemic risk in the RTGS system.

Comparison from the Perspective of Required Liquidity Another aspect of comparison is “liquidity,” which means the required amount of funds for settlement, or the outstanding amount in the settlement account. Each participant in a payment system required to have enough liquidity for payment processing. In a RTGS system, a participant should have the liquidity equivalent to or more of each payment order to be processed. If a participant sends some payment orders of sizable amount, it should hold an aggregate amount of liquidity in its account, which might be a heavy burden on the payer. If the liquidity is not enough, the payment order is put in the queue and the settlement is not executed on a real-time basis. On the other hand, the necessary liquidity for each participant is just a “net debit position” (i.e. difference between the paying amount and the receiving amount to/from other participants) in a DTNS system. Usually the net amount is much lower than the aggregate gross amount. Moreover, the participants with “net positive position” (i.e. the participants whose receiving amount is larger than the paying amount) need no liquidity for the final settlement, since such participants only receive the funds from other participants. Therefore, the DTNS system has an advantage on the aspect of liquidity required for settlement. That is to say, the DTNS system is superior to the RTGS system in terms of “efficiency.” In other

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words, the RTGS system can eliminate credit risk, but it does so at the expense of requiring a much higher level of liquidity than the DTNS system. Because of this characteristic, it is often said that the RTGS systems are “liquidity hungry” relative to the DTNS systems. Central banks can mitigate the liquidity cost of participants in the RTGS system by providing intraday liquidity at low cost (to be discussed later).

Comparison from the Perspective of Operational Burden The third aspect of comparison is operational burden. The “cash position manager” who is responsible for the settlement function in a financial institution should monitor the processing situation of payment orders and manage the liquidity in the settlement account for smooth settlement. In a DTNS system, the only thing the manager should do is prepare the fund for the net position (much smaller than the gross amount of payments) before the settlement time, usually at the end of the day. In a RTGS system, the manager should manage the liquidity in its account on a real-time basis during the day. In this case, the operational burden is much heavier than that of a DTNS system. When the RTGS system is introduced, however, many banks (especially large-scale banks) introduce the system which automatically manages the release of payment orders according to the liquidity situation of the bank. These “release control systems” reduce the operational burden of cash position managers.

Trade-Off between Safety and Efficiency As explained above, there is a trade-off between the DTNS and RTGS system, or more concretely between safety and efficiency in a payment system. The DTNS system has an advantage in efficiency, but is inferior in safety. That is, the DTNS system

DTNS System and RTGS System

Figure 1. Trade-off between safety and efficiency in payment systems

requires only small liquidity for settlement, but cannot achieve the intraday finality. On the other hand, the RTGS system is superior in safety, but has a disadvantage in efficiency (see Figure 1). A great deal of effort has been made to strike the right balance between safety and efficiency in payment systems, which has lead to the evolution of payment systems (see Chapter 5 and 6 for more details).

Setting a Limit

RISK MANAGEMENT MEASURES IN DTNS SYSTEM

Bilateral Net Credit Limit

As mentioned above, the DTNS system has a drawback in terms of settlement risk. Thus, how to manage the settlement risk is an important issue for the DTNS system. There are two methods to cope with the issue. The first one is to set a “limit” (or “cap”) on the paying amount or receiving amount of each participant. This is a risk management measure to confine the risk among the participants, or between the system and each participant. The second one is to introduce a “Loss-Sharing Rule,” which stipulates the allocation of any loses arising from the default of participant in the system.

It is rather common that the DTNS system adopts risk management measures, such as a Net Credit Limit or Net Debit Cap. When these measures are adopted, such a system is generally called “Protected DTNS system,” which has a high level of security. Without these measures, the system is called “Unprotected DTNS system,” in which the risk management needs to be improved.

“Bilateral Net Credit Limit” is a limit on the credit exposure a participant incurs vis-à-vis another participant as a result of the payments received that have not yet been settled. This Limit is on a “Net Credit Position” between two parties, which is calculated by subtracting the sum of the “payments sent” from the sum of the “payments received” between the two participants. By setting the “Net Credit Limits” for each participant bilaterally, a participant can confine the risk exposures to other participants within the upper limit because the system blocks the payment orders which make the net position go above the limit. This limit is also called “Net Receiver Limit.” If a participant sets a Net Credit Limit at very lower level, it can reduce the bilateral risk exposure substantially, but it may make it difficult to receive

33

DTNS System and RTGS System

payments due to the limit restraint. Therefore, not only the level of credit risk of each participant, but also the smooth operation of its own is a factor to be considered when each participant decides the limit for other participants.

be requested to share some losses. Therefore, each participant should fully understand the LossSharing Rule and probability of loss-sharing.

Multilateral Net Debit Cap

The Loss-Sharing Rule can be classified into three categories, namely, (i) defaulters pay, (ii) survivors pay, and (iii) third parties pay.

“Multilateral Net Debit Cap” is a limit on the funds transfer activity of individual participants to a payment system. While the Net Credit Limit is set bilaterally, the Net Debit Cap is set multilaterally. This Cap intends to reduce the risk exposure of the system as a whole below a certain level by limiting the sum of payments sent from each participant. In general, the Net Debit Cap of a participant is calculated by multiplying the sum of the Net Credit Limits which the participant gets from the other participants by the “system-wide rate.” Thus, the larger the participant’s Net Credit Limits total become, the larger the participant’s Net Debit Cap becomes. The system-wide rate ranges from 3 to 5%, depending on each payment system.

Loss-Sharing Rule Definition of the Loss-Sharing Rule In a “Protected DTNS system” which adopts the risk management measures described above, the settlement risk is limited to a certain level. In spite of these risk reduction measures, one or more participants of payment system may possibly fail to meet their obligation on the same day. The Loss-Sharing Rule is an arrangement that stipulates how the loss will be shared among the parties concerned in such a case. This is also called the “Loss-Sharing Agreement.” In the case of default, the Loss-Sharing Rule finalizes a settlement by sharing the loss among participants without unwinding of all the settlements in the system. Depending on the Rule, even a participant that has no transaction with the defaulter could

34

Classifications of the Loss-Sharing Rule

Defaulters Pay “Defaulters Pay” is a loss-sharing arrangement where the defaulting party (or parties) itself bears the whole loss. To achieve this arrangement, each participant is required to provide the collateral in advance for the possible maximum exposure it may create for the other participants. In a payment system with Defaulters Pay, each participant should decide the Net Debit Cap and pledge the collateral for equivalent amount of the Cap before the start of the settlement day. If the arrangement is solid enough, the participants other than the defaulters can complete the settlement without suffering any losses, regardless of the number of the defaulters. This arrangement has an advantage that the risk is mitigated sufficiently for all the participants. On the other side of the coin, the collateral burden is rather heavy on all the participants in this arrangement.

Survivors Pay “Survivors Pay” is a loss-sharing arrangement where the survivors, i.e. the participants other than the defaulting parties, bear a loss jointly. In the event of a participant’s inability to settle, this arrangement requires losses to be borne by the surviving participants according to some predetermined formula. The DTNS system tends to adopt this losssharing arrangement. This is because the collateral burden is so heavy in the Defaulters Pay that it

DTNS System and RTGS System

almost cancels out the efficiency merit of the DTNS system. To achieve this arrangement, each participant is requested to set Bilateral Net Credit Limits with the other participants. If a participant falls into default, the survivors should bear the loss on a “pro-rata basis” of Net Credit Limits for the defaulting party. Accordingly, if a participant admitted a large limit to the defaulter, it should bear a large share of the loss. Usually, each participant is required to provide collateral which is equivalent to the largest limit out of the limits it admitted to the other participants. The initial merit of this arrangement is that the collateral burden is much less than the Defaulters Pay, because the losses are paid jointly by all the participants other than the defaulter. The second merit is that this arrangement tends to promote mutual monitoring among the participants in the payment system and serve as an incentive to take appropriate risk management. That is because the sharing of loss will be proportional to the Net Credit Limit of each participant to the defaulting party. If a participant does not appropriately monitor the other participants and admits an excessive limit, there is a risk of bearing the excessive loss-sharing. On the other hand, this arrangement has a weakness in risk management in exceptional circumstances. More specifically, in the event of two or more major participants defaulting, there is a possibility that the total losses cannot be covered by the survivor’s collateral which was originally intended for a single default. To avoid such a serious situation, some DTNS systems introduce the collateral schemes which brace for the default of the largest two participants in the system.

Third Parties Pay “Third Parties Pay” is a loss-sharing arrangement in which a third party, i.e. other than the defaulters or survivors, bears the loss. Usually, this arrange-

ment is not a main scheme of loss-sharing but rather adopted as a mechanism to complement the Defaulters Pay or Survivors Pay. A typical example of a third party is a central bank. For instance, the Bank of Canada is stipulated to bear a loss if the collaterals of participants are insufficient to cover the loss in the Large Value Transfer System (LVTS). Depending on the content of the Rule, this arrangement may create a “moral hazard” in the participants. That is to say, if the central bank bears a large extent of the loss, each participant will not pay much attention to its risk of loss-sharing. The loss-sharing of a central bank in this arrangement can be regarded as the role of a “Lender of Last Resort” (LLR), which constitutes as a “safety net” for financial stability. The central bank’s involvement can be considered as a scheme similar to the insurance, which is provided in cases of extremely low probability, like the simultaneous defaults of multiple major participants. Without the involvement of the central bank, a heavy burden of collateral would be enforced on all the participants in preparing for any such extreme events.

Role of Liquidity Providers In the loss-sharing arrangement mentioned above, the collateral is generally provided in the form of securities, mainly in government bonds. The collateral must be sold in order to raise the funds needed to cover the defaulter’s obligation. Since it takes time to sell the securities in the market, the deadline of settlement cannot be met. For this reason, “Liquidity Providers” are set up in some DTNS systems. Each Liquidity Provider sets a “Commitment Line” to a payment system for a rainy day. A Commitment Line is an agreement under which an operator of a payment system can borrow funds up to a predetermined amount when a default breaks out. When a default occurs, the Liquidity Providers provide the required funds immediately to cover the obligation of the defaulter

35

DTNS System and RTGS System

in accordance with the agreement. With the funds from the Liquidity Providers, the operator of the payment system is enabled to complete the settlement in a timely manner. Generally, the Liquidity Providers are major private banks which have a strong fund-raising capacity in the market. And sometimes a central bank may act as a Liquidity Provider. The loans from the Liquidity Providers are repaid with the funds raised from selling the collateral in the market at a later date.

RISK REDUCTION BY INTRODUCING RTGS SYSTEM Reduction of Credit and Liquidity Risk To introduce a RTGS system makes a great contribution to the reduction of settlement risk. As payment orders are processed continuously during the day and settlements became final immediately in the RTGS system, it eliminates the credit and liquidity risk among the participants during the process of settlement. More concretely, the RTGS system shortens the period of duration substantially for the exposure to credit and liquidity risk. Provided there is sufficient liquidity for a payment order in the payer’s account, the payment lag is practically zero and the cause of risk is removed.

Elimination of Systemic Risk Introducing a RTGS system is also a powerful measure to take away systemic risk for the following reasons. First, the RTGS system reduces the exposure among participants during the day, which eliminates the possibility of loss or liquidity shortage arising from the default of other participants.

36

Second, the RTGS system never executes the unwinding, which is the main cause of systemic risk in the DTNS system. Third, the settlement time is not fixed in a RTGS system, and a participant can make a settlement with finality at any time of the day. If a temporary shortage of liquidity takes place during the day, a participant can cope with such a situation with time to spare, by taking measures of fund-raising from the market or waiting for the incoming payments from other participants. Fourth, the RTGS system can be a basic infrastructure for the DVP and PVP mechanism. With the linkage to other systems, the RTGS system can contribute to the risk reduction for securities settlement and FX settlement.

LIQUIDITY MANAGEMENT IN RTGS SYSTEM Liquidity management is an important factor in the RTGS system. As the RTGS system is a gross settlement system, there is no netting executed and payment orders are processed individually with a gross amount. As a result, the level of liquidity required in the RTGS system is much higher than that in the DTNS system. At the same time, because the RTGS system is a real-time settlement system, a settlement with finality is made continuously, as far as there is sufficient liquidity in the payer’s account. In short, a participant can secure the intraday finality as long as the payer has sufficient liquidity.

Source of Liquidity Generally speaking, the market liquidity as a whole is provided to the financial market by a central bank, and the supplied liquidity is distributed among the participants through a payment system.

DTNS System and RTGS System

Four Kinds of Sources of Liquidity When the payer seeks to make payments in the RTGS system, there are four kinds of sources of liquidity. The first source of liquidity is the outstanding balance in the payer’s settlement account. By the reserve requirements, the banks are required to keep certain level of a reserve balance in the current account at the central bank. Normally, the settlement account in the RTGS system is, at the same time, the account for the required reserves. When the settlement day starts, this reserve deposit at the end of the previous day is the origin of liquidity to be used for the settlement of the day. The second source is the incoming payments from other participants in the payment system. The incoming payments are created as a result of the securities trades, FX trades as well as customer payments. The third source is the funds raised from the money market. The participants of the RTGS system usually participate in the money market and can borrow funds from other banks, in case of necessity. The fourth source is the liquidity provided by a central bank. A central bank supplies liquidity when necessary to the participants of the RTGS system by means of intraday overdraft or intraday repo transaction.

Supply and Distribution of Liquidity The market liquidity as a whole is provided by the central bank to the financial market through the open market operations. Since the settlement of the RTGS system takes place through the transfer of funds among the participants’ accounts at a central bank, the liquidity is provided in the form of “central bank money.” Once provided, the liquidity is distributed among the participants through the payment system. Liquidity distribution is made by the

incoming and outgoing payments in the payment system as well as the money market transactions.

Intraday Liquidity Demand for Intraday Liquidity As mentioned above, the RTGS system requires a large quantity of liquidity for settlement. Because of this, it is rather inevitable for central banks to provide intraday liquidity to the participants of a RTGS system. “Intraday Liquidity” is provided by central banks to the participants of the system during the day to process payments, and the borrowed funds are to be repaid by the end of the settlement day. If the borrower is unable to repay the funds by the deadline, it must pay the penalty rate which is much higher than the market rate. The Intraday Liquidity is solely for facilitating a smooth settlement in the system during the day, and the character of the liquidity is extremely different from that of overnight lending by a central bank.

Two Methods for Providing Intraday Liquidity The two main methods to provide Intraday Liquidity are “Intraday Overdraft” and “Intraday Repo transaction.” Intraday Overdraft “Overdraft” (O/D) is an agreement that central bank allow the financial institutions to withdraw funds exceeding deposit balance, which means the account balance become temporarily negative (i.e. below zero). When an overdraft is admitted only during the day, it is called “Intraday Overdraft” (Intraday O/D). In this case, the account balance should be restored to be positive (i.e. above zero) by the end of the day. In concrete terms, the borrower of an Intraday O/D should repay the intraday loan by the end of the day. If unable to do so, the situation is called the “spillover” of intraday credit to the

37

DTNS System and RTGS System

overnight credit. In this case, the borrower should pay a penalty rate on the overnight credit. When admitting Intraday O/D, many central banks require collateral for the temporary lending. That is to mitigate credit risk of the central bank arising from a possible default of the borrower. In this case, the possible borrower should provide collateral to the central bank in advance, and can make overdrafts within the limits of the collateral value. Intraday O/D with collateral is usually provided at no charge. In other words, the borrower does not have to pay any interest rate on the O/D. The US is a sole exception on this point. The Federal Reserve provides Intraday O/D to the participants of the Fedwire without collateral. Meanwhile, the Intraday O/D is subject to charges, which are imposed on a minute-by-minute basis. Intraday Repo Transaction “Repo transaction” is a financial transaction where the seller commits to buy back the securities from the buyer at a specified price at a designated future date. It is also known as “Repurchase Agreement.” Even though it takes the form of selling and buying back of securities, the underlying nature of the transaction is collateralized short-term lending from the buyer to the seller. “Intraday Repo transaction” means that the selling and buying back of securities is executed on the same day, which is mainly used by central banks in Europe. As a repo is economically similar to a secured loan, a central bank becomes the buyer and provides funds while receiving securities as collateral to protect against the possible default of the seller. As this is an intraday transaction, the seller (i.e. financial institution) should buy back the securities by the end of the day and repay the fund to the central bank. In general, Intraday Repo transaction is made with no charge, which means that the prices of selling and buying back are identical. In sum, the nature of the Intraday Repo transaction is similar

38

to Intraday O/D which is made with collateral and no charge.

Opportunity Cost of Intraday Liquidity In both the Intraday O/D and Intraday Repo transactions, with the exception of the Federal Reserve, central banks provide intraday liquidity with no charge. Therefore, there is no explicit cost for intraday credit from the central bank. However, it does not mean that there is no cost entailed for the intraday liquidity. This is because many central banks require “full collateralization” of intraday liquidity. This greatly reduces the credit risk of the central bank, but imposes an implicit cost of posting collateral. The hidden cost caused by holding securities as collateral is known as “opportunity cost” in economics.

Illiquidity What is Illiquidity? When a participant’s central bank account balance is smaller than the amount of the payment order in the RTGS system, such a situation is called “illiquidity” or lack of funds. In this situation, the payment order is not executed in the RTGS system until the participant comes up with the funds. That is, the “delay risk” takes place due to the shortage of funds. In this situation, the participant needs to obtain funds from the market or the central bank as soon as possible.

Impact of Illiquidity Nonetheless, the situation of illiquidity does not necessarily bring a severe impact immediately in the RTGS system. The degree of impact depends on the urgency of payment order. If the payment order is nonurgent, the risk implication is rather limited. On

DTNS System and RTGS System

the contrary, if the payment order is highly urgent, the delay risk has a material impact.

the settlements in the payment system cannot make the slightest progress.

Gridlock

System-Wide Liquidity and Liquidity Distribution

What is Gridlock? “Gridlock” is a situation where the failure of some payment instructions to be executed prevents a substantial number of other instructions of other participants from being executed in a payment system. These chain-reaction consequences lead to a temporary stop of recycling of liquidity in a payment system. The initial cause of this circumstance might be a shortage of liquidity. And higher cost of liquidity will encourage banks to delay their payments. For example, Bank A is holding back a payment order to Bank B, waiting for the payment from Bank C, while Bank B is holding back a payment order to Bank C until the receipt of the payment from Bank A. And Bank C is also holding back a payment to Bank A, waiting for the payment from Bank B (see Figure 2). This is a typical situation of gridlock, where each participant is waiting for the payment from others. If this kind of situation arises, the settlements would be stuck and the circulation of liquidity in the system would be blocked. As a result of this defensive strategy taken by many participants,

The gridlock situation tends to take place especially when the “system-wide liquidity” is insufficient, which means that there are not enough funds in the market as a whole. However, even when the system-wide liquidity is sufficient, if the distribution among the participants does not work well and an extremely uneven distribution of funds takes place, the gridlock situation may also emerge. Furthermore, if each participant has a tendency to delay as much as possible sending outgoing payments intentionally in order to save its own liquidity, the gridlock situation is prone to occur. If the liquidity costs are considerably-high reflecting the central bank’s policy on providing intraday liquidity, the banks would have a strong incentive to delay payments as late as possible2.

Preventive Measures against Gridlock To avoid such a situation, some payment systems introduced a “Gentlemen’s Agreement” or a “Throughput Guideline” that obliges all the participants to send out certain percentage of pay-

Figure 2. Gridlock situation (example)

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DTNS System and RTGS System

ment orders of the day (on a volume basis and/or a value basis) by a certain time. Other systems use an “Incentive Pricing Policy” to promote the sending out of payment instructions during the early hours of the day. That is to say, a “timing-based fee structure” was introduced to promote an early submission of payment orders. For instance, the surcharge is imposed on the late payment orders sent after a fixed time. Or on the contrary, the lower charge is applied to the payment instructions sent early in the morning. In addition, some payment systems adopt offsetting mechanisms to solve the gridlock situation (to be addressed later).

Queuing Mechanism What is a Queue? “Queue” is a mechanism where payment orders are held pending by the system until the predefined conditions are met. In the DTNS system, the limitation of a Bilateral Net Credit Limit and a Multilateral Net Debit Cap are considered as required conditions for processing. As for the RTGS system, by contrast, sufficient liquidity in the payer’s account is the only and decisive condition. Payment order is held in the queue until the sufficient funds are available in the payer’s account. In some cases, the credit availability from the central bank may be taken into account to judge the sufficiency of liquidity.

Central Queue and Distributed Queue It is rather common that a queuing facility is built in the central processing system of a payment system, which is called “Central Queue.” The queue also can be built in the system of an individual financial institution, which is called “Distributed Queue.” Meanwhile, some RTGS systems do not have a central queuing mechanism. In such a system,

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when the account balance of the payer is insufficient, the payment order is rejected by the system and returned to the payer.

Central Queuing Facilities as a Global Trend To have a central queuing facility is a growing trend of RTGS systems. According to the 2008 Global Payment Systems Survey of the World Bank, the majority of RTGS systems worldwide (83 out of 98 systems, or 85%) have centralized queuing facilities and allow payment orders to wait in a queue until all required conditions for the processing of such payment orders are met. Queue management mechanisms have made impressive progress in recent years, which led to more advanced and sophisticated payment systems (to be addressed in the next chapter).

Structural Factors Influencing Liquidity The liquidity situation in a payment system is influenced by some structural factors of the participants.

Number of Participants First of all, the number of participants in a system has some effects on the liquidity situation. In a system with rather a limited number of participants, the “internalization” plays an important role, which means that a larger number of customer payments are processed internally in major banks. In this case, the payment orders processed by the payment system as interbank settlements get fewer. As a result, the intraday liquidity necessary for a settlement tends to be reduced.

Difference in the Size of Participants The difference in the size of the participants in the system also has some impact on the liquidity

DTNS System and RTGS System

situation. More concretely, Intraday Liquidity required for a payment system with both large scale banks and small-and medium-sized banks and that of a system with only uniformly-sized banks are possibly different. Generally speaking, the large scale banks tend to have the same scale of inflow and outflow payments especially for customer payments, and the required liquidity for outgoing payments is frequently covered by incoming payments. On the other hand, the small-and medium-sized banks deal with a limited number of payment orders and tend to be one-sided, i.e. excess in payment or in receipt.

Difference in the Specialized Field of Participants It is rational to assume that a system with many specialized banks and a system with homogeneous banks have diverse patterns of payments and different requirements for intraday liquidity.

Net Positions of Other Payment Systems The net positions of other payment systems also affect the liquidity requirement of a RTGS system. Such payment systems include the Bill and Check Clearing Systems, Retail payment systems, and Securities Settlement Systems. The net positions of these systems are usually settled through the RTGS system, or settled at the central bank account which the RTGS system also uses. That has a direct effect on the liquidity situation of the RTGS system. That is one aspect of interdependencies of payment systems already mentioned in Chapter 1.

REFERENCES Bank for International Settlements. (1989, February). Report on Netting Schemes (the Angell Report). Bank for International Settlements. (1990, November). Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (the Lamfalussy Report). Bank for International Settlements. (1993, September). Central Bank Payment and Settlement Services with Respect to Cross-Border and MultiCurrency Transaction (the Noël Report). Bank for International Settlements. (1997, March). Real-Time Gross Settlement Systems (the RTGS Report). Bank for International Settlements. (2001, January). Core Principles for Systemically Important Payment Systems.

ENDNOTES 1



2



“Unwind” or “unwinding” is a procedure when a default occurs in the net settlement system. If a participant fails to settle, some or all the provisional transfers involving the default participant are deleted from the system and the settlement obligation from the remaining payments are then recalculated. This is one of the major reasons that many central banks have not charged interest on the intraday credit.

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Chapter 5

Hybrid System and Integrated System

ABSTRACT This chapter takes an analytical approach to two types of advanced payment systems, namely the “Hybrid system” and “Integrated system.” The Hybrid system is a combination of the best features of the DTNS system and RTGS system. The Hybrid system is characterized by the frequent net settlement during the day. The Integrated system is defined as the payment system which has both the RTGS mode and Hybrid mode. The participants of Integrated system can use the two modes depending on the urgency of the payments. These advanced payment systems became possible through the progress of Information Technology (IT). The progress of IT enabled to achieve several mechanisms to support the sophisticated payment systems. This chapter gives the explanation of such mechanisms, which include (i) the frequent netting and continuous processing, (ii) partial netting, (iii) offsetting, (iv) searching and matching facility, (v) queue management function, (vi) pre-funding account, and (vii) multiple functions in a single payment system.

INTRODUCTION In the 1990s, it was a worldwide trend of payment systems to make the transition from the DTNS system to the RTGS system. And from the late DOI: 10.4018/978-1-61520-645-2.ch005

1990s, the new types of payment systems emerged. The first one was called “Hybrid system.” In the Hybrid system, net settlements are executed many times a day, while the traditional DTNS system executes a net settlement only once, at the end of the day.

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Hybrid System and Integrated System

The second one was called “Integrated system.” The characteristic of the Integrated system is that this type has two processing modes of payment instructions. One is the RTGS mode and the other is the Hybrid mode. Payment systems in advanced nations have evolved from the two basic payment systems, i.e. the DTNS system and RTGS system to the two advanced payment systems, i.e. the Hybrid system and Integrated system. With the introduction of the advanced payment systems, the classical type RTGS system tends to be called the “pure RTGS system,” suggesting that the function is rather limited and old-fashioned.

HYBRID SYSTEM Feature of Hybrid System “Hybrid” is a word which means a thing made by combining two different elements. In the payment system area, the “Hybrid system” means a combination of the advantages of the DTNS and RTGS system. To be more precise, this system combines the liquidity-savings features of the

DTNS system with the immediate finality offered by the RTGS system in order to improve the riskefficiency trade-off. The Hybrid system is a logical extension of the DTNS system, where the final settlement takes place only once at the end of the day. The characteristic of the Hybrid system is derived from the fact that the net settlements are made at frequent intervals or continuously. And the net settlements become final at the time of frequent settlements. These frequent net settlements succeeded in combining the liquidity-saving features and immediate finality. The DTNS system has a disadvantage that the transfer of funds become final only at the end of the day, even though it has an advantage that settlement can be made with small liquidity only for the net position. With the frequent net settlement, the Hybrid system realizes the merit of the RTGS system, that is early finality and free from systemic risk. At the same time, being a net settlement system, the Hybrid system still keeps the merit of the DTNS system, i.e. the settlement capability with small liquidity. The combination of the merits of the two systems is achieved by this means (see Figure 1).

Figure 1. Characteristics of hybrid system

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Hybrid System and Integrated System

That is the reason why this system is called “Hybrid system.” This system is also sometimes referred to as “Continuous Net Settlement” (CNS) system, compared to the DTNS system.

Development of Hybrid Systems EAF2 as the First Hybrid System The first Hybrid system in the world emerged in Germany, which was called “EAF2.” In March 1996, it became a Hybrid system from the DTNS system. In the EAF2, the bilateral net settlements were made every twenty minutes in the morning session. It was a true milestone, considering that net settlement was executed only once a day in the traditional DTNS system. In addition to the frequent bilateral net settlements in the morning session, two multilateral netting settlements were made in the afternoon session. This was for the payment instructions unsettled in the morning session. The settlements became final at each net settlement. It was a small invention, but a breakthrough innovation in the history of payment systems.

Subsequent Hybrid Systems Following the EAF2, the Paris Net Settlement (PNS) in France, and the Clearing House Interbank Payments System (CHIPS) in the US became the Hybrid systems, transformed from the DTNS system successively during 1999-2001. The new feature of these systems was that the net settlement was made continuously based on settlement events, instead of at regular time intervals as in the EAF2. It can be recognized that the Hybrid system took another step forward. The settlement events include the receipt of incoming payments and the addition of liquidity up to the settlement amount.

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CHIPS as the Most Advanced Hybrid System Under the existing circumstances, the CHIPS in the US is the latest and the most advanced Hybrid system. The settlement engine of the CHIPS judges the capability of net settlement for each payment instruction, and the net settlement is made continuously, if possible. A system, which is called the “balanced release engine,” selects the processing mode from three types: “Individual release,” “Bilateral release” and “Multilateral release,” according to the available balance of the payer and payee and the incoming and outgoing payment situation. Individual release is a simple transfer of funds of a single payment order. Bilateral release is the bilateral net settlement between the two participants. Multilateral release is the multilateral net settlement among three or more participants (see Chapter 9 for more detail). It is incredibly amazing that the automatic selection of processing mode is possible almost in real time, considering that the traditional DTNS system made the simplest form of net settlement only once a day. By adopting continuous settlement, the frequency of the settlement increased drastically compared to the only one-time settlement in the DTNS system. As you can see, even belonging to the same category as Hybrid system, the processing method of payments has made substantial progress, which was largely supported by the technological progress.

Hybrid System and Tradeoff in Payment System As mentioned in the previous chapter, there is a trade-off in payment systems between safety and efficiency. Safety means that settlement risk is reduced and efficiency means that the required liquidity for settlement is small. As explained in Chapter 4, the DTNS system has an advantage on

Hybrid System and Integrated System

Table 1. Trade-off between safety and efficiency Safety

Efficiency

DTNS system

Low

High

RTGS system

High

Low

the liquidity required for the settlement, which means its efficiency is “High.” However, the DTNS system is vulnerable to settlement risk, including the possibility of systemic risk, which means its safety is “Low.” On the other hand, the RTGS system requires larger liquidity to process settlements, which means the “Low” efficiency. But the RTGS has an advantage for the reduction of settlement risk, which means its safety is “High” (see Table 1). With the presence of this trade-off relationship, the RTGS and DTNS systems are to be found on the same “indifference curve.” This means by improving the safety, the efficiency will be decreased, and if the efficiency is enhanced, the safety will be degraded. When the efficiency comes first, the DTNS system is chosen, and when priority is placed on the safety, the RTGS system is selected in the traditional world with only two choices.

However, the Hybrid system made it possible for early finality and settlement capability with small liquidity at the same time. This is more than just the middle point of the two systems. This combination of merits from two systems realized the higher utility for the participants of the system, which meant an upward shift of the ‘indifference curve’ or ‘trade-off curve’ (see Figure 2). Thus, it can be concluded that the Hybrid system was a true innovation that achieved an enhancement of utility in the payment system.

INTEGRATED SYSTEM Feature of Integrated System The next evolution of payment systems was the transition to Integrated system. An Integrated system is defined as the payment system which has both the RTGS mode and Hybrid mode. Participants of an Integrated system can use both modes as the situation demands. More concretely, participants can use the RTGS mode for the urgent and time-critical payments, while they can use the Hybrid mode for the non-urgent payments. The Hybrid mode performs the continuous or frequent settlement with netting effect and is often

Figure 2. Indifference curve and payment systems

45

Hybrid System and Integrated System

referred to as “Liquidity-Saving mode,” because participants can execute their payment with a small balance in their accounts and can save the liquidity (see Figure 3). Usually, a participant can use the RTGS mode and Liquidity-Saving mode from a single liquidity, i.e. single account, in an Integrated system. If the RTGS mode and Hybrid mode were two independent systems, a participant should manage the two liquidities during the day separately, which might be a heavy burden on the participant. So, it was a logical advancement to integrate the two functions into one payment system, which allows participants to manage liquidity in a single account.

Development of Integrated Systems LVTS in Canada The pioneer of the Integrated system was the Large Value Transfer System (LVTS) in Canada. The LVTS started operation in February 1999. The LVTS has two functions for processing of payment instructions. One function is called “Tranche 1,” which is the RTGS mode. The other is called “Tranche 2,” which is the Liquidity-Saving mode. Participants can select either Tranche 1 or Tranche

Figure 3. The concept of Integrated system

46

2, and send their payment instruction through the selected Tranche.

PIS in France The second Integrated system was the Paris Integrated System (PIS) in France. In 1999, France had two large-value payment systems for euro. One was the Paris Net Settlement (PNS), which became the Hybrid system from the DTNS system in April 1999, operated by Centrale des Règlements Interbancaires (CRI: The Interbank Settlement Center). The other was the Transferts Banque de France (TBF), which was the RTGS system, operated by the Banque de France. In April 1999, the CRI developed a “liquidity bridge” between the TBF and PNS. The liquidity bridge is a scheme allowing participants to transfer liquidity between the two payment systems at any time of the day. By this means, the PNS and TBF became closely linked. Even though these were two independent payment systems, they looked like a single combined payment system from the viewpoint of participants. Therefore, these two systems were called “Paris Integrated System” (PIS) as a whole, and regarded as one of the Integrated systems (see Figure 4).

Hybrid System and Integrated System

Figure 4. The Concept of Paris Integrated System (PIS)

RTGSplus in Germany The RTGSplus in Germany was the third Integrated system, which started operation in November 2001. The RTGSplus had two modes; the “EX payment mode” and “Limit payment mode.” The EX payment mode was an RTGS settlement for high priority payment. The settlement was executed only if there was enough liquidity in the payer’s account. On the other hand, the Limit payment mode was a Liquidity-Saving mode with the continuous

offsetting functionality. When payment instructions were sent to the system, a special algorithm searched the central queue to see if another set of payment instructions might offset each other. Once such a set of payment instructions was found, these instructions were settled by offsetting (see Figure 5). “Offsetting” meant the simultaneous booking of the outgoing and incoming payment. Offsetting was considered as a gross settlement, but the effect was quite similar to the netting. In the Limit Payment mode, participants were able to set the

Figure 5. Settlement Scheme of RTGSplus

47

Hybrid System and Integrated System

Sender Limits bilaterally or multilaterally to control their own liquidity. Participants could manage their liquidity in a single liquidity pool and used two modes according to the priority of the payment.

TARGET2 When euro was introduced in January 1999, the “TARGET” (Trans-European Automated Realtime Gross settlement Express Transfer system) started its operation. The TARGET was a decentralized system which linked the RTGS systems of the countries that introduced euro. It was a useful payment system that deals with the crossborder euro payment within EU. However, the TARGET had some inefficiency because it was constructed by connecting a number of RTGS systems in EU. Some functions were somewhat different and each central bank still operated each system individually. The Eurosystem (the ECB and national central banks) decided to upgrade the TARGET by introducing the Single Shared Platform (SSP). The new payment system was called “TARGET2.” The TARGET2 is a centralized system with single platform and the fee and service became uniform throughout the euro area. The TARGET2 started its operation in November 2007. Advanced features of the RTGSplus, new BI-REL (in Italy) and PIS were transplanted into the TARGET2. To be more precise, the TARGET2 was built as an Integrated system with the RTGS mode and the Liquidity-Saving mode. In addition, the new features were introduced in the TARGET2, including the liquidity control with sender limits, prioritization of payments, and liquidity reservation for urgent payment. Thus, the TARGET2 is the one of the most advanced Integrated systems (see Chapter 10 for more details).

48

MEPS+ in Singapore The MEPS+ is an Integrated system in Singapore, which started its operation in December 2006. The MEPS+ was the first Integrated system in the Asia-Pacific region. The previous system, the MEPS, was a pure RTGS system. By adding the Liquidity-Saving mode, it became an Integrated system.

Next Generation RTGS of the BOJ-NET The BOJ-NET in Japan also used to be a pure RTGS system. In 2006, the Bank of Japan (BOJ) published a plan to enhance the BOJ-NET into an Integrated system. The project was called “Next Generation RTGS Project” (RTGS-XG project). The main point of the RTGS-XG was to add the Liquidity-Saving Feature (LSF) and centralized queuing function. And the Bilateral and Multilateral Offsetting functions which are similar to those of the RTGSplus were also introduced. By this means, the BOJ-NET joined the family of Integrated systems. The only thing that was different from other Integrated systems was that the BOJ-NET adopted a two-account system: the current account for the RTGS settlement and the LSF account for the Liquidity-Saving function (see Chapter 11 for more details).

Share of Advanced Payment Systems According to the calculation1 in Bech et al. (2008), only 3% of wholesale payments by value were settled over the Hybrid and Integrated systems in G10 countries in 1999. By 2005, the percentage had risen to 32%. This figure has continued to rise, as the Hybrid systems and Integrated systems were introduced in several more countries since 2005.

Hybrid System and Integrated System

MECHANISMS THAT SUPPORT ADVANCED PAYMENT SYSTEMS Advanced payment systems, such as the Hybrid systems and Integrated systems, are supported by several sophisticated mechanisms. The progress of IT has facilitated the achievement of such mechanisms at a reasonable cost. Such mechanisms that contribute to the evolutionary progress of payment systems include (i) the frequent netting and continuous processing, (ii) partial netting, (iii) offsetting, (iv) searching and matching facility, (v) queue management function, (vi) pre-funding account, and (vii) multiple functions in a single payment system.

Frequent Netting and Continuous Processing When the DTNS system was developed, most systems executed netting only at the end of the day, due to the constraint of computer capacity. Furthermore, in some systems, it took such a long time to calculate the netting positions of all participants that they could not make the final settlement on the same day, and the final settlement of the net position was made on the next day. In recent years, thanks to the enhanced processing capability of the computers and other technical

progress, “Frequent Netting” became possible, which led to the emergence of the Hybrid system. The form of frequent netting progressed from the netting with regular intervals to the netting of continuous processing. The latter processing executes netting when some settlement events happen, such as the addition of liquidity, a new payment order or the change of sender limit.

Partial Netting “Full Netting” is executed in the DTNS system, which means that all the payment orders of all the participants are incorporated into the calculation of net positions. Due to the progress of IT, “Partial Netting” became possible, which executes netting only the payments of a limited number of participants (see Figure 6). Partial netting includes the “Bilateral Partial Netting” between two participants and “Multilateral Partial Netting” among three or more participants. The Liquidity-Saving mode was realized thanks to the capability of partial netting. In some systems, the Bilateral and Multilateral Partial Netting are treated separately. For example, the Bilateral Netting is regarded as a main function of processing and is up and running during the operating hours. While, the Multilateral Netting is regarded as a supplemental

Figure 6. Full Netting and Partial Netting

49

Hybrid System and Integrated System

method, and is executed only at scheduled times of the day or when a gridlock situation happens.

Offsetting What is Offsetting? “Offsetting” means a simultaneous booking of the outgoing payment and incoming payment. As with the netting, there is “Bilateral Offsetting” and “Multilateral Offsetting.” Bilateral Offsetting is a simultaneous processing of payments between two participants. Multilateral Offsetting is a simultaneous processing of payments among more than three participants, typically all the participants of the system.

Offsetting and Netting In Offsetting, each payment is regarded to be executed on a gross basis. However, the result of the processing is exactly the same as the netting. For instance, assuming that Bank A sends a payment of 40 to Bank B, and Bank B sends a payment of 100 to Bank A. In the case of netting, the net positions (+60 for Bank A and -60 for Bank B) are calculated and the positions are put on each account, which leads to the increase of 60 on Bank A’s account and the decrease of 60 on Bank Figure 7. Offsetting and Netting

50

B’s account. In the case of Bilateral Offsetting, two payments between Bank A and Bank B are processed simultaneously. As a result, Bank A’s account will increase by 60, and Bank B’s account will decrease by 60 (see Figure 7). No difference is found between the two outcomes. The Offsetting concept was adopted by the RTGSplus in Germany for the first time ever in the world. That was in order to avoid the netting concept, because only the RTGS system could connect to the TARGET and once one of the functions is judged to be the netting, the RTGSplus could not link to the TARGET. Later on, other payment systems implemented Offsetting facilities. It was because the netting-like effect could be materialized in the RTGS system by adopting the Offsetting facilities. This led to more substantial progress in payment systems.

Searching and Matching Facility Technological progress made it possible to search for appropriate pairs of payment instructions in a waiting queue, based on the payment and liquidity conditions of the concerned parties. Such conditions include the liquidity situation and the Sender Limit of the sender, the Credit Limit of the receiver and so on. The search engine can find

Hybrid System and Integrated System

out and match the appropriate pair of payments to be netted or offset. In addition, the searching and matching facilities can process a large number of payments in the queue as quick as a flash. This capability of high-speed searching and matching resulted in inventing the Liquidity-Saving function.

Queue Management “Queue” is a scheme whereby payment instructions are held pending according to certain rules until the instructions meet some conditions. Most RTGS systems and advanced systems have the central queuing mechanisms for the better control of payment flows. By holding the unsettled payments in the queue, the system is capable of combining some payment instructions and netting (or offsetting) them. A participant also can control its payment flow and liquidity by managing the payment instructions in the queue. In recent years, the queue management techniques have made amazing progress, which played a key role in the evolutionary progress of payment systems.

Basic Queue Processing Rule The payment instructions in a queue are processed in accordance with the prescribed rule. The basic queue processing rules include the following (see Table 2).

First-In, First-Out (FIFO) The most basic rule of queue processing is the “First-In, First-Out” (FIFO). In the FIFO rule, the payments are waiting in the queue by arrival sequence to the system, and the processing would be tried in sequence from the top payment in the queue.

Bypass FIFO “Bypass FIFO” is a variation of the FIFO rule. In the Bypass FIFO, when the top payment in the queue does not satisfy the condition of settlement, the second payment would be tried to be processed. In the RTGSplus of Germany, the strict FIFO rule was adopted for the EX Payment mode and the Bypass FIFO rule was applied to the Limit

Table 2. The basic queue processing rule FIFO

Payments are placed in the queue in the order of arrival to the system. Processing is done on a first-in first-out basis, which means from the top payment in the queue.

by-pass FIFO

When the first payment in the queue cannot be processed, the second payment would be tried.

FAFO

Regardless of the orders in the queue, processing is made as much as possible with the available liquidity.

Table 3. Queue processing rule of selected payment systems FIFO ELLIPS (Belgium), LVTS (Canada), TBF (France), PNS (France), RTGSplus (Germany), HKD CHATS (HK), USD CHATS (HK), Euro CHATS (HK), BI-REL (Italy), TOP (Netherlands), K-RIX (Sweden), E-RIX (Sweden), SIC (Switzerland), euroSIC (Switzerland)

Bypass FIFO ELLIPS (Belgium) PNS (France) RTGSplus (Germany) BI-REL (Italy) K-RIX (Sweden) E-RIX (Sweden)

Note: Some of these payment systems were closed or consolidated into the TARGET2 at a later date. Source: BIS (2005)

51

Hybrid System and Integrated System

Payment mode. Other payment systems in Europe also adopted the Bypass FIFO rule (see Table 3).

First-Available, First-Out (FAFO) “First-Available, First-Out” (FAFO) is the rule that tries to execute as many payments as possible to settle, regardless of their order in the queue. In some systems, the FAFO rule takes over the FIFO rule at the end of the day, in order to process as many unsettled payments as possible.

Advanced Queue Management Functions It is the tendency of newly designed payment systems to add the queue management functions which allow the participants to actively control payment orders in the queue. These advanced queue management functions include (i) prioritization, (ii) reordering, (iii) timed payments, and (iv) optimization. These queue management functions heavily depend on the real-time capability of monitoring and controlling of payments in the queue by the participants, which are made possible by interactive network services.

Prioritization

payments with high priority are processed and deleted from the queue, the payments with low priority will not start to be processed. In some systems, the Prioritization is set at two levels, e.g. “urgent” and “normal.” In other systems, the Prioritization is set at three levels, such as “high,” “normal” and “low” priority. More sophisticated way of Prioritization is also possible.

Reordering “Reordering” is a function of changing the order of payments in a queue. For example, when the strict FIFO rule is applied, and a large payment is at the top of the queue and blocks all the processing, it is possible to promote the processing of the other payments by relocating the top payment to the lower order temporarily (See Table 4).

Timed Payment “Timed Payment” is a function to appoint the execution time of each payment order. This function includes the “Till Payment” function which appoints the completion time of settlement, and the “From Payment” function which appoints the starting time of execution. The Timed Payment is useful especially for the time-critical payments.

“Prioritization” is a function to add a priority code to each payment to assign its priority. Until the

Table 4. Prioritization and reordering capability in selected payment systems Payment system with Prioritization ELLIPS (Belgium), TBF (France), RTGSplus (Germany), HKD CHATS (HK), USD CHATS (HK), Euro CHATS (HK), BI-REL (Italy), TOP (Netherlands), SIC (Switzerland), euroSIC (Switzerland), CHAPS Euro (UK), CHAPS Sterling(UK) CHIPS (US)

Payment system with Reordering RTGS (Germany), HKD CHATS (HK), USD CHATS (HK), Euro CHATS (HK), BI-REL (Italy), TOP (Netherlands), K-RIX (Sweden), E-RIX (Sweden), SIC (Switzerland), euroSIC (Switzerland), CHAPS Euro (UK), CHAPS Sterling(UK) CHIPS (US) plus

Note: Some of these payment systems were closed or consolidated into the TARGET2 at a later date. Source: BIS (2005)

52

Hybrid System and Integrated System

Optimization “Optimization” is a mechanism which promotes the processing of unsettled payments in the queue, typically when a gridlock situation arises. When this mechanism is executed, the FIFO rule is usually substituted by the FAFO to promote the processing of as many payments as possible, regardless of the order in the queue. In the process of Optimization, the method of offsetting is often used to process payment orders waiting in a queue. In this case, the Multilateral Offsetting is more commonly used than the Bilateral Offsetting, because it is suitable to match payments as much as possible. Optimization is put in motion at a fixed time, at odd intervals, or only when necessary. In some systems, its Optimization is done manually by the system operator when the operator confirms necessity based on its monitoring of the system. In other systems, Optimization is done automatically by the system in a specific interval of time or based on other parameters.

Pre-Funding Account It is often the case that the advanced payment systems have special accounts for settlement. In this case, the participants have to make “Prefunding,” which means to put the funds in their accounts for the settlement of that day at the beginning of the day. The DTNS system is based on the concept of “pay later,” in which participant should pay the net debit position at the end of the day. The DTNS system requires some risk mitigation arrangements including setting a Sender Limit and pledging collateral, because there are some possibilities of default in the pay-later scheme. In the Pre-funding system, as the payment orders are processed using the fund paid in advance, there is no need for a risk mitigation arrangement, which reduces the risk management burden on the participants.

However, it should be noted that the Prefunding scheme is workable only in a payment system which has a considerable high speed of liquidity circulation in the system. If the Pre-funding scheme is introduced to a payment system with inefficient liquidity circulation, a huge amount of funds must be paid in advance, which is the big burden on the participants. For example, in the CHIPS, the settlement amount of the day is 500 to 600 times of the initial funding amount. Thus, the Pre-funding and efficient circulations of liquidity are closely connected to each other.

Multiple Functions in a Single Payment System Historically, it was quite common that one payment system adopted only one method of processing, such as the RTGS mode or the DTNS mode. Because it was quite difficult to realize the multiple payment processing modes in one system from the perspective of system development. In addition, the risk management scheme was another reason, which varied considerably according to the processing mode. The rapid progress of IT has enabled two modes to exist in a single payment system, which has paved the way for the Integrated system. Adopting the Offsetting concept has helped to combine two functions in one system by avoiding the netting concept which requires a different risk management scheme.

Future Trends The BOJ-NET became an Integrated system in 2008. But, ahead of BOJ-NET, the Monetary Authority of Singapore (MAS) successfully implemented the “MEPS+” in December 2006. The MEPS+ was the first Integrated System in Asia, which replaced the previous national interbank payment system, the MEPS. The Managing Director of MAS mentioned that the changes in the financial landscape had led to

53

Hybrid System and Integrated System

a need for more efficient liquidity management, improved risk management and more streamlined payment flows, and the MEPS+ was designed to meet these needs. If market demand works in the same way, it is highly possible that payment systems will continue to evolve progress with the aid of technological innovation in order to meet the market needs. Shortly after the RTGS system was invented, only a handful country adopted this innovative system, even though it was quite effective in reducing settlement risk. However recently, it is reported that more than 100 countries had adopted the RTGS system. Therefore, one can predict that those “Advanced Systems” would gradually become the prevalent systems throughout most of the world. It is worth noting that the RTGS system took more than 20 years to become the most prevailing system in the world.

Bech, M., Preisig, C., & Soramäki, K. (2008, June). Global Trends in Large-Value Payments. FRBNY Economic Policy Review. European Central Bank. (2006, August). The Evolution of Large-Value Payment Systems in the Euro Area. ECB Monthly Bulletin. Martin, A. (2005). Recent Evolution of LargeValue Payment Systems: Balancing Liquidity and Risk. Economic Review, First Quarter 2005. Federal Reserve Bank of Kansas City. McAndrews, J. & Trundle, J. (2001, December). New Payment System Designs: Causes and Consequences. Financial Stability Review. Bank of England.

ENDNOTE 1

REFERENCES Bank for International Settlements. (2005, May). New Development in Large-Value Payment Systems.

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In their calculation, the Hybrid and Integrated systems include PNS, LVTS, CHIPS and RTGSplus.

Section 3

Innovations in Payment Systems

56

Chapter 6

Evolutionary Trends of Payment Systems

ABSTRACT This chapter presents an analysis about the evolutionary process of payment systems. Payment systems showed remarkable changes in the past two decades. The first evolutionary trend was observed in the central bank payment systems. That was the transition from the traditional DTNS system to the RTGS system. A technology diffusion analysis of the RTGS technology across the world is also presented. The second step in the evolution of payment systems was the introduction of the Hybrid system. Several Hybrid systems in Europe and the US are discussed in detail. The third trend was the adoption of the Integrated system. Emergence of some Integrated systems are discussed, which include the LVTS in Canada, PIS in France, MEPS+ in Singapore, TARGET2 in EU and Next Generation BOJ-NET in Japan. And then, a hypothesis on the typical evolutionary pattern from the simple DTNS system to more sophisticated systems is proposed. This chapter also reviews another line of evolutionary trends, including the “Multi-Currency Payment Systems” and “Offshore Payment Systems,” and the linkage between payment system and “Securities Settlement System” (SSS). It also gives an explanation about the adoption of “Financial EDI” capability, which is the scheme that enables the processing of remittance information with payment instructions in the payment system. DOI: 10.4018/978-1-61520-645-2.ch006

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Evolutionary Trends of Payment Systems

INTRODUCTION During the past twenty years, payment systems have evolved in step with the progress of Information Technology (IT). In the early days, the payment systems could make a net settlement only once a day and process payment instructions in only a very simple manner. Gradually, the payment systems have become capable to carry out the real-time settlements and continuous processing, and handle payments based on the sophisticated algorithms. Such progress has brought about a reduction in settlement risk and improvement in settlement efficiency. The evolutionary trends of payment systems include (i) the transition from the DTNS systems to RTGS systems, (ii) introduction of the Hybrid systems and Integrated systems, (iii) emergence of the Multi-Currency Payment Systems and Offshore Payment Systems, (iv) linkage between payment system and Securities Settlement System (SSS), and (v) adoption of Financial EDI capability.

TRANSISION FROM DTNS SYSTEM TO RTGS SYSTEM The first evolution was observed in the payment systems operated by central banks. The evolutionary growth was the transition from the DTNS system to the RTGS system.

DTNS System and RTGS System In many countries, when the electronic payment systems were first introduced, they were the Designated-Time Net Settlement (DTNS) systems. DTNS system is a net settlement system, thus the settlement of funds occurs on a net basis. In concrete terms, a net position of each participating bank is calculated, which is defined as the sum of the value of all the transfers a participant has received up to a particular point in time minus the

value of all transfers it has sent. DTNS system is a designated-time settlement system, in which the final settlements take place at a certain time, typically once, at the end of the day. In short, the final settlement of net positions occurs at the end of the day in DTNS system. On the other hand, the Real-Time Gross Settlement (RTGS) systems have two features. The first feature is that the settlement of funds occurs on a gross basis, which means payment instructions are processed on a one-by-one basis without netting. The second feature is that the final settlement is made on a real-time basis during the day. Thus the settlements become final immediately.

Merits of RTGS System As mentioned in the previous chapters, the RTGS system is superior in reducing settlement risk compared to the DTNS system. Settlement risk is the risk that a participant of a payment system will suffer a liquidity problem and/or loss because the other party does not make payments as expected. Settlement risk includes the credit risk, liquidity risk, legal risk, operational risk and systemic risk (see Chapter 3 for more detail). The DTNS system tends to be vulnerable to settlement risk. First, the unsettled payment instructions accumulate until the end of the day in the DTNS system. Therefore, until the final settlement is completed at the end of the day, settlement risk stays around. On the other hand, the RTGS system processes each payment instruction one-by-one and makes them final during the daytime. Thus, the RTGS system can effectively reduce settlement risk. Second, “systemic risk” is the keyword. This is the risk that the failure of one participant to meet its required obligations will cause other participants to be unable to meet their obligations when due. Such a failure may cause widespread liquidity or credit risk problems and, as a result, might threaten the stability of financial markets. As overseers of payment systems and financial markets, central

57

Evolutionary Trends of Payment Systems

banks are particularly concerned with systemic risk. The DTNS system has a potentiality of systemic risk, because if one participant is unable to settle its net debit position, the payment system has to recalculate a new set of net positions for each of the remaining participant by deleting all the payments involving the defaulted participant. This procedure is called “unwinding.” Unwinding can lead to the unexpected changes in the net positions of the remaining participants, which could cause a “knock-on effect” or “cascade effect” of settlement failures. Specifically, other participants could fail to meet their obligations, which would generate a “contagious default.” The worst thing of unwinding is that a bank’s net position may be adversely affected by the failure of another bank even if it had no direct transactions with the failed bank. On the other hand, the RTGS system has no possibility of systemic risk, because each transfer of funds becomes final instantly when processed. As there is no netting in the RTGS system, there is no unwinding risk. Hence, the RTGS system is more robust than the DTNS system in terms of settlement risk. However, the elimination of risk comes at the cost of an increased demand for intraday liquidity. This is the only demerit of the RTGS system. To cover such liquidity demand, central banks usually provide intraday credit to the participants in RTGS system. Even if intraday credit is provided without a fee, the intraday liquidity is not free, because usually collateral is required for the intraday credit, which causes a collateral cost.

Global Trend toward RTGS System Early Adopters of RTGS System As of 1985, there were only two RTGS systems observed; namely, the “Fedwire1” in the US and “DN Inquiry and Transfer System” in Denmark (see Table 1). From the late 1980’s, the number of RTGS systems increased gradually, especially in

58

industrialized countries, which include the “RIX” in Sweden (1986), “SIC” in Switzerland (1987), and “EIL-ZV” in Germany (1988).

Changeover to RTGS System in EU In the European Union (EU), the RTGS system spread rapidly in the late 1990’s. It was because the TARGET system was planned to prepare for introducing the single currency euro. The TARGET was the payment system for the whole euro area and was developed by connecting the payment systems of each member country. A decision was made that only the RTGS system would link to the TARGET system. Since the settlement method and risk management of the RTGS system were completely different from those of the DTNS system, it was impossible to link the two different types of systems. Because of Table 1. Introduction of RTGS system in selected countries Country

RTGS System1

Timing of introduction

Denmark

DN Inquiry and Transfer System

1981

US

Fedwire

1982

Sweden

RIX

1986

Switzerland

SIC

1987

Germany

EIL-ZV

1988

Korea

BOK-Wire

1994

Thailand

BAHTNET

1995

UK

CHAPS

1996

Belgium

ELLIPS

1996

Hong Kong

CHATS

1996

France

TBF

1997

Italy

BI-REL

1997

Netherlands

TOP

1997

Australia

RITS

1998

Singapore

MEPS

1998

EU

TARGET

1999

Japan

BOJ-NET

2001

1 The name when the RTGS system was introduced.

Evolutionary Trends of Payment Systems

this, it became a prerequisite to become a member of the Economic and Monetary Union (EMU) to have a RTGS system. Therefore, the concerned central banks were obliged to implement the RTGS system by January 1999, the target date of introducing euro, to meet the requirement. In this way, the central banks which planned to introduce euro reconstructed their payment systems into the RTGS system one after another during 1996-1997.

Introduction of RTGS System in Other Countries Influenced by these movements, some Asia-Pacific countries also introduced the RTGS systems in late 1990s, which included the “BOK-Wire” in South Korea (1994), “BAHTNET” in Thailand (1995), “CHATS” in Hong Kong (1996), “RITS” in Australia (1998) and “MEPS” in Singapore (1998). The use of RTGS systems also grew outside the industrialized countries. Some countries in Eastern Europe, Latin America, Middle East, and Africa were similarly introduced the RTGS systems. In South America, Uruguay was the first country to adopt the RTGS system in 1995. Saudi Arabia (1997) was the first country in the Middle

East, and South Africa (1998) was the first comer in Africa. Some of these countries constructed their electronic payment systems from scratch as RTGS systems. According to the survey of the Federal Reserve Bank of New York, 90 out of 174 countries in the world had adopted a RTGS system by the end of 2006 (Bech & Hobijn, 2007). By this means, the adoption of RTGS system has become the global trend of payment systems (see Figure 1). It can be observed that the RTGS system has became the de facto standard in the central bank payment systems.

Global Situation toward RTGS System According to the “Global Payment System Survey 2008” conducted by the World Bank, 112 countries2 out of 142 (or 79%) were using the RTGS system as of December 2006. With regard to the timing of introducing the RTGS system, the survey shows 45 systems were implemented in 1997 or before, 31 systems in 1998-2001, 24 systems in 2002-04, and 12 systems in 2005-06. In summary, about 70% of the RTGS systems in the world were introduced before 2001 (see Table 2).

Figure 1. Number of countries that adopted the RTGS System (Source: Bech and Hobijn (2007))

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Evolutionary Trends of Payment Systems

Table 2. The year of implementation of the RTGS system Year of Implementation

1997 or before

1998-2001

2002-04

2005-06

Total

45

31

24

12

112

40%

28%

21%

11%

100%

number of systems share Source: The World Bank (2008)

Among the 112 countries which use the RTGS system, the central bank is the operator of the RTGS system in 108 countries3. And in all cases of the 112 countries, the central bank is the settlement agent for the RTGS system. This result shows that central banks assume a key role for RTGS systems as both the operators and settlement agents.

Adoption of RTGS System in Japan The adoption of the RTGS system in Japan was rather special. When the Bank of Japan (BOJ) developed the BOJ-NET in 1988, the BOJ-NET had two modes; the DTNS mode and the RTGS mode. Some argued that the RTGS system was introduced in the BOJ-NET at this point (Bech & Hobijn, 2007). But actually, this was not the case. The RTGS mode was seldom used4 by the participants due to the high liquidity cost, and we should conclude that the characteristic of the

old BOJ-NET was basically a DTNS system at that point. The BOJ changed the BOJ-NET into a RTGS system by abolishing the DTNS mode in January 2001. At that time, the BOJ-NET was transformed from the de facto DTNS system into the genuine RTGS system.

Technology Diffusion in the Case of RTGS General Theory on Diffusion of Innovations General theory on diffusion of innovations tells us that the rate of adoption follows a predictable pattern. The rate of adoption of a new technology is slow at first. Then, adoption rate becomes high until a substantial share of members (or agents) has adopted the technology. After that, the adoption rate levels out and eventually falls off.

Figure 2. S-shaped curve and bell-shaped curve of technology adoption

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Evolutionary Trends of Payment Systems

This pattern makes a “S-shaped diffusion curve,” which indicates the share of adopters over the course of time (see Figure 2). It is also a well-known fact that the adopter distributions make a “bell-shaped curve” for a successful innovation. Rogers (1995) divided this bell-shaped curve into five categories. The first 2.5% of adopters are named “innovators.” The following 13.5% are labeled “early adopters.” The next 34% of adopters up to the median are called “early majority,” while the 34% above the median are labeled “late majority.” And the remaining 16% of adopters are called “laggards” (see Figure 2). It is extremely interesting to know that the adoption pattern of the RTGS technology by central banks follows an S-shaped diffusion curve, almost identical to that observed in other technologies (see Figure 3). It is amazing that central banks follow the general pattern of technology adoption, even though their principles of behavior are quite different from that of the private sector.

Diffusion of RTGS Technology Bech and Hobijn (2007) examined the diffusion of the RTGS technology across the world’s 174 central banks. They concluded that the central

banks can be divided into five categories according to Roger’s classification. • • • •

The central banks that adopted RTGS prior to 1987 are considered to be “innovators.” Central banks that adopted RTGS before 1998 are “early adopters.” Central banks that adopted RTGS during1998-2004 are the “early majority.” Central banks that adopted after 2004 are the “late majority.”

According to this classification, the Federal Reserve System was an innovator; Bank of England was an early adopter; Bank of Japan was part of the early majority; and National Bank of Romania was part of the late majority. Bech and Hobijn (2007) made an analysis to identify the determinants of RTGS adoption and found the following results. •

•

(i) real GDP per capita, (ii) population, (iii) education, and (iv) the investment price has a positive impact on the adoption. As for the spillover effect from one central bank to other central banks, the bilateral trade relationships have the strong effect on the adoption.

Figure 3. Actual and fitted adoption rates of RTGS (Source: Bech and Hobijn (2007))

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Evolutionary Trends of Payment Systems

These results suggest that larger countries (reflected by population), with a higher standard of living (reflected by real GDP per capita), and a high level of human capital (reflected by education), seemed to be more likely to adopt the RTGS system than others. Moreover, countries with a relatively low price of capital (reflected by the investment price) also are more likely to adopt. On the other hand, the spillover effect seems to play a significant role in the adoption. Trade relationships seem to have a strong impact on the spillover effect from one central bank to another. This implies that if country A has a strong relationship with Country B in trade, they also have a significant relationship in financial transactions.

the transfer of funds becomes final only at the end of the day; even though it has an advantage that settlement can be made with small liquidity for a net position. With the frequent net settlement, the Hybrid system keeps the merit of the DTNS system, i.e. the settlement capability with small liquidity, and in addition realizes the merit of the RTGS system, which is the early finality. That is why this system is called “Hybrid system.” It is also sometimes referred to as “Continuous Net Settlement” (CNS) system, when compared to the DTNS system. The emergence of the Hybrid system was to overcome the trade-off between safety and efficiency, stated differently, risk reduction and liquidity cost.

INTRODUCTION OF HYBRID SYSTEMS

Emergence of Hybrid Systems

The second evolutionary step in payment systems was the emergence of Hybrid systems (see Table 3). As mentioned in the previous chapter, the Hybrid system is the combination of the best features of the DTNS and RTGS system.

Feature of Hybrid System The Hybrid system derived from the DTNS system in which final settlement takes place only once, usually at the end of the day. In the Hybrid system, the net settlements are made at frequent intervals or continuously and the transfer of funds becomes final at the time of these settlements. The traditional DTNS system has a disadvantage which Table 3. Introduction of Hybrid System in selected countries Country

Hybrid System

Timing of introduction

Germany

EAF2

March 1996

France

PNS

April 1999

CHIPS

February 2001

US

62

EAF2 in Germany The first Hybrid system in the world was the “EAF2” in Germany. Before becoming a Hybrid system in March 1996, the old EAF was a typical DTNS system, which executed the final settlement at the end of the day. In the EAF2, the netting was made at regular intervals. Bilateral net settlements were made every twenty minutes in the morning session and two multilateral netting settlements were made in the afternoon session. The settlements became final at each net settlement. This was the most elementary form of the Hybrid system.

PNS and CHIPS Following the EAF2, the “PNS” in France, and “CHIPS” in the US became the Hybrid system during 1999-2001 (see Table 3). In these systems, the net settlements were made continuously based on the settlement events, like the receipt of a new payment order and addition of liquidity, instead of at regular intervals. The CHIPS is the latest and the most advanced Hybrid system, where the system judges the

Evolutionary Trends of Payment Systems

capability of net settlement for each payment instruction, and net settlement is made continuously, if possible. The system, which is called the “balanced release engine,” selects the processing mode from the three types: Individual Release, Bilateral Release and Multilateral Release, according to the available balance of the payer and payee and the incoming and outgoing payment situation. Bilateral Release is just like bilateral net settlement between the two participants. Multilateral Release is a kind of multilateral net settlement among the three or more participants.

No Hybrid System in Asia-Pacific For some reason or other, no Hybrid system appeared in the Asia-Pacific region, including Japan and Singapore. In the case of these two countries, the RTGS system jumped to the Integrated system, without going through a Hybrid system phase.

INTRODUCTION OF INTEGRATED SYSTEMS Feature of Integrated System The next step in the evolution of payment systems was the transition to the Integrated System (see Table 4). The Integrated System is defined as the payment system which has both the RTGS function and Hybrid function. Participants of the Integrated System can use both functions as the situation demands. For example, the participants can use the RTGS function for urgent payments and time-critical payments, whereas they can use the Hybrid function for non-urgent payments. The Hybrid function performs continuous or frequent settlement and is often referred to as “LiquiditySaving mode,” because participants can execute their payment with small liquidity.

Table 4. Introduction of Integrated System in selected countries Country

Integrated System

Timing of introduction

Canada

LVTS

February 1999

France

PIS(PNS and TBF)

April 1999

Germany Italy

RTGS

plus

new BIREL

April 2004

MEPS +

December 2006

TARGET2

November 2007

BOJ-NET(RTGS-XG)

October 2008

Singapore EU Japan

November 2001

Emergence of Integrated Systems LVTS in Canada The earliest adopter of Integrated system was the “Large Value Transfer System” (LVTS) in Canada, which started its operation in February 1999. The LVTS has two modes of payment; Tranche 1 and Tranche 2. Tranche 1 is the RTGS mode, which is suitable for urgent payments. Tranche 2 is the Liquidity-Saving mode, which is suitable for non-urgent payments and has the merit of small liquidity settlement capability.

PIS in France The “Paris Integrated System” (PIS) in France was the second to come. In April 1999, a “Liquidity Bridge” was established between the Paris Net Settlement (PNS), a Hybrid system and Transferts Banque de France (TBF) which is a RTGS system. The Liquidity Bridge allowed the participants to transfer the liquidity freely between the PNS account and TBF account. With this integrated management, these two systems were collectively referred to as “Paris Integrated Systems” (PIS). The PIS is also regarded as one of the Integrated systems.

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Evolutionary Trends of Payment Systems

RTGSplus in Germany and new BIREL in Italy The third one was the “RTGSplus” in Germany, which started operation in November 2001. The RTGSplus also had two payment modes; EX payment mode and Limit payment mode. The EX payment mode is a RTGS mode, which is suitable for high priority payments. The Limit payment mode is a Liquidity-Saving mode with the continuous offsetting settlement. Just like the RTGSplus, the Bank of Italy added the Liquidity-Saving mode to the BIREL, a pure RTGS system in April 2004. The new system, called the “new BIREL,” was another Integrated system with two payment modes.

MEPS+ and BOJ-NET The Integrated system was spread to the AsiaPacific region. The first one was the “MEPS+” in Singapore. By adding the Liquidity-Saving mode to the MEPS, the pure RTGS system, the MEPS+ became the integrated system in December 2006. The second one was the “BOJ-NET” in Japan. The project to enhance the BOJ-NET was called “Next-Generation RTGS” (RTGS–XG) project. The important aspect of the project was to add a Liquidity-Saving Feature (LSF) to the pure RTGS mode of the BOJ-NET. At the completion of the project, the BOJ-NET became an Integrated system in October 2008 (see Chapter 11 for more details).

TARGET2 In Europe, the TARGET2 began operation in November 2007. The TARGET2 was an enhancement made from the TARGET. It is interesting to note that the enhancement project, called “next generation project,” was exactly the same project name used in Japan. The biggest feature of the project was the transition from the decentralized structure to the centralized structure with a Single Shared

64

Platform (SSP). However, that was not all. The TARGET2 has the advanced features which were derived from the RTGSplus, new BIREL and PIS. That is to say, the TARGET2 has the LiquiditySaving mode as well as the RTGS mode, which means that it is one of the Integrated systems. Currently, the advanced feature of the TARGET2 is available all across the euro area (see Chapter 10 for more details).

EVOLUTIONARY PROCESS OF PAYMENT SYSTEMS From Basic to Advanced Payment Systems As mentioned above, payment systems evolved from the basic payment systems to the advanced payment systems. They progressed from the simple DTNS system to the RTGS system, and then to the Hybrid system and Integrated system. With the emergence of such sophisticated and elaborated systems, the conventional forms of the RTGS system and DTNS system tend to be called “pure RTGS system” and “pure DTNS system” respectively, with the implicit meaning of a simple payment system.

Typical Evolutionary Pattern The typical evolutionary pattern from the simple DTNS system to the sophisticated system can be described as below5 (see Figure 4). •

•

In the first stage, a central bank and a private sector operate each DTNS system in a country, respectively. In the second stage, the central bank enhances its system to a RTGS system, because it tends to focus on the reduction of settlement risk and the RTGS system has an advantage in this aspect.

Evolutionary Trends of Payment Systems

Figure 4. Evolution process of payment systems (typical case)

•

•

In the third stage, the private payment system becomes a Hybrid system in order to obtain intraday finality with the continuing merit of net settlement. In the final stage, the RTGS mode and the Hybrid mode are integrated in order to collectively manage the liquidity, which leads to the Integrated system.

In some cases, the process of a Hybrid system is skipped, and the RTGS system and/or DTNS system would jump directly into the Integrated system.

Driving Forces The evolution and sophistication of payment systems have been pushed by some driving forces, which include the rapid growth of settlement values and settlement risk, the global standards for reducing settlement risk and the competition between payment systems (to be described in Chapter 7).

In addition, the progress of Information Technology (IT) has paved the way for enabling the payment processing in a complicated way and facilitated the evolution of payment systems.

MULTI-CURRENCY PAYMENT SYSTEMS AND OFFSHORE PAYMENT SYSTEMS Traditionally, a payment system processes the payment instructions of the national currency in a country. Recently, some payment systems come to deal with payment orders in multi-currencies, and others are operated outside of the country where the currency is issued. These systems were invented mainly in order to reduce foreign exchange (FX) settlement risk.

Emergence of Multi-Currency Payment Systems A typical example of a multi-currency payment system is “CLS Bank,” which started its operation

65

Evolutionary Trends of Payment Systems

in September 2002. CLS Bank was established in order to reduce the foreign exchange (FX) settlement risk arising from time-zone differences. It was established as a bank in the US, but it serves as a payment system for multi-currencies. It settles seventeen currencies, including the US Dollar (USD), euro, UK Pound, Japanese Yen (JPY), Swiss Franc, Canadian Dollar, Australian Dollar, Singapore Dollar, and others. To give an example, when Bank A and Bank B make a USD/JPY transaction, the delivery of USD and JPY are made simultaneously in the form of Payment versus Payment (PVP) in CLS Bank. Through this scheme, the Herstatt Risk, which means FX settlement risk caused by the time differences, is eliminated (see Chapter12 for more detail).

Emergence of Offshore Payment Systems Offshore Payment Systems in Hong Kong There are typical examples of Offshore Payment Systems in Hong Kong.

Three Offshore Payment Systems in HK The Hong Kong Monetary Authority (HKMA) has operated6 the “Clearing House Automated Transfer System” (CHATS) since 1996. The CHATS is the RTGS system for Hong Kong dollar and is sometimes referred to as “HKD-CHATS.”

In addition to the payment system of domestic currency, the HKMA started the operation of the “USD-CHATS” in August 2000, which is the payment system for the US dollar. In addition, it also started the operation of the “Euro-CHATS” in April 2003, which is the payment system of euro. On top of this, it launched the “RMB-CHATS” in June 2007, which is the payment system for the Chinese currency, Renminbi (See Table 5). As these payment systems are for the foreign currencies operated in Hong Kong, they are regarded as “Offshore Payment Systems.” The reason why the HKMA established these systems is to meet the needs of financial institutions to make settlements in the PVP scheme in these currencies in the time zone of Asia. Another incentive is to make Hong Kong a regional hub of financial transactions in Asia. Since these systems are established as a complete “replica” (an exact copy) of the HKDCHATS, these systems are operated as RTGS systems just as the CHATS. The settlement institutions are not the HKMA, but private banks; the Hong Kong and Shanghai Banking Corporation (HSBC) for the USDCHATS, Standard Chartered Bank for the EuroCHATS and Bank of China for the RMB-CHATS. The participants of each system open an account in each currency at each settlement institution. The settlement is executed by the fund transfer among the accounts at each settlement institution. Intraday liquidity is not given by the central bank (HKMA), but by the settlement institution, if necessary, depending on the commercial decision. Therefore, these are the typical

Table 5. Payment systems in Hong Kong

66

Payment System

Currency

Settlement Institution

Time of launch

CHATS

HK Dollar

HKMA

December 1996

USD-CHATS

US Dollar

HSBC

August 2000

EUR-CHATS

euro

Standard Chartered Bank

April 2003

RMB-CHATS

RMB

Bank of China

June 2007

Evolutionary Trends of Payment Systems

examples of payment system with “Commercial Bank Money.”

PVP Linkages and DVP Linkages The four systems (CHATS, USD-CHATS, EuroCHATS and RMB-CHATS) are linked with each other, and therefore the Payment versus Payment (PVP) settlement is possible for each pair of the currencies: USD/HKD, USD/EUR, USD/RMB, EUR/ HKD, EUR/RMB and HKD/RMB (see Figure 5). Additionally, the USD-CHATS has PVP links with the “BI-RTGS,” Rupiah payment system in Indonesia, and the “RENTAS” (Real Time Transfer of Funds and Securities), Ringgit payment system in Malaysia. And three systems (CHATS, USD-CHATS and Euro-CHATS) have payment links with the “China’s Domestic Foreign Currency Payment System,” which is another Offshore Payment System in mainland China and covers eight foreign currencies. On the other hand, the CMU (Central Moneymarkets Unit), which is the bond settlement system in Hong Kong, has linkages with the four payment systems (CHATS, USD-CHATS, Euro-CHATS and RMB-CHATS). And the CCASS (Central

Clearing and Settlement System), which is the equities settlement system in Hong Kong, has the linkages with the CHATS and USD-CHATS. Through these linkages, the Delivery versus Payment (DVP) settlement is possible between securities and funds in each denominated currency.

Offshore Payment Systems in a Global Context According to the “Global Payment Systems Survey 2008” of the World Bank, a total of 15 countries indicated that their RTGS system handles transactions both in local currency and in at least one foreign currency. These are: Argentina, Armenia, Bolivia, Costa Rica, Denmark, Estonia, Guatemala, Indonesia, Jordan, Kenya, Peru, Philippines, Sweden, United Kingdom7 and Uruguay. In addition, Poland has a designated foreign currency system (for euro). They are regarded as Offshore Payment Systems.

The euroSIC in Switzerland Another example of an Offshore Payment System is the “euroSIC” in Switzerland. The “SIX

Figure 5. Overview of Payment Infrastructure in Hong Kong (Source: HKMA, modified)

67

Evolutionary Trends of Payment Systems

Interbank Clearing” has operated the euroSIC interbank payment system for transactions in euro on behalf of Swiss banks since 1999. As Switzerland is a non-EU member state, euro is a foreign currency for Swiss banks. The euroSIC was established to allow Swiss banks to send and receive euro payments under this circumstance. The euroSIC was established as a replica of the “Swiss Interbank Clearing” (SIC), the payment system for the Swiss franc, and has been operating as a RTGS system. The settlement institution of the euroSIC is the “Swiss Euro Clearing Bank” (SECB), which was established jointly by Swiss banks as a special purpose bank in Germany. Participants of the euroSIC open an euro-denominated accounts at the SECB, and the euro settlement is executed by transferring the euro funds between the participants’ accounts at the SECB. The euroSIC has two interfaces. One is the “remoteGATE,” which enables financial institutions outside of Switzerland to access the euroSIC as well as the SIC. Financial institutions around the world can access the two Swiss RTGS systems via the international network of SWIFT. In other words, the remoteGATE allows the “remote ac-

cess” to banks from outside of Switzerland (see Figure 6). The second interface is the “swisseuroGATE,” which links the euroSIC with TARGET2 for large-value payments with the banks in the eurozone countries. As for retail payments, the euroSIC has a connection to the EMZ8 and STEP2 (see Figure 7). Through these schemes, the euroSIC provides interbank Euro settlements between Swiss banks as well as cross-border euro payments between Swiss banks and banks in eurozone countries. The euroSIC is operated in Switzerland, which is outside of the eurozone, and can be regarded as an Offshore Payment System.

The Tokyo Dollar Clearing in Japan The Tokyo Dollar Clearing (TDC) is a book transfer system for banks located in Japan to settle the US dollars (USD) during Tokyo operating hours. The TDC is a service provided by JPMorgan Chase. JPMorgan Chase Tokyo is the settlement institution, where each participant has their own USD account.

Figure 6. The euroSIC and its two interfaces (Source: SIX Interbank Clearing, modified)

68

Evolutionary Trends of Payment Systems

Figure 7. The euroSIC and its connections to the EU (Source: SIX Interbank Clearing, modified)

All settlements are executed by funds transfers among the participants’ USD accounts at JPMorgan Chase Tokyo (see Figure 8). The TDC provides finality of settlement in USD in Japan with the provisions of the account condition agreement. That is, the settlements at JPMorgan Chase Tokyo become final when processed. The account at JPMorgan Chase Tokyo is closely linked with the account at JPMorgan Chase NY. The remaining balance of the Tokyo account is linked with the NY account balance. Participants can pay out the excess funds from the JPMorgan Chase Tokyo account to the JPMorgan Chase NY account. On the other hand, when a participant wants to increase the Tokyo balance, it can make a request to JPMorgan Chase NY for granting credit in the

form of an intraday overdraft. When the overdraft is extended, the participant is able to transfer the funds in the USD from the NY account to the Tokyo account during Tokyo operating hours. The cover payment to repay the overdraft will be made later to JPMorgan Chase NY during NY operating hours. With a usual correspondent banking service, a Japanese bank and its customer can confirm the receipt of the USD only on the next day of the payment, due to the time differences. By using the TDC service, a bank and the customer can affirm payment and receipt of USD on the day of settlement. This is the major merit of the TDC. The operation of the TDC started in 1986 and has a long history of more than 20 years.

Figure 8. The book transfer on the TDC (Source: JPMorgan Chase, modified)

69

Evolutionary Trends of Payment Systems

The TDC is the settlement system operated in Japan for banks in Japan to process the USD payments. Therefore, it is supervised and monitored both by the Fed and the Bank of Japan. It is particularly worth noting that the TDC is a purely private scheme, where the settlement service is provided by a private financial institution.

LINKAGE WITH CSD Role of CSD “Central Securities Depository” (CSD) is an institution that provides a settlement service of securities, including the government bonds, cor-

porate bonds, equities and money market instruments. The CSD manages securities accounts in an electronic form, and processes settlements by means of book entries. For the electronic transfer of securities, the CSD operates a computer system, which is sometimes called the “securities settlement system” (SSS9). Every country has a CSD / CSDs which provides the settlement of securities issued in the country (See Table 6). In this case, the CSD is called “National Central Securities Depository” (NCSD). Some NCSDs deal with all the securities issued in a country. And other NCSDs provide settlement service only for a limited scope of securities, so two or more NCSDs share the responsibility for all the securities issued in a country.

Table 6. Central securities depositories in selected countries The name of CSD

Scope of Securities Government Bond

Equities

Other Securities

Fed

○

×

×

DTC

×

○

○

Canada

CDS

○

○

○

UK

Euroclear UK & Ireland

○

○

○

France

Euroclear France

○

○

○

Germany

Clearstream Banking Frankfurt (CBF)

○

○

○

Italy

Monte Titoli

○

○

○

Switzerland

SIS

○

○

○

Spain

IBERCLEAR

○

○

○

ICSD

Euroclear Bank

○

○

○

ICSD

Clearstream Banking Luxembourg (CBL)

○

○

○

Japan

Bank of Japan

○

×

×

JASDEC

×

○

○

CMU

○

×

○

CCASS

×

○

×

MAS

○

×

×

CDP

×

○

○

Austraclear

○

×

○

ASX

×

○

×

US

Hong Kong Singapore Australia

(Note1) ○: The CSD provides settlement service of these securities. ×: The CSD does not basically provide service of these securities. (Note2) Other securities include the corporate bond, commercial paper, certificate of deposit and so on.

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Evolutionary Trends of Payment Systems

Meanwhile, there is a CSD which settles international securities or cross-border transactions of domestic securities. Such a CSD is called “International Central Securities Depository” (ICSD). Well-known ICSDs are the Euroclear Bank and the Clearstream Banking Luxembourg (CBL).

Linkage between Payment System and SSS In some countries, the operator of a payment system also acts as a CSD for securities, especially for government bonds. In such a case, the operator holds and manages both the fund account and securities account (see case (a) of Figure 9). For example, the Fed operates the Fedwire, which is the payment system for the USD as well as the settlement system for government bonds. The Bank of Japan (BOJ) operates the BOJ-Net, which is the fund transfer system and government bond book-entry system at the same time. Furthermore, the European Central Bank (ECB) is planning to handle all euro securities settlements with the TARGET2. The project, which will make the TARGET2 a securities settlement system, is called “TARGET2-Securities” (see Chapter 10 for more detail). On the other hand, in other countries, the CSD has been developed separately from payment systems (see case (b) of Figure 9). In this case, it is the global trend that the linkage is built between the payment system and CSD.

Merits of Linkage Such a linkage between the payment system and CSD has two merits to be pointed out. The first merit is to attain Delivery versus Payment (DVP). By linking the fund settlement system and securities settlement system, a scheme is possible that links the delivery of securities and transfer of funds. As mentioned in Chapter 3, the DVP is a useful method to eliminate settlement risk arising from the time-lag between the delivery of securities and transfer of funds. A typical example of DVP function in such a linkage is as follows. At the first setout, the “Provisional Settlement” of securities is executed in the CSD, and the notice is sent to the payment system. Responding to the notice of Provisional Settlement sent from the CSD, the transfer of funds corresponding to the securities settlement is executed in the payment system, and the notice is sent back to the CSD. Receiving the notice of fund settlement, the “Final Settlement” of securities then takes place (see Figure 10). The second merit is to make it possible to deliver the coordination between the fund and collateral. If a payment system and a CSD system are closely linked, borrowing funds from a central bank and making a pledge of collateral, and repaying funds and returning collateral can be made in synchronization. In more advanced systems, the buyer of securities can pledge the bought securities to the

Figure 9. Payment system and CSD

71

Evolutionary Trends of Payment Systems

Figure 10. DVP settlement by means of linkage

central bank, obtain intraday overdraft with the collateral, and make payment to the seller of securities with the funds just obtained from the central bank. These three processes are executed at the same time. Such a mechanism is called “self-collateralization” or “In-Transit Collateral.”

FINANCIAL EDI CAPABILITY Concept of Financial EDI Recently, exchanges of information on business trades are often made electronically through the Figure 11. The concept of financial EDI

72

network. Electronic ordering has become widely used, instead of paper-based or telephone-based ordering in business communities. This process is called “Electronic Data Interchange” (EDI). When the upstream of the trade processes, like ordering, delivering and invoicing, become electronic, there is the need that the downstream processes of trade should be electronic too. As the most downstream of trade is the payment process, there is a growing need that commercial data, including invoice data, should be processed handin-hand with payment instructions electronically. The scheme that enables the processing of remittance information with payment instructions

Evolutionary Trends of Payment Systems

is called “Financial EDI.” It is a great benefit for the company (especially for the seller) because if it can receive funds with the detailed data including an invoice number, name of the buyer, date of delivery, order number, and total amount charged, the seller can streamline the reconciliation process of their accounts receivable substantially (see Figure 11).

Bech, M. (2008). The Diffusion of Real-time Gross Settlement. In Haldane, A., Millard, S., & Saporta, V. (Eds.), The Future of Payment Systems. Routledge.

EDI Capability in Payment Systems

Bech, M., Preisig, C., & Soramäki K. (2008, September). Global Trends in Large Value Payments. Federal Reserve Bank of New York Economic Policy Review.

Against this background, payment systems tend to be capable of Financial EDI. That is to say, the payment system can carry the remittance data with payment instructions. In the US, the Automated Clearing House (ACH) introduced the Financial EDI service in the early 1990s, and the volume of EDI has been growing substantially year by year. And the CHIPS and Fedwire are planning to introduce the same kind of service to the large-value payment systems in 2011. The EU is trying to establish the Single Euro Payments Area (SEPA). In this project, the standard form of credit transfer, the “SEPA Credit Transfer” (SCT), requires that all payment orders should be able to carry 140 characters of EDI information. That means that all the banks in the EU will have EDI capability in the near future. In Japan, the Zengin system, the retail payment system of Japan, is planned to be upgraded in 2011. The old Zengin system has very limited EDI capability in its fixed-length message format of up to only 20 characters, which is seldom used. The new Zengin system will adopt a flexible XML format and have adequate EDI capability.

Bech, M., & Hobijn, B. (2007). Technology Diffusion within Central Banking: The Case of RealTime Gross Settlement. International Journal of Central Banking, 3(3).

Fry, M. (1999, February). Risk, Cost and Liquidity in Alternative Payment Systems. Bank of England Quarterly Bulletin. Millard, S., & Saporta, V. (2005, December). The Future of Payments. Financial Stability Review. Bank of England. Nakajima, M. (2003). March). Global Trends in Payment Systems and Their Implications for Japan. Forum of International Development Studies, Nagoya University. (in Japanese) Rogers, E. (1995). Diffusion of Innovations. The Free Press World Bank. (2008). Payment Systems Worldwide, a Snapshot: Outcomes of the Global Payment Systems Survey 2008.

ENDNOTES 1



2



REFERENCES Bank for International Settlements. (2005, May). New Developments in Large-Value Payment Systems.

The origin of Fedwire can date back to 1918 when the Federal Reserve inaugurated a network of wire communications among the individual Reserve Banks. The Fedwire system migrated to a fully computerized platform, and became a real RTGS system in the early 1970s (Bech, 2008). In this survey, the Central Bank of West African States (BCEAO) and the Eastern Caribbean Central Bank (ECCB) are counted

73

Evolutionary Trends of Payment Systems

3



4



5

6





74

as 8 different countries for each, even though only one RTGS system is used in both cases. That is one of the reasons that the number of countries in this survey is larger than that in the Fed’s survey. The four exceptions are Canada, Hong Kong, Iceland and Switzerland. In September 2000, only 0.1%, in terms of amount, was processed by the RTGS mode, the rest was handled by the DTNS mode. It is needless to say that there are other patterns of evolutionary progress depending on the individual situation of each country. For example, the RTGS is the only payment system in some countries. The computer operator of CHATS is the “Hong Kong Interbank Clearing Limited”

7



8



9



(HKICL). The HKICL is a private company jointly owned by the HKMA and the Hong Kong Association of Banks (HKAB). The CHAPS Euro clearing system was closed in May 2008 after nine years of service. The system began operation in January 1999, and used the same settlement mechanisms as the CHAPS Sterling. Abbreviation of Elektronischer Massenzahlungsverkehr. The EMZ is a retail payment system in Germany. This is the definition of SSS in a narrow sense. In a broad sense, the SSS means the full set of institutional arrangements for confirmation, clearance and settlement of securities trades and safekeeping of securities.

75

Chapter 7

Driving Forces for Innovations in Payment Systems

ABSTRACT This chapter makes an analysis of the driving forces that advanced the evolutionary progress of payment systems, as mentioned in the previous chapters. The first driving force was the growing recognition of settlement risk. As financial transactions grew, the settlement values over payment systems increased dramatically throughout the 1980s, 1990s and 2000s, which was accompanied by substantially-increased settlement risk. It was self-evident that the larger settlement risk becomes, the higher the need increases to control it. Especially, the central banks became worried about the greater risk, which was the strongest motivation to improve the payment systems in each country. The second driving force was the role of the Bank for International Settlements (BIS), which should not be underestimated. The BIS published several reports which explained the theory and practice of payment systems, including the cause of settlement risk and the protective measures for it. The BIS reports included some global standards with which the targeted payment systems should comply. Each country made great efforts to meet the goals of minimum standards presented in the reports. The third driving force was the competition between the payment systems. In a situation where the payment systems compete with each other, the system has a strong incentive to make it more efficient and safer by improving its settlement mechanism. This was the bright side of market mechanism, which could not be observed in a natural monopoly situation. Fourth, the progress of Information Technology (IT) also played a critical role. Enhanced computer capacity, improved communication networks and reduced technology cost contributed greatly to the innovation of payment systems. DOI: 10.4018/978-1-61520-645-2.ch007

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Driving Forces for Innovations in Payment Systems

INTRODUCTION As mentioned in Chapter 6, payment systems evolved from the DTNS system to the RTGS system, and further to the Hybrid system and Integrated system. It can be pointed out that it was a great revolutionary era of payment systems during the past two decades. However, the great transformation of payment systems did not arise spontaneously or automatically. There were some driving forces behind the evolutionary process of payment systems. Some of them are discussed in more details below.

RAPID GROWTH OF SETTLEMENT VALUES AND SETTLEMENT RISKS Fast-Growing Settlement Values First, the settlement values of payment systems in industrialized countries have increased at a very rapid pace, which has been higher than that of economic growth. Figure 1 shows the settlement values of payment systems in eleven developed countries and the euro area (from 1999). This chart tells us that the settlement amount became more than double during the past fifteen years. The progress in globalization and liberalization of financial transactions has had a direct impact on the drastic increase on settlement amounts.

Settlement Values Relative to Nominal GDP Table 1 and Figure 2 show the settlement values of payment systems relative to the nominal GDP in thirteen industrialized countries. In most countries, this ratio is between 40 and 100 times1 the annual nominal GDP (see Table 1 and Figure 2). The average ratio is 75.3 times in 2007. This fact means that a one-week settlement amount of a payment system is larger than the annual nominal GDP of the nation. In other words,

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a payment system settles the nominal amount of annual GDP in only three or four days. With this knowledge in mind, you can imagine the tremendous social impact there would be if there were to be a malfunction with a payment system. It is needless to say that larger settlement values are accompanied with larger settlement risk.

Recognition of Settlement Risk Increased settlement values indicate the greater potential risk inherent in payment systems. The risk comes out if settlements are not made properly due to the default of a participant or something. It should be noted that potential risk does not always remain dormant. Actually, settlement risk sometimes became a reality and caused huge losses. Some examples are shown in Chapter 3, which include the Herstatt Bank incident, Bank of New York incident, BCCI incident and Bearings incident. The rise of awareness on the increased potential risk encouraged a sweeping reform on payment systems. Moreover, the awareness that settlement risk is not an imaginary risk but a “real risk” is a strong driving force for the reform of the payment systems in each country. Especially, the central bank in each country became concerned about the inherent risk in the payment systems.

ENLIGHTENMENT BY THE BIS The Bank for International Settlements (BIS) published several important reports on payment systems and reduction measures of settlement risk. These educational campaigns of the BIS successfully increased the awareness for settlement risk across the globe. With the growing recognition of settlement risk, the operators and overseers of payment systems have started to actively work on the reduction of settlement risk. Such active movements have led

Driving Forces for Innovations in Payment Systems

Figure 1. Settlement values of selected payment systems (Source: statistics on payment and settlement systems in selected countries, BIS, each year)

to the evolutionary progress of payment systems as well as the improvement of risk management.

Role of the CPSS The Committee on Payment and Settlement Systems (CPSS) played the pivotal role in publishing the reports on payment systems.

History, Function and Organization of the CPSS Originally, a “Group of Experts on Payment Systems” was set up in 1980 by the Governors of the central banks of the Group of Ten (G10). After a detailed review of payment system developments in the G10 countries and several analytical works on payment systems, the Group was reorganized into the CPSS in 1990 in order to extend the activities of the Group. The CPSS was set up as

one of the permanent central bank committees2, which reports to the Central Bank Governors of the countries of the Group of Ten. The functions of the CPSS are to monitor and analyze developments in domestic payment, settlement and clearing systems as well as in crossborder and multicurrency systems. The CPSS also focuses on the standard-setting activities. The CPSS cooperates with other international groups, including the International Organization of Securities Commissions (IOSCO), the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB) to address issues for common concern. Members of the CPSS are senior officials responsible for the payment and settlement systems in each central bank. The CPSS had consisted of the representatives of the central banks from Belgium, Canada, the European Central Bank (ECB), France, Germany, Hong Kong, Italy, Japan, the

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Driving Forces for Innovations in Payment Systems

Table 1. Settlement values of payment systems relative to nominal GDP . (As of 2007)

--- Times

Country

Payment System

Settlement values relative to Nominal GDP 1

Belgium

ELLIPS

79.5

Canada

LVTS

30.0

France

TBF

76.7

PNS

8.6

Germany

RTGS

plus

95.9

Hong Kong

HKD CHATS

134.2

Italy

BIREL

27.4

Japan

BOJ-NET

57.2

FXYCS

10.9

Netherlands

TOP

68.9

Singapore

MEPS

62.8

Sweden

RIX 2

48.9 4

Switzerland

SIC

102.1

UK

CHAPS 3

65.9 4

US

Fedwire

48.6

CHIPS

35.2

---

75.3

Total Note1: Settlement value (annual) / Nominal GDP (annual) Note2: RIX = K-RIX + E-RIX Note3: CHAPS = CHAPS Sterling + CHAPS Euro Note4: Sweden and UK are figures of 2006. Source: BIS (2009)

Figure 2. Settlement values of payment systems relative to nominal GDP (As of 2007) Source: BIS (2009)

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Netherlands, Singapore, Sweden, Switzerland, the United Kingdom, and the United States. In July 2009, the emerging market economies joined the activities of the CPSS when the CPSS broadened the membership to include the central banks of Australia, Brazil, China, India, Mexico, Russia, Saudi Arabia, South Africa and South Korea (see Table 2).

CPSS Reports The CPSS reports encompass a broad range of issues on payment systems, which include the large-value payment systems, retail payment instruments and systems, and foreign exchange settlement. In addition, the reports covered the area of the securities settlement systems and the clearing and settlement arrangements for derivatives transactions, both of which are unfortunately outside the scope of this book. Among them, some reports are regarded as important ones, which had major impact on the payment system reforms. Such reports include the “Core Principles Report,” “RTGS Report,” “Lamfalussy Report,” “Angell Report,” “Allsopp Report” and “Noël Report.” Some reports were named after the chairman of the working group that prepared the report. Table 3 shows the list of important reports concerning payment systems. Having heavily affected by a series of these reports, the central banks across the globe promoted the introduction of the RTGS system. On the other hand, the DTNS systems improved their risk management, and the private banks tightened the management of settlement risk. Furthermore, the reports on the foreign exchange settlement were conduced to the establishment of CLS Bank by private sector. In what follows, this section describes the Lamfalussy Standard and Core Principles, both of which are particularly important in designing and evaluating payment systems.

Table 2. Membership of the CPSS The Existing Members Belgium Canada the European Central Bank (ECB) France Germany Hong Kong Italy Japan the Netherlands Singapore Sweden Switzerland the United Kingdom the United States

The New Members from July 2009 Australia Brazil China India Mexico Russia Saudi Arabia South Africa South Korea

Source: CPSS

The Lamfalussy Standards The Lamfalussy Standards as a Global Standard The “Lamfalussy Standards” were derived from the “Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries” (Lamfalussy Report) in 1990. The Standards were set forth originally as the minimum standards for a cross-border and multicurrency payment system with a netting scheme. Later on, the Standards became regarded as the standards for the net settlement systems in general. Currently, the standards are regarded as a global standard with which the DTNS systems should strictly comply.

Six Standards of Lamfalussy Standards The Lamfalussy Standards are made up of six standards (see Table 4). Of which, two standards are particularly important. One is standard III, which represents that the limits should be placed on the maximum level of credit exposure that can be produced by each participant. Another important one is standard IV, which requires the

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Driving Forces for Innovations in Payment Systems

Table 3. List of the CPSS reports on payment systems date of publication

the name of the report

1. Payment Systems: General Issues June 2008

The Interdependencies of Payment and Settlement Systems

January 2006

General Guidance for National Payment System Development

May 2005

Central Bank Oversight of Payment and Settlement Systems

August 2003

The Role of Central Bank Money in Payment Systems

2. Large-value Payment Systems January 2006

Cross-border Collateral Arrangements

May 2005

New Developments in Large-value Payment Systems

January 2001

Core Principles for Systemically Important Payment Systems (Core Principles Report)

March 1997

Real-time Gross Settlement Systems (RTGS Report)

November 1990

Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy Report)

February 1989

Report on Netting Schemes (Angell Report)

3. Retail Payment Instruments and Systems January 2007

General Principles for International Remittance Services

March 2004

The Survey of Developments in Electronic Money and Internet and Mobile Payments

March 2003

Policy Issues for Central Banks in Retail Payments

November 2001

Survey of Electronic Money Developments

September 2000

Clearing and Settlement Arrangements for Retail Payments in Selected Countries

May 2000

Survey of Electronic Money Developments

September 1999

Retail Payments in Selected Countries: A Comparative Study

August 1996

Security of Electronic Money

4. Foreign Exchange Settlement May 2008

Progress in Reducing Foreign Exchange Settlement Risk

July 1998

Reducing Foreign Exchange Settlement Risk: A Progress Report

March 1996

Settlement Risk in Foreign Exchange Transactions (Allsopp Report)

September 1993

Central Bank Payment and Settlement Services with respect to Cross-border and Multicurrency Transaction (Noël Report)

Source: CPSS

capability of ensuring the timely completion of daily settlements, even if the participant with the largest single net debit position is unable to settle. As well as being compliant with other standards, if the maximum debit position for each participant is fixed (standard III), and the maximum amount is covered by collateral or other measures (standard IV), the system is regarded as compliant with the Lamfalussy Standards. When a net settlement system complies with these

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six standards, such a system is generally called “Lamfalussy-compliant system” or “Secured net settlement system3.”

Lamfalussy-Compliant System During the 1990s, many net settlement systems became the Lamfalussy-compliant systems, by setting the net debit cap, stipulating the loss-sharing

Driving Forces for Innovations in Payment Systems

Table 4. The Lamfalussy standards I. Netting schemes should have a well-founded legal basis under all relevant jurisdictions. II. Netting scheme participants should have a clear understanding of the impact of the particular scheme on each of the financial risks affected by the netting process. III. Multilateral netting systems should have clearly-defined procedures for the management of credit risks and liquidity risks which specify the respective responsibilities of the netting provider and the participants. These procedures should also ensure that all parties have both the incentives and the capabilities to manage and contain each of the risks they bear and that limits are placed on the maximum level of credit exposure that can be produced by each participant. IV. Multilateral netting systems should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net-debit position. V. Multilateral netting systems should have objective and publicly-disclosed criteria for admission, which permit fair and open access. VI. All netting schemes should ensure the operational reliability of technical systems and the availability of back-up facilities capable of completing daily processing requirements. Source: BIS (1990)

rule, and introducing the collateral scheme for the maximum debit amount. At the first setout, the CHIPS in the US became Lamfalussy-compliant by introducing the loss-sharing rule and collateral scheme in 1990. In Europe, the EAF in Germany and PNS in France also became the Secured net settlement systems in late 1990s. In Japan, the FXYCS became compliant with the Standards by introducing its risk reduction measures in 1998.

Lamfalussy-Plus System “Lamfalussy-plus system” is a net settlement system with a stronger form of risk prevention measures than the Lamfalussy-compliant system. More concretely, the system can assure the final settlement in a timely matter, even in the event of more than one participant failing. In other words, if more than one participant becomes unable to settle, and the total default amount is more than the largest net debit position of single participant, the Lamfalussy-plus system assures the certainty of settlement.

Lamfalussy Plus One System When a net settlement system can ensure the timely completion of daily settlement, even if the top two participants with the largest net debit position would be unable to pay at the same time, such a

system is called “Lamfalussy plus One system.” The BIS requires achieving Lamfalussy plus One for the Systemically Important Payment Systems (SIPSs) as a best practice. The CHIPS in the US was the first in the world to achieve Lamfalussy plus One in January 1997. It achieved it by introducing the procedures that would cover the simultaneous failure of any two participants with the largest net debit positions. At the same time, by taking these measures, the CHIPS could stand for the simultaneous failure of the twenty-five smallest participants. This means that the CHIPS would still be able to settle, even if, although practically impossible, one-quarter of all the CHIPS participants failed on the very same day. In Japan, the Zengin system achieved Lamfalussy plus One in May 2002, and the FXYCS in March 2004.

The Core Principles The “Core Principles” derived from the Report on “Core Principles for Systemically Important Payment Systems,” which was published by the CPSS in January 2001.

The Core Principles and the SIPS The Core Principles are applied to “Systemically Important Payment Systems” (SIPSs). Payment

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Driving Forces for Innovations in Payment Systems

system is regarded as SIPS, if a disruption within the system could trigger or transmit further disruptions amongst participants or systemic disruptions in the financial area more widely. Systemic importance is judged mainly by the size and/or nature of the individual payments or their aggregate value. Therefore, large-value payment systems would normally be considered to be SIPSs. A SIPS does not necessarily handle only high-value payments. Some SIPSs can handle both high-value and lowvalue payments. The critical point is whether the system has a possibility to trigger or transmit disruption by virtue of certain segments of its traffic. The SIPSs may be owned and operated by central banks, by the private sector, or jointly by public and private agencies. In some cases, the boundary between SIPS and non-SIPS is not clear enough, and the central bank should determine it with careful consideration. The Core Principles were drawn up with the intention of being used as universal guidelines to encourage the design and operation of safer and more efficient SIPSs worldwide. The Core Principles are being applied not only to the developed countries but also to the emerging economies.

The Scope of the Core Principles The Core Principles are made of ten principles and cover a much wider range than the Lamfalussy Standards (see Table 5). More concretely, they include the recommendations on the legal basis　(Principle I), understanding financial risks (Principle II), management of financial risks (Principle III), prompt final settlement (Principle IV), settlement in multilateral netting systems (Principle V), settlement assets (Principle VI), security and operational reliability (Principle VII), efficiency (Principle VIII), access criteria (Principle IX), and governance (Principle X). The Core Principles have some points which are not covered by the Lamfalussy Standards, such as follows. A SIPS should preferably use central bank money as settlement asset. A SIPS

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should have contingency arrangements as well as a high degree of security and operational reliability. A SIPS should maintain efficiency in designing and operating a system. A SIPS should disclose the criteria for participation.

Minimum Standard and Best Practice Principle IV and V have double standards, namely, “minimum standard” and “best practice.” The minimum standard is the lowest standard to be achieved by the emerging countries and the best practice is a higher standard meant for the developed countries.

Principle IV: Prompt Final Settlement Principle IV defines the daily settlement timing under normal circumstances. The Principle requires the final settlement to be provided by the end of the day as a minimum standard. Normally, the DTNS system for large value payments executes the final settlement at the end of the day. In this case, the system is considered to meet the minimum standard. For the developed countries, Principle IV requires more prompt settlement during the day. To adopt a RTGS system is a common way to accomplish the intraday finality. Hybrid system and Integrated system also can provide a similarly prompt settlement during the day. Even the DTNS system could meet the higher standard, if it executes several settlements in the course of an operating day, instead of only a one-time settlement at the end of the day. This higher standard is deemed to be desirable particularly when the payment system handles large volumes of high-value payments and the country has a well-developed financial market.

Driving Forces for Innovations in Payment Systems

Table 5. Core principles for systemically important payment systems I. The system should have a wellfounded legal basis under all relevant jurisdictions. II. The system’s rules and procedures should enable participants to have a clear understanding of the system’s impact on each of the financial risks they incur through participation in it. III. The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. IV.* The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. V.* A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. VI. Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk and little or no liquidity risk. VII. The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. VIII. The system should provide a means of making payments which is practical for its users and efficient for the economy. IX. The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. X. The system’s governance arrangements should be effective, accountable and transparent. * Systems should seek to exceed the minima included in these two Core Principles. Source: BIS (2001)

Principle V: Settlement in Multilateral Netting Systems

standard, the Principle requires such types of secured systems.

Principle V is applied only to the systems that settle on a multilateral net basis, and is not relevant to the RTGS system. Multilateral netting can create the risk that, if a participant is unable to meet its settlement obligations, other participants will face unexpected credit and liquidity risks. As a minimum standard, the Principle requires multilateral netting systems to ensure the timely completion of daily settlement, even if a participant with the largest net debit obligation is unable to settle. Reduced to its simplest terms, the Principle requires the Lamfalussy-compliant System at minimum, where the maximum debit position for each participant is fixed, and the maximum amount is covered by collateral, credit lines or other measures. As a best practice, the Principle requires that a payment system can still operate in the case that more than one institution might be unable to settle. A more adverse case includes two participants with the largest individual settlement obligations being unable to settle. Only the Lamfalussy-plus system and more preferably the Lamfalussy Plus One system can meet this requirement. As a higher

Use of Core Principles in International Community The Core Principles are included in “12 Key Standards for Sound Financial Systems” published by the Financial Stability Board4(FSB). As a part of Key Standards, the Core Principles are used in the “Financial Sector Assessment Programme” (FSAP) and the “Reports on the Observance of Standards and Codes” (ROSC), conducted jointly by the International Monetary Fund (IMF) and World Bank. In concrete terms, the staff of the IMF and World Bank would visit each country every few years and check whether or not the payment system is compliant with the Core Principles. This might be a systematic pressure for action to be compliant with the Principles in the international community.

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Driving Forces for Innovations in Payment Systems

COMPETITION BETWEEN PAYMENT SYSTEMS The competition between payment systems is another factor which encourages the evolutionary progress of payment systems. As is often the case, a payment system has the tendency to be a natural monopoly in a domestic market. This means that there tends to be only one payment system operated for specific payments in a country. However, occasionally, there are cases that multiple payment systems compete with one another in the same payment market in the same currency. The competition arises from the currency integration or homogenization of the plural payment systems. Where there is a competition among payment systems, each payment system makes all-out efforts to get ahead of the competition, which includes improving functionality, allowing widespread participation both from home and abroad, and reducing settlement fees. If one payment system enhances the functionality and gets an advantage, the other system devotes itself to catch up and hopefully get ahead of the front runner. In the process of such competition, some striking innovations were brought out and the new schemes of processing payments were developed. What follows are examples of a competition that was a driving force to encourage the innovation of payment systems.

Competition by European Monetary Union Coexistence of Multiple Payment Systems in Euro Area The single currency euro was introduced in 1999. Before the introduction of euro, there was a single payment system in each country, i.e. in national currency area. For example, German mark payments were settled through the German payment system and French franc payments were settled through the French payment system. That is to

84

say, the natural monopoly was firmly established in each national currency area. However, this situation changed drastically, because the payment systems of the legacy currencies (including German mark, French franc) became the payment systems of the euro in one stroke. As a historical fact, there were fifteen RTGS systems and four DTNS systems that coexisted in single currency area when the euro was introduced. Especially, the competition was very fierce between the German payment system and the French payment system, since both countries were filled with ambition to take the initiative in the integration process of the euro payment market.

Evolution of the EAF It is noteworthy that the competition started far in advance of the introduction of the euro in January 1999. First, the German payment system, the EAF enhanced its settlement mechanism drastically in 1996 and transformed from the DTNS system into the Hybrid system. It was the very first Hybrid system in the world. Additionally in 1998, the EAF allowed the “remote access,” which permitted foreign financial institutions to access the EAF from abroad. The indirect access (indirect participation) was also admitted for the first time in the EAF. The transaction fee was reduced from 0.40 DM to 0.30 DM per payment order. In January 1999, the EAF changed its German name (“Electronischen Abrechnung Frankfurt”) to an English name (“Euro Access Frankfurt”), with an aim to make foreign banks feel a sense of affinity. At the same time, the EAF made two important changes to its service. First, the multilateral netting was added to the previous bilateral netting in the phase I (in the morning session). Second, the “Liquidity Bridge” was established between the EAF special account and the Bundesbank account which was used for the settlement of the ELS (the German RTGS system). Through this Liquidity Bridge, the participants were able to transfer liquidity between the two accounts,

Driving Forces for Innovations in Payment Systems

i.e. between the two payment systems. The convenience and flexibility in liquidity management was improved with these changes. However, the function was still limited and the transfer of funds was possible only once every hour.

Evolution of the PNS Observing the development of German payment system, the French payment system started its own innovation. The PNS, the French DTNS system changed its settlement scheme in April 1999 from the net settlement once a day to the continuous settlement during the day, which made the PNS into a Hybrid system, just like the EAF. At the same time, the PNS changed its name from its French name (“Système Net Protégé”) to an English name (“Paris Net Settlement”), keeping the abbreviation unchanged. The processing scheme of the PNS was quite similar to that of the EAF, which was the combination of bilateral optimization and multilateral optimization with a bilateral sender limit. Here, the “optimization” meant the same kind of processing as the netting. The Liquidity Bridge was also established between the PNS and the TBF (the French RTGS system). Through this Bridge, the participants could transfer the liquidity freely between the two payment systems at anytime during the operating hours. In this respect, the PNS was superior to the EAF. The combination of the PNS and the TBF was called “Paris Integrated System” (PIS), as they looked like an integrated and consistent payment system. With this enhancement, the PNS caught up to the EAF and had a lead over the German payment system in terms of flexible liquidity transfer with the RTGS system.

Introduction of the RTGSplus After the French payment system caught up, the German payment system stepped forward further. The Deutsche Bundesbank built a new

payment system “RTGSplus” and started operation in November 2001. The RTGSplus was developed by integrating the EAF, a hybrid system, and the Euro Link System (ELS), a RTGS system. The RTGSplus had two processing modes, which were the “Express Payment” and “Limit Payment.” The Express Payment was a RTGS mode, where the processing was made on a gross and real time basis, just like the ELS. The Limit Payment was a Liquidity-Saving mode, where continuous offsetting was made with the function of a sender limit. “Offsetting” meant the simultaneous booking of an incoming payment and an outgoing payment, and the outcome of the processing was exactly the same as the netting. The RTGSplus was the first Integrated system in the world. By introducing the cutting-edge system, the German payment system got a long lead on the French payment system again.

Introduction of the new BIREL Stimulated by the innovation of the German and French payment systems, the Italian payment system also moved forward. The Bank of Italy renovated the RTGS system BIREL and built the “new BIREL.” The new BIREL was built by adding the Liquidity-Saving mechanism to the RTGS mode of BIREL. The functionality of the new BIREL was almost identical to that of the RTGSplus. This meant that the new BIREL was another Integrated system.

Development into the TARGET2 As described above, several payment systems coexisted in parallel in a single currency area and were placed in a very competitive situation after the introduction of euro. Such competition encouraged each payment system to take evolutionary and innovative measures. The evolutionary process created the advanced payment systems, such as the Hybrid system and Integrated system. It can

85

Driving Forces for Innovations in Payment Systems

be concluded that the competition was a major driving force for the enhancement of payment systems especially in euro area. In 2007, the TARGET2 was introduced instead of the TARGET. The TARGET2 was built by combining all the functions of the PIS, RTGSplus and new BIREL. Thereby, the euro area countries could broadly enjoy the benefits of the excellent functioning of an advanced payment system. Probably, a re-evaluation should be made about the importance of these advanced systems as the groundbreakers in the evolutionary process of payment systems.

Competition between Two Payment Systems in the US In the US, the competition between the Fedwire and CHIPS was a driving power to promote innovation in the payment systems.

Sharing Roles between the Two Systems Until the mid-1990s, the US banks used to handle the domestic payments and foreign exchange related payments in separate divisions. At that time, the domestic payments were sent to the Fedwire, and the foreign exchange related payments were sent to the CHIPS automatically. However, from the late 1990s, the US banks tended to integrate the payment operations into one division as a cost-cutting measure. By this integration of business, the same division could handle both domestic and international payments, which meant that any payments could be sent to either the Fedwire or CHIPS, if the receiving bank was a participant of these payment systems. To sum it up, the customers were given options to choose between the two payment systems when submitting payment orders. In this way, the competition between the Fedwire and CHIPS was kicked off.

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Introduction of CHIPS Finality At this stage, the Fedwire had an advantage of being able to provide the intraday finality, since the Fedwire was a RTGS system and payments were processed on a real-time basis. As the CHIPS was a DTNS system, where the final settlement took place only at the end of the day, there was still remained settlement risk. For this reason, some customers who wanted one-hundred percent certainty of the completion of their payment had a tendency to choose the Fedwire. Especially large companies, who had a large volume of payments, had a strong tendency to prefer the Fedwire. This meant that the CHIPS was losing a large volume of payments due to the lack of intraday finality. Against this background, the CHIPS introduced the “CHIPS Finality” in 2001. The CHIPS Finality is a scheme that continuously matches, makes netting and settles payment orders. By this continuous processing, the CHIPS could provide the intraday finality, which is nearly a real-time finality. This was an endeavor for the CHIPS to try to catch up with the Fedwire in respect of intraday finality. This was another example of how the competitive situation led to the innovation in payment systems.

TECHNOLOGICAL PROGRESS The progress of Information Technology (IT) also made significant contributions to the enhancement of functionality in payment systems. With the progress of IT, payment systems became enabled to make the frequent netting, execute the continuous offsetting and handle payments with the sophisticated algorithms.

Enhanced Computer Capacity Due to the tremendous increase in processing power of computers, it became possible to execute

Driving Forces for Innovations in Payment Systems

the frequent netting or the continuous offsetting during the operating hours. The partial netting also became possible. In the early days, only the full netting was possible, and the netting processing was possible only once a day mainly due to the constraint of computer capacity. In addition to that, the increased processing capability of computers enabled the process of payments with highly sophisticated algorithms. That led to payments processing with the elaborated rules and advanced queue management, such as the prioritization, reordering, and timed payment. Based on these functions, the Hybrid system and the Integrated system became feasible.

Improved Communication Network Improved communication networks also made a great contribution to the evolution of payment systems. High-speed lines and interactive messaging services became available at reasonable costs. With enhanced network functionality, the payment-related messages could be sent between payment system and participant at the speed of light. With this network capability, it became possible to do a real-time monitoring of the account balance, situation of settlement and status of payment instructions in the queue. It was also possible to change the debit cap or credit limit and to change the order of payments in the queue in real-time and in an interactive way.

Reduced Technology Cost No less important is the fact that the cost of utilizing advanced technology has reduced drastically. Widespread use of software package in system development instead of custom-ordered development is one of the reasons of such cost reduction. This means that investment costs were substantially reduced for establishing new payment systems. The reduced technology cost encouraged the adoption of advanced technology, and the fruit

of technological innovation was smoothly introduced to the new systems. In sum, the advanced technology became available at a reasonable cost, which led to the remarkable innovation in payment systems.

REFERENCES Bank for International Settlements. (1989, February). Report on Netting Schemes (the Angell Report). Bank for International Settlements. (1990, November). Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (the Lamfalussy Report). Bank for International Settlements. (1992, September). Delivery versus Payment in Securities Settlement Systems. Bank for International Settlements. (1993, September). Central Bank Payment and Settlement Services with Respect to Cross-Border and MultiCurrency Transaction (the Noël Report). Bank for International Settlements. (1996, March). Settlement Risk in Foreign Exchange Transactions (the Allsopp Report). Bank for International Settlements. (1997, March). Real-Time Gross Settlement Systems (the RTGS Report). Bank for International Settlements. (1998, July). Reducing Foreign Exchange Settlement Risk: A Progress Report. Bank for International Settlements. (1999, September). Retail Payments in Selected Countries: A Comparative Study. Bank for International Settlements. (2000, September). Clearing and Settlement Arrangements for Retail Payments in Selected Countries.

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Bank for International Settlements. (2001, January). Core Principles for Systemically Important Payment Systems. Bank for International Settlements. (2003a, March). Policy Issues for Central Banks in Retail Payments. Bank for International Settlements. (2003b, August). The Role of Central Bank Money in Payment Systems.

ENDNOTES 1



2



3



4



Bank for International Settlements. (2005, May). Central Bank Oversight of Payment and Settlement Systems. Bank for International Settlements. (2006a, January). Cross-border Collateral Arrangements. Bank for International Settlements. (2006b, January). General Guidance for National Payment System Development. Bank for International Settlements. (2007, July). Progress in Reducing Foreign Exchange Settlement Risk. Bank for International Settlements. (2009, March). Statistics on Payment and Settlement Systems in Selected Countries.

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The difference of ratio may mainly come from the volume of financial transactions in each currency. The other permanent committees of the BIS include the Basel Committee on Banking Supervision (BCBS) and the Committee on the Global Financial System (CGFS). When a net settlement system does not comply with the Lamfalussy Standards, such a system is called the “Unprotected net settlement system” or “Unsecured net settlement system.” The FSB was established to coordinate, at the international level, the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. The FSB is comprised of the representatives from central banks, national regulators on financial institutions and international institutions.

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Chapter 8

Critical Issues on Payment Systems

ABSTRACT This chapter discusses the public policy matters which should be considered to design and evaluate payment systems. First, the governance structure of payment systems is discussed. Some payment systems are managed by central banks and others are operated by private sectors. The division of labor between the central banks and private sectors varies considerably from country to country. Governing approaches essentially affect the way the payment systems are managed, including the participation rules, risk management schemes and efficiency of the system. Second, the legal issues concerning payment systems are reviewed. Needless to say, a payment system should have a well founded legal basis. It is conceivable that the insolvency law may have an adverse impact on the settlement finality of a payment system. Thus, careful considerations are necessary to confirm the validity of settlement in a payment system under the laws of the jurisdiction. Third, the operational reliability of payment systems is discussed. Modern payment systems are the “electronic payment systems” and are comprised of computers and networks. It is absolutely imperative to ensure the operational security of a payment system by securing the reliability of hardware, software, telecommunication networks, power supplies and staff. It is particularly desirable to ensure the operational reliability for the “systemically important payment systems”(SIPSs). Fourth, the efficiency of payment systems is discussed. Since a payment system provides a service with public nature, the operator should take the cost-effective way to manage the system. The cost of a payment system includes the processing cost of the system and the internal processing costs of the participants. It also includes the liquidity cost of participants, which means how much liquidity the participants should hold in order to process payments. DOI: 10.4018/978-1-61520-645-2.ch008

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Critical Issues on Payment Systems

INTRODUCTION Public policy matters of payment systems should be considered when making a system’s design. A number of factors of payment systems relate to public policy matters including the processing mechanisms, risk management schemes, participation rules, fee structures, and so on. Public policy matters can also be used as criteria for evaluating payment systems by public authorities. In many countries, the central bank is responsible for oversight of private payment systems, and some central banks publish the results as an oversight report regularly. As criteria of assessment for oversight, these public policy matters are useful for making evaluations. Actually, the Core Principles for Systemically important Payment Systems (Core Principles), which is the global standard for payment systems published by the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) in 2001, provides some suggestions on these matters. Core Principle I is about the “legal basis,” and Core Principle VII handles the matter of “security and operational reliability.” In addition, Core Principle VIII deals with the “efficiency” and Core Principle X is about the “governance.”

GOVERNANCE STRUCTURE OF PAYMENT SYSTEMS Ownership of Payment Systems Governance structures of payment systems vary widely between countries. This fact is intimately related to the form of ownership of each payment system. The ownership of payment systems can be divided into three main categories.

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•

•

•

Central bank-owned systems. Some payment systems are owned and operated by central banks. It is usually the case that the central bank operates the RTGS system which has a close linkage with the central bank accounts. In this case, the central bank determines the regulations and procedures of the system, and discloses information about the system. Privately-owned systems. On another front, other payment systems are owned and operated by the private sector. In most cases, the payment system operators are organized as the member-owned co-operatives. In some countries, however, the operator takes the form of a stock company owned by shareholders. In this case, it is more common that a majority of shareholders are the participants of the system, but there is a chance that some non-users could be included. Jointly-owned systems. In some cases, the central bank and the private sector own and operate the infrastructure jointly or separately own the various parts of the system which make up the whole system.

Required Condition for Governance of Payment Systems Core Principle X requires the systemically important payment systems to have the effective, accountable and transparent governance. That is because there are normally only a very few payment systems in a country and participants have no freedom of choice. First, the governance arrangements should be clearly specified and publicly available. And the objectives of a payment system should be disclosed to the owners, participants and public authorities. Even taking the form of a stock company, the main objective of the company should not be profit-making.

Critical Issues on Payment Systems

The key component of governance is the composition of the board which makes important decisions on the system. The board should have the composition which reflects the interest of various participants, including the large users and small-scale users. And the board should contain members who have the necessary expertise in the payment business. The reporting lines between management team and board member is another key factor. The reporting line should be clear and direct. The reporting line of risk management and audit functions should be independent from the line of day-to-day operations. Public disclosure of governance structure is a requisite for the transparency of the payment system.

A crucial risk might come from an insolvency law. In some countries, the “zero hour rules” are stipulated as a provision of insolvency law. The rules may have the adverse effect on the settlements of payments which are completed in the payment system. If the zero hour rules are applied, all transactions by a bankrupt institution from midnight on the date of bankruptcy become retroactively rendered ineffective. The effect could be reverse payments that have apparently already been settled and were thought to be final. This situation would cause a grave legal risk to the participants of the payment system. When a legal framework in a jurisdiction is not clear enough, it is recommendable that the operator takes legal opinions in order to protect the operator and participants from the legal disputes in the future.

LEGAL ISSUES ON PAYMENT SYSTEMS

Legal Issues in International Context

Legal Basis for Payment Systems A specific area of legal structure is deeply involved with the validity of settlement in a payment system. Such legal structure includes the contract laws, insolvency laws, banking laws, and laws of secured interests. Thus, the operator of a payment system should clarify the relationship between the system rule and relevant laws. In this regard, Core Principle I states: •

The system should have a well founded legal basis under all relevant jurisdictions.

A well founded legal basis provides a framework as for the rights and obligations of the participants and operator. It also gives a clear definition when the finality of settlement is ensured in the system. When the netting scheme is adopted, the payment system should have a robust legal base that ensures the enforceability of netting arrangements.

In cases where a payment system is operated in an international context, the operator should ensure that the system rules are legally valid in all relevant jurisdictions. Such a situation includes the case that a payment system admits the remote participation and/or collateral from abroad. The operator should clearly decide the applicable law for each aspect of the payment activities. It is also necessary for the payment system operator to address the possibility of conflicts of laws.

OPERATIONAL RELIABILITY OF PAYMENT SYSTEMS Operational Failures of Payment Systems As payment systems become increasingly dependent on computer and network systems, the operational reliability of these systems is a key element to prevent operational risk. The defect and malfunction of a central computer or network

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of payment systems could lead to the systemic risk implication. If such operational failures were to happen in a payment system, it would lead to a serious situation. At first, the operational failure would cause on late or failed settlements of interbank transactions, which would lead to the confusion in the money, FX and securities markets. Second, the customer payments would not be settled in a timely manner, which would cause another disorder affecting the whole market economy. The customer claims would result in huge business losses and degrading of bank reputations. In short, an operational failure of a payment system would lead to significant adverse effects on the financial markets and economic activities of the nation.

Measures to Ensure Operational Reliability A primary response in order to minimize the operational failure is to make a “full duplication” of the system and network. Each component of the system (including hardware, software, network, power supply, and staff) should be duplicated in case anything goes wrong. The backup facilities are a functional necessity in cases where a major accident occurs at the main computer site. At least one backup system should be immediately available (so-called “hot backup”), which is usually used in combination with a “cold backup” system(s). It should be kept in mind that only a backup system is not enough. The backup system should be operated by an adequate number of well trained staff and personnel. It should also be remembered that the staff requires the office space to work. It is not very wise to build a back-up site near the primary site. It should be built as far away from the primary site as necessary to avoid being subject to the same set of risks as the primary location. It is a minimum condition that the back-up sites do not rely on the same infrastructure components (e.g.,

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transportation, telecommunications, water supply, and electronic power) used by the primary site. A secondary response is to prepare a wellconceived “Business Contingency Plan” (BCP). The payment industry took an increasing interest in the BCP after the September 11 incident in 2001. The BCP is the preparation and testing of measures that protect business operations and also provide the means for recovery of technologies in the event of any damage or failure of facilities. Such events include the building fires, earthquakes, terrorist attacks and pandemic diseases. As a first step, a BCP requires the analysis of the threats and business impact from the disruption. Then, a disaster recovery plan should be designed and implemented, which should be followed by sufficient training. The timely recovery of operations is especially significant for payment systems. In the interagency paper1, the FRB, OCC and SEC in the US recommend that core clearing and settlement organizations should develop the capacity to recover and resume clearing and settlement activities “within the business day” on which the disruption occurs. And the paper recommends that the overall goal should be set that recovery and resumption can be made “within two hours” after an event.

EFFICIENCY ISSUES OF PAYMENT SYSTEMS The efficiency of transactions in a market economy is to a large extent determined by the efficiency of the payment system. Thus, the efficiency is largely a matter of social welfare.

Cost-Efficiency of Payment Systems Recommendation 15 of the Recommendations for Securities Settlement Systems (RSSS) (BIS, 2001) describes the efficiency as follows;

Critical Issues on Payment Systems

•

While maintaining safe and secure operations, securities settlement systems should be cost-effective in meeting the requirements of users.

The words of “securities settlement system” should be replaced by “payment systems” here in the context of this book. It is difficult to assess the efficiency of a particular payment system in any definitive manner. The cost of a payment system should be carefully balanced with the requirement of participants and the safety and security of the system. The first priority of a payment system is to assure the payments of participants will be consistently settled in a timely manner with absolute safety. Thus, only the efficiency should not be overstressed by itself. In many countries, however, there is only one or very few payment systems, and therefore it enjoys a monopoly situation. Without sound competition, the market forces cannot induce a payment system to achieve the cost-efficiency automatically. In addition, the member-owned co-operatives, as is often the case with privately-owned payment systems, tend to fall into the “collective action problems.” According to this theory, participants in any group attempting collective action will have incentives to “free ride” on the efforts of others. And this would be true especially when the group is working to provide public goods, like payment system service. Such problems can potentially lead to inefficiency in payment systems. That is why several global standards about payment systems set independent recommendations about efficiency and try to draw people’s attention to the cost-efficiency of the system.

Overall Costs of Payment Systems When analyzing the efficiency of a payment system, the overall costs should be evaluated. The overall costs include both the “direct costs” and “indirect costs.” The direct costs are the processing

costs of payments, which are reflected in fees and charges. Initial setup costs for participants to join the payment system are also included. The indirect costs are the “liquidity costs” for participants. If the system’s design requires each participant to hold a high level of liquidity in order to process its payments, the system’s liquidity cost is regarded as high. Liquidity cost also depends on the central bank’s policy on intraday liquidity. If a central bank provides intraday liquidity to each participant easily and at low rates, the liquidity cost of the system becomes low. It is common that the intraday facility of central bank requires collateral; the opportunity cost of holding the collateral should be taken into account when considering the overall cost.

REFERENCES Bank for International Settlements. (2001, January). Core Principles for Systemically Important Payment Systems. Bank for International Settlements and IOSCO. (2001, November). Recommendations for Securities Settlement Systems. Bank for International Settlements and IOSCO. (2004, November). Recommendations for Central Counterparties. Manning, M., Nier, E., & Schanz, J. (2008a). Market Failure in Payment and Settlement Systems. In Manning, M. (Eds.), The Economics of Large-value Payments and Settlement. Oxford University Press. Manning, M., Nier, E., & Schanz, J. (2008b). Ownership, Governance and Regulations of Payment Systems. In Manning, M. (Eds.), The Economics of Large-value Payments and Settlement. Oxford University Press Khiaonarong, T., & Liebenau J. (2009). Banking on Innovation: Modernisation of Payment Systems. Physica-Verlag Heidelberg.

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ENDNOTE 1



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“Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System,” FRB, OCC, and SEC, April 2003.

Section 4

Developments of Payment Systems in Selected Countries

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Chapter 9

Payment Systems in US

ABSTRACT This chapter provides a case study on the payment systems in the US. In general, each country has Large-value payment system(s) and Retail payment system(s). In the case of the US, the “Fedwire” and the “CHIPS” are the Large-value payment systems which process the large-value funds transfer, such as the interbank payments for the money market, government bond market, and FX market. The Fedwire is a central bank payment system, owned and operated by the Federal Reserve. While, the CHIPS is a private payment system, owned and operated by the TCH Payments Co. From the viewpoint of the settlement method, the Fedwire is a Real-Time Gross Settlement (RTGS) system. On the other hand, the CHIPS belongs to the Hybrid system, where the net settlements are made continuously during the day. The new settlement method of the CHIPS, i.e. the “CHIPS Finality,” is scrutinized closely. As for the Retail payment system, the “Automated Clearing House” (ACH) handles small value payments in the US. The ACH is a nationwide electronic file transfer mechanism that processes the retail credit and debit transfers between the customer accounts. The Federal Reserve is the largest ACH operator in the US. Meanwhile, the TCH Payments Co. is a private-sector operator of ACH. As for the ACH payments, the settlements are made between the sending banks and receiving banks only on the next day of the processing on a net-basis. That means that the ACH is a Designated-Time Net Settlement (DTNS) system. The function of the “FedGlobal ACH” and “Financial EDI” capability on the ACH network is also discussed. DOI: 10.4018/978-1-61520-645-2.ch009

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Payment Systems in US

INTRODUCTION The US is the largest economy in the world as well as having one of the world’s biggest financial markets. In addition, the US dollar (USD) still has its dominant role as a key currency, which is widely used in the international trade, global finance and investment, and as a reserve currency. This situation leads the massive flow of funds in the USD domestically and internationally. For this reason, the US payment systems handle such a massive fund transfers of the USD within the nation and also between the US and foreign countries. Therefore, it is extremely important to obtain a detailed knowledge about how the USD payments are settled.

FEDWIRE Outline of Fedwire Status of Fedwire in US Payment Systems The “Federal Reserve’s wire transfer system” (the Fedwire) is a Large-value payment system, owned and operated by the Federal Reserve (the Fed). There are two Large-value payment systems in the US, namely the Fedwire and the CHIPS. The Fedwire mainly handles the domestic payments between the US banks. And the CHIPS mainly processes the international payments, such as the foreign exchange transactions. In addition to these Large-value payment systems, the Automated Clearing House (ACH) is a retail payment system, which handles the fund transfers of small values. The Fedwire offers two kinds of services to the banking sector in the US. One is a secure and reliable service of handling large-value and time-critical payments. This is often referred to as the “Fedwire Funds Service.” The other is a book-entry securities transfer service for mainly government bonds, which is usually called the

“Fedwire Securities Service.” These two services are collectively known as the “Fedwire Services.” The Fedwire Funds Service is mainly described in this section.

Characters of Fedwire The Fedwire transfers the funds between the “Federal Reserve accounts” which each financial institution holds at the Federal Reserve Banks. The Fedwire Funds Service is generally used to make large-value and time-critical payments, such as the federal funds transactions and government bond transactions. The Fedwire is a credit transfer system. Participants (the depository institutions) originate a funds transfer by instructing a Federal Reserve Bank to debit the funds from its own account and credit it to the account of another participant. The Fedwire is a Real-Time Gross Settlement (RTGS) system. Thus, payment orders are settled individually on a gross basis. And if and only if the payer bank has a sufficient balance in its account, a payment order is settled immediately on a real-time basis. With this RTGS function, the participants are able to send and receive timecritical payments for themselves or on behalf of their clients. The funds transfers on the Fedwire become final and irrevocable immediately when the payments are processed1.

Settlement Volumes of Fedwire Figure 1 shows the volumes and values of the Fedwire. The average daily volume of transfers was 495 thousand in 2009. And the average daily value was $2,504 billion in the same year. These figures are indicative of the importance of the Fedwire in the US payment market. The average value per transfer was $5.1 million, which was very large amount. The average daily volume and value of transfers demonstrate

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Figure 1. Volumes and values of the Fedwire (Source: the Federal Reserve)

showed a sharp decrease in 2009 after the longterm upward trend. Only depository institutions (and certain other financial institutions) can hold an account with a Federal Reserve Bank, and are eligible to participate in the Fedwire. In 2009, approximately 7,300 participants used the Fedwire for funds transfer. In fact, large banks use the Fedwire quite extensively, and the top 50 banks account for approximately 80% of settlement value of the Fedwire. The Fedwire handles both the “interbank payments” which are the funds transfer for bank’s own account, and the “customer payments” which are made on behalf of their clients. The customer payments account for about 80% in volume, and about 40% in value.

Access to Fedwire The participants make an online access to the Fedwire by the “FEDNET,” which is the dedicated communication network for the Fedwire. The FEDNET is a nationwide high-speed network which connects between the participants and Federal Reserve Banks.

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The large-sized Banks tend to connect to the Fedwire through the “computer interface connection,” in other words, the compute-to-computer connection. While the medium-sized banks use the “Fedline,” which is the dedicated terminal to send payment orders to the Fedwire. The very small-sized banks are exceptionally admitted to have the “off-line connection,” where participants can make payment instructions by telephone. Almost 90% of the participants have online connection, either through the compute-to-computer connection or the Fedline. And these online participants account for almost every transactions (99%) of the Fedwire.

Intraday Liquidity at Fedwire Method of Providing Intraday Liquidity Since the RTGS system requires a lot of liquidity to execute the settlement, it is a common practice that a central bank provides intraday liquidity to the participants of the RTGS system. There are two methods in providing intraday liquidity.

Payment Systems in US

Table 1. Providing methods of intraday liquidity in selected countries (Source: Nakajima & Shukuwa, 2005) Intraday Repo Transaction

Intraday Overdraft (collateralized, free of charge)

Intraday Overdraft (Uncollateralized, with fee)

France Hong Kong Switzerland UK

Belgium Germany Italy Japan Netherland Sweden

USA

One is a “daylight overdraft” that central bank admits the participants to have the negative balance in the account at the central bank during the daytime. This temporal credit is only for the daylight usage and should be repaid by the end of the day. Another method is an “intraday repo transaction” that central bank buys securities from the participants with repurchase agreement by the end of the day. In the case of the daylight overdraft, “collateral is necessary but free of charge” is the common style of providing intraday liquidity. But the US is the only exception in major countries. This is because the Federal Reserve provides intraday liquidity without collateral but charges a fee on daylight overdraft (See Table 1).

Payment System Risk (PSR) Policy As the Federal Reserve Banks are exposed to credit risk by the uncollateralized intraday overdraft, the Federal Reserve has its Payment System Risk (PSR) policy. The policy provides a guideline to manage their risk on the daylight overdraft, as follows. First, the “net debit cap” is set for each participant according to its financial condition. The net debit cap means the upper limit of daylight overdraft, which each institution are not allowed to exceed. There are two kinds of caps. The “single day cap” is the maximum allowable overdraft on any day. And the “two-week average cap” is the

maximum allowable average of the peak daily overdrafts in a two-week period. Second, the Federal Reserve charges the daylight overdraft fees to the participants. The calculation of the fee depends on the usage of negative balance of the Federal Reserve account on a minute-by-minute basis. This minute-byminute counting system is intended to encourage the participants to repay the overdraft as soon as possible. Third, if the overdraft is not repaid by the end of the business day, the high penalty is imposed. Besides, if an institution will fall into such a situation in a repetitive manner, the institution will be prohibited from using the intraday overdraft. The Federal Reserve monitors the usage of intraday overdraft of each participant every minute, using the “Daylight Overdraft Reporting and Pricing System” (DORPS).

Revision of PSR Policy In December 2008, the Federal Reserve Board decided to revise its Payment System Risk (PSR) policy. This revision was mainly designed to improve the intraday liquidity management and payment flows for the banking system. But it is also targeted to mitigate the credit exposures of the Federal Reserve Banks caused by the daylight overdraft. The main point of the revised PSR policy is to approve a “voluntary collateral regime.” This new approach was taken in order to encourage

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the pledging of collateral to cover the daylight overdrafts. The fee for the collateralized daylight overdrafts is set to be zero, as with other major central banks. On the other hand, the fee for the uncollateralized daylight overdrafts is raised in order to promote the collateralization. The revised PSR policy took effect in March 2011. With the revision, the way of providing intraday liquidity of Federal Reserve moved a few steps closer to the method of other major central banks.

Operating Hours of Fedwire Extensions of Operating Hours The operating hours of the Fedwire Funds Service has been extended in several times. In December 1997, the operating hours was extended from 10 hours (from 8:30 a.m. to 6:30 p.m., Eastern Standard Time <EST>) to 18 hours (from 0.30 a.m. to 6:30 p.m.). Then, in May 2004, the Federal Reserve brought forward the starting time of the Fedwire to 9:00 p.m. of the previous day, which extended the operating hours to 21 hours and 30 minutes. Usually, a central bank payment system is operated during the daytime, when transactions are actively made in the financial market of the country. The reason why the Federal Reserve extended the operating hours was to take measures against the foreign exchange (FX) settlement risk. Each currency is settled in the payment system of the currency-issuing country, which inevitably leads to the differences of settlement time. Where

there is a time difference in the exchange-for-value settlement, there is settlement risk. The risk is known as the “Herstatt risk” in the FX settlement (see Chapter 3 for more detail). Therefore, if the overlapping time of payment system is established between the US and AsiaPacific countries, the USD and the Asia-Pacific currencies could be settled in the same time zone. That means that the FX settlement risk arising from the time differences could be eliminated. Since the USD is the key currency widely used in the international trades and financial transactions, and the time differences are biggest between the US and the Asia- Pacific countries, the overlapping time between the two areas is most beneficial. The ultimate solution for this purpose must be the “24-hour Fedwire,” which had been discussed for a long time in the central banking society. The current situation is not exactly 24 hours but very close to it.

Current Operating Hours of Fedwire The operating hours of the Fedwire Funds Service begin at 9:00 p.m. (EST). During the three hours from 9:00 p.m. to 0:00 a.m. (EST), the value date of the settlement is regarded as the next day. As 9:00 p.m. in EST is 6:00 p.m. in Pacific Time Zone, the payment instructions in San Francisco after 6:00 p.m. (in Pacific Time) are handled as the next day value payments. The cut-off time for customer payments is set at 6:00 p.m. And only the interbank payments are available for the time zone from 6:00 to 6:30 p.m. (see Table 2). More specifically, only the

Table 2. Operating hours of the Fedwire funds service (Source: Federal Reserve Financial Services, 2006) On-line Participants

Off-line Participants

Opening

9:00 p.m.

9:00 a.m.

Cut-off for customer payments

6:00 p.m.

5:30 p.m.

Cut-off for interbank payments

6:30 p.m.

6:00 p.m.

Note: All the time is in US Eastern Time (ET).

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“settlement payment order” is possible from 6:00 p.m. to 6:30 p.m. A settlement payment order is a payment order in which the originator and the beneficiary are each other (i) a bank subject to the reserve requirement of the Federal Reserve, or (ii) a participant in a net settlement arrangement approved by a Reserve Bank. The operating hours for the off-line participants are still limited from 9:00 a.m. to 6:00 p.m.

Other Services of Fedwire National Settlement Service (NSS) The Federal Reserve also provides the “National Settlement Service” (NSS). The NSS allows participants in the private-sector clearing arrangements to exchange and settle transactions on a multilateral basis through the designated “master accounts” held at the Federal Reserve Banks. There are approximately 40 clearing arrangements using the NSS, including the check clearing house associations, Automated Clearing House (ACH) networks, and credit card processors. The NSS provides an automated mechanism for submitting the “Settlement Files” to the Federal Reserve Banks. This scheme improves operational efficiency and reduces settlement risk

for participants by granting the settlement finality on the day when the File is sent. The NSS business day begins at 8:30 a.m. and ends at 5:00 p.m. EST, Monday through Friday. In this service, the “Settlement Agent” who is the operator of clearing arrangement, calculates the debit and credit balances as a result of the clearing activities, and sends the balances as a “Settlement Files” to the Reserve Bank. When the Federal Reserve Bank receives a Settlement File, it processes each “Debit Balance” to the “Master Account” of the “Settler” who is a participant of clearing activities and has an account at Reserve Banks. The Debit Balances are debited from the Master Accounts of the Settlers and the same amounts are immediately credited to the “Settlement Account,” which is an account at Reserve Bank that is used during the settlement processing to hold funds temporarily until the settlement process is completed. Once all the debit processing is completed and the Settlement Account has been fully funded, the “Credit Balances” are debited from the Settlement Account, and the same amounts are immediately credited to the Master Accounts of the Settlers with credit balance (See Figure 2). When the settlement processing is finished, the balance of

Figure 2. Settlement scheme of national settlement service (NSS)

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Table 3. Eligible securities for Fedwire securities service (Source: Federal Reserve Financial Services, 2009) Type of Issuer

Issuer

U.S. Treasury

Treasury Bills, Treasury Notes, Treasury Bonds

Federal Government Agencies

Department of Veteran Affairs, Financing Corporation, Tennessee Valley Authority (TVA), Resolution Funding Corporation

Government Sponsored Enterprises

Federal Home Loan Banks, Fannie Mae, Freddie Mac, Ginnie Mae, Farm Credit Bank, Farmer Mac, Sallie Mae

International Organization

African Development Bank, Asian Development Bank, Inter-American Development Bank, World Bank

the Settlement Account becomes zero. The credit and debit processing is final and irrevocable when processed. The NSS is similar to the service that the Federal Reserve has provided to the CHIPS. The NSS was implemented in March 1999, by extending the local settlement sheet service provided by each Reserve Bank. Since the NSS is a nationwide service, the debit and credit processing among multiple Federal Reserve Banks are also possible. The average daily number of Settlement Files was 60, and the average daily settlement value (dollar value of debits only) was $66 billion in 2009.

Fedwire Securities Service The Federal Reserve provides the “Fedwire Securities Service” as well as the Fedwire Funds Service. The Fedwire Securities Service consists of a safekeeping function and a book-entry securities transfer function. The safekeeping function involves an electronic storage of securities records in custody accounts, that is to say, in a book-entry form. The securities transfer function involves transfers and settlements of securities between the securities accounts of participants. The Fedwire-eligible securities include the securities issued by the US Treasury, other federal agencies, Government-Sponsored Enterprises (GSE), and certain international organizations, such as the World Bank (see Table 3).

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In this service, the business day begins at 8:30 a.m. and ends at 3:15 p.m. EST, Monday through Friday. During these hours the participants can originate online securities transfers. The securities transfers can be made both in the form of “free of payment” or “Delivery versus Payment” (DVP). For the sake of safety, however, most securities settlements are made in the DVP. In the DVP settlement, the funds and securities are exchanged simultaneously. Since the Fedwire is a RTGS system, the Fedwire Securities Service provides a real-time delivery-versus-payment function that enables the participants to transfer securities to other participants and simultaneously receive funds for such securities. Once processed, the securities transfers are final and irrevocable. The Fedwire is a securities settlement system as well as a fund settlement system. Some may feel odd that central bank provides the securities settlement service. As for the government bond, however, it is not unusual that central bank provide the settlement service. Several central banks in Asia including Japan offer the same kind of securities settlement service. Moreover, many European central banks provided the settlement service for the government bond until late 1990s. The central banks are involved in the government bond settlement because the fund and government bond is tightly linked each other. That is, the government bond is the most suitable collateral for the central bank money. In 2009, approximately 2,300 participants made the Fedwire securities transfers. The average

Payment Systems in US

daily volume of the transfers was 83 thousand, and the average daily value of the transfers was $1,173 billion in 2009. The average value per transfer was $14 million in the same year.

CHIPS The “Clearing House Interbank Payments System” (CHIPS) is the Large-value payment system in the US, along with the Fedwire. The CHIPS used be a Designated-Time Net Settlement (DTNS) system, where the settlements are made only at the end of the day on a net-basis. In February 2001, the CHIPS made a drastic change in the settlement method. In the new scheme, the net settlements are made continuously during the day. This new scheme is known as the “CHIPS Finality,” and the CHIPS became the Hybrid system as a consequence of the reform. In what follows, the outline of the CHIPS is given, and after that, the way how this Hybrid system works is discussed in detail.

Outline of CHIPS Operator of CHIPS The CHIPS started its operation in April 1970. At that point, the operator was the “New York Clearing House” (NYCH). In March 1998, the

“Clearing House Interbank Payments Company LLC” (CHIPCo) was established as an operating company of the CHIPS, as an affiliated company of the NYCH. The NYCH was the oldest clearing house in the US, established in 1853. The NYCH was originally established in order to simplify the daily check exchanges in New York City. Later it moved on to the electronic funds transfer service, the CHIPS. In November 2003, the NYCH merged with the Chicago Clearing House, and changed its name to “The Clearing House” (TCH). Then, the CHIPCo became the subsidiary of the TCH. In July 2004, the TCH published the streamlining plan, in which the TCH and five affiliated companies2 were merged into a single payments company with a single governing board. The name of the new company was “The Clearing House Payments Company LLC” (TCH Payments Co.). The company is sometimes referred to as the “TCH” or the “PaymentsCo” in short. The CHIPCo became a part of the company. After the lengthy past background mentioned above, the CHIPS is now owned and operated by the TCH Payments Co. (See Figure 3). The TCH Payments Co. is owned by 19 private banks which are primary users of the CHIPS. The Board of the Company consists of 15 senior executives of the owner institutions. The Board of TCH Payments Co. makes the strategic decision of the company.

Figure 3. Transition of Operator of the CHIPS

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Payments Processed by CHIPS The CHIPS processes the international USD payments, including the foreign trade transactions, the FX transactions and the cross-border securities transactions. Needless to say, most of them are the large-value payments. The CHIPS is the main channel of crossborder payments in the USD. Over 95% of the USD cross-border payments are processed by the CHIPS. Recently, the Asia-related payments have been growing, and the transactions to, from, or within Asia represent 41% of the CHIPS volume as of the end of 2009. In the meantime, more and more domestic payments are also becoming to be processed by the CHIPS. This means that the homogenization is going on between the CHIPS and the Fedwire.

Settlement Volumes of CHIPS The CHIPS processed 337 thousand payments average per day in 2009. The settlement volume is on a scale of about 70% of the Fedwire. The average daily value of transfer in the CHIPS was $1,446 billion in the same year. The

settlement value is approximately 60% of the Fedwire. Judging from these figures, the CHIPS is the largest private payment system in the world. The average value per transfer was $4.29 million in 2009. The average dollar amount per payment is decreasing year by year, from $6.48 million in 1994. This trend suggests that the CHIPS is attracting more and more customer payments, most of which are the retail payments. The total settlement values showed the consecutive decrease from 1998 to 2000. One of the backgrounds of the decline was the adverse impact of the Asian currency crisis in 1998. Another reason was the introduction of the single currency “euro” in January 1999. Before the introduction of the euro, the legacy European currencies (Mark, Franc, Lira, Peseta, and the rest) were traded each other using the USD as an intermediary currency: e.g. Mark to the USD and the USD to Lira. But the legacy currencies were merged into a single currency, and then the demand for the USD as a “vehicle currency” was dropped out. After these decreases, the settlement values of the CHIPS moved back into the upward trend again (see Figure 4).

Figure 4. Volumes and Values of the CHIPS (Source: TCH)

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Participants of CHIPS

Access to CHIPS

When the CHIPS started operation in 1970, the participants were just 9 banks. From there, the participants increased year by year, and reached 142 banks in 1985. After that, however, the number of participants came to decrease gradually. The primary cause was a number of successive mergers among the US banks, especially between the big banks. In addition, some foreign banks withdrew from the USD settlement business as part of the rationalization and cease the direct membership of the CHIPS. Hitting the bottom as 44 banks in 2007, the number of participants began to recover and became 50 banks at the end of 2010 (see Figure 5). The main force of the recovery was Chinese banks. Three big Chinese banks participated in the CHIPS in 2009. This fact shows the rising economic power of China. The CHIPS participants include the US commercial banks and the foreign banks with the offices in the United States. The nationality of the CHIPS participants ranges over 22 countries worldwide.

There are two ways for the participants to make access to the CHIPS. One is to use the CHIPS’s own dedicated network. Another is to use the SWIFTNet, which is provided by SWIFT. Most participants use the dedicated network in practice.

Payment Message of CHIPS A CHIPS participant sends a “payment message” to the CHIPS in a structured, computer-readable format. The payment message includes some information, including the dollar amount, value date, sending participant, receiving participant, beneficiary, originator and intermediary bank (See Table 4). Some information fields are mandatory to fill in and the others are optional. Upon receipt of a payment message from the participant, the CHIPS carries out a format check. Any payment messages will be rejected, if they do not pass the format check. Once the check has been completed, the system will move the payment message to a “waiting queue” where the payment messages will stay until the processing is made.

Figure 5. Participants of the CHIPS (Source: TCH)

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Table 4. Information in Payment Messages of the CHIPS (Source: TCH, 2007) Item

€€€€€Information

Amount and Date

Dollar Amount Value Date

Sending and Receiving Participant

Sending participant’s CHIPS identification number Receiving participant’s CHIPS identification number Intermediary bank identification

Beneficiary and Originator

Beneficiary’s bank identification Beneficiary identification Originator identification Originator’s bank identification Instructing bank identification

Operating Hours of CHIPS The operating hours of the CHIPS is from 9:00 p.m. to 5:00 p.m. EST. During these 20 hours, the participants can send and receive the payments. The payments received from 9:00 p.m. to 0:00 a.m. EST is handled as the next day value payments as in the Fedwire. The starting time is identical to the Fedwire, which was moved forward from 0:30 a.m. to 9:00 p.m. in May 2004. This extension was in tandem with the extension of the Fed’s operating hour.

Comparison between Fedwire and CHIPS Table 5 shows the comparison between the Fedwire and the CHIPS. These are both the Large-value USD payment systems, but there are some differences in the settlement method, the operator, the number of participants, the main transactions processed, and the settlement volumes.

Situation Before CHIPS Finality Traditional Settlement Method The CHIPS had been operated as a typical “Designated-Time Net Settlement” (DTNS) system

Table 5. Comparison between Fedwire and CHIPS Fedwire

CHIPS

Method of settlement

RTGS System

Hybrid System

Operator

Federal Reserve (central bank)

TCH Payments Company (private sector)

Number of participants

approximately 7,300

48

Settlement Area

across the US

New York

Main transactions processed

Domestic payments in US Federal Funds transactions Government bond Transactions Commercial Payments

International payments Foreign trade transactions Foreign exchange transactions Cross-border securities transactions

Settlement Volume (Daily average, in 2009)

495 thousand

337 thousand

Settlement Value (Daily average, in 2009)

$2,504 billion

$1,446 billion

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until February 2001. To be more precise, the participants sent payment orders to the CHIPS, and once received, the CHIPS calculated the net position of each participant during the day. And at the end of the business day, the CHIPS informed each participant of the final net position of the day. The participants with the net debit position should pay-in the net debit amount to the “CHIPS Account” at Reserve Bank of New York by a certain time. This process was known as the “funding stage.” When all the participants finished making the pay-in and the funding stage is completed, the CHIPS paid out the credit amount to each participant with the net credit position. This process was called the “payment stage” (see Figure 6). In other words, the CHIPS collected the net debit amount from the participants with the net debit position, and distributed the net credit amount to each participant with the net credit position. The DTNS system is a zero sum system, in which the total of the net debit positions and net credit positions are identical. Therefore, the balance of

the CHIPS account became zero after finishing the funding and payment stage.

Strengthening of Risk Management The CHIPS had taken some measures to improve the risk management of the DTNS system step by step (See Table 6).

Same-Day Settlement First, the CHIPS was a next-day settlement system, where the final settlements among the participants were executed at the next morning of the day. In 1981, the CHIPS moved to the same-day settlement system, where the settlements are made at the end of the day. This measure was taken in order to eliminate the overnight risk that the net creditors had for the net debtors.

Figure 6. Traditional Settlement Method of CHIPS (until February 2001)

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Table 6. Strengthen of Risk Management in CHIPS (Source: Nakajima & Shukuwa, 2005) Strengthen measures of risk management

Substances

Same-day Settlement (1981)

To changeover from the next-day settlement to the same-day settlement.

Bilateral Net Credit Limit (1984)

To introduce Bilateral Net Credit Limit, which is the limit on the net credit exposure a participant incurs vis-à-vis another participant. This is to limit the net credit position between two parties.

Sender Net Debit Cap (1986)

To introduce Multilateral Net Debit Cap, which is a limit on the net debit amount a participant can bear to the CHIPS. The Cap was set to be 5% of the sum of Net Credit Limit a participant obtained from other participants. This is to reduce the risk exposure of the CHIPS as a whole.

Settlement Finality by Loss-sharing Rule and Collateral Scheme (1990)

To introduce the Loss-sharing Rule and Collateral Scheme in order to ensure the timely completion of daily settlement, even if the participant with the largest single net debit position is unable to settle. The Loss-sharing Rule stipulated that the surviving participant should bear the loss on a pro-rata basis of net credit limit for the defaulting party. The loss-sharing amount was called “Additional Settlement Obligation” (ASO). Each participant was obliged to pledge the collateral equivalent to 5% of ASO to the collateral account at Federal Reserve Bank of New York. The “Settlement Finality” was ensured by these two measures, even in case of the default of the participant with the largest net debit position.

Lamfalussy plus One system by reinforcements of Sender Net Debit Cap and Collateral Scheme (1997)

The system-side rate to calculate the Sender Net Debit Cap was reduced from 5% to 3%. While, the Collateral Scheme was reinforced by introducing the minimum collateral amount of 10 million dollar, and by raising ASO calculating rate from 5% to 5.1%. With these two reinforcements, the CHIPS became the Lamfalussy plus One system, which could stand for the defaults of top two participants with largest net debit position on the same day.

Bilateral Net Credit Limit Second, the CHIPS introduced the “Bilateral Net Credit Limit” in 1984. Each participant was obliged to set up the Limits on the net credit exposure that it allowed vis-à-vis another participants. The Limit was to confine credit risk bilaterally between the participants.

Sender Net Debit Cap Third, the “Sender Net Debit Cap” was introduced in 1986. The Cap was a limit on the net debit amount that a participant could hold vis-à-vis the CHIPS. The Cap was set to be 5% of the sum of the Bilateral Net Credit Limit a participant admitted from the other participants. This Cap was introduced in order to confine the risk exposure of the CHIPS to all the participants in total.

Achievement of Settlement Finality Fourth, the “Loss-sharing Rule” and the “Collateral Scheme” were introduced in 1990. These

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two schemes were brought in to ensure the daily settlements to complete in a timely manner, even if the participant with the largest single net debit position will become default. The “Loss-sharing Rule” prescribed that the “surviving participants,” i.e. the other participants than the default participant, should bear the loss jointly. The share of the losses is not equal among the surviving participants, but on a “pro-rata basis” which is based on the Net Credit Limit amount each participant admitted to the defaulting party. That meant that if a participant admitted the larger Net Credit Limit to the defaulter, then it will bear the larger shares of the losses. The loss-sharing amount was called “Additional Settlement Obligation” (ASO). In the “Collateral Scheme,” each participant was obliged to pledge the collateral which was equivalent to 5% of ASO. The collateral was to be provided to the CHIPS’s “Collateral Account” at the Federal Reserve Bank of New York. With these two measures, the CHIPS achieved the “Settlement Finality,” which means that the settlement can be accomplished in a timely manner,

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even if the participant with the largest net debit position will be unable to settle.

referred to as the “security deposit” because the fund is already secured in the system.

Advancement to Lamfalussy Plus One System

Initial Prefunded Balance

Finally, the Sender Net Debit Cap and the required collateral were tightened up in 1997. With these measures, the CHIPS reached the minimum standard of Lamfalussy standards and become a “Lamfalussy Plus One System.” This meant that the CHIPS could withstand the coincidental defaults of top two participants with the largest net debit positions on the same day (See Chapter 7 for more detail).

CHIPS Finality Introduction of CHIPS Finality In February 2001, the CHIPS changed the settlement method drastically. This new method is known as the “CHIPS Finality.” The remarkable features of the CHIPS Finality are; the settlement is made, (i) in real-time basis, (ii) with the continuous matching, and (iii) on a net basis. The most important outcome of these features is that the payments have the “intraday finality” during the day. The main points which delivered the risk reduction were as follows: The first point was the scheme of “prefunding.” In this scheme, each participant should pay-in the amount necessary for the settlement of the day to the CHIPS Account before the start of the settlement processing. Second, the processing of payments will be executed only within the balance of each account, which means that any negative balances are not permissible in the CHIPS. In other words, the CHIPS Finality is the payment system of prefunding type, where the safety is ensured by paying-in the necessary fund in advance. The prefunded funds are sometimes

The CHIPS holds the “Prefunded Balance Account” at the Federal Reserve Bank of New York (FRBNY). Each day, each CHIPS participant is required to pay-in a predetermined amount (the “opening position requirement”) to this account. Once paid-in, the amount is recorded as the “Initial Prefunded Balance” of each participant. When an additional liquidity is necessary for the smooth settlements, each participant can make additional pay-ins of funds during the day to increase the Prefunded Balance, which is called the “Supplemental Funding.” There is no limit on the amount of Supplemental Funding, and the participants are able to add supplemental funds throughout the day until the closing time of the system. On the other hand, when the liquidity is more than enough, each participant can withdraw of funds from the Initial Prefunded Balance during the day, which is called the “Withdrawal.” The amount of Withdrawal should be less than the amount of the Supplemental Funding.

Available Balance The “Available Balance” of each participant is calculated by adding Initial Prefunded Balance with all the incoming and outgoing payments, and the Supplemental Funding and Withdrawal (see Table 7). The Available Balance is also referred to as the “Current Position” of each participant. Table 7. The relationship between initial prefunded balance and available balance Available Balance = Initial Prefunded Balance + Daytime Incoming and Outgoing Payments + Supplemental Funding and Withdrawal

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The Available Balance is a record on the system book of the CHIPS. When a participant makes a pay-in for the Initial Prefunded Balance, the balance is recorded as an “Opening Position” of the participant. Following the recording of a participant’s opening position, the CHIPS system will change the Current Position of each participant to reflect all the processing of incoming and outgoing payments throughout the day.

Pay-in to Prefunded Balance Account The pay-in to the Prefunded Balance Account is made through the Fedwire. That means the fund is transferred from the participant’s account at the Federal Reserve Bank to the Prefunded Balance Account of the CHIPS. In case that a participant does not have an account at the Federal Reserve Bank, the participant can have the other bank to pay-in on behalf of itself, which holds the account at the Federal Reserve Bank. The participant who makes pay-in by itself is called the “Funding Participant.” And the participant who outsources the pay-in procedure to other bank is referred to as the “Non-funding Participant.” The required amount of the opening position is recalculated by the CHIPS for each participant periodically at least once each month. The calculation is based on the volume and value of the sending payments of each participant. The new Initial Prefunded Balance is calculated and informed at the weekend and applied from the beginning of the next week. Unless all the participants complete the pays-in of the required amounts to the Prefunded Balance Account, the CHIPS will not start the processing of payment orders. The pay-in to the Prefunded Balance Account starts at 9:00 p.m. EST which is the opening time of the Fedwire, and should be completed by 9:00 a.m. (by 7:00 a.m. on the day after holiday).

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Conditions for Processing of Payments The CHIPS keeps a separate record of each participant’s Current Position. When a payment order is processed, an amount is deducting from the sending participant’s Current Position and the same amount is added to the receiving participant’s Current Position. The deducting and adding are deemed to be processed at the same time, which is called the “Simultaneous Processing.” There are two conditions which are necessary to start the processing of payments. No payment message will be processed, unless the situation of both sending participant and receiving participant meet these two conditions. The first condition is that the Available Balance of the sending participant will not become less than zero after the processing of the payment. This condition is called the “Minimum Position Limit.” The second condition is that the Available Balance of the receiving participant will not exceed an amount equal to twice of its opening position (Initial Prefunded Balance) after receiving the payment. This condition is called the “Maximum Position Limit.” The first condition is set in order to avoid creating credit risk among participants, which the ordinary net settlement systems inevitably retain. The second condition is set in order to prevent the situation of liquidity imbalance in the system, which leads to deteriorate the settlement efficiency of the CHIPS. More concretely, if a great deal of liquidity in the CHIPS concentrates on only a handful of participants, the other participants will suffer from a lack of liquidity and the processing of payments from these participants will be hampered. This condition is set in order to avoid such a situation of maldistribution of liquidity in the system. With these two conditions, the Available Balance of each participant changes from moment to moment between zero and a twice of its Initial Prefunded Balance (see Figure 7).

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Figure 7. Minimum Position Limit and Maximum Position Limit

Input of Payment Orders In order to ensure the smooth processing of payments, each participant are obliged to input more than 65% of payments of the day in volume, and more than 55% of payments in value by 12:00 p.m. A participant can send a pressing payment order with two kinds of preference flags: the “urgent flag” and “preferred flag.” The urgent payment messages are processed before the preferred payment messages, and the preferred payment messages are released before the non-priority payment messages. With the exception of the general rule, the urgent and preferred payment messages can be processed without consideration of Maximum Position Limit of the receiving participant. A participant is able to change the status of payment message, e.g., from the non-priority to the preferred payment, from the preferred to the urgent payment and vice versa, only when the payment is not yet processed. A participant also can cancel the payment messages which are not yet processed. The “CHIPS Online Cash Management Tool” allows each participant to know the Available Balance and payment messages waiting in the queue in real time. With this Tool, a participant also can assign and change the status of payment orders.

Three Processing Methods of Payments The core system for the CHIPS Finality is called the “Balanced Release Engine,” which takes charge of the matching, netting and processing of payment orders. When the CHIPS receives a payment order, it is once stored in the “waiting queue.” Payment orders which satisfy two conditions of the Maximum Position Limit and Minimum Position Limit are picked up from the queue, which is called “released,” and processed. There are three processing methods to handle the payment orders in the CHIPS Finality.

Individual Release The first one is called the “Individual Release,” in which a payment order is processed individually. In this Release, the CHIPS decrease the Available Balance of the sending participant and increase the Balance of the receiving participant by the amount of the payment order. The recording of decrease and increase of each Balance is deemed to be effective simultaneously. The way of processing of Individual Release is quite similar to that of the RTGS system.

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Bilateral Release The second method comes when the Individual Release is not applicable, which means either (or both) of the two conditions is not satisfied to process a payment order individually. In this case, the payment orders between the two participants (e.g., the payments from Bank A to Bank B, and the payments from Bank B to Bank A) are picked up and netted. Then the net amount, the “bilateral net balance,” is calculated. If the processing of the bilateral net balance satisfies the two conditions, the system makes the debit and credit processing of the net amount to each Available Balance. This processing method is referred to as the “Bilateral Release.”

Multilateral Release When both the Individual Release and Bilateral Release are not applicable, the third method is applied. In this case, the payment orders among more than two participants (e.g., Bank A, Bank B and Bank C) are picked up and netted. Then the net amounts, the “multilateral net balances” are debit and credit to the Available Balances of the involved participants. This method is referred to as the “Multilateral Release.”

Concrete Descriptions of Three Kinds of Releases Some examples are given here as concrete descriptions of three kinds of Release as mentioned above.

Example of Individual Release Assume that the Available Balance of Bank A is $10 million and the Balance of Bank B is $8 million, and that Maximum Position Limit of each bank is $20 million. If Bank A sends a payment order of $3 million to Bank B under this situation, the payment order is processed immediately and individually because the outcome of the Balances of both Bank A and Bank B will fall within the Maximum Position Limit and Minimum Position Limit. The Balances after processing of the payment order become $7 million for Bank A and $11 million for Bank B (see Figure 8).

Example of Bilateral Release Assume that the Available Balances of participants are close to the Maximum Position Limit. In the example of Figure 9, the Balance of Bank B is $25 million and close to the Maximum Position Limit of $30 million. If the payment orders from Bank A to Bank B are processed individually, the

Table 8. Three processing methods of CHIPS finality Processing Method

Contents

Individual Release

A payment order is processed individually. e.g., a payment order from Bank A to Bank B is processed individually.

Bilateral Release

The payment orders between two participants are netted and the net balance is processed in a batch. e.g., The payment orders between Bank A and Bank B are netted, and the “bilateral net balance” is debit from and credit to each Available Balance.

Multilateral Release

The payment orders among more than two participants are netted and the net balances are processed in a batch. e.g., The payment orders among Bank A, Bank B and Bank C are netted, and the “multilateral net balances” are debit from and credit to each Available Balance.

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Figure 8. Example of individual release

Balance of Bank B will exceed the Maximum Position Limit. In this case, the payment orders from Bank A to Bank B and the payment orders from Bank B to Bank A are netted by the Bilateral Release, and the “bilateral net balance” is processed in a batch. In consequence, $1 million is debited from the Balance of Bank A and $1 million is credited to the Balance of Bank B simultaneously (see Figure 9).

By using the bilateral netting method, the exceedance of the upper limit of Bank B can be avoided.

Example of Multilateral Release Assume that the Available Balance of each participant is rather low, and the Balance of sending participant will become less than zero if payment orders are processed individually or bilaterally netted.

Figure 9. Example of bilateral release

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Figure 10. Example of multilateral release

In this case, the payment orders of more than two participants (e.g., Bank A, Bank B and Bank C) are picked up, and netted multilaterally. If the “multilateral net balances” satisfies the two conditions of the involved participants, the net balances are debited from or credited to the Balance of each participant (see Figure 10).

Real-Time Finality and High Efficiency of Fund By the combination of three processing methods (Releases) mentioned above, almost all of the payment orders are processed within 15 seconds in the CHIPS. Therefore, the TCH Payments Co. describes the way of settlement in the CHIPS as the “Real-Time Netting.” And it explains that the CHIPS settlement has the “real-time finality.” However, it possibly will take more than several hours to process a payment order, in the case of liquidity shortage on the account of the sending participant. Thus, strictly speaking, so-called the “real-time finality” in the CHIPS is quite different from that of the RTGS system. In the CHIPS, the settlement value of the day is around 600-700 times of the Initial Prefunded Balance, the opening position. In concrete terms,

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the CHIPS transfers an average total value of about $2 trillion a day, with only $3 billion in prefunding. This ratio of the opening position to the daily settlement value is significantly better than other payment systems. For example, this figure is reported to be approximately 12 times in the Fedwire. This means the CHIPS achieves the high efficiency of funds, which is highly beneficial to the participants. Stated another way, a participant can make a large value of payments with a small liquidity utilizing these three processing methods of the CHIPS Finality.

End-of-Day Closing Procedure As mentioned above, almost all of the payments are processed in a very short time during the day. However, some payments3 possibly continue to stay in the queue until the cut-off time (5:00 p.m.) of the system, mainly because of the liquidity shortage of the sending participant. In that case, the CHIPS carries out the “Endof-Day Closing Procedure,” which intends to process as many payment messages as possible. The Closing Procedure is made in the following four stages.

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First Stage: Remove the Maximum Position Limit When it becomes 5:00 p.m., the cut-off time, the CHIPS closes the system for receiving payment orders. At this time, the system tries to process as many unsettled payment orders as possible by lifting the Maximum Position Limit. In contrast, the Minimum Position Limit is still valid.

Second Stage: Calculation of Closing Positions If any payment messages still remain in the queue after the first stage, the CHIPS will calculate the “multilateral net balance” as for the all the unsettled payments in the queue. This is a kind of provisional calculation, and no actual processing of payments is executed. The resulting multilateral net balance for each participant will be combined with the participant’s Available Balance to calculate the “Closing Position” (see Table 9). The CHIPS informs each participant of the Closing Position with Initial End-of-Day Balance Report. If the Closing Position is negative (less than zero), the participants are required to pay-in the funds to make up the negative position, which is called the “Closing Position Requirement.”

Third Stage: Final Prefunding Each participant with a negative Closing Position should pay-in the amount of its Closing Position within 30 minutes from receiving the Balance Report. This process is referred to as the “Final

Prefunding.” That is to say, the participant with negative position should pay-in the funds to the Prefunded Balance Account at the FRBNY.

Fourth Stage: Two Scenarios Two scenarios are possible after the third stage or the Final Prefunding. If all the participants with the negative Closing Position successfully make the required pay-in within 30 minutes, all the unsettled payments in the queue are processed and settled. This scenario is known as the “Full Final Prefunding,” where all the settlements are accomplished. If one or more participants with the negative Closing Position are unable to make the requested fund transfer within 30 minutes, the system will match, net and process as many payments in the queue as possible, using the Available Balance and Additional Funding. This scenario is called the “Partial Final Prefunding.” If there are any payment messages remained as unsettled in the queue after the processing of Partial Final Prefunding, these payments are treated as “expired,” and the CHIPS notify the expiration of the payments to the sending participant. If the expiration of payments happens by any possibility, the participant can re-route the payment through the Fedwire or correspondent banking relationship. The effect of expiration is quite limited because only the limited number of payments could be expired and they can be recovered by re-routing. Furthermore, it is worth mentioning that there are neither the unwinding nor loss-sharing in any case, both of which are the system-wide incidents and affect many participants of the system.

Table 9. Example of closing position Available Balance + |. $ 30 million

Multilateral Net Position of Unsettled Payments | △ $ 50 million

= Closing Position |. △ $ 20 million

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Pay-Out Procedure After all the payment orders have been processed or have expired, the CHIPS makes a “pay-out” procedure. That is to transfer the funds through the Fedwire from the Prefunded Balance Account to the participants’ accounts with the positive closing position (greater than zero). The total amount of pay-out is equal to the final balance at the Prefunded Balance Account. Eventually, the balance of the Prefunded Balance Account becomes zero after all the pays-out.

CHIPS’s Schedule of the Day Table 10 summarizes the CHIPS’s settlement schedule of the day, as described above.

Merit of CHIPS Finality By introducing the CHIPS Finality, the risk management of the CHIPS changed substantially. In the traditional DTNS scheme, the un-settled payment orders were accumulated during the day, which lead to settlement risk. In order to reduce such risk, the CHIPS had introduced several countermeasures, such as the net credit limit, debit cap and loss-sharing rule.

In the CHIPS Finality, however, settlements are made continuously and in near real-time basis, which will prevent the accumulation of the unsettled payments. In the new scheme, the intra-day finality became reality. Therefore, with the introduction of the CHIPS Finality, the CHIPS abolished the whole risk management measures, including the Loss-sharing Rule, Collateral Scheme, Bilateral Net Credit Limit and Sender Net Debit Cap. The participants became completely free from the burden of such risk management measures.

Remittance Information on Wire Transfer Customer Transfer Plus (CTP) The CHIPS is planning to introduce a new message format to support business remittance information, in tandem with the Fedwire. This new message format is called the “Customer Transfer Plus” (CTP) and will be implemented in November 2011. The key point of the CTP message is that the participants of the CHIPS and the Fedwire can add and send the remittance information with a payment order.

Table 10. CHIPS’s schedule of the day Period of Time

Processing

Contents

From 9:00 p.m. (of the previous day) to 9:00 a.m.

Pay-in

Each participant are obliged to pay-in the required amount to the Prefunded Balance Account.

From 9:00 a.m. to 5:00 p.m.

Processing of Payments

Payments are processed by three methods with the limitation of Minimum Position and Maximum Position.

From 5:00 p.m.

End-of Day Closing Procedure

1) Remove the Maximum Position Limit 2) Calculation of Closing positions 3) Final Prefunding

Around 5:30 p.m.

Two Scenario

1) Full Final Prefunding: all the settlements are completed. 2) Partial Final Prefunding: some payments are treated as expired.

After the Final Prefunding

Pay-out

The CHIPS transfer the funds to the participants with positive closing position.

(Note): Time is in US Eastern Time.

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The “remittance information” is the additional details of fund transfer related to the underlying commercial payment being settled. To send the remittance information with a payment order is referred to as the “Financial Electronic Data Interchange” (“Financial EDI”). The ultimate benefit of the Financial EDI is that the beneficiary is able to know the details of the payment. When getting the details of payments, the suppliers (payees) can automatically reconcile the payments received from the customers (payers). It will bring significant streamlining of reconciliation process by introducing the automatic reconciliation, which leads to the elimination of data entry errors by manual handling.

Two Sequences of the Payment Message The new CTP message has two “Sequences,” the groups of information: the Sequence A and Sequence B. The “Sequence A” is for the core payment messages which include the sending participant, receiving participant, payment amount, originator, beneficiary, and routing information. The “Sequence B” is for the addenda information up to 9,000 characters. The Sequence B is set to support the remittance information4, such as the contents of invoice or bill number. The participants have an option whether or not to use the new CTP message when sending payments. However, all the participants of the CHIPS will be required to be able to receive the CTP message and to ensure that the internal systems can handle the new message format.

Data Elements of Financial EDI The CHIPS (and also the Fedwire) basically supports the two data elements in the Sequence B: the “EDI STP 820” and “ISO 20022.” The “EDI STP 820” is an electronic file format that establishes the data content of the payment order/remittance advice transaction set within the

context of an EDI environment. This format was developed by the Electronic Payments Network (EPN), which was the operator of the “Automated Clearing House” (ACH, to be described later). Therefore, this format can be regarded as the US national standard for remittance information. On the other hand, the “ISO 20022” is a universal financial industry message scheme prepared by the Technical Committee (TC) 68 of the International Organization for Standardization (ISO). The ISO 20022 standard provides the financial industry with a common platform for the development of messages in a standardized “eXtensible Markup Language” (XML). The ISO 20022 coves a wide range of financial services, including the payments, securities, trade services, FX trades, and cards. Of these, the customer credit transfer standard which includes the structured remittance information is used in the CTP message. In addition to the two standard data elements, several local formats are allowed to use in the CTP message. These are the UEDI, the ANSI, the IXML, the GXML, the NARR and the S820. When using these local formats, the senders and receivers should agree how to use the free text of 9,000 characters in advance. The CHIPS (and Federal Reserve Banks) will not be validating against these standards.

Background of CTP The Federal Reserve Banks and the TCH conducted a research5 in 2006 to examine the corporate demand for the structured remittance information in the “wire transfer,” which means the CHIPS and Fedwire. From this comprehensive research, it was concluded that the corporates had a clear preference for including structured remittance information as part of payment message in wire transfer in order to eliminate the existing inefficiencies. The key findings showed that 94 percent of respondents said it was ‘valuable’ or ‘very valuable’ for the

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wire transfer to include the remittance information in the payment messages. And, importantly, these companies are willing to pay for such efficiencies. The findings showed that 58 percent of the respondents said they were willing to pay additional amount for the wire transfers that include the remittance information. On average, the respondents indicated that they would be willing to pay additional $1.67 for payments that include the remittance information. According to the estimate of the TCH and Federal Reserve Banks, if only 2 percent of the corporate check volume moved to the wire transfer, the wire volume will increase by 47 percent. It will be a remarkable increase of the wire transfer business, if it will possibly happen. Most corporates found the check payments quite inefficient and have tended to move to the ACH payment. However, there will be a potential demand for some high-value items to move to the wire transfer because of the speed and security of the CHIPS and Fedwire. To add a capability of remittance information is a way to meet such a potential needs and to migrate the high-value payments from the check payments to the wire transfer. Being a project for the improvement of convenience for the participants of the wire transfer, this is a business decision under a competitive environment between the ACH and wire transfer.

ACH Outline of ACH Role of ACH The “Automated Clearing House” (ACH) is a retail payment system in the US. The ACH payments include the payroll, social security benefits, tax refunds, and bill payments for utilities, mail order and internet shopping, and business-to-business payment. While the ACH handles huge volume of payment orders, the average amount of which is

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rather small. More than 15,000 depository financial institutions originate and received 15.2 billion ACH payments in 2009. The average amount of ACH payment was about $2,000. The ACH services include both a credit transfer service and a debit transfer service. There are two operators of the ACH in the US: the Federal Reserve Banks (hereinafter referred to as the FedACH) and “The Clearing House Payments Company LLC” (hereinafter TCH Payments Co.). The FedACH is operated by the central bank and the TCH Payments Co. is a private-sector operator. The ACH is operated according to the operating rules established by the “National Automated Clearing House Association” (NACHA). The NACHA represents nearly 11,000 financial institutions through 18 regional payments associations and direct membership. The NACHA is a non-profit association, established in 1974. The NACHA provides the rules and guidelines, educational service, and member communications. It also develops the new payment applications and provides the marketing and promotion activities. The settlement of ACH payments is executed on the next morning of the day that the ACH received the payment files, which means the ACH is the Next-day settlement system (see Chapter 2 for more detail).

History of ACH The concept of the ACH came up in the late 1960s, when it seemed that the increasing volume of the paper checks used by businesses and consumers will exceed the processing capacity of financial institutions. The first ACH in the US was the “Calwestern Automated Clearing House Association” (CACHA) in California. The CACHA started operation in October 1972, using the computer processing service of the Federal Reserve Bank of San Francisco. Following the CACHA, many local ACH associations began ACH service with

Payment Systems in US

the help of local Federal Reserve Bank which provided the facilities, equipment, and staff to operate an ACH. At this stage, the ACH was the local service among the depository institutions in a specific area. In 1974, the NACHA was formed by several regional ACH associations to develop the uniform rules and standard formats to establish the nationwide clearing network of ACH payments. At an early stage, the ACH system relied on the magnetic tapes and diskettes to exchange the ACH files which contained a number of payments. This file exchange method required the physical transport of the tapes and diskettes between the participants and ACH. By the end of 1978, arrangements were made between the New York Clearing House (NYCH, became the TCH later), the NACHA and the Federal Reserve Banks to implement an inter-regional exchange system. Then, the ACH became the nationwide network. In 1994, the Federal Reserve mandated that all ACH payment files should be deposited electronically and all output files will be delivered to the participants electronically. That is to say, all depository institutions dealing with the Federal Reserve directly were required to have an electronic link through the computers and networks. Until 1996, the Federal Reserve integrated the local ACH services into a nationwide service and the computer center was also consolidated into a single center.

Operators of ACH As mentioned above, there are two ACH operators in the US.

Federal Reserve Banks It is a distinctive characteristic of the US that central bank is directly and deeply involved in the retail payment. In other industrial countries,

central bank tends to leave the retail payment area to the private sector and is not directly involved. There was a historical background behind it. When the establishment of the ACH was discussed in the industry in the late 1960s, the Federal Reserve participated in the early discussions and offered to provide the computer systems and staff necessary for the ACH service. Right from the start, the Federal Reserve had a deep involvement in the ACH operations. The ACH service of the Federal Reserve is referred to as the “FedACH.” All the government payment is made through the FedACH. The FedACH handles approximately 70% of the ACH payments in the US.

TCH Payments Co. “The Clearing House Payments Company” (TCH Payments Co.) is a sole private-sector operator of the ACH6. It became the first private-sector ACH operator in 1975. At this time, it was called the “New York Automated Clearing House” (NYACH) as an affiliated business of the New York Clearing House (NYCH) which handled the check clearing. In March 1998, the “Small Value Payments Company LLC” (SVPCo) was established to govern and operate small value payment. The SVPCo carried on the electronic check presentment and the ACH operation. In April 1999, the NYACH changed its name to the “Electronic Payments Network” (EPN). It was a step to reconstitute as a national ACH from the local ACH in NY area. In October 2000, the “Electronic Payments Network LLC” (EPN LLC) was established as a subsidiary of the SVPCo. In July 2004, “The Clearing House Payments Company LLC” (TCH Payments Co.) was established, and the EPN LLC was merged into the Company with other four affiliated company. Through this streamlining process, the TCH Payments Co. provides the ACH service, along

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with the CHIPS service, check clearing, and electronic check clearing.

Scheme of ACH The ACH executes the batch-processing of files which contains payment messages. As the files are processed by the store and forward method, a payment messages is not processed individually, unlike the Large-value payment system. This section gives an explanation about the scheme of ACH in the case of the credit transfer (see Figure 11). 1. The Originator and Receiver should make an agreement beforehand that payments will be made through the ACH. 2. The Originator sends the payment orders in an electronic file to the “Originating Depository Financial Institution” (ODFI). 3. The ODFI puts together the files from a number of customers as the “ACH payment file” and sends the file to the ACH. The closing time of the FedACH is 14:15.

Figure 11. Scheme of the ACH (credit transfer)

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4. The ACH sorts out the payment orders to create a separate “output file” for each depository institution, and distributes the file to each “Receiving Depository Financial Institution” (RDFI). The FedACH sends the file to each participant four times a day. 5. The RDFI receives the payment file from the ACH, makes credit processing to the Receiver’s account, and makes a credit advice to the Receiver.

Transaction Volumes of ACH Growth Rate of ACH Traffic From 1990s, the transaction volumes of the ACH kept the strong growth of more than 10% consistently. It was followed by the sharp decline during 2008-2009 (see Figure 12). The volume of the network ACH transaction (excluding the on-us volumes) in 2009 was 15.3 billion, which was about 2.5 times of 2001. Some of these transaction volumes were considered to be shifted from the paper check. Reflecting such a conversion, the paper check volume

Payment Systems in US

Figure 12. ACH transaction volume (Source: NACHA)

has declined significantly. According to the survey of the Federal Reserve, the number of checks paid in the US has fallen from 42 billion in 2001 to 37 billion in 2003, and to 30 billion in 2006. It is worth mentioning that the growth rate of ACH transactions in 2009 was only 2%, which was the lowest in the last 20 years. It was because of the overall slump of the US economy due to the global financial crisis.

Debit and Credit Transfers in ACH The credit transfers accounted for 36% of ACH volume, while the debit transfer volumes made up 64% in 2009. The proportion of debit transfers

Figure 13. Commercial and government payments in ACH (Volumes in 2009) (Source: NACHA)

Commercial and Government Payments in ACH The commercial sector (companies and individuals) uses the ACH for the deposit of payroll, payment for utility bill, loan payment, and so on. The federal government also uses the ACH for the social security benefits, pensions and payments for public works. The government payments made up 7.9% of the ACH network volume in 2009 (see Figure 13). The rests, 92.1% of the volume are the commercial payments.

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has been increasing from 41 percent in 2001 (See Figure 14).

Figure 14. Debit and credit transfers in ACH (Volumes in 2001 and 2009) (Source: NACHA)

On-Us Payments in ACH When both the originator and beneficiary have the accounts at the same deposit institution, the ACH-formatted payments remain within a single institution and will not be sent to the ACH. This kind of payments are known as the “on-us payments” and sometimes called the “off-network payments.” The on-us payments are executed as the internal settlements in a bank, and accounted for 18.7 percent of all the ACH volume in 2009.

Concentration of ACH Usage The top 50 originating institutions accounted for 88.3 percent of all the network ACH payments in 2009. The top five originating institutions accounted for 61.9 percent of all the ACH payments (see Figure 15). On the receiving side, the top 50 banks made up 55.6 percent of payment volume. And the top 5 receiving institutions accounted for 31.1 percent Figure 15. Concentration of ACH usage (Originating Institution, in 2009) (Source: NACHA)

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of the volume. The degree of concentration was much higher in the originating side. Both on the originating and receiving side, the big banks have a sizable proportion, which suggests the concentrated account structure of the companies and individuals.

Basic Services of ACH The basic services of the ACH are referred to as the “Direct Deposit” and the “Direct Payment.” The Direct Deposit is a credit transfer service. And the Direct Payment is a debit transfer service, especially for the recurring bill payment, such as the telephone and utilities.

Direct Deposit The “Direct Deposit” is a credit transfer service which allows a company to credit the accounts of its employees, customers, and beneficiaries with funds due to them. Direct Deposit is often used for the deposit of payroll. It is also used to distribute funds of the healthcare, benefits and pensions. In addition, a consumer can make bill payments for the mail order shopping or internet shopping through the Direct Deposit.

Direct Payment The “Direct Payment” is a debit transfer service which is typically used for a recurring bill payment. At the outset, a consumer should give the originating depository institution or Originator (e.g., mobile-phone company) an authorization to debit his/her account on a regular basis. Then, the funds are debited from the consumer’s account automatically at a certain time (e.g., every month) according to the authorization. Typical payments of the Direct Debit include the utility payments, mortgage/rent, automobile loan payments, charitable contributions, insurance premiums, membership dues, tuition payments, and nonprofit organization fees. It is the most

convenient way for the Originator to collect funds from a significant number of customers.

Settlement Procedures of ACH Transactions The interbank settlement regarding the ACH transaction is made among the accounts at the Federal Reserve Banks. Unlike the CHIPS and Fedwire, the ACH payments are processed on Day 1, but the settlements for those payments are executed on Day 2 or Day 3.

Settlement of FedACH Transactions The settlements of the FedACH transactions are carried out, as described below.

(i) Settlement of FedACH Credit As for the “FedACH Credit,” an ACH credit file is sent from the Originator to the ODFI. Then, the ODFI processes the file and sends the transactions to the Federal Reserve Bank. The Federal Reserve Bank delivers the files containing the ACH credit payments to the RDFIs. Those processing of the ACH payments are made on the day that the credit file is sent to the ODFI. This day is called the “Day 1” or “Process Day.” For the settlement of these payments, the Federal Reserve Bank debit the ODFI’s account, and credit the RDFI’s account. This settlement is made on the following business day of the Process Day, the “Day2” or the next day of Day 2, the “Day 3.” They are called the “Settlement Day” (see Figure 16). The credit and debit processing to the participant’s accounts are made at 8:30 a.m. eastern time of the Settlement Day. These fund transfers become final when posted to the participant’s accounts. For the smooth settlements, the participants are required to prefund for own ACH credit transactions. This means that the ODFI are required to have the adequate liquidity in its account at the

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Figure 16. Settlement of FedACH credit (Source: Federal Reserve Financial Services, 2001)

Federal Reserve Bank before 8:30 a.m. of the Settlement Day. This is called the “Settlement-day Finality” for the ACH credit transfers, which was introduced in 2001.

(ii) Settlement of FedACH Debit Regarding the “FedACH Debit,” an ACH debit file is sent from the Originator to the ODFI. Then, the ODFI processes the file and sends the transactions to the Federal Reserve Bank. The Federal Reserve Bank delivers the ACH debit payments to the RDFIs. Those processing of payments are made on Day 1 (or the Process Day). On Day 2 (or the Settlement Day), the Federal Reserve Bank debits the RDFI’s account, and credits the ODFI’s account. Then, the RDFI debit the Receiver’s account, and the ODFI credits the Originator’s account (see Figure 17). As for the settlement of debit transfer, the processing to the participant’s account is made at 11:00 a.m. eastern time of Settlement Day. But these fund transfers do not have the finality until the following day or Day 3. This is because the debit transactions may be subject to the return,

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mainly due to insufficient funds at Receiver’s account.

Settlement of TCH’s ACH Transactions As for the ACH service of the TCH Payments Co., the settlements are made through the National Settlement Service (NSS) of the Fedwire. The TCH Payments Co. submits the settlement file to the Federal Reserve Bank as a Settlement Agent. The file contains the net positions of the participants as a result of the ACH credit and debit transactions. And the net positions are settled among the participant’s settlement accounts at the Federal Reserve Banks, utilizing the NSS function. The credit and debit processing of the net positions become final when posted to the settlement account.

Settlement of Inter-Operator ACH Transactions When either an ODFI or a RDFI belongs to the FedACH network, and the other belongs to the

Payment Systems in US

Figure 17. Settlement of FedACH debit (Source: Federal Reserve Financial Services, 2001)

TCH’s network, the payments file will be exchanged and the settlement is executed between the Federal Reserve Bank and TCH Payments Co. This kind of transaction is known as the “InterOperator ACH transaction.”

information specific to cross-border payments, including the FX related data, destination country, and currency codes.

FedGlobal ACH

The FedGlobal ACH allows some options in the foreign exchange and the delivery of payment.

Outline of FedGlobal ACH The FedACH provide the cross-border payment service, which is called the “FedGlobal ACH.” With this service, a customer can make credit payments to more than 35 countries and debit payments from Canada. To build this scheme, the Federal Reserve Bank of Atlanta (Atlanta Fed) serves as a “Gateway Operator” (GO) on the US side. The Atlanta Fed appoints the “Foreign Gateway Operator” (FGO) in each country, and closely works with the FGO to make cross-border payments. The cross-border payments are formatted using the NACHA “Standard Entry Class” (SEC) code of “International ACH Transaction” (IAT). The header record of payment message contains the

Options in FedGlobal ACH

Foreign Exchange Options The FedGlobal ACH allows three options for currency value exchange: (i) the “Fixed-to-Variable” (FV) option, (ii) the “Fixed-to-Fixed” (FF) option and (iii) the “F3X” option.

(i) FV Option In the “FV option,” the USD amounts are converted to a variable amount of destination currency based on a competitive foreign exchange rate provided as part of the payment flow. The settlements are made in the USD between the participating US financial institutions and the Federal Reserve Banks.

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(ii) FF Option

(i) A2A Option

In the “FF option,” the payments are both transferred and received in the USD to the USD-denominated accounts (the “USD to USD” option). This option is applied to the countries that allow the banks to provide the USD accounts to the customers. The settlements are made in the USD between the participating US financial institutions and the Federal Reserve Banks.

In the “A2A option,” the funds are deposited to the bank account of the receiver. This is a standard option of payment delivery.

(iii) F3X Option The “F3X” is the option where payments are both transferred and received in foreign currency (the “foreign currency to foreign currency” option). The foreign exchange rate and settlement is managed and processed by the participating US financial institutions and the respective FGO via their foreign correspondent banks. The settlements are conducted outside of the ACH network through a foreign correspondent.

Delivery Options The FedGlobal ACH also offers the payment delivery options in the selected countries: the “Account-to-Account” (A2A) option and the “Account-to-Receiver” (A2R) option.

(ii) A2R Option In the “A2R option,” the receiver can get paid in cash at either a financial institution or at a trusted third-party provider. When this option is used, the supplemental information is required in the payment message to identify the receiver properly. The additional information to identify the receiver includes: (i) unique payment password, (ii) Receiver’s date of birth, and (iii) Receiver’s cell phone number.

Merit of FedGlobal ACH The Federal Reserve explains the background of the FedGlobal ACH that this service is to keep pace with customers’ demand for the low-cost and efficient cross-border payments. Traditionally, the cross-border payments have been handled by private banks through the correspondent banking network. But there have been complaints from the customers that the crossborder payments are too expensive and take too

Table 11. Options of FedGlobal ACH (Source: Federal Reserve Financial Services) FX Options North America

Delivery Options

FF

FV

F3X

A2A

A2R

Canada

○

○

○

○

×

Mexico

×

○

○

○

○

Central & South America

Panama

○

×

×

○

×

Other 12 countries1

○

○

×

×

○

Europe

22 countries2

×

○

○

○

×

○:Available, ×:Not Available 1. Argentina, Bolivia, Brazil, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Nicaragua, Peru, Uruguay 2. Austria, Belgium, Cyprus, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Malta, Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, Switzerland, United Kingdom

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long. One of the reasons of the high-cost and the delay is that the correspondent banking is based on the bilateral relationship and may require different procedure for each transaction. The justification is that the Federal Reserve Banks tries to provide more low-cost and efficient service for the cross-border payments by standardizing and streamlining the procedures. With this service, the customers in the US can send payments to overseas with lower cost and in a shorter time frame. The FedGlobal ACH will deliver the funds to the foreign receiving bank in one day or two.

Financial EDI on ACH Network In addition to the basic services mentioned above, the ACH operators are actively promoting the “Financial EDI” (Electronic Data Interchange). The Financial EDI is a scheme that allows the originator to send the remittance information with a payment order to the receiver of the payments. This scheme is mainly used between the buyer and the seller of business transaction. With Financial EDI, the seller company (the receiver

of the fund) can make reconciliation on electronic basis without the paper documents.

Benefits of Financial EDI Under the circumstances without Financial EDI, the buyer company (the payer) sends the payment order to its bank, and delivers the remittance advice to the seller company (the payee) by mail or through another network than the payment system, e.g., the value-added network. For this reason, the seller company receives the credit advice and the remittance information separately, with the paper documents or electronic file. These separations lead to manual processing of reconciliation at the seller company, which is costly and timeconsuming (see Figure 18). By contrast, if the buyer and seller use the Financial EDI, the seller company is able to receive the remittance information along with the credit advice from its bank. Getting the remittance information electronically, the seller company can improve the reconciliation process substantially and reduce the cost (see Figure 19). Although the ultimate beneficiary of Financial EDI is the corporate sector, the banking sector is

Figure 18. Credit advice and remittance advice (traditional way)

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Figure 19. Credit advice and remittance information (with financial EDI)

able to improve the customer service and make service fee revenue.

EDI Format on ACH Network Two kinds of formats can be used for the Financial EDI on the ACH network. One is the “CCD+” (Corporate Credit or Debit +) and the other is the “CTX” (Corporate Trade Exchange). The CCD+ can carry only one addendum record with 80 characters maximum. The “addendum

record” is a file which can contain remittance information. The normal “CCD” format cannot carry any addendum. On the other hand, the CTX can carry up to 9,999 addenda records with up to 80 characters each, which means almost 800,000 of total characters, can be added per payment. That means the enormous volume of data can be transferred on the ACH network.

Figure 20. Financial EDI on ACH Network (Source: the NACHA)

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Usage of Financial EDI on ACH Network The transactions of Financial EDI are increasing steadily year by year. In 2008, the payments with addenda records were 311 million, 16 percent increase from the previous year. The number of addenda records was 1,004 million in 2008, which was 13 percent increase over the previous year. The average number of addenda records per CTX was approximately 15, which was much less than the maximum number of records to be attached.

The Clearing House http://www.theclearinghouse. org/home.php

ENDNOTES 1



2



3



4



5



6



REFERENCES CHIPS http://www.chips.org/ Federal Reserve Bank Services http://www.frbservices.org/ Federal Reserve Financial Services. (2001, April). Getting Started with FedACH Origination. Federal Reserve Financial Services. (2006, September). Federal Reserve Banks Operating Circular No.6. Federal Reserve Financial Services. (2009, March). Fedwire Securities Service Guide. NACHA http://www.nacha.org/ Nakajima, M., & Shukuwa, J. (2005). All about Payment Systems (2nd ed.). Toyo Keizai Inc.in Japanese

The finality of funds transfer on the Fedwire is prescribed in Regulation J of the Federal Reserve. The five affiliated companies merged were as follows: the Small Value Payments Company (SVPCo), Clearing House Interbank Payments Company (CHIPCo), Electronic Payments Network (EPN), Electronic Clearing Services (ECS), and National Check Exchange (NCE). Usually, around 500-750 payment messages may remain unreleased (TCH, 2007). Cover payment information is also included in Sequence B. “Business-to-Business Wire Transfer Payments: Customer Preferences and Opportunities for Financial Institutions,” October 2006, The Clearing House and the Federal Reserve Banks. There used to be two other private-sector ACH operators: the “American Clearing House Association” (ACHA) and “Visa ACH.” Due to the competitive pressure from the EPN and FedACH, the ACHA ceased operation in October 2002 and Visa ACH left the network in March 2003. Those cessations of business made the TCH Payments Co. a sole private-sector ACH operator.

The Clearing House. (2007, November). Clearing House Interbank Payment System (CHIPS): SelfAssessment of Compliance with Core Principles for Systemically Important Payment Systems.

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Chapter 10

Payment Systems in EU

ABSTRACT This chapter provides details of the payment systems in the EU. The landscape of payment systems in the EU was changed drastically by the introduction of the single currency “euro” in January 1999. As for the large-value payment system, the “TARGET” was introduced in 1999, which was a distributed system linking the national RTGS systems with the interlinking network. The “TARGET2” was introduced in 2007-2008 instead of the first-generation TARGET. The TARGET2 is a centralized system with a single platform. The “EURO1” is another payment system used for the large value transfer of funds in euro. The EURO1 is a private payment system operated by the EBA CLEARING. In preparation for introducing the euro, the evolutionary progress of payment systems has been observed in the EU since the mid-1990s. The evolutions include the changeover from the RTGS System to the Hybrid System and also to the Integrated System. These sophisticated systems included the “RTGSplus” in Germany, the “PNS” and the “PIS” in France, and the “new BIREL” in Italy. The settlement mechanisms of those advanced payment systems are also discussed in greater detail. It can be concluded that these evolutions of payment systems in each country led to the successful development of the TARGET2. The reforms of retail payment systems were also sought in response to the introduction of the euro. However, the retail payment systems in the EU are still fragmented, which means that each country has its own retail payment system. In order to overcome such a situation, the European Central Bank (ECB) and European Commission have promoted the project of “Single Euro Payments Area” (SEPA). The aim and situation of the SEPA project is described in detail. The cross-border retail payment systems, i.e. the “STEP1” and “STEP2,” are also discussed in this chapter. DOI: 10.4018/978-1-61520-645-2.ch010

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Payment Systems in EU

INTRODUCTION In January 1999, the Economic and Monetary Union (EMU) started and the single currency “euro” was introduced. And the “euro area,” the single currency area, was born with the introduction of the European single currency. Before the EMU, the payments in German Mark were settled through the German payment system, and the payments in French Franc were settled in the French payment system. In this way, there had been a “one to one relationship” between the currency and the payment system. However, the legacy currencies (Mark, Franc, Lira, and the rest) were integrated into the euro, and the payment systems for each national currency were converted to the payment systems for euro. That brought about the co-existence situation of the multiple euro payment systems in a single currency zone. It is rather common that different kind of payment systems co-exist with different purposes in a country, for instance, the RTGS system and DTNS system, and the large-value payment system and retail payment system. But it is quite exceptional that the multiple payment systems with the same nature co-exist in a single currency area. Just after the introduction of the euro, there were fifteen RTGS systems and four DTNS systems as large-value payment systems. In addition to that, there were more than twenty retail payment systems in the euro area. The European Central Bank (ECB) has been trying to improve such a decentralized and distributed situation.

FROM TARGET TO TARGET2 TARGET Nature of TARGET When the euro was introduced in January 1999, the TARGET started its operation for the euro

settlement in the EU. The “TARGET” stands for Trans-European Automated Real-time Gross settlement Express Transfer system. The TARGET was composed of fifteen RTGS systems in the EU countries, intended to make the euro settlement across the EU area. The basic concept was that the TARGET provided the euro settlement service for the cross-border payments as well as the domestic payments. As with the RTGS system in each country, the TARGET was the large-value payment system mainly for the interbank fund transactions, FX transactions, and securities transactions. The TARGET was intended to integrate the financial markets in the euro area through the smooth settlements of the euro. Besides, it was aimed to become an infrastructure for the European Central Bank (ECB) to pursue the monetary policy in an efficient manner. It is worth mentioning that the TARGET was the first “cross-border RTGS system” in the world, which provided the real-time and gross settlement service across the borders. The ECB laid out three main objectives to develop TARGET as follows; 1. To provide a safe and reliable mechanism for the settlement of euro payments on an RTGS basis; 2. To increase the efficiency of inter-Member State payments within the euro area; 3. To serve the needs of the monetary policy of the Eurosystem. After its start of operation in January 1999, the TARGET became the main payment system which handled the majority of euro payments. In 2008, the share of the TARGET in total large-value payment system traffic in euro was 90% in value terms and 59% in volume terms1. The operation policy of the TARGET was decided by the Governing Council of the ECB. The operating rule was given as the TARGET Guideline.

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The TARGET was migrated over to its second generation, the “TARGET2” during 2007- 2008 (to be discussed below).

System Structure of TARGET The TARGET was composed of (1) the 15 RTGS systems in the EU, (2) Interlinking Network, which was the communication network linking between the RTGS systems, and (3) the ECB Payment Mechanism (EPM), which was the application of the whole system (see Figure 1). In fact, the most distinctive feature of the TARGET was to be a decentralized payment system, instead of the centralized system in which all the processing were executed in the centralized computer system (see Figure 2). Therefore, the cross-border payments were exchanged bilaterally between the involved two central banks. Each RTGS system processed the cross-border payments individually, instead of concentrating all the payments to the ECB. And the settlement accounts of the participants (i.e., financial institutions) were placed in and managed by the home central banks. Figure 1. System Configuration of TARGET

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The reason why the TARGET took such a system configuration was to minimize the system development cost by building only the common parts, and to pay due respect to the national circumstances in each country. The SWIFTNet, the network of SWIFT, was adopted as an Interlinking Network.

Components of TARGET Table 1 shows the components of the TARGET, which were the RTGS systems in the EU countries. As of the end of 2006, there were 15 RTGS systems connected to the TARGET system, of which 12 systems were from the “in-countries” that have adopted the euro. And three systems were from the “out-countries,” which were Denmark, Sweden and the UK.

Settlement at TARGET The TARGET was the gross settlement system and payments are processed individually without netting. Besides, the TARGET was a real-time settlement system and the processing of debit and

Payment Systems in EU

Figure 2. Decentralized Structure of TARGET

Table 1. Components of TARGET Country

RTGS System

Vo l u m e S h a re (2006, %)

Austria

ARTIS

1.5

Belgium

ELLIPS

3.6

Denmark

KRONOS

0.6

Finland

BOF-RTGS

0.7

France

TBF

25.3

Germany

RTGS

Greece

HERMES

1.3

Ireland

IRIS

1.2

plus

28.3

Italy

BI-REL

7.1

Luxembourg

LIPS-Gross

1.5

Netherlands

TOP

4.7

Portugal

SPGT

0.6

Spain

SLBE

14.2

Sweden

Euro RIX

0.3

UK

CHAPS Euro

8.1

Source: ECB (2008c)

credit of the accounts were executed in nearly real-time2, and the settlements became final when processed.

When a sending amount was debited from the sending bank’s account at the sending central bank, the same amount was credit to the “Interlinking Account.” At this time, the debit processing became irrevocable. At the receiving central bank, the sending amount was debited from the Interlinking Account and credited to the receiving bank’s account. At this point of credit processing, the settlement became final. When the credit processing of a payment was completed at the receiving central bank, an acknowledgement was sent to the sending central bank.

Payments through TARGET The Eurosystem comprises the ECB and the National Central Banks (NCBs) of “in- countries.” When the Eurosystem executed the operation for monetary and credit control, the payment for the monetary operation should be made through the TARGET. Other large-value payments processed by the TARGET included the payments for the foreign exchange transactions, money market transactions and securities transactions. Although the TARGET was built mainly for the large-value payment, there was no limit for

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the minimum value3. Therefore, the retail payments were also possible to be settled through the TARGET. As there were no limits for the type of transactions, the TARGET could handle customer payments as well as interbank payments. The TARGET was the payment system for the credit transfer, but not for the debit transfer.

TARGET Volume The TARGET handled the huge volumes and values of the euro payments, and was the largest payment systems in the world, along with the Fedwire in the US. In 2008, the average daily volume was 370 thousand transactions. Of which, 270 thousand transactions were domestic traffic, in other word, the “Intra-Member state transactions.” The rest of 100 thousand transaction, or 27% of daily transaction was the cross-border traffic, which is called the “Inter-Member State transactions.” As for the cross-border traffic, the customer payment (57%) is larger than the interbank payment (42%) in volume. In terms of settlement value, the daily average value of the TARGET was €2,667 billion in 2008. This means that the TARGET settled the value which is equivalent of the annual GDP of the whole euro area in only 3.5 days. The domestic traffic

accounted for 68% of the daily average value, while the cross-border traffic was 32%. As for the cross-border traffic, 93% was the interbank payment and the rest 7% was the customer payment in value (see Table 2). This suggests the fact that the average amount per payment is huge in the cross-border interbank payment.

TARGET Participants The TARGET is open to the banking community in the euro area. More specifically, the credit institutions established in the European Economic Area (EEA4) are allowed to become the participants of the TARGET. At the end of 2008, there were 747 direct participants and 3,806 indirect participants. In addition to that, 11,031 institutions worldwide were accessible through the TARGET with the addressable BICs. These institutions were called the “Correspondent.” To add the number of branches of the direct and indirect participants to these numbers, 55,867 credit institutions around the world are addressable via the TARGET. Surprisingly, this total number is equivalent to around 60% of banks connected to the SWIFTNet worldwide. Of them, two-thirds are the credit institutions from the Member States of the EU and one-third are from the other countries worldwide.

Table 2. Volume and Value of TARGET (in 2008)

TARGET overall Domestic Cross-border Interbank Customer

Volume (thousand)

Value (EUR billion)

370 (100.0)

2.667 (100.0)

270 (73.0)

1,823 (68.3)

100 (27.0)

845 (31.7)

43 < 42.5>

786 <93.0>

57 < 57.5>

59 < 7.0>

Note1: Domestic traffic is payment of Intra-Member state. Cross-border traffic is payment of Inter-Member State. Note2: Figures in ( ) are percentage in TARGET overall. Figures in < > are percentage in Cross-border traffic. Source: ECB (2009)

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The Bank Identifier Code (BIC) and routing information of participants and addressable institutions via the TARGET were listed in the “TARGET Directory.”

Message Format on TARGET The domestic formats of each RTGS system were used in the first-generation TARGET. Therefore, each participant sent the payment message using the domestic format to the RTGS system of its own country. When the payment message was transferred from the sending central bank to the Interlinking System, the domestic format was converted to the Interlinking Format, namely the SWIFT format. In a similar way, when the payment message was transferred from the Interlinking System to the receiving RTGS system, the message was converted from the SWIFT format to the domestic format of the receiving country. Thus the sending and receiving banks could send and receive the message in a domestic format without being bothered with formatting.

Operating Hours of TARGET The operating hours of the TARGET was 11 hours; from 7:00 a.m. to 6:00 p.m., Central European Time (CET). The deadline for the customer payments was 5:00 p.m., and one hour between 5:00 p.m. and 6:00 p.m. was the time frame only for the interbank payments.

Intraday Liquidity in TARGET As the TARGET was the RTGS system which required large liquidity for settlements, the participants in the TARGET were allowed to get intraday liquidity from each central bank through the collateralized overdraft or the intraday repo transaction. This intraday liquidity was free of charge and unlimited within the range of collateral. Three countries-Denmark, Sweden and the UK-opted out from the EMU. In other words, these

countries did not introduce the euro. However, the ECB admitted that the central banks of these three “out-countries” could provide the intraday liquidity in euro to the credit institutions in each country. The intraday liquidity of the out-country’s central bank was guaranteed by the euro deposit that each central bank held at the ECB. This scheme was admitted as a “very specific exception” of the basic rule that the credit of euro should be made only by the central banks of the euro area.

TARGET2 Background of TARGET2 Project Shortcomings of TARGET From the start of operation in January 1999, the first-generation TARGET operated successfully over a several years. The TARGET has met all its main objectives: it supported the implementation of the single monetary policy and it handled the vast traffics of euro both at the national and cross-border level. In spite of these considerable successes, it became apparent that the decentralized structure of the TARGET had some limitations and shortcomings. First, under the decentralized structure, each central bank should make respective investments on totally fragmented IT infrastructures, and operate its own system separately. It was far from the ideal situation and resulted in the highlyinefficient situation as a whole. Second, the service level and fee structure differed from one RTGS system to another. More harmonized and enhanced services with a single fee structure were increasingly required. And finally, the EU enlargements were considered to worsen such a situation. In May 2004, ten courtiers in Central and Eastern Europe were decided to join the EU, which meant the components of the TARGET would increase to 25 in the

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future. In other words, about 25 RTGS systems will connect to the TARGET, if the TARGET will keep the decentralized system configuration. To address the challenge, the Eurosystem started to consider redesigning the system configuration of the TARGET.

Long-Term Strategy of TARGET In October 2002, the Governing Council of the ECB published “the Long-term Evolution of TARGET,” which showed the main principles and the basic structures of the next-generation TARGET. At this stage, the Governing Council advocated that the second-generation TARGET would continue to be a multiple-platform system. The “Single Shared Platform” was proposed, but the use of the Platform was on a voluntary basis, and the national platforms would be allowed to use if some NCBs wanted to continue to use their own systems. In December 2002, the ECB published the consultation paper, “TARGET2: Principles and Structure.” In this document, the “same service, same price principle” was proposed as follows: 1. All TARGET components should provide the “core service.” 2. Those services should be offered at a “single price.” 3. The single price will be based on a most efficient RTGS system which has the lowest average cost per transaction. 4. By the end of four-year period after the start of TARGET2 operations, the platforms which do not comply with this requirement will have to be closed.

Proposal of Single Shared Platform In July 2003, three Eurosystem central banks-the Banca d’Italia, the Banque de France and the Deutsche Bundesbank-jointly made a proposal to develop the “Single Shared Platform” (SSP) for the

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Eurosystem. These three central banks proposed to develop the SSP and operate it on behalf of the Eurosystem. It was regarded as an “outsourcing” within a European central banking society. After a lengthy discussion, all the NCBs finally agreed to use the SSP provided by the three central banks. This agreement changed the concept of TARGET2 from a multiple-platform system to a single platform system.

Nature of TARGET2 The second-generation TARGET is called the “TARGET2.” The most distinctive feature of the TARGET2 is a centralized system with a single platform, changing from the decentralized configuration of the first-generation TARGET. It is worth mentioning that it is not only a system concentration project but also a project for function enhancement. Under the TARGET circumstances, each national component was the “pure RTGS system” with only RTGS function, but the TARGET2 adopted some advanced features which were used in German, French and Italian payment systems. By the changeover to the TARGET2, the enhanced functionalities used only in a few countries were extended to the whole euro area. These enhanced functions will be described later in this chapter in more detail.

System Structure of TARGET2 Modular Approach The TARGET2 adopts a “modular approach” and the SSP (Single Shared Platform) are made of several modules. Each module is designed for a specific service and closely related to each other. Some modules are mandatory to use and the others are optional. The mandatory modules includes the Payments Module (PM), the Information and Control Module (ICM), the Contingency Module (CM) and the Static Data (SD) Module.

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Backup System

Of them, the most important module is the PM which is in charge of processing of payments (see Table 3). The optional modules include the Home Accounting Module (HAM), the Standing Facilities (SF) Module, and the Reserve Management (RM) Module. The national central banks can use these modules if they want to use them. And if the central banks do not want to use them, they may provide the respective services via the proprietary applications in their own domestic systems.

To secure the high level of business contingency, the TARGET2 adopts the “multi-region/multisite” architecture. More concretely, there are computer centers in two regions and two distinct sites in each region. The main and backup function rotates periodically between the two regions. That is to foster the experienced staff in both regions.

Participation Framework of TARGET2

Network

There are four ways to participate in the TARGET2. These include: (i) Direct participation, (ii) Indirect participation, (iii) Addressable BICs, and (iv) Multi-addressee access (see Table 4).

The SWIFTNet is used as a network which connecting between the TARGET2 and its participants. Several SWIFT services, including the FIN, InterAct, FileAct and Browse, are used to send, monitor and manage the payment messages in the TARGET2.

Direct Participation The “Direct participants” hold a “RTGS account” on the TARGET2. They can submit and receive payments directly to/from the system. They can

Table 3. Modular Approach of TARGET2 Mandatory

Optional

Payments Module (PM) Information and Control Module (ICM) Contingency Module (CM) Static Data (SD) Module

Home Accounting Module(HAM) Standing Facilities (SF) Module, Reserve Management (RM) Module

Source: ECB (2005)

Table 4. TARGET2 Participation Framework Account on TARGET2

Way to submit/receive payments

Settlement of payments

Subject to the system rules

Listed in TARGET2 directory

Direct participation

Yes

Directly

Own account

Yes

Yes

Multi-addressee access

No

Directly

Account of the direct participant

Yes

Yes

Indirect participation

No

Via direct participant

Account of the direct participant

Yes

Yes

Addressable BICs

No

Via direct participant

Account of the direct participant

No

Yes

Source: ECB, modified

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settle directly with the other direct participants. Only the credit institutions established in the European Economic Area (EEA) can become the direct participants.

Indirect Participation The “Indirect participant” does not hold a RTGS account, and payment orders are always sent to/ received from the system via a direct participant which acts on the indirect participant’s behalf. Payments are settled in the direct participant’s account on the TARGET2. Indirect participants are registered in the TARGET2 Directory and are under the responsibility of the direct participants. Only the supervised credit institutions established within the EEA are able to become the indirect participants.

Addressable BICs The “Addressable BICs” are quite similar to the indirect participants in respect that they do not hold a RTGS account, and payment orders are always sent to/received from the system via a direct participant which acts on the indirect participant’s behalf. There are two differences between the Addressable BICs and Indirect participants. First, any financial institution that holds a BIC can become an Addressable BIC, irrespective of its place of establishment. That means that any financial institutions in the world can become the Addressable BICs, once a direct participant of the TARGET2 admits them to provide such a service. As any criteria were not established for the Addressable BICs, the direct participant can decide which institutions should become the Addressable BICs based on a marketing strategy of its own. Second, only the Indirect participants are recognized by the TARGET2 system, and they are protected by the “Settlement Finality Directive” (SFD), which aims to protect the participant of payment systems from the bankruptcy of another

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participant(s) in the system. In sum, the Addressable BICs are not recognized by the system, and not protected by the SFD.

Multi-Addressee Access In the TARGET2 system, the direct participants are able to authorize their branches and other credit institutions in the same group, located in the EEA countries, to channel the payments through the direct participant’s main account without its involvement by submitting/receiving the payments directly to/from the system. The payments are settled on the main account of the direct participant. Only the direct participant has to manage the liquidity as a whole, and the other affiliated banks or branches are not bothered with liquidity management. Accordingly, this scheme offers a direct participant’s affiliated banks or branches greater efficiency on their liquidity management and payment business.

Processing of Payments in TARGET2 Priority of Payment Every payment order can be assigned a specific payment priority; the “normal,” “urgent,” or “highly urgent” (see Table 5). The “Normal payment” is a payment without urgency and processed in the Liquidity-Saving mode. The “Urgent payment” is a payment with some urgency and processed by the RTGS mode. Table 5. Payment Priority in TARGET2 Priority

Intended transactions and features

Highly urgent

Settlement with other payment systems Settlement with a central bank Pay-in/pay-out to/from the CLS Bank

Urgent

Payment with some urgency Processed with gross settlement mode

Normal

Payment without urgency Processed with liquidity saving mode

Source: ECB, modified

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The “Highly urgent payment” is the payment with highest priority, which is used for the settlement with the other payment systems, the settlement with a central bank, or the pay-in/payout to/from CLS Bank. These payments are also processed by the RTGS mode. If some payments with the higher priority remain in the queue, the payments with the lower priority are not processed.

Timed Payment The participants are able to submit a payment order with a “debit time indicator” to assign an execution time. There are two options; the “payment till” option and the “payments from” option. The “payment till” option assigns the deadline of processing of a payment. The “payments from” option assigns the starting time of processing of a payment. These schemes are useful for the time critical payments, such as the payments for CLS Bank.

Postdated Payment The participants are able to submit payments to the TARGET2 system up to five working days in advance. This function is referred to as the “warehouse functionality.” In the first-generation TARGET, the submissions of payments were possible only on the day of the settlement.

Debit Function The TARGET2 provides the direct participants a debit transfer function as well as a credit transfer function. With this function, a participant is able to bring the fund from the account of the other direct participants. However, the usage of debit function is limited to the transfer of funds between the credit institutions. This function is supposed to be used to make an adjustment of liquidity among several banks in a group, or between the head office and the branches

of the same credit institution. The first-generation TARGET did not have the debit function.

Queue Management Until the payments are processed, they are placed in a queue. The TARGET2 provides the several control functions of the queued payments. A participant can: (i) change the priority (e.g., from the normal payment to the urgent payment), (ii) re-ordering (change the order in the queue), (iii) change the settlement time, and (iv) cancel the queued payment.

Liquidity Reservation and Limits Liquidity Reservation Facilities The TARGET2 provides the direct participants the “Reservation Facilities” in order to control liquidity. With these facilities, the direct participants are able to reserve liquidity for the higher priority payments. Liquidity reservation is possible separately for the urgent payments and highly urgent payments. Assume that the total liquidity in an account is 1,000, and the participant reserves 100 for the highly urgent payments and 200 for the urgent payments. Then, the maximum amount of liquidity for the normal payments is 700 because 300 are reserved for the higher priority payments. And the maximum amount of liquidity for the urgent payments is 900. The maximum amount of 1,000 could be used for the highly urgent payments (See Figure 3). Aside from these facilities, a direct participant can “set aside” liquidity (the “Dedicated Liquidity”) for the settlement of the “Ancillary Systems” (ASs). While the Ancillary Systems include the Securities Settlement Systems (SSSs) and the retail payment systems, this function is especially for the night settlement of the SSSs. The Dedicated Liquidity is transferred from the main

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Figure 3. Example of Liquidity Reservation

account to the sub-account of a RTGS account, and reserved for the future settlements of the ASs.

Bilateral Limits and Multilateral Limits The TARGET2 allows the direct participants to set the “Limits” in order to control their liquidity. There are two kinds of Limits, both of them are optional. First, “Bilateral Limits” can be set up. These are the sender limits for the payment amount that a participant is willing to pay vis-à-vis other individual participant, without having received payments first. With these Limits, a participant can control the outflow of liquidity from its account to other participant. In addition, the participant can synchronize the payment flow with the other direct participants, by offsetting the inflow and outflow of payments. The other limits are “Multilateral Limits.” These Limits are also the sender limits, and can be set up to the direct participants for whom a Bilateral Limit has not been set. With these Limits, a direct participant can restrict the use of liquidity to the other participants without the Bilateral Limits.

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Attention is necessary that these limits are valid only for the normal payments. As for the highly urgent payments and urgent payments, the settlements are executed on a gross basis regardless of the presence of these Limits. These Limits should be set on the previous day of the effective date. However, the participants can change the Limits at any time during the operating day and the change has the immediate effect.

RTGS Mode and LiquiditySaving Mode RTGS Mode For the “highly urgent” and “urgent” payments, the system checks the account of sending participants, and if there is a sufficient fund for the payments in the account, the payments are settled immediately. Payments are picked up from the queue according to the “First-In, First-Out” (FIFO) principle. That is, the payments are settled in the chronological order which the system received them. The nature of this processing can be characterized as the settlements in the normal RTGS mode.

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Liquidity-Saving Mode As for the “normal” payments, the system makes two kinds of checks. One is the check whether there is a sufficient fund in an account of the sending participant. Another is the check of Limits and Liquidity Reservations. If-and only if-both conditions are met, the settlement is executed. More specifically, the “offsetting” is made bilaterally or multilaterally within the Bilateral Limits and Multilateral Limits. In an offsetting processing, the inflow payment and the outflow payment are processed simultaneously, and the result comes to reduce/increase the liquidity by the difference of the sending and receiving payments. This process is referred to as the “optimization procedures.” The settlement of the normal payments in the queue is made as effective as possible by several optimization procedures on a continuous basis. The optimization procedures are used in order to save liquidity, and the nature of this settlement can be characterized as the “Liquidity-Saving mode.” The normal payments are executed using the “Bypass FIFO” principle. With this principle, the normal payments can be executed even if other normal payments with large value which arrived earlier are still in the queue, provided that the sufficient funds are available for the payments with smaller value which arrived later.

Liquidity Pooling The TARGET2 provides two types of liquidity pooling functionality. They are to avoid liquidity fragmentation in the TARGET2 and to simplify liquidity management for the banking groups which have more than one account in the TARGET2. In these functions, a participant can assign a “group of accounts,” and the “group of accounts manager” who manages all the accounts in the group as a whole.

One option is the “Virtual Account Option,” and the other is the “Consolidated Information Option.” Both options are mainly for the large banks, which have several branches and subsidiaries in the EU, to manage the liquidity of the group at a single location. As of the end of 2008, there were 66 accounts benefiting from these liquidity pooling functionalities.

Virtual Account Option In the Virtual Account Option, all the accounts belonging to one banking group are consolidated and the “virtual account” is created (see Figure 4). In other words, the available liquidity in all the members’ accounts of the group is consolidated in a single liquidity pool (the “global liquidity”) in the virtual account during the day. Payments are always checked against the global liquidity of the group, but settled on a single account of the sender. Therefore, each account holder can make payments if the global liquidity in the virtual account is sufficient. Accordingly, the balance of each account is allowed to be negative (less than zero). The queues of each bank are also consolidated into a “single payment queue.” By using this option, the multi-country banks can centralize the processing of payments and concentrate the liquidity management function across many branches and subsidiaries in the euro area. At the end of the business day, if some of accounts are negative, the automatic end-of-day procedure is executed and liquidity is transferred from the positive accounts to the negative accounts to cover the overdraft. Only the accounts of the participants in the euro area are allowed to be included in a virtual account.

Consolidated Information Option The Consolidated Information Option offers the information with regard to the liquidity positions

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Figure 4. Management of Global Liquidity Position by Virtual Account

of all the single accounts in the TARGET2 belonging to the same group. This function is “information only” and processing is still carried out exclusively at the individual account level. If a participant wants to concentrate liquidity to one location, the pooling of liquidity should be done by the participant using the direct debit functionality. The Consolidated Information Option is also available to the participants from the non-euroarea countries.

Home Account In the TARGET2 system, all the processing to the account is made by the Payments Module (PM). An account in the TARGET2 is called the “RTGS account.” Nevertheless, each central bank is allowed to maintain so-called additional “Home Accounts” as an option. This scheme is referred to as the “dual account structure.” When the dual account structure is adopted, the payment processing is made against the RTGS account, and the Home Account is mainly used for the reserve deposit. The Home Account concept was adopted because some banks may not be in-

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terested to participate directly in the TARGET2. In spite of nonparticipation, they are subject to the minimum reserve requirement in the home country, and they also require an ability to manage the cash withdrawals directly from the home central bank. The Home Accounting function is achieved either through the “Proprietary Home Accounting” (PHA) on the local systems, or the “Home Accounting Module” (HAM) on the SSP. Of the 21 national central banks that connected to the TARGET2 at the end of 2008, 12 central banks chose to keep the local PHA.

Ancillary System The TARGET2 provides the fund settlement services in central bank money for other payment and settlement systems. These systems are referred to as the “Ancillary Systems” (ASs). The Ancillary Systems include the retail payment systems, the large-value payment systems, the FX systems, the money market systems, the clearing houses (CCP), and the Securities Settlement Systems (SSSs). The main advantage of the TARGET2 for the ancillary systems is to be able to access any ac-

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counts on the TARGET2 system via the standardized interface, the “Ancillary System Interface” (ASI). The TARGET2 offers six standardized interface, of which two are real-time procedures and four are batch procedures. The participants can use a single RTGS account for the settlement of several ancillary systems, even some of them are the cross-border systems. A total of 69 ancillary systems settled in the TARGET2 as of the end of 2008. Of them, 36 were the retail payment systems and clearing houses, and 33 were the Securities Settlement Systems. 57 of these systems settled directly on the TARGET2 system, while the 12 others settled on the systems of national central banks.

Operating Hours As for the “day-time window,” the TARGET2 has the same operating hours as the first-generation TARGET. The TARGET2 is open from 7:00 a.m. to 6:00 p.m. CET on each of its working days. However, the cut-off time for customer payments is set at 5:00 p.m. CET. In addition to the day-time window, the TARGET2 has the “night-time window” as well. The night-time window is available from 7:30 p.m. of the previous day to 6:45 a.m., interrupted by a technical maintenance period of three hours between 10:00 p.m. and 1:00 a.m. CET. The night-time window is to facilitate the night-time settlements of the ancillary systems, especially the Securities Settlement Systems (SSSs), in central bank money with finality. The participants can set aside the “Dedicated Liquidity” in the dedicated sub-account, which is exclusively reserved and used for the DVP settlement with the SSSs. During the night-time window, the liquidity transfers between the main account (of RTGS account) and the dedicated sub-account are possible at any time.

Monitoring Function The “Information and Control Module” (ICM) of the TARGET2 allows the participants to access all the information related to their accounts and the control measures. In particular, the participants may benefit from the “single window access” function of the ICM, which allows the access to any Module of the TARGET2 system. The ICM enables the direct participants to control and manage their liquidity and payment flows. Using the ICM, the participants can observe the incoming and outgoing payments in the queue. Information is not automatically provided, but obtained by the operation of the participants, which is called the “pull mode.” Technically, the participants can access the ICM either through the “Application-to-Application” (A2A) mode or the “User-to-Application” (U2A) mode.

Migration to TARGET2 Country Window Approach As for the migration from the TARGET to TARGET2, the phased migration policy was adopted, instead of the “big bang” migration approach. Three “country windows” were set; in November 2007, February 2008, and May 2008. Each country, including central bank and national banking community, was assigned to one of the three windows. The migration was successfully completed in a six-month period.

Migration of UK Traffic Surprisingly, the Bank of England (BOE) decided not to connect to the TARGET2. And the CHAPS Euro, which was connected to the TARGET, was closed down in May 2008. Some people worried that the euro payments in the UK would be excluded from the TARGET2. Fortunately for the UK banking community, this was not the case.

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There are two ways for the British banks to access the TARGET2. One way is to make an access to the TARGET2 from the branches or subsidiaries in the euro area. Another way is to make a remote participation directly from the head office in London to the central bank in the euro area. The German and Dutch central banks accepted the remote access positively and became the two main access points for the British banks in practice. According to the research of the ECB, the large majority of the British bank’s traffics stay in the TARGET2 by one of two methods, which used to be handled by the CAHPS Euro.

Share of Each Country in TARGET2 Although the TARGET2 is a unified system with a single platform, it is still possible to break down the TARGET2 traffic by country, or national banking communities.

Figure 5. Share of TARGET2 by Value

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Share by Value The TARGET2 traffic is concentrated on the relatively small number of countries. In 2008, only five countries had the share of more than 80% in value. More concretely, Germany, France, Spain, the Netherlands and Italy had high traffic turnover and the total share of these five countries accounted for 82% of the value exchanged (see Figure 5). These figures basically reflected the fundamentals of economic power and the activities of financial market in each country. Additionally, the fact should be taken into account that the British bank’s traffic is now included mainly in Germany and the Netherlands, as mentioned above.

Share by Volume On a volume basis, the concentration of the TARGET2 traffic on a few countries is even more marked. One single country, namely Germany, represented almost half of the volumes exchanged on the TARGET2. The total share of five countries, i.e. Germany, the Netherlands, Italy, Spain

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Figure 6. Share of TARGET2 by Volume

and France, accounted for 86% of the volumes on the TARGET2 (see Figure 6).

Net Settlement Systems In EU Net Settlement Systems when Euro was introduced When the single currency euro was introduced in 1999, there were five net settlement systems for euro, namely the EAF, the EURO1, the PNS, the SEPI and the POPS. Of them, the PNS, the SEPI and the EAF have already ceased operations and the remaining systems are only two; the EURO1 and the POPS. However, as the POPS is a local payment system in Finland with small scale and is planned to be closed by the end of 2011. Therefore, the EURO1 is substantially the only net settlement system in the euro area. Before getting into the detail of the EURO1, the other net settlement systems are explained briefly.

EAF The “Euro Access Frankfurt” (EAF) was a German net settlement system operated by Deutsche Bundesbank, which started its operation in March 1990. It was one of the major net settlement systems of the euro, and the first Hybrid system in the world. The innovation in the EAF had a great impact on the progress of other payment systems. When started its operation, the EAF was a payment system for Deutsche Mark and changed into the payment system for euro in January 1999 when the euro was introduced. At that time, the EAF changed its name from the German name (“Electronischen Abrechnung Frankfurt”) to the English name (“Euro Access Frankfurt”). Originally, the EAF was a typical DesignatedTime Net Settlement (DTNS) system, which executed settlements only once at the end of the day. In March 1996, the EAF changed the settlement process drastically to perform the frequent nettings during the day, which meant the EAF became the world’s first Hybrid system (See Chapter 5 for more detail).

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When the Bundesbank started the operation of the RTGSplus in November 2001, the function of the EAF was integrated into the new system and the EAF was closed down. The RTGSplus was an Integrated system, which had both the RTGS mode and the Liquidity-Saving mode. Of them, the essential part of Liquidity-Saving mode came from the EAF. Thus, it can be described that the TARGET2 was indirectly inherits the functionality of the EAF.

PNS The “Paris Net Settlement” (PNS) was a French net settlement system operated by the Centrale des Règlements Interbancaires (CRI). The shareholders of the CRI were nine private banks and Banque de France. The PNS started operation in February 1997 as a payment system for French Franc, and became the payment system for euro in 1999. As in the case of the EAF, the PNS was originally a DTNS system and changed its settlement process into a Hybrid system in April 1999. At that point, the PNS changed its name from the French name (“Système Net Protégé”) to the English name (“Paris Net Settlement”). At the same time, the CRI built the “Liquidity Bridge” between the PNS and TBF, the French RTGS system. By using this bridge, the participants can transfer liquidity freely between the two payment systems. For this reason, the two systems were collectively called the “Paris Integrated System” (PIS) as a whole. The PIS was regarded as one of the Integrated system (see Chapter 5 for more detail). When the French RTGS system (TBF) was integrated into the TARGET2 in February 2008, the PNS ceased its operation.

SEPI The “Servicio Espanõl de Pagos Interbancarios” (SEPI) was a Spanish net settlement system operated by the Madrid Clearing House. The SEPI

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started operation in October 1997 as a payment system for Spanish Peseta, and changed into the payment system for euro in 1999. Unlike the EAF and PNS, the SEPI did not change the settlement method into a Hybrid System and continued to be a DTNS system. The SEPI was a small-scale and local settlement system and closed down in December 2004 due to the competitive pressures.

POPS The “Pankkien On-line Pikasiirrot ja Sekit” (POPS) is a Finnish settlement system, operated by Finnish Banking Association. Settlements are made either on a gross basis or on a net basis. As for the large-value payments, defined by the “RTGS Limit,” the settlements are made on a gross basis. Regarding the retail payments below the Limit, the settlements are made on a net basis. The POPS is a small-scale and local settlement system compared to the two major large-value payment systems, the TARGET2 and EURO1. For this reason, the POPS is no longer included in the payment system statistics of the Eurosystem from the beginning of 2009. The Finnish banking society decided to shut down the POPS by December 2011.

EURO1 Outline of EURO1 The “EURO1” is a private sector owned payment system for the domestic and cross-border payments in euro, operated by the EBA CLEARING. The EBA CLEARING was established in June 1998 by 52 major banks under the French law with the mission of owning and operating the EURO1 system. The EBA CLEARING was established as a business administrator under the umbrella of the “Euro Banking Association” (EBA) and continues its close cooperation with the EBA.

Payment Systems in EU

The EURO1 is a large-value payment system for euro and covers the whole area of EU. As of the end of 2009, the EBA CLEARING has 66 shareholders and also provides the retail clearing services of the STEP1 and STEP2. The EURO1 went live in January 1999, and had become the single pan-European net settlement system for the high-value payments in euro by the closedown of the other net settlement systems, as mentioned above. In December 2009, the EURO1 processed on average 238 thousand payments per day for a value of €247 billion.

Participants of EURO1 The EURO1 is open to banks with a registered address or branch in the EU with certain level of capital and credit rating and a head office in an OECD or an EU country. As of the end of 2009, the EURO1 had 66 direct participants and 62 sub-participants. The EURO1 participants can exchange the interbank and customer payments in euro with nearly 10,000 banks, including the branches and subsidiaries. When the “third party banks” are added, which are the clients of EURO1 banks, more than 25,000 banks are reachable through the EURO1. The accessible banks are listed in the EURO1/STEP1 Directory.

System of EURO1 The EURO1 relies heavily on the messaging and IT infrastructure provided by SWIFT. First, the EURO1 uses the SWIFTNet as a network. Second, the EURO1 adopts the FIN-Copy service of SWIFT for message processing. Third, the EURO1 uses the SWIFT message standards, which includes MT103, MT202, MT 204 and MT400. If “EBA” is filled in the field 103 of the SWIFT message header, the payment message is recognized as for the EURO1. The messages with this tag are partially copied to the EURO1 system via the FIN-Copy service of SWIFT.

Processing of Payments in EURO1 The EURO1 system starts processing at 7:30 CET. And the cut-off time stands at 16:00 CET. During these operating hours, the EURO1 participants send payment messages to the EURO1 and the system checks the sending and receiving participant’s position. Payment messages are processed on an individual basis and the system calculates the multilateral position of each participant resulting from the processing of payment messages. When the FIN-Copy send the copy of payment messages to the EURO1 system, the “limit check” is made as a first step. The limit check is carried out both for the sending participant’s “debit cap” and the receiving participant’s “credit cap.” If and only if, the checking meets the both conditions, the system process the payment message and calculate the new positions of the sending and receiving participant. If the checking does not satisfy the conditions, the payment message will not be processed, and put into an “on-hold queue.” Once the payments are processed, the EURO1 sends the authorization to the FIN Copy, and the original payment message is forwarded to the receiving bank.

Risk Management of EURO1 For the risk management purpose, each participant is required to set a “debit cap” and a “credit cap” in the EURO1 system. Each participant is required to extend to each other participant a “mandatory limit” of €5 million. In addition to the mandatory limit, each participant may grant a limit up to €25 million at the discretion of own policy. This means that the “bilateral limit” ranges from €5 million to €30 million per participant. The “debit cap” of a participant is the sum of the bilateral limits received from the other participants. This is the upper limit for a participant to processing paying messages, or to have the debt position on a multilateral basis. On the other hand,

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the “credit cap” of a participant is the sum of the limits given to the other participants. This is the upper limit for a participant to receive payments on the EURO1 system. To limit systemic risk, the participants collectively contribute the “liquidity pool” of €1 billion, which is maintained by the ECB. This fund is to prepare the default of any of EURO1 participants. Therefore, the debit and credit cap of a participant cannot exceed €1 billion. The bilateral limits can only be changed until 18:00 CET on the previous day of the settlement. And a participant cannot change the bilateral limits during the day until after the final settlement of the day. The system ensures that the multilateral net position of each participant never exceeds its debit and credit cap. When a payment is processed, the system revisits the related participant’s on-hold queue to check whether an adjusted position allows

Figure 7. Processing of Payments in EURO1

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for further processing of payments in the queue. The “Bypass FIFO” is adopted for the processing method of the on-hold queues.

Settlement Process of EURO1 (see Figure 8) The final settlement takes place at the ECB after the cut-off time. The cut-off time is set at 16:00 CET in order to give sufficient time for all the participants to make pay-in and pay-out processes prior to the closing time of the TARGET2, which is 18:00 CET.

Calculation of Final Balance At the cut-off time, the system calculates the final balance (multilateral net position) of each participant resulting from all the processing of payment messages. The system informs each participant

Payment Systems in EU

Figure 8. Settlement Process of EURO1

as well as the EBA CLEARING and the ECB, of the amount of its balance.

Pay-in of Short Participants Receiving the notice of the final balance, each participant with a debit balance (the “short participant”) should send payments via the TARGET2 to pay-in to the “EBA Settlement Account” to cover the short position. As an alternative method, a short participant is able to authorize the EBA CLEARING to directly debit its RTGS account for the amount of its short position. This method is called the “direct debit option5.”

Pay-out to Long Participants Upon receipt of all the funds from the short participants, the EBA CLEARING sends the instruction to the TARGET2 to distribute funds to each participant with a credit balance (the “long participant”). The long participants will receive the funds which are equivalent to their credit balances. With the instruction from the EBA CLEARING,

the TARGET2 debits the EBA Settlement Account and makes payments to each long participant. Once the EBA CLEARING confirms the completion of all the pay-in and pay-out, it notifies all participants that the EURO1’s settlement of the day is completed.

Legal Structure of EURO1 The EURO1 adopts the “Single Obligation Structure” (the “SOS”) as a legal basis, which is based on the German law. The SOS is a legal concept that participants always have the claims or obligations only on a net basis. More specifically, once a payment message is processed, the resulting position of multilateral net basis is only the single claim (in the case of positive balance) or the single obligation (in the case of negative balance) toward all the other participants. This means that participants do not assume any claim or obligation of gross basis (the gross amount of individual payments before netting). The single obligation (or single claim) of each participant changes from moment to moment, that is, each time when a payment is processed.

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Under this legal structure, the single obligation/claim does not allow for an unwinding. The combination of the liquidity pool, risk management and legal structure, the payment messages become irrevocable and final when processed.

systems during the daytime and allow the flexible liquidity management. The Liquidity Bridge has two functionalities: (i) prefunding function and (ii) liquidity distribution function (see Figure 9).

Traffic of EURO1

Prefunding Function

As the EURO1 is a pan-European payment system along with the TARGET2, the main traffics are the cross-border payments. However, the domestic payments processed by the EURO1 have been increasing gradually. For example, the Italian Bankers Association decided to use the EURO1 for the Italian domestic payment traffic in 2008.

The “prefunding function” is used to move liquidity from the TARGET2 to the EURO1. This function is available from 7:00 CET, the opening time of the TARGET2, to 15:30 CET. The prefunding function is useful when a EURO1 participant has reached its debit cap and is unable to process more sending payments. In this case, the participant is able to cut down the debit balance far below its debit cap by transferring liquidity form the TARGET2 to EURO1. This function can be regarded as a kind of pay-in at an early hour.

Liquidity Bridge between EURO1 and TARGET2 The EBA CLEARING and Eurosystem have established the “Liquidity Bridge” between the EURO1 and TARGET2. This functionality enables the participants of the two systems to transfer liquidity between the two large-value payment

Liquidity Distribution Function The “liquidity distribution function” is used to transfer liquidity from the EURO1 to the TARGET2. There are four distribution windows es-

Figure 9. Liquidity Bridge between EURO1 and TARGET2

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tablished: at 13:00, 14:00, 15:00, and 15:30 CET. First, 14:00 and 15:00 windows were established in June 2006, and 13:00 and 15:30 windows were added in July 2008. The liquidity distribution is useful when a EURO1 participant received a large amount of funds and the net position is closer to its credit cap. In this case, the participant is able to cut down the credit balance far below its credit cap by transferring liquidity from the EURO1 to TARGET2. As you can see, the two functionalities of Liquidity Bridge serve an important role to correct the imbalances of liquidity between the two large-value payment systems.

RETAIL PAYMENT SYSTEMS IN EU Fragmented Situation of Retail Payment Systems in EU As mentioned above, the large-value payment systems in the euro area were integrated into two:

the TARGET2 and EURO1. Currently, these two payment systems cover the large-value payments market of the whole euro area. We can conclude that the large-value payment markets have been integrated into a single market. Any credit institution can send or receive the funds to/from the other credit institutions throughout the euro area with the TARGET2 or EURO1. On the other hand, the retail payment markets are still very fragmented in the euro area, even more than ten years after the euro’s launch. Figure 10 shows the image of such fragmented situation of retail payment systems in the EU. Each country keeps the Automated Clearing House (ACH), which is providing the retail payment service domestically with the domestic format. Thus, the retail payment markets are divided into pieces, and the individuals and corporates are unable to fully enjoy the benefits of introducing the single currency euro. Table 6 shows the participant of the “European Automated Clearing House Association” (EACHA), which is the cooperation forum of

Figure 10. Fragmented Situation of Retail Payment Systems in EU

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European ACHs. This table shows that there are 22 ACHs from 21 different countries, which also includes some non-EU and non-euro countries.

SEPA Project Outline of SEPA Project Responding to such a fragmented situation of the retail payment market, a project has been proceeded to integrate the whole euro area into a single retail payment area. This project is called the “Single Euro Payments Area” (SEPA). The SEPA is a project that tries to make the situation which allows the customers and corporates to Table 6. Participating ACHs of EACHA Country

Name of ACH

Austria

National Central Bank of Austria

Belgium

CEC

Bulgaria

BS

Croatia

FINA

Denmark

PBS

France

STET

Germany

Deutsche Bundesbank

Germany/Netherlands /Italy

Equens

Greece

DIAS

Hungary

GIRO Zrt.

Italy

Banca d’Italia

Italy

ICBPI

Italy

SIA-SSB

Macedonia

KIBS

Norway

BBS

Poland

KIR

Portugal

SIBS

Romania

TransFonD

Spain

Iberpay

Sweden

BGC

Switzerland

SIX Interbank Clearing

United Kingdom

VocaLink

Source: EACHA, website

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make retail payments in euro throughout the euro area using a single bank account and a single set of payment instruments. The SEPA project was started in 2002 as a part of the Lisbon Agenda which aims to boost the competitiveness of the EU economy. The final goal is to develop an integrated retail payments market, the SEPA. Once the SEPA is achieved, there will be no differences between the crossborder payments and domestic payments in the euro area as for the retail payments.

SEPA Countries The targeted countries of the SEPA project encompass 32 countries, which are referred to as the “SEPA countries.” The SEPA countries include 16 euro countries, 11 other EU countries, 3 countries in the EEA (Iceland, Liechtenstein and Norway), Monaco and Switzerland.

Targeted Payments of SEPA Project The intended payments of the SEPA project are the non-cash euro payments. Even though the SEPA countries include some “out-countries” which do not introduce the euro as a national currency, the target of SEPA project is absolutely the payments in euro. The non-cash euro payments of SEPA project include three payment instruments: (i) credit transfer, (ii) direct debit and (iii) card payment. In what follows, the first two instruments are mainly described in more detail.

Main Players in SEPA Project A wide range of players take part in the SEPA project. They include the public authorities, the banking industry, the operators of retail payment systems, the corporates, and so forth.

Payment Systems in EU

Public Authorities The Eurosystem and the European Commission are the two public authorities which actively promote the SEPA project. The Eurosystem consists of the European Central Bank (ECB) and the national central banks (NCBs) in the euro area. Substantially, the ECB can be deemed as one of main promoter of the project. The ECB closely monitors the progress and development of the project, and publishes the progress reports on the SEPA project once in a while. The European Commission is a policy-implementation organization of EU and has developed the strategies and published some Directives. The two authorities keep close contact in monitoring and promoting the project.

Banking Industry The banking industry in the EU established the “European Payments Council” (EPC) in 2002 for the SEPA project. The EPC is a self-regulation body of pan-European banking industry. The EPC is a coordination body of banking industry as well as a decision-making body which made the Rulebook and the Guideline for the SEPA project. As of the end of 2009, the EPC consisted of 76 members, composed of banks and the representatives from the three banking associations6. The EPC plays a leading role7 to promote the SEPA project. The EPC already developed and published the two Rulebooks regarding the “SEPA Credit Transfer” (SCT) and the “SEPA Direct Debit” (SDD), and also the “Framework for SEPA Card Payment.” With regard to the SCT and the SDD, the EPC adopts the “replacement strategy,” which intends to replace the existing schemes with a new scheme. That is because each country has its own national scheme for the credit transfers and direct debits and it is quite difficult to eliminate

the differences among countries and establish the common scheme. As for the Card payment, the EPC adopts the “adaption strategy,” which intends to adjust the existing schemes of each country to the new standard of business and technologies.

Operators of Retail Payment Systems As for the operators of retail payment systems, the “Euro Banking Association” (EBA) and the “European Automated Clearing House Association” (EACHA) play a key role to implement the SEPA project. The EBA is the parent organization of the EBA CLEARING which operates the pan-European payment systems, such as the EURO1, STEP1 and STEP2. The EACHA is the cooperation forum of Automated Clearing Houses (ACHs) in Europe. As of the end of 2009, 22 ACHs are members of the EACHA (see Table 6). The EACHA published the “Technical Interoperability Framework,” which facilitate building of bilateral linkages between ACHs.

Corporate From the corporate community, the “European Associations of Corporate Treasures” (EACT) actively participates in the activities of the SEPA project. The EACT is an association of corporate treasurers, comprising more than 4,500 members.

National Community In each SEPA country, a national body for the SEPA migration is established, which is called the “national SEPA migration committee” or the “SEPA Forum.” The body is composed of the banks, corporates and public organizations, and usually co-chaired by the central bank and a major bank in the country. The national body develops

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a policy how to respond to the SEPA project and makes a migration plan of the country.

SEPA Credit Transfer (SCT) Features of SCT The “SEPA Credit Transfer” (SCT) is a SEPA scheme for credit transfer payments. First, an Originator asks the Originating Bank to send a certain amount of fund to the Beneficiary. Then, the Originating Bank sends the payment message to the Beneficiary Bank which is the bank the Beneficiary has an account, through an ACH or an intermediary bank. Upon receiving the payment message, the Beneficiary Bank credits the sending amount to the Beneficiary’s account (see Figure 11). The characteristics of the SCT are as follows. 1. Originator is able to make payments8 to any account of any bank in the euro area. 2. Payments are made for the full original amount and there are no deductions. 3. There is no limit for the sending amount.

Figure 11. Scheme of Credit Transfer

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4. The credit to the beneficiary’s account should be made within three days (maximum settlement time). 5. “International Bank Account Number” (IBAN) and “Bank Identifier Code” (BIC) should be used in order to identify the accounts. 6.140 characters of remittance information are delivered to the beneficiary without alternation or omission. 7. The ISO 20022 message in XML format should be used between banks. 8. The SCT scheme is separated from the processing infrastructure.

Utilization Status of SCT The EPC has developed the Rulebook for the SCT. And the SCT was launched in January 2008. At this stage, more than 4,300 banks in 31 countries, representing roughly 95% of payment volumes in Europe, confirmed that they were able to send and receive the SCT messages. However, the traffic using the SCT is much less than previously expected. Transaction in the

Payment Systems in EU

SCT format as of total transactions in the euro area was only 14.7% as of January 2011. Most of them are the cross-border transactions and the usage of the SCT for the domestic transactions are extremely limited.

Obstacle for Penetration of SCT The first reason why the SCT penetration is low is that there is no obligation to use and no penalty for not using the SCT. The SEPA project has adopted the “self-regulation approach” thus far. Therefore, the usage of the SCT is completely on a voluntary basis. The lack of binding power puts the limitation on the broad use of the SCT. The second reason for the low adoption rate of the SCT is the presence of the domestic ACHs. In each country, an ACH is providing an efficient retail payment service at a low price with a domestic format. Even though many ACHs became the SCT compliant, there are no incentives for the banks and customers to use the new SCT scheme instead of the domestic scheme which they get accustomed to. Third, the obligation usage of the BIC and the IBAN is another obstacle to implement the SCT.

Until a company collects all the BICs and IBANs of the business partners, it will not start sending payments in the SCT. For large companies, it usually takes so much time and cost to build the database of the BICs and the IBANs for the vast numbers of business partners. Therefore, a large majority of companies keep a wait-and-see attitude to the SEPA project.

SEPA Direct Debit (SDD) Features of SDD The SEPA Direct Debit (SDD) is a SEPA scheme for direct debit payments. In the direct debit, a Creditor will ask his/her bank (Creditor Bank) to debit the Debtor’s account and credit the amount to his/her account (Creditor’s account). For this purpose, the Creditor Bank sends the direct debit instruction to the Debtor Bank. Upon receiving this instruction, the Debtor Bank will debit the Debtor’s account and send the amount to the Creditor Bank. Receiving the amount from the Debtor Bank, the Creditor Bank will credit the amount to the Creditor’s account (see Figure 12).

Figure 12. Scheme of Direct Debit

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The direct debit is often used for the recurring payment, such as payment for the utility charges, electric bills and phone charges. This is a useful and convenient way of payment for both the payers and payees. The Debtor should submit the “mandate” (written paper or electronically-based instruction) to the Creditor and the Debtor Bank in advance. In the euro area, as the case now stands, the direct debit was possible only at the national level, or within the borders. When a company provides a service to the customer who lives in the neighboring country, it was unable to collect the service charges by way of direct debit from the customer’s bank in another country. It was a very inconvenient situation for the company and also for the customers. The SDD is a scheme that allows such a company to collect charges from any bank in the euro area. The characteristics of the SDD are as follows.

Two Schemes of SDD

1. Creditor is able to make direct debit from any account of any bank in the euro area. 2. Both recurring debit and one-time debit are possible. 3. Creditor is able to appoint the exact due date. 4. Creditor should send a pre-notification to the debtor more than 14 days prior to the due date. 5. Direct debit instruction to ACH should be sent more than 5 days prior to the due date for the first time, and more than 2 days for the second time or after in recurring debit. 6. “International Bank Account Number” (IBAN) and “Bank Identifier Code” (BIC) should be used in order to identify the accounts. 7. The ISO 20022 message in XML format should be used between banks. 8. Direct debit scheme is separated from the processing infrastructure.

The SDD was introduced in November 2009. This means that the SDD scheme is available, if all the relevant parties (the Creditor, Debtor, Creditor Bank and Debtor Bank) are agree to use and ready to offer the service. However, both the companies and customers are not prepared for the SDD; the actual usage of the SDD is still quite limited. The SDD as a percentage of total transaction was only 0.07% as of January 2011.

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The EPC has developed the two schemes for the SDD. One is the “SEPA Core Direct Debit Scheme,” which is for the direct debit where the debtor is an individual. The other is the “SEPA Business to Business (B2B) Direct Debit Scheme,” which is for the direct debit where payments are made between corporates as part of their business transactions. Main differences between the two schemes are as follows. First, the Core Direct Debit Scheme admits the broad rights for the consumer (Debtor), such as a refund. Second, the B2B scheme requires the Debtor Bank to ensure that the collection is authorized, and also requires the Debtor Bank and the Debtor to agree on the verification to be performed for each direct debit.

Launch of SDD

Response of Retail Payment Systems to SEPA Project SEPA Compliance of ACHs Under the SEPA project, the Automated Clearing House (ACH) has become to be called the “Clearing and Settlement Mechanism” (CSM). That is because the ACH has a subtle nuance of domestic service, and the CSM has a connotation of crossborder activities. This implies that the ACHs are required to extend their business to the whole euro

Payment Systems in EU

area, instead of confining their functions only to the domestic services. However, the term of ACH will continue to be used in what follows, which is more familiar to the reader. The ACHs in the euro area has made response to the SEPA project. As of the end of 2009, 17 ACHs (or CSMs) made a declaration that they were SCT Scheme-compliant (see Table 7). The Eurosystem has defined four criteria to assess the SEPA-compliance of infrastructures. The four criteria are as follows: 1. To comply with the requirements of Rulebook and Guidelines of the EPC. 2. To adopt interoperability rules between infrastructures. 3. To have full reachability: be able to send or receive euro payments to/from all banks in the euro area. 4. To enable banks to make choice of ACH based on service and price.

Approach to the SEPA Project There have been several approaches of ACHs to the SEPA project. The first approach was to create a “Pan-European Automated Clearing House” (the “PEACH”). The PEACH is a country neutral ACH, which covers the whole euro area and handles both the cross-border and domestic retail payments. But later, another idea was put forward. That was the concept of linking between the local ACHs bilaterally and creating the widerange ACH network in the euro area. As the situation stands, the PEACH Concept and Cross-border Linkage Concept have been making progress in parallel. There will be a long way to go before the retail payment systems in the euro area become SEPA-compliant as a whole.

Table 7. SCT Scheme-compliant CSMs (as of the end of 2009) Country, Area

Name of CSM

Austria

National Central Bank of Austria

Belgium

CEC

Bulgaria

Bankservice JSC

Denmark

Eurogiro

France

STET

Germany

Deutsche Bundesbank

Germany / Netherlands

Equens

Greece

DIAS

Italy

Banca d’Italia

Italy

ICBPI

Italy

SIA-SSB

Poland

KIR S.A

Portugal

SIBS

Slovenia

Bankart

Spain

Iberpay

United Kingdom

VocaLink

Euro Area

STEP2

Source: EPC

PEACH Concept Definition of PEACH The “Pan-European Automated Clearing House” (PEACH) is defined as a country neutral ACH, which process the cross-border and domestic payments of the whole euro area. The PEACH should have the SEPA-wide reachability, that is, any bank in the euro area should be reachable through the PEACH. The PEACH is supposed to handle both the credit transfer (SCT) and the direct debit (SDD). The PEACH is a concept of country neutral ACH and is not necessarily limited to one ACH. It is very natural that a single ACH will cover the whole euro area, as with other currency zones. Figure 13 shows the concept of the PEACH. In an early stage, only the cross-border payments are

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Figure 13. Concept of PEACH

supposed to go to the PEACH and the domestic payments continue to be processed by the local ACH in the country (see the Country B’s case in Figure 13). At a later stage, however, the domestic payments are supposed to make a shift from the local ACH to the PEACH, and the PEACH will process both the cross-border and domestic transactions (see the Country A’s case in Figure 13).

First PEACH The first and only PEACH so far in the EU is the “STEP2.” The STEP2 is a retail payment system for bulk payments in euro, which is operated by the EBA CLEARING. The STEP2 provides the SCT and SDD service; both are fully compliant with the SEPA Scheme Rule book. The STEP2 started its operation in April 2003 and was accredited as the first PEACH by the EPC in the same year. This is the only PEACH identified until now.

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As for the SCT Service on the STEP2, there are 117 Direct Participants and more than 4,300 Indirect Participants, as of the end of 2009. Regarding the SDD Service, there are 56 Direct Participants for the SDD Core Service, and 40 Direct Participants for the SDD B2B Service. Through these Direct Participants, more than 2,200 banks across Europe are reachable. With the SCT and SDD services, the STEP2 provides the reachability to all 32 SEPA countries. In addition to these cross-border transactions, the banking community of Luxembourg mitigated its domestic traffics to the STEP2 in 2006. It was the first community to move from a local ACH to the PEACH. In November 2006, another service was launched to process a part of the Italian domestic traffics, which is called the “Italian Credit Transfer” (ICT) Service. Thus, parts of Italian traffics are processed by the STEP2, with 7 Direct Participants and 69 Indirect Participants. The STEP2 provides the wide reachability across Europe, and processes over 190 thousand

Payment Systems in EU

payments per day. However, the traffic is rather small compared to the whole retail payments in the euro area. Therefore, it can be concluded that the situation is far from the “real PEACH,” which processes the large portion of euro traffics in Europe. In sum, the PEACH concept is still in its infancy.

Cross-Border Linkage Concept Linkage Concept and EACHA From around 2005, some ACHs in the euro area began to consider the alternative idea to the PEACH concept. That was the “Cross-border Linkage Concept” which each ACH becomes the SEPA scheme-compliant first, and then establishes the bilateral linkages in order to process the crossborder transactions through the linkages. For this purpose, the European Automated Clearing House Association (EACHA) was established in September 2006. The EACHA aimed to be a forum of European ACHs as well as to work on the specific issues such as developing common standards for interoperability between the ACHs.

The EACHA membership consists of 22 ACHs from 21 different countries as of the end of 2009. The EACHA published the “Technical Interoperability Framework9” in 2007, which was a technical paper to set the minimal specifications of the technical elements needed to secure interoperability between the ACHs. In this linkage model, the domestic transactions are processed by the local ACH in the country and only the cross-border transactions are exchanged between the two ACHs concerned using the bilateral linkage (see Figure 14).

Spaghetti Model Figure 14 shows the relationship between the two ACHs. However, in a real situation, the single linkage is not enough to cover many markets in Europe. Each ACH should have quite a lot of linkages, if it wants to have a wide range of accessibility to many markets in the euro area. Therefore, this concept is sometimes criticized as the “Spaghetti Model” because a shape of many linkages looks like Spaghetti (see Figure 15). If twenty ACHs want to have bilateral linkages each other, the number of linkages reaches the startling figure

Figure 14. Cross-border Linkage Concept of ACHs

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Figure 15. Spaghetti Model in real situations

of 190. To build such a huge number of linkages is unrealistic and next to impossible. It is worth mentioning that the same kind of linkage model was discussed in the past years as for the securities settlement. Concretely, the integration of Central Securities Depositories (CSDs) in the EU was discussed during 19982002. Some linkages between the CSDs were actually built following the linkage concept, but the ambitious concept was abandoned on the way due to the complexity and troublesome task of building a large number of linkages. This case shows the difficulty of the cross-border linkage model.

Settlement Scheme of EACHA Framework The EACHA Framework adopts the “Fiduciary account model.” When payment messages are exchanged between the two ACHs, the settlements for the payments are made through the TARGET2. The ACHs are eligible to have an account at the TARGET2. In the Fiduciary account model, such accounts of ACH (hereinafter referred to as

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the “T2 ACH account”) will be used to hold the intra-day funds for the settlements between the two ACHs. Assume that one bank send payments to another bank through the linkage between the ACH1 and ACH2. In the first cycle (the “sending cycle”), the ACH1 (ACH of sending side) debit the funds from the account of Originating Bank and credit to the T2 ACH account. In the second cycle (the “receiving cycle”), on successful completion of settlement, the ACH2 (ACH of receiving side) debit the funds from the T2 ACH account and credit to the Receiving Bank (see Figure 16). Both fund transfers are initiated by the ACH1 and ACH2. In this model, the T2 ACH account will hold the funds in a time between the first and second cycle. That is why this model is called the “Fiduciary account model.” The funds are held in the name of the ACH2, although the fund is owned by the Receiving Bank. The funds are held in the T2 ACH account only intraday and the overnight balance in the account is not envisaged. In order to eliminate settlement risk, a “settlement before output model” is used, such that the payment messages are forwarded from the ACH

Payment Systems in EU

Figure 16. Settlement Model of EACHA Interoperability Framework

1 to the ACH 2, only when the first settlement cycle has been successfully completed. There is no unwinding of the inter-ACH multilateral balances, since only gross credit positions are dealt with and there is no netting executed.

Linkages Built Some bilateral linkages were already built between the ACHs in Europe. These linkages are based on the “Technical Interoperability Framework” of the EACHA.

The main player is the Equens, which came into existence in 2006 by the merger between the Dutch and German ACH. As of the end of 2009, the Equens has bilateral linkages with DIAS (Greece), Iberpay (Spain), ICBPI/Banca d’Italia (Italy), OeNB (Austria), SECB (Switzerland) and VocaLink (UK). These linkages have the “hub & spoke” structure, and the Equens became the hub of these bilateral linkages (See Figure 17). Only the linkage that the Equens is not involved is the link between the Vocalink and the STET (France). If a linkage will be built between the

Figure 17. Bilateral Links between ACHs

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Equens and the STET, the “golden triangle” will emerge among the three big markets: Germany, France and the UK. The cross-border payments can be processed with these linkages, but only among the eight countries and only bilaterally. In sum, there is a serious limitation in this linkage model at this stage. Therefore, the situation is still far from the fundamental solution, which a single ACH or a network of linkages between the ACHs will cover the whole euro area.

Single ACH Concept One ACH in One Currency Zone Generally speaking, one ACH is sufficient for one currency zone. Most countries have only one ACH, and almost all financial institutions in the country usually have the connection to the ACH. Such situation creates the nation-wide network and a bank can send/receive payments to/from any banks in the country. To apply this “one-country model” to the euro area, the ultimate conclusion is that only a single Figure 18. Single ACH Concept

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ACH is necessary and sufficient in the euro area. If one ACH handles both the domestic and crossborder transactions in euro, it will be the most efficient way to handle the whole retail payments in the euro area. This way of thinking is referred to as the “Single ACH Concept.” Figure 18 shows this concept, where one and only ACH processes both the domestic and cross-border transactions.

Single ACH and SEPA If this situation will be materialized, the aim of the SEPA project, to treat the cross-border payments in the same way as the domestic payments, will be achieved in a complete manner. Besides, the cost of single ACH will be much lower than the distributed local ACHs due to the economy-ofscale advantages. Additionally, each bank has no need to accommodate several schemes or to keep the connections to the multiple ACHs. In sum, the Single ACH concept has the greater merits and is the ideal situation for the integration of retail payment systems in the euro area. In order to realize the Single ACH situation, however, it is necessary to abolish the local ACHs

Payment Systems in EU

in each country. This is quite a major surgery and difficult to implement, considering the political resistance and national sentiments. Therefore, for the time being, it is realistic to integrate the retail payment infrastructure gradually in a slow manner by consolidating payment flows into the STEP2 and promoting the bilateral linkages between the ACHs.

Comparison with Other Cases of Integration In the case of the integration of large-value payment systems for reference, the TARGET was introduced at first as a distributed system, which connected the national RTGS systems with the interlinking network. Later on, the TARGET was transformed into the TARGET2 as a centralized system. This might be a final situation for this matter. As this case shows, a steady way has been taken in the integration process of financial infrastructure in the euro area. More concretely, the general principles were established in the first place, and then a consensus among the parties concerned was tried to be created following the general rules. In this approach, it takes considerable time to reach a consensus with containing oppositions from the local point of view. Thus far, the same kind of approach has been adopted for the integration of retail payment systems. It seems very possible that the Single ACH Concept will be pursued in the long run, which will be an ultimate situation. By comparison, the Eurosystem has launched a project, called the “TARGET2-Securities” (T2S), which is the integration project of Central Securities Depositories (CSDs) in the euro area. The Eurosystem embarked the T2S project because it had fully frustrated the slow progress of the integration of the CSDs by the private sector initiative. If the same situation will occur due to the blundering response in the private sector, the possibility cannot be ruled out that the Eurosystem

will launch on a new challenge for the integration of retail payment systems in the euro area as its own initiative.

STEP1 The following part gives an explanation of the clearing and settlement mechanism of two EUwide retail payment systems; the STEP1 and STEP2.

Features of STEP1 The “STEP1” is a retail payment system for euro in the EU-wide economy. The EBA CLEARING owns and operates the STEP1. The STEP1 was launched in November 2000 to enable banks in the EU to make the cross-border retail payments in euro within a short period of time at low cost. The STEP1 is a service for the individual commercial payments in euro, which contrast sharply with the fact that the STEP2 is a service for the bulk payments or payment files (to be discussed below). The STEP1 service is provided using the platform of the EURO1. Even though a bank does not comply with the strict EURO1 participation criteria, it can be the “STEP1 Banks,” the participants of the STEP1. The admission criteria for the STEP1 participation neither involves a minimum credit rating nor a minimum own funds requirement. Each STEP1 Bank designates one of EURO1 Banks as a “clearing bank” and delegate the clearing of own position in the STEP1 to the clearing bank. The STEP1 comprises 99 direct participants and 50 sub-participants from the EU-wide countries as of the end of 2009. On a daily basis, the STEP1 processes on average 232,000 transactions for a total value of €250 billion.

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Risk Management of STEP1

Processing Cycle of STEP1

The STEP1 set the debit cap of each participant at zero (the “zero debit cap”) in order to avoid the occurrence of systemic risk. In other words, when a participant has a negative potential balance (i.e., position is less than zero), the payments of the participant are not processed and released to the receiving bank until the clearing bank of the participant makes a pay-in and make the participant’s balance more than zero. On the other hand, each STEP1 Bank is required to set a “credit limit” between €2 million and €10 million. This is the upper limit that the participant allows to receive the payments from other participants. The credit position of a participant is not allowed to exceed the credit limit. If the position of a participant after the netting satisfies both conditions of the debit cap and credit limit, the payments are processed and released to the receiving bank. On another front, if the participant’s position does not meet the conditions, the payments are kept in the waiting queue as “on-hold payments”.

The processing of the STEP1 starts at 7:30 at the same time of the EURO1, and ends at 16:00 (all times are in CET). The cut-off time for the same-day value payments is 14:30. The EBA CLEARING executes the netting and informs the “Potential Net Balance” (PNB) to each STEP1 Bank at around 14:40. The participant with the negative balance ask its clearing bank to pay-in to make up the debit position, while the participant with the positive balance ask its clearing bank to pay-out the credit balance. These pay-ins and pay-outs are called the “capacity transfer.” After the capacity transfer, the balances of all the participants are assumed to be zero (see Figure 19).

Figure 19. Processing Cycle of STEP1

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STEP2 As the name suggests, the STEP2 is an extension of the STEP1. The several different types of services and the settlement mechanisms of the STEP2 are as follows.

Payment Systems in EU

Several Services of STEP2 The STEP2 is the “Pan-European Automated Clearing House” (PEACH) for bulk payments in euro, which is operated by the EBA CLEARING. The first service of the STEP2 was launched in April 2003, which was to process credit transfers. This service is called the “XCT Service,” and is in line with the “CREDEURO Convention” of the European banking industry. The second service was the Italian Credit Transfer (ICT) Service, launched in November 2006. That was a specific service for the Italian domestic transactions. The third service was the SEPA Credit Transfer (SCT) Service, which went live in January 2008. The SCT Service allows the European banks to send their SEPA-compliant credit payments. The fourth service was the SEPA Direct Debit (SDD) Service, which went live in November 2009. The SDD Service includes both the “SEPA Core Direct Debit Service” for consumer direct debits and the “SEPA B2B Direct Service” for business-to-business direct debits. The EBA CLEARING is offering these services in parallel on the platform of the STEP2. In other words, the STEP2 provides the SEPA-compliant services as well as the non-SEPA-compliant services. With these services, the STEP2 allows banks across Europe with a single channel to send and receive the credit and debit payments. In line with the PEACH concept defined by the EPC, the STEP 2 provides the full reachability to the banks in the euro countries, and the European countries as well.

Processing and Settlement in XCT Service Participants Any Bank operating in the European Economic Area (EEA) is able to become a participant of the STEP2 XCT Service. There were 105 Direct

Participants and over 1,700 Indirect Participants for the service as of the end of 2009. The STEP2 service is based on the network and service of SWIFT. For sending the payment files, the SWIFTNet File Act is used. The payment message is based on the MT103+ with formatting in the XML (eXtensible Markup Language) using the SWIFT Bulk Payment standard.

Processing and Clearing Stage The XCT Service has only one clearing cycle on a daily basis. The participants are able to send “Input Payment File” (IPF) which contains many payments, to the STEP2 until 22:00 CET on D-1 (the previous day of the settlement date). The STEP2 processes the files during the night. More concretely, the files are opened and validated whether key fields are in accordance with the formatting rules. If an individual payment message fails to pass the validation check, it is rejected and returned to the sending participant with the reason. The payment messages which passed the validation are sorted into the “bilateral sub-files.” The sub-file is created per receiving participant, which contains payments to each receiving participant from the various sending participants. For each sub-file resulting from the sorting of the payment messages, the STEP2 calculates the amount of the bilateral payment obligations between the sending participant and receiving participant. Once the bilateral payment obligations are calculated, the STEP2 generate and send the payment messages to the EURO1. They are the payment instructions for the amount of each subfile. Settlements of the sub-files are made through the EURO1.

Settlement Stage When the EURO1 starts up processing at 7:30 CET on D (the settlement date), the Euro1 executes

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Figure 20. Processing and Settlement in STEP2

the payments regarding each sub-file, and send a confirmation message of settlement to the STEP2 by 8:00 CET (see Figure 20). Upon receiving the confirmation message, the STEP2 release the sub-file as the “Settled Payment File” (SPF) to the receiving participant by 8:30. Then, the sending participant will receive a report that notifies the payment messages are settled and forwarded.

Roles of STEP1 and STEP2 Until an integrated retail payment market becomes a reality by the successful implementation of the SEPA project, the STEP1 and STEP2 will play a critical role in the retail payment area in the EU.

REFERENCES Deutsche Bundesbank/TARGET2: EACHA (2009, March). Technical Interoperability Framework for SEPA (version 4.1). EBA CLEARING (2008, March). Report on Activities 2007.

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EBA CLEARING (2009, March). Report on Activities 2008. European Automated Clearing House Association. (2009, March). Technical Interoperability Framework for SEPA – Compliant Payments Processing Version 4.1. European Central Bank. (1999, September). Improving cross-border retail payment services - The Eurosystem’s view. European Central Bank. (2000, September). Improving cross-border retail payment services - Progress report. European Central Bank. (2001, November). Towards an integrated infrastructure for credit transfers in euro. European Central Bank. (2003, June). Towards a Single Euro Payments Area – (2nd) Progress Report. European Central Bank. (2004, December). Towards a Single Euro Payments Area – Third Progress Report.

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European Central Bank. (2005, November). Single Shared Platform. European Central Bank. (2006a, February). Towards a Single Euro Payments Area: Objectives and Deadlines – Fourth Progress Report. European Central Bank. (2006b, August). The Evolution of Large-Value Payment Systems in the Euro Area. ECB Monthly Bulletin. European Central Bank. (2006c, November). Information Brochure: SEPA. European Central Bank. (2007, July). Single Euro Payments Area (SEPA) from Concept to Reality – Fifth Progress Report. European Central Bank. (2008a, November). Single Euro Payments Area – Sixth Progress Report. European Central Bank. (2008b, April). Terms of reference for the SEPA-compliance of infrastructures. European Central Bank. (2008c, May). TARGET Annual Report 2007. European Central Bank. (2009a, March). Eurosystem’s SEPA Expectations. European Central Bank. (2009b, May). TARGET Annual Report 2008.

WEBSITES EBA CLEARING: http://www.abe.org/ ECB/ Payments & Markets: http://www.ecb.int/paym/ html/index.en.html European Payments Council. http://www.europeanpaymentscouncil.eu/ http://www.bundesbank.de/zahlungsverkehr/ zahlungsverkehr_2target.en.php VocaLink. http://www.voca.co.uk/

ENDNOTES 1



2



3



4



5



6



7



8



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European Central Bank. (2009c, July). The Single Euro Payments Area (SEPA): An Integrated Retail Payments Market. European Commission/ SEPA. http://ec.europa. eu/internal_market/payments/sepa/ European Payments Council. (2002, May). Euroland – Our Single Payment Area. European Payments Council. (2009a, January). Making SEPA a Reality. European Payments Council. (2009b, January). Shortcut to the SEPA Credit Transfer Scheme. European Payments Council. (2009c). Shortcut to the SEPA Direct Debit Schemes.

The other large-value payment systems are the EURO1 and POPS. It took two to three minutes from the debit processing of the sending bank’s account to the credit processing of the receiving bank’s account. The TARGET had also no limit for the maximum value. The EEA includes Iceland, Norway and Liechtenstein as well as the EU member countries. The direct debit option had not been available under the TARGET, and became available by the migration to the TARGET2. More than half of the participants have adopted this option, which has shortened the settlement phase of the EURO1. They are: the European Banking Federation (EBF), European Savings Banks Group (ESBG), and European Association of Cooperative Banks (EACB). It is sometimes said that it is the EPC which is at the pilot’s seat of the plane called SEPA. Both single payments and bulk payments are supported. Bulk payment comprises one debit to the originator’s account and multiple credits to different beneficiaries. The latest version is version 4.1, published in March 2009. 167

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Chapter 11

Payment Systems in Japan

ABSTRACT This chapter takes a close look at the payment systems in Japan. There are three payment systems in Japan: the Bank of Japan Financial Network System (the “BOJ-NET”), the Foreign Exchange Yen Clearing System (the “FXYCS”) and the Zengin Data Telecommunication System (the “Zengin System”). The BOJ-NET is operated by the Bank of Japan (BOJ), and the FXYCS and Zengin System are operated by the private sector. The BOJ-NET is a large-value payment system, which is mainly used for payments for the money market transactions and government bond transactions. It also handles the settlement of net positions of the private-sector netting systems and the payments for the BOJ’s open market operations. The BOJ-NET is the equivalent of the Fedwire in the US, and the TARGET2 in the euro area. The BOJ-NET was originally a Designate-Time Net Settlement (DTNS) system, and became the Real-Time Gross Settlement (RTGS) system in 2001. Then, the BOJ-NET enhanced its functionality and became the Integrated system in 2008, which has both the RTGS mode and Liquidity-Saving mode. The enhancement of the BOJ-NET to the Next-Generation RTGS system is explained in detail. The FXYCS is a payment system that handles the Japanese Yen (JPY) leg payments for the foreign exchange transactions and international treasury settlements. In this sense, the FXYCS is the equivalent of the CHIPS in the US. With the reform of the BOJ-NET in 2008, the importance of the FXYCS has decreased substantially. DOI: 10.4018/978-1-61520-645-2.ch011

Copyright © 2011, IGI Global. Copying or distributing in print or electronic forms without written permission of IGI Global is prohibited.

Payment Systems in Japan

The Zengin System is a nationwide electronic fund transfer network mainly for the customer payments. Almost all the financial institutions in Japan, approximately 1,400 institutions, participate in the Zengin System. As most of the payments made through the System are the consumer and commercial payments, the transaction volumes are huge, while the amount of each payment is rather small. In addition to the single payments, the Zengin System also supports the batch payments, such as the payroll and pension payments. The Zengin System is a DTNS system, where the final settlement of the net positions takes place at the end of the day. The Zengin System is planned to be upgraded to the sixth generation system in November 2011. The details of new mechanisms of the six generation system are described in the chapter.

INTRODUCTION The BOJ-NET and FXYCS are mainly for the interbank payments and characterized as a large-value payment system. On the other hand, the Zengin System is mainly for the customer payments and regarded as a retail payment system. However, we have to pay some attention that some large-value payments are also processed in the Zengin System. The Foreign Exchange Act had stipulated that the international related payments should be processed by the FXYCS for the purpose of foreign exchange control1. As a result, the Zengin System is dedicated to the domestic payments, which include some largevalue payments. In other countries, the division of roles between payment systems is generally made by the value of the payments between the large-value payments and retail payments. In the case of Japan, however, the assignment of roles is made between the international payments and domestic payments due to the above legal reason. This was one of the features of Japanese payment systems. The second feature was the delay in the reform of payment systems. The major advanced countries in Europe, North America and the AsiaPacific region introduced the RTGS systems in late 1990s, but the BOJ-NET finally became the RTGS as late as in 2001. Besides, the Hybrid systems and Integrated systems were introduced one after another in the US and European countries during 1996-2004, the Japanese payment systems showed little sign of the sweeping reform.

But at length, the BOJ enhanced its RTGS system to a sophisticated system in 2008. This project was called the “Next-Generation RTGS (RTGS-XG) project” of the BOJ-NET. As a result of this project, the Japanese payment systems caught up with the global trend and became one of the cutting-edge payment systems in the world.

BOJ-NET Outline of BOJ-NET Two Roles of BOJ-NET The BOJ-NET is a payment system owned and operated by the Bank of Japan (BOJ), the central bank of Japan. The functionality of the BOJ-NET can be divided broadly into two. One is a function as a fund settlement system, and the other is as a function as a settlement system of the Japanese Government Bonds (JGBs). First, the BOJ-NET as a fund settlement system (the BOJ-NET Funds Transfer System) process the large-value payments concerning the money market transactions, the government bond transactions, and the settlement for net settlement systems, such as the Bill and Cheque Clearing Systems and the Zengin System. Second, the BOJ-NET as a securities settlement system (the BOJ-NET JGB Services) handles the settlements of the JGBs including the buying and selling, the issuing, and the BOJ’s operation.

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The BOJ-NET is quite similar to the Fedwire in respect that it is not only the fund settlement system but also a government bond settlement system.

Participants of BOJ-NET The Participants of the BOJ-NET as a fund settlement system is 348 as of the end of 2009. The participants cover wide range of financial institutions, which include the major commercial banks, regional banks, trust banks, foreign banks, credit unions, securities companies, securities finance companies, clearinghouses and money brokers. The BOJ does not allow foreign institutions to access to the BOJ-NET from outside of Japan in principle. Only the exception to this restriction on the “remote access” is CLS Bank.

Traffic of BOJ-NET The average daily volume of the BOJ-NET funds transfer settlement service was 50,675 in 2009. The average daily value of transfer was \112 trillion in the same year. To break down the transaction value, the payments for JGBs transactions accounted for 38%, and the money market transactions was 34%. In addition, the money market operations of the BOJ and the receipts and disbursements of banknotes was 14%, and the traffic from the FXYCS accounted for 12%. As most of the transfers are interbank transactions, the average value per payment was $2.2 billion, which was a very large amount. The BOJ-NET is open to the customer payments as well as the interbank payment, but the usage of customer payments are quite limited, i.e., less than 1% in volume and 4% in value in 2009. As the figure shows, the BOJ-NET is almost dedicated to the interbank payments. This is a distinctive feature of the BOJ-NET compared to the Fedwire and the TARGET2, both of which

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processes the significant amount of customer payments.

Access to BOJ-NET The computer center of the BOJ and the participants are connected by the dedicated communication line. The participants with low volumes can send the payment messages and monitor the situation of own account by using the terminal for the BOJNET. On the other hand, the major participants with large volumes of traffic can make a “CPU connection” to the BOJ-NET, which is the direct connection between the computer of the BOJ and that of the participant. As an exceptional measure, the BOJ accepts the payment orders in writing from the small-scale participants.

Operating Hours of BOJ-NET The operating hours of the BOJ-NET are 10 hours from 9:00 a.m. to 7:00 p.m. in Japan Standard Time (JST). The closing time was extended by two hours2 from 5:00 p.m. in 2001. The BOJ is now studying the possibility to extend the operating hours of the BOJ-NET to more than 20 hours as is the case in the Fedwire and TARGET2. If the plan is realized, the settlement of the JPY payments will be possible late at night or early in the morning in JST.

TRANSITION OF BOJ-NET TO RTGS SYSTEM Framework of Real-Time Gross Settlement Changeover to RTGS System When started operation in 1988, the BOJ-NET was a Designated-Time Net Settlement (DTNS)

Payment Systems in Japan

system, settling on a net basis at designated times during the day. In January 2001, the BOJ changed the settlement method of the BOJ-NET from the DTNS to the Real-Time Gross Settlement (RTGS). Before the transition to the RTGS system, the BOJ-NET had two settlement modes: the “RealTime Processing” and the “Designated-Time Processing.” In 2001, the Designated-Time Processing was abolished and only the Real-Time Processing, the RTGS mode, continued to be available.

Simultaneous Settlement As an exception of the RTGS processing, some transactions are processed at a fixed time, which is called the “Simultaneous Settlement.” The Simultaneous Settlement is limited to the payments that one party of the transaction is the BOJ, and therefore there is no systemic risk involved. Such transactions include the payments with the deposits of the foreign central banks, and the transfers arising from the open market operations of the BOJ. The Simultaneous Settlement is not a net settlement but a simultaneous processing of the gross payments as of a specific time.

Settlement Service to Net Settlement Systems The BOJ-NET provides a settlement service to the Net Settlement Systems, which includes the Bill and Cheque Clearing System and the Zengin System. In other words, the net positions calculated in these systems are settled through the BOJ-NET. For this purpose, each Net Settlement System opens the “System Account” at the BOJ and informs the BOJ the net positions of each participant of the system by a certain time. Upon receiving the notice of the net positions, the BOJ debits the accounts of the “short participants” (the participants with a net debit balance) and credit the amount to the System Account. After all the debits processing from the short participant’s accounts are completed, the BOJ debits the System

Account and distributes the funds to the accounts of the “long participants” (the participants with a net credit balance). The settlement time for the Bill and Cheque Clearing System is 12:30 p.m. and 4:15 p.m. for the Zengin System3.

Situation Before Changeover to RTGS System Two Processing Modes Before the changeover to the RTGS system in 2001, the BOJ-NET had two processing modes: the “Real-Time Processing” and the “DesignatedTime Processing.” The Real-Time Processing is equivalent to the RTGS mode, where payments are settled individually on a gross basis. As for the Designated-Time Processing, the distinctive feature was that there were four settlement times: 9:00 a.m., 1:00 p.m., 3:00 p.m., and 5:00 p.m. Participant could send a payment assigning one of these settlement times. And the payments are processed through the net settlement mode at the designated time, which calculates the net position of each participant with the outgoing payments and incoming payments assigned for the same settlement time. In short, this was the DesignatedTime Net Settlement mode. Even though two settlement options were provided, the Real-Time Processing was seldom used and almost every payment was settled with the Designated-Time Processing. That was because the Real-Time Processing is a gross settlement mode and required a lot of liquidity for settlements. From the participant’s point of view, the Designated-Time Processing was more efficient, which requires a small liquidity only for the differences between the outgoing payments and incoming payments. In fact, the settlement value in September 2000 shows that the Real-Time Processing accounted only for 0.1% and the rest, 99.9% of the payments were processed with the Designated-Time Process-

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ing. Practically, the BOJ-NET can be defined as a DTNS system at that time as this figure shows. The settlement at 1:00 p.m. had the largest share of 59%, and the settlement at 3:00 p.m. came second with the share of 35%.

Purpose of Changeover to RTGS System The changeover of the BOJ-NET to the RTGS system was intended to reduce settlement risk involved in the DTNS method. Depending heavily on the Net Settlements at the Designated times, there was systemic risk, which is the risk the failure of one participant might have the wideranging impact over the other participants. Since this risk is inherent to the DTNS system, it could be removed by adopting the RTGS method. In the RTGS system, each payment is processed individually and given the finality and there is no accumulation of the unsettled payments. Another motivation of the changeover to the RTGS system was to catch up with the global trend of payment systems. Ahead of the BOJ, many central banks adopted the RTGS system in late 1990s (see Chapter 6 for more detail).

Supply of Intra-day Liquidity As the RTGS system requires larger amounts of liquidity compared with the DTNS system, many central banks provide the intraday liquidity to the participants of the system as a “lubricant” for smooth settlements. The BOJ also supply intraday liquidity to the participants of the BOJ-NET in the form of “Intraday Overdraft” (Intraday O/D). The Intraday O/D is free of charge but it requires to be fully collateralized. Any participant who wants to use the Intraday O/D is able to utilize the scheme. There is no fixed limit for the Intraday O/D; however, the usage amount should be within the range of collateral that the participant pledged to the BOJ in advance.

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The eligible collateral includes the Government Bond, Treasury Bill, Municipal Bond, Corporate Bond, Asset-Backed Securities, Bill, and Commercial Paper (CP). In practice, the Government Bond is mainly used. The loan-to-value ratio is determined according to the type of securities and the remaining period to the maturity. The Intraday O/D is provided automatically by the system, when a sending payment is larger than the balance in the sending participant’s account, provided there is enough collateral pledged. A participant is able to monitor own usage situation of Intraday O/D in real time. The Intraday O/D is essentially meant only for the daytime use. So if the Intraday O/D is not repaid until the end of business day, the penalty rate (6% over the official discount rate) is imposed on the participant for the overnight lending.

Next-Generation RTGS Project of BOJ-NET The Bank of Japan (BOJ) enhanced the functionality of the BOJ-NET in October 2008 and plans another reform in 2011. This project is called the “Next-Generation RTGS (RTGS-XG) project” of the BOJ-NET. It is interesting to know that the project to implement the TARGET2 in the euro area was also called the Next-Generation RTGS project. The two enhancement projects of the payment systems were progressed in the different parts of the globe at the same time, respectively.

Background of RTGS-XG Project Dispersed State of Large-Value Payments As mentioned above, there are three payment systems in Japan: the BOJ-NET, the FXYCS and the Zengin System. Actually, the large-value payments are divided into those three systems. Interbank payments such as the money market transactions are processed by the BOJ-NET, and the JPY settlements of the foreign exchange (FX) transactions are made through the FXYCS. On the other hand,

Payment Systems in Japan

the commercial large-value payments are handled by the Zengin System. The daily average value of large-value payments processed in 2008 was \121 trillion in the BOJ-NET, \21 trillion in the FXYCS, and \11 trillion in the Zengin System (see Table 1).

Effort to Comply with the Global Standard The Japanese Bankers Association (JBA), which is responsible for deciding the operation policy of the FXYCS and the Zengin System, had conducted a comprehensive study for improvement of these payment systems. The main point of the review was to ensure the “intraday finality” in these systems. Concretely speaking, these two systems were operated as the Designated-Time Net Settlement (DTNS) systems, where the net positions are settled at the end of the day. In these DTNS systems, the finality of settlement is ensured only at the end of the day. The Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) published the “Core Principles for Systemically Important Payment Systems” (hereinafter called the “Core Principles”) in January 2001. The Core Principles are regarded as a global standard with which payment systems in the world should comply. In the Core Principles, the two levels of standards are set regarding the finality of settlement. As a “minimum standard,” the final settlement should occur by the end of the day of value. This is to ensure the “end-of-day finality.” On top of that,

the Core Principles stipulates that it is desirable to provide the real-time final settlement during the day as a “best practice.” This kind of finality is referred to as the “intraday finality.” The Core Principles describes that to ensure the intraday finality is particularly desirable in the countries with large volumes of high-value payments and sophisticated financial markets. It is obvious that Japan belongs to the group of countries which the intraday finality is required. To comply with the global standard, it was an urgent task for the Japanese payment community to make fundamental reform to the DTNS systems. After a long discussion, the JBA published a report on the reform of the DTNS systems in March 2004. In this report, the JBA made the two proposals. One is to add the Liquidity-Saving mode to the BOJ-NET. And the other is to aggregate the large-value payments on the FXYCS and Zengin System to the BOJ-NET. Upon receiving these proposals, the BOJ started the project in February 2006. Tracking back to the start of the project, it can be pointed out that the global standard (the Core Principles) was a strong driving force for the RTGS-XG project.

Two Sub-Projects of RTGS-XG Project The RTGS-XG project is composed of the two Sub-Projects: the Sub-Project A and Sub-Project B. The Sub-Project A is to add the LiquiditySaving Features (LSF) to the BOJ-NET, which had been the pure RTGS system. The Sub-Project B is to aggregate the large-value payments from

Table 1. Division of Large-Value Payments by Three Payment Systems The BOJ-NET

The FXYCS

The Zengin System

Value

¥120.6 trillion

¥21.1 trillion

¥11.0 trillion

Share

79%

14%

7%

Source: BOJ

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Table 2. Sub-Project A and Sub-Project B of RTGS-XG Project Sub-Project A

Sub-Project B

Contents of project

Introduce Liquidity-Saving Features (LSF) into the BOJ-NET

Incorporate large-value payments handled by the FXYCS

Incorporate large-value payments handled by the Zengin System

Timing of implementation

October 2008

October 2008

November 2011

Objective

To further enhance the safety and efficiency of large-value payment systems in Japan.

Source: BOJ

the FXYCS and Zengin System to the enhanced BOJ-NET. The Sub-Project A was implemented in October 2008. With regard to the Sub-Project B, the aggregation of payment flows from the FXYCS was realized in October 2008, and incorporating the large-value Zengin payments will be executed in November 2011 (see Table 2). The two SubProjects will be described below in more detail.

Sub-Project A of RTGS-XG Project The Sub-Project A is made up of three components: (i) to establish the centralized queuing function, (ii) to introduce the Liquidity-Saving Features

Figure 1. Three Components of Sub-Project A

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(LSF), and (iii) to develop the special account for the LSF (see Figure 1).

Centralized Queuing Function The BOJ-NET before the reform did not have a “centralized queuing function.” For this reason, a payment order was rejected and returned to the sending participant by the system, if the sending participant did not have enough liquidity in its account. With the new queuing function, a payment order is placed in the waiting queue when the system receives it. Then, the system will check the processing capability of the payment later on.

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A participant is able to monitor its settlement situation in real time, including the balance in the account, the settlement situation of each payment order (already settled or non-settled), the waiting payments in the queue. Each participant is also able to actively control the payments in the queue with the “queue management function,” which include the payment priority, reordering, and cancellation of payments. The “payment priority” is a function that each participant is able to assign a priority to each payment: “high priority” or “normal.” The queue is managed separately between the high priority payments and the normal payments. And if any high priority payment remains in the queue, the normal queued payments are not processed. The “reordering” is a function that each participant is able to move a payment to the top of the queue or to the bottom of the queue (see Figure 2). Participant can manage the processing order of payments with this function.

Liquidity-Saving Features (LSF) (i) Functionality of LSF The “Liquidity-Saving Features” (LSF) were introduced to the new BOJ-NET. This function is identical to the “offsetting mechanism” in the European payment systems. The “Offsetting” means the simultaneous processing of the outgoing and incoming payment instructions. The offsetting algorithm searches for the pair (or a group) of participants which have submitted payments for each other (or one another), and calculates the net inflow/outflow. When the net outflow has sufficient cover, which means the balance of the outflow participant is larger than the net outflow, the system processes the incoming and outgoing payments simultaneously on a gross basis. The new BOJ-NET introduced two kinds of offsetting mechanisms: the “bilateral offsetting” and “multilateral offsetting.”

Figure 2. Queue Management Function of RTGS-XG

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(ii) Example of LSF The concrete example of the “bilateral offsetting” is as follows. Assume that there is a payment of 40 from Bank A to Bank B, and another payment of 100 from Bank B to Bank A. If Bank B has a sufficient balance in its account, these two payments are processed simultaneously on a gross basis with bilateral offsetting (see Figure 3a). This process will result in increasing of 60 in the Bank A’s account and decreasing of 60 in the Bank B’s account. In short, the outcome of the bilateral offsetting is exactly the same as the netting of the two payments. Only the difference is whether two individual payments are processed on a gross basis, or once the net positions are calculated and processed on a net basis. With this mechanism, the participants are able to make settlements with smaller liquidity. That is, only the net amount of the two payments is necessary to proceed the settlement. That is why this mechanism is referred to as the “LiquiditySaving Features” (LSF). The processing of two payments on a gross basis become final when processed. This means that the finality is ensured during the day.

Figure 3. Liquidity-Saving Features (LSF)

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In the case of the “multilateral offsetting,” the same mechanism works for the payments among three or more participants (see Figure 3b).

(iii) Bilateral Offsetting and Multilateral Offsetting An offsetting algorithm searches for a set of payments that can be settled when taking into account the incoming payments as a source of liquidity, and settles the selected payments simultaneously. In this process, each payment is settled on a gross basis, and a group of payments is never replaced by a net obligation. The bilateral offsetting algorithm runs continuously throughout the day. This is the main engine for settlements. The bilateral offsetting algorithm is “event driven” and it will run when one of the following events occur: (i) the submission of a new payment order; (ii) the increase in the LSF Account balance; or (iii) the settlement, reordering or cancellation of a top-queued payment. On the other hand, the multilateral offsetting algorithm is regarded as a complementary function to the bilateral offsetting. This algorithm is “time driven” and it runs at designated times of the day4.

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LSF Account Participant who wants to use the Liquidity-Saving Features (LSF) has to open5 the special account for the LSF (the “LSF Account”). The LSF Account is different from the “Current Account” which is used for the settlement of the RTGS mode. The Current Account is also used for the reserve requirements (see Table 3). The LSF is available only for payments between the LSF Accounts. On the other hand, the settlement of RTGS mode is executed only between the Current Accounts in the past. No settlement takes place between the LSF Account of a participant and the Current Account of other participant. The Intraday O/D is not available at the LSF Account. Thus, the only way of funding the LSF Account is the liquidity transfer from the Current Account. This means that the participant should manage the liquidity of two accounts: the Current Account and LSF Account. In this regard, the participants are able to transfer funds between the two accounts at any time during the day. Usually, the first thing in the morning, the participants transfer the funds necessary for the settlements of the day to the LSF Account, and transfer the additional funds to the LSF Account during the day if necessary.

At the end of the day, the balance in the LSF Account is transferred back to the Current Account automatically. Therefore, the outstanding of the LSF Account become zero at the end of the day. Most of the interbank transactions and customer transactions are eligible for the settlement at the LSF Account; however, some transactions should be settled only in the Current Account. Such transactions include the transactions with the BOJ and the government, the settlement obligation arising from the clearing systems, and the cash legs of securities transactions.

Sub-Project B of RTGS-XG Project Dispersed Situation of LargeValue Payments in Japan As mentioned above, the large-value payments in Japan were divided into three payment systems. First, the BOJ-NET was the main settlement channel of the large-value payments mainly for the money market transactions and securities transactions. The second one was the FXYCS, which handled mainly foreign exchange related payments. The last one was the Zengin System, which handled mainly the customer payments. However, a part of payments in the Zengin System, just 0.2% of total volume, were the large-value payments that are \100 million and up per transac-

Table 3. Current Account and LSF Account Current Account

LSF Account

Types of transactions settled

-Interbank transactions -Third-party transactions -Transactions with BOJ/government -Settlement obligations arising from clearing systems -The cash legs of securities transactions

-Interbank transactions -Third-party transactions

Liquidity supply

Intraday overdrafts

Liquidity transfer from the current account

Liquidity saving

Not applicable (pure RTGS)

LSF

Balance management

Overnight

Intraday (zero balance at the end of the day)

Time available

9:00-19:00

9:00-16:30

Source: BOJ (2005), modified

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tion. These 0.2% large-value payments accounted for 65% of total value. These fragmented large-value payments led to some issues. First, despite the Zengin System was characterized as a retail payment system and deployed the risk management scheme for the small value payments, the System also handled the large-value payments and there was a mismatch between the character of payments and its risk management. Second, the Zengin System and the FXYCS were both the same type of payment system, i.e., the DTNS system at the end of the day. It used to be the request of the Foreign Exchange Act to divide the foreign exchange related payments from the domestic payments, but the regulation of Act was relaxed substantially in 1996 and there was no need for the distinction between the international related payments and domestic payments any more. As a result of the changing legal environment, the duplication was created between the two payment systems: the Zengin System and the FXYCS. More specifically, there were the two same types of payment systems, both of which perform the end-of-the-day net settlement.

Consolidation of FXYCS Flows In October 2008, the FXYCS payments were consolidated into the BOJ-NET. At the same time, the DTNS mode of the FXYCS was abolished. In other words, the payments sent from the participants of the FXYCS are forwarded to the BOJ-NET and settled in the BOJ-NET either by the LSF or RTGS mode (see Figure 4). Only the RTGS mode of the FXYCS continues to be used, which was mainly used for the pay-ins/pay-outs to/from CLS Bank. The main flows of the FXYCS go through the FXYCS and forwarded to the BOJ-NET, where the payments are processed with the LSF mode. The framework of the FXYCS is maintained, which includes the system rules, participation rules and cost sharing. Especially, the framework of the direct and indirect participant is most important because the BOJ-NET does not have the scheme of indirect participation. With the new scheme, most of the payments just go through the FXYCS and the settlements take place at the BOJ-NET. In sum, the role of the FXYCS was significantly reduced by the aggregation of the payment flows to the enhanced BOJ-NET.

Figure 4. Incorporation of Payment Flows from FXYCS

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Consolidation of LargeValue Zengin Payments As for the Zengin System, a newly developed “Interface” will pick up the large-value payments (\100 million and up) from the Zengin payment flows and send them to the BOJ-NET. The forwarded large-value Zengin payments are processed with the LSF mode at the enhanced BOJ-NET. Meanwhile, the remaining small-value payments are processed in the Zengin System with the DTNS method as in the past (see Figure 5). By this consolidation, the Zengin System will become a hundred-proof retail payment system. When the Interface sends large-value payments to the BOJ-NET, only the interbank payment information will be sent, while the customer information will be kept in the Zengin System. This aggregation of the large-value Zengin payments is going to be implemented in November 2011.

Reconstruction of Payment Systems With the incorporation of large-value payment flow from the FXYCS and Zengin System, the

BOJ-NET will be substantially the one and only large-value payment system in Japan. On the other hand, the Zengin System will become the pure retail payment system. Now, the division of roles between payment systems becomes crystal clear. The estimated values derived from the statistics of 2008, the new BOJ-NET will process \142 trillion, or more than 97% of payment flows in value. Meanwhile, the Zengin System will handle \4 trillion, less than 3% of the whole payment values in Japan (see Figure 6).

Features of RTGS-XG Regarding the features of the RTGS-XG, three characteristics could be identified: (i) Integrated system, (ii) two-account system, and (iii) offsetting system.

Integrated System The enhanced BOJ-NET (the RTGS-XG) has two modes for settlements. In the Current Account, the settlements are made in a simple RTGS method, just the same as the BOJ-NET in the past. This mode can be called as the “pure RTGS mode.”

Figure 5. Incorporation of Large-Value Zengin Payments

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Figure 6. Consolidation of Large-Value Payment Flows

On the other hand, the settlements are made continuously with bilateral and multilateral offsetting in the LSF Account. This is called the “Liquidity Saving mode” or “Hybrid mode,” where the offsetting is executed on a continuous basis. Having both the RTGS mode and Hybrid mode, the RTGS-XG can be defined as an Integrated system (see Chapter 5 for more detail). The participants are able to select the mode of settlement according to the urgency and character of the payment. Most of the payments are supposed to go to the Liquidity-Saving mode, because a participant can make settlements with fewer amount of liquidity using this mode, which means the participant can save the liquidity cost. By the nature of things, the urgent payments or time-critical payments are supposed to be processed in the pure RTGS mode. Also some transactions, including the BOJ-related and government-related transactions and the DVP settlements of the JGBs are also assigned to the pure RTGS mode. With the evolutionary reform, the RTGS-XG became one of the cutting edges of the world payment systems, standing comparison with the TARGET2 in the euro area and the LVTS in Canada.

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Two-Account System The RTGS-XG has two separate accounts in one system: the Current Account and the LSF Account. Participant has to monitor and manage the two liquidities in each account during the day. In some Integrated systems, the single liquidity pool scheme is adopted, and the participants can control the liquidity in a single account. It can’t be denied that the single liquidity pool might be more user-friendly than the two-account system. However, the RTGS-XG allows participants to transfer the liquidity flexibly between the two accounts anytime during the day, which could be called the “full-time Liquidity Bridge.” Thus, it can be presumed that the management burden of two liquidities is not so heavy. A lighter burden is apparent when compared to the EAF2 in Germany, which allowed transferring the liquidity only once every hour. In terms of two accounts, the RTGS-XG has a similar structure to the Paris Integrated System (PIS) in France, where the Liquidity Bridge combines the PNS account and the TBF account (see Chapter 5 for more detail).

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In the case of the RTGS-XG, the consideration for the system development was the major factor to choose the separate account system. The BOJNET provides not only the fund transfer service but also the government bond settlement service. Therefore, the Current Account already has a very complicated link with the JGBs account in the BOJ-NET through the DVP mechanism and the self-collateral scheme. It seemed concerned that it might make the account structure too much complicated to add the LSF function to the Current Account.

Offsetting System The RTGS-XG adopts the offsetting scheme. As mentioned earlier, there is not much difference between the netting scheme and offsetting scheme, with regard to the outcome of the processing. In both cases, the amount of difference between the outgoing payment and incoming payment is added or debited from the participants’ accounts. Originally, the concept of offsetting was introduced in the RTGSplus in Germany in 2001 for the first time in the world. It was because the RTGSplus should be a part of the TARGET which allowed the linkage only to the RTGS systems. So to avoid becoming the netting system that could not be linked to the TARGET, the Deutsche Bundesbank invented the concept of “offsetting,” which means the simultaneous booking of the offsetting payment flows on a gross basis. In the case of the BOJ-NET, there is no such a constraint and the BOJ could possibly have adopted the netting concept. But only a situation was that the BOJ abolished the netting mode in 2001 when the BOJ-NET became a pure RTGS system. So it will presumably be rather difficult for the BOJ to explain the LSF as adding a netting function again only several years after. It’s just conceivable that this might be a sort of reason to adopt the offsetting concept instead of the netting concept.

Benefits of RTGS-XG Based upon the characteristics of the RTGS-XG mentioned above, the benefits of the enhanced project can be interpreted as follows.

To Achieve Earlier Settlement The first benefit of the RTGS-XG is to realize the earlier settlement and ensure the finality in the daytime, which lead to the risk reduction. In the past, the large-value payments that were processed in the FXYCS and Zengin System obtained the finality of settlements only at the end of the day. After incorporating all the large-value payments into the RTGS-XG, all the settlements will be made on a continuous or real-time basis. Thus, all the settlement has the finality during the day, which is called the “intraday finality.” It is a major benefit of the RTGS-XG to give the intra-day finality to all the large-value payments and reduce settlement risk.

To Reduce Liquidity Cost The second benefit is to reduce the liquidity cost for the participants. With the LSF, the participants can make the continuous gross settlement with small amount of liquidity by offsetting their outgoing payments with the incoming payments from the other participants. Although the BOJ provide the intraday overdraft with no fee, the participants have to pledge the collateral to get the overdraft, which is accompanied by the collateral cost. Thereafter, the RTGS-XG reduces the intraday liquidity cost for the participants by reducing the liquidity amount necessary for settlements.

To Prevent Gridlock The third benefit is to prevent a “gridlock” in the payment system. In the pure RTGS system, the participants tend to wait for the incoming payments before sending their outgoing payments,

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or sometimes try to send the payment instructions as late as possible in order to save their liquidity. If many participants try to do the same thing, the circulation of liquidity in the system will be blocked and prevents a substantial number of instructions from being executed. This kind of situation is called the “gridlock.” With the LSF, the RTGS-XG matches the offsetting payment flow and save the liquidities of both sides. This substantially reduces the necessity for the participants to hold the sending payments. This means that there is no incentive any more for the late payments which might bring the gridlock. Accordingly, the participants are expected to send their instructions earlier than before and the overall settlements should become earlier in the system.

To Comply with Global Standard As described above, the effort to comply with the Core Principles was the outset of the RTGS-XG project. After the project is completed, all the large-value payments are forwarded to the BOJNET and will be settled with the intraday finality during the day. This situation meets the “best practice” of the Core Principles, which requires large-value payment systems to provide the intraday finality. The enhanced BOJ-NET as well as the FXYCS and Zengin System meet the requirement of the Core Principles. This is another important benefit of this project.

FXYCS Outline of FXYCS Role of FXYCS The Foreign Exchange Yen Clearing System (the FXYCS) is a private payment system operated by the Tokyo Bankers Association (TBA).

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The FXYCS handles the JPY leg of the foreign exchange transactions. When it started its operation in 1980, the paper-based instructions were exchanged manually between the participants. And the net position of each participant was settled at the accounts in the BOJ. In 1989, the FXYCS became the electronic payment system, utilizing the computers and networks. At that time, the operation of the system was outsourced to the BOJ. It was rather exceptional, the central bank became the IT system operator of the private payment system.

Participants of FXYCS The participants of the FXYCS were 212 banks as of the end of 2009. Direct Participants are less than 30 banks, and almost 90% of participants were Indirect Participants, which outsourced the sending and receiving of the payments and the fund settlement to one of the Direct Participants.

Settlement Method of FXYCS The FXYCS was originally a DTNS system, settling the net positions at the end of the day. In 1998, the RTGS mode was added. The RTGS mode was introduced to achieve the pays-in to CLS Bank, which is the time-critical payment.

Risk Management of FXYCS In order to strengthen the risk management, the FXYCS introduced the “bilateral net credit limit” (the net receiver limit) and the “multilateral net debit cap” (the net sender cap) in 1998. The lossshare rule, liquidity provider scheme, and collateral scheme were also introduced. With these risk management schemes, the FXYCS accomplished the “Lamfalussy Plus One” in 2004. When the net settlement mode was closed in 2008, all of these risk management schemes were

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abolished because these schemes are to brace for the risk arising from the net settlement.

Decreased Role After RTGS-XG Project As explained above, the FXYCS payments were incorporated to the BOJ-NET in October 2008. In other words, the payments sent to the FXYCS are just forwarded to the BOJ-NET and the settlements take place at the BOJ-NET. This means that the FXYCS became a payment system through which the payment messages just pass. Stated differently, the role of the FXYCS decreased substantially after the incorporation of the payment flows to the BOJ-NET.

ZENGIN SYSTEM Outline of Zengin System Role of Zengin System The Zengin Data Telecommunication System (the Zengin System) is a nationwide electronic fund transfer network mainly for the customer payments. It is operated by the Japanese Banks’ Payment Clearing Network (the Zengin-Net). The Zengin System is regarded as a retail payment system mainly for the small-value payments by individuals and corporates. The Zengin System is the equivalent of the Automated Clearing House (ACH) in the US, the Vocalink in the UK, or other retail payment systems in euro area, such as the Equens (Germany/Netherlands), the STET (France), the ICBPI (Italy), the Iberpay (Spain), the DIAS (Greece), and the rest. One of the features of the Zengin System is that it is dedicated to the domestic payments. This is because the international payments (e.g., the payments for the FX transactions) were allocated to the FXYCS by the law. Consequently, the Zengin

System is sometimes called the “Domestic Fund Transfer System.” Another feature of the Zengin System is that it is basically a retail payment system but also handles the large-value payment. The large-value payments (\100 million or more) are just 0.2% of the payments handled by the Zengin System in volume, but it is equivalent to 65% of the payments in value. It is planned the large-value Zengin payment will be incorporated to the new BOJ-NET in November 2011, as mentioned above. When the Zengin System started operation in 1973, it was originally a payment network mainly for the city banks and regional banks. Later, it extended its participation to other categories of financial institutions, including the credit unions, credit cooperatives and agricultural credit cooperatives. With the phased expansion of the participating categories, it became the nationwide network which almost all financial institutions participated in. All thanks to the nationwide coverage of the Zengin System, individual and corporate can make the yen payment from any banks to any financial institutions in Japan. The Zengin System upgrades its system every eight years. The current system is the fifth-generation system, which started operation in November 2003. The six-generation system, or the next generation system with enhanced functionality, is planned to go into operation in November 2011.

Participants of Zengin System The participants of the Zengin System were 1,396 financial institutions and 32,865 branches, as of the end of 2009. It covers from the leading commercial banks to the small credit cooperatives and agricultural cooperatives. It can be described that almost all financial institutions in Japan are the participants of the Zengin System. However, the number of participants and participating branches are on a downward trend from 1990s. That is because of the mergers between financial institu-

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Figure 7. Number of Participating Banks and Branches of Zengin System

tions, and the eliminations and consolidations of branches as a streamlining measure (see Figure 7).

Traffic of Zengin System The average daily volume of Zengin System was 5.7 million in 2009. On a peak day, the transaction volumes exceeded 21 million, which was more than three times of the daily average. In terms of transaction value, the average daily value was \9.8 trillion, and the value of the peak day was \53.8 trillion in 2009. The figure of \9.8 trillion was the amount before netting and the amount after netting and settled at the BOJ-NET was \1.8 trillion, or 19% of the transaction value. The credit transfer accounted for 81% in volume and the direct deposit of payrolls made up 18% of the traffic. On the contrary to the decrease of the participating banks and branches, the traffic of Zengin System is growing year by year gradually. The transaction value of the Zengin System fluctuates according to the economic situations of Japan. For example, the transaction value of 2009 decreased by 9.8% from the previous year due to

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the economic downturn as a result of the global financial crisis (see Figure 8). The average value per transaction was \1.7 million, which was much smaller than \2.2 billion of the BOJ-NET, and \512 million of the FXYCS. This figure shows that the characteristic of the Zengin System is retail payment system.

Settlement Method of Zengin System The Zengin System is a Designated-Time Net Settlement (DTNS) system, settling the net positions at the end of the day. The participants are able to send payment messages to the Zengin center from 8:30 a.m. to 3:30 p.m. Payment messages can be sent one by one, or by the batch file transfer. Once received by the system, the payment messages are exchanged between the participants nearly in real time. With these payment messages, the system calculates the net position of each participant by netting, and transmits the final net position information to the BOJ-NET at around 3:50 p.m. Following the instructions, the BOJ-NET debits the accounts of the “short participants” and credits the amount to the Zengin-Net account at 4:15 p.m.

Payment Systems in Japan

Figure 8. Traffic of Zengin System (daily average of each year)

And after the completion of these processing, the BOJ-NET debits the Zengin-Net account and distributes the funds to the accounts of the “long participants.” Then, the settlements of the net positions are completed (see Figure 9). A participant can monitor its own net position in real time in order to manage its own liquidity.

Risk Management of Zengin System Same-Day Settlement The Zengin System was originally a “Next-Day Settlement System,” where the final settlement is made at 1:00 p.m. on the next business day

Figure 9. Message Traffic and Settlement of Zengin System

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after the payments are exchanged. The Next-Day Settlement System is accompanied by the overnight settlement risk, as the unsettled obligations are carried forward until the next day. Therefore, the Zengin System changed the settlement cycle in 1993, and currently the settlement is executed on the same day when the participants send the payment messages.

Net Sender Cap The “Net Sender Cap” was introduced in 1990. The “excess amount” is calculated for each participant by subtracting the amount of incoming payments from the amount of outgoing payments. The system automatically controls the excess amount under a certain level. More concretely, if the excess amount of a participant exceeds a certain level, the system sends the warning message to the participant. And if the excess amount goes over the Net Sender Cap, the outgoing payment message is returned to the participant as an error message. This scheme plays a role to control the risk of overall unsettled obligation under a certain level for the whole system. When introduced in 1990, the warning level was set at the five times of a participant’s average daily value of the previous year, and the Cap was set at the ten times of that. In 1994, the “self-assessment method” was introduced, and each participant was able to decide its own Cap. In return, each participant should pledge the collateral in accordance with the Cap. Later, the Cap management and the required collateral were strengthened. By tightening the risk management, the Zengin System accomplished the “Lamfalussy Plus One” in 2002, which the system can complete the timely settlement even if the top two participants with the largest debit position would become default on the same day.

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Bank Guarantee Scheme Choice between Collateral and Bank Guarantee In 2001, the Zengin System introduced the “Bank Guarantee Scheme.” Under this scheme, the participants make a choice between the collateral and the Bank Guarantee. In principle, the participants should pledge the collateral equivalent to 100% of the Net Sender Cap which each participant declared. However, a participant is able to substitute the Bank Guarantee for collateral as for a portion or entire Cap. The merit of this scheme is that the participant which received the Guarantee can save the collateral and reduce the collateral burden. Meanwhile, the bank which gives the Guarantee to the other participants is able to gain a fee income. However, the bank should increase its own collateral by the amount which is equivalent to the top two Guarantees given to the other participants.

Example of Bank Guarantee The concrete example of the choice between the collateral and the Bank Guarantee is as follows. Assume that Bank X and Bank Y declared each the Net Sender Cap of 100 to the Zengin-Net. When Bank X received the Guarantee of 50 from Bank A and the Guarantee of 30 from Bank B, the collateral of 20 is enough to cover the Cap. On the other hand, if Bank Y does not receive any Guarantees from other participants, it should pledge the collateral of 100 to the Zengin-Net (see Figure 10).

Collateral Required for the Guarantees Assume that Bank Z gave the Guarantee of 50 to Bank C, 30 to Bank D and 20 to Bank E. In this case, Bank Z has to pledge the collateral for the top two Guarantees (i.e. 80 = 50 + 30), in addition to the collateral for its own Cap (see Figure 11).

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Figure 10. Bank Guarantee Scheme of Zengin System

Loss-Share Rule The loss-share rule of the Zengin System is basically based on the “Defaulter’s Pay.” Each participant should pledge the collateral or receive a Guarantee from other participants, the total of which should be equivalent or more to the Net Sender Cap of each participant. If a participant becomes unable to pay the obligation of the day,

the Zengin-Net borrows the funds from the “Liquidity Providers” with the collateral pledged by the defaulter. With the borrowed funds, the Zengin-Net completes the settlements of the day in a timely manner. Later, the Zengin-Net repays the borrowed funds with the money received from sale of the collateral. The Zengin-Net assigns more than twenty Liquidity Providers with borrowing facility of more than \2 trillion.

Figure 11. Collateral entailed by Giving Guarantee

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If a defaulter received a Guarantee from the other banks, the banks should bear the cost of default within the range of the Guarantee. To put it the other way around, unless a participant gives the Guarantee to the defaulter, no loss-share will arise from the default of the other participants.

Sixth Generation of Zengin System The Zengin-Net is planning to upgrade the Zengin System to the sixth generation system in November 2011. With this upgrade, the new communication protocol and message format will be introduced and some new functionality will also be added.

New Communication Protocol and Message Format Communication Protocol The Zengin System uses the communication protocol and message format which are specific to the Japanese market, and are sometimes criticized as not fitting with the international standard. In the sixth generation system, the new protocol and format will be adopted to comply with the international standard. As for a communication protocol, the “Transmission Control Protocol/Internet Protocol” (TCP/IP) will be adopted, which is regarded as the standard of communications throughout the world. And as a communication network, the “Internet Protocol-Virtual Private Network” (IP-VPN) will be adopted instead of the current Frame Relay network.

Message Format The new message format will be introduced, which is using the XML (eXtensible Markup Language) and based on ISO 20022. The “XML” is a markup language for describing the messages and data. The XML has a wide interoperability and flexibility, and also has the

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features of computer-processable and humanreadable. With these characteristics, the XML is becoming widely used in the financial industry. The “ISO 20022” is the international standard that defines the scheme for the development of financial message standards. This is regarded as the next-generation international standard for message format used in the financial industry. This is the reason why the Zengin-Net decided to adopt the future de facto standard. The adoption of the XML and ISO 20022 will contribute to enhance the flexibility in connection mechanism between the Zengin System and other systems. Especially, it will be a great benefit for the foreign banks, which should convert the message format between at home and abroad. It should be noted that the usage of the new message format with the XML and ISO 20022 is an option. Therefore, the participants who want to continue to use the old format can stick to it. The central system makes the mutual conversions between the new and old message format.

EDI Capability The sixth generation system of the Zengin System will have the “Electronic Data Interchange” (EDI) capability. The participants are able to send several EDI files with a payment message, which contains the remittance information, or the information to identify the transaction which caused the payment. A single “EDI file” is able to contain up to 140 characters. And a number of EDI files can be added to one payment message within the limit of maximum length of the whole message. This means that more than 30 EDI files can be sent with a single payment message. The EDI capability is available, only when both the sending bank and the receiving bank adopted the new message format with the XML and ISO 20022. The fact is that the current Zengin System had the very limited EDI capability, which could handle only a single file with the maximum length of 20 characters. However, the 20 characters were

Payment Systems in Japan

too limited to be used in the real business. As a result, this function was seldom used. With the drastic enhancement of the EDI capability, it is predicted that the Zengin System will handle a lot of EDI files, which will be a great benefit to the corporate sector (see Chapter 9 for more detail).

REFERENCES Bank of Japan. (2005, December). Proposal for the Next-Generation RTGS Project of the BOJNET Funds Transfer System. Bank of Japan. (2006a, February). Framework for the Next-Generation RTGS Project of the BOJ-NET Funds Transfer System (in Japanese). Bank of Japan. (2006b, September). The New Development of the BOJ-NET Funds Transfer System (in Japanese). Bank of Japan. (2006c, October). Japan’s NextGeneration RTGS. Bank of Japan. (2009, May). BOJ-NET Funds Transfers after the Implementation of Phase 1 of the Next-Generation RTGS Project. Bank of Japan. (2006-2008). Payment and Settlement Systems Report (in Japanese). Bank of Japan/ Payment and Settlement Systems. http://www.boj.or.jp/en/theme/psys_seibi/index. htm

Nakajima, M. (2007). Coincidental Developments of the Two “Next Generation RTGS Projects” in EU and Japan (in Japanese). Reitaku International Journal of Economic Studies, 15(1). Nakajima, M. (2008). Global Trends of Payment Systems and the Next-Generation RTGS Project in Japan. In Kubota, T. (Ed.), Cyberlaw for Global E-Business: Finance, Payment, and Dispute Resolution. Hershey, PA: IGI Global. Zengin Net. http://www.zengin-net.jp

ENDNOTES 1



2



3



4



5



Although the foreign exchange control had been already relaxed, the division of roles between the payment systems continued. The closing time is 5:00 p.m. for the participants that have not applied for the access to the extended hours. On the last business day of the month, the settlement time is extended by 30 or 60 minutes because the transaction volumes are very high at the end of the month. The multilateral offsetting algorithm runs four times a day: at 10:30 a.m., 1:30 p.m., 2:30 p.m., and 3:30 p.m. in Japan Standard Time. Approximately 300 institutions, or 80% of the participants, opened the LSF Account as of March 2009.

Imakubo, K., & McAndrews, J. (2005, August). Initial Funding Levels for the Special Accounts in the New BOJ-NET. Bank of Japan Working Paper Series. Japanese Bankers Association. (2004, March). Proposal for Reorganizing Fund Transfer Systems in Japan – Introducing a “Large Value Settlement System” (in Japanese).

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Chapter 12

CLS Bank

ABSTRACT This chapter focuses on the CLS Bank. CLS Bank International (hereinafter referred to as “CLS Bank”) was established in 1999 to eliminate settlement risk associated with settling foreign exchange (FX) transactions in different time zones. It provides the unique multi-currency Payment versus Payment (“PVP”) settlement service for the major players in the FX market. Although CLS Bank was established as a private bank in the US, the main purpose of the Bank is neither to accept deposits nor to make loans. Its function is dedicated to providing a multi-currency settlement service. Thus it is more appropriate to regard CLS Bank as a kind of payment system, or market infrastructure than just a private bank. This chapter elaborates on the mechanism of CLS Bank, which includes the organization, the shareholders, the eligible currencies, and the accounts used for CLS settlement. The funding and settlement procedures and risk management schemes of CLS Bank are discussed in greater detail. In addition, the impact of CLS Bank to FX settlements and the FX market is also analyzed.

INTRODUCTION In FX settlements, there is settlement risk arising from settling two currencies in different jurisdictions and often different time zones. That is the risk that one party of a FX transaction pays the currency it sold but does not receive the currency it bought. For example, the Japanese Yen-leg is settled at Tokyo market in the Japan time zone, the euro-leg

is settled in the European time zone, and the US dollar-leg is settled in the US time zone. In the case of transaction between Japanese Yen (JPY) and the US dollar (USD), there is a time-lag between the settlement time of the JPY-leg and that of the USD-leg. Therefore, one party has the risk that it cannot receive the counter value in the USD, even if it delivers the JPY amount. This kind of settlement risk caused by the time difference is referred to as the “Herstatt risk.”

DOI: 10.4018/978-1-61520-645-2.ch012

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CLS Bank

The presence of this risk was widely recognized for the first time by the financial community and regulators in 1974, when Herstatt Bank in Germany was closed on 26th June. Herstatt Bank was ordered the closure at 3:30 p.m. in Frankfurt, after the close of the interbank payment system in Germany. The closure time of the Bank was 10:30 a.m. in New York. Under such circumstances, the FX counterparts of Herstatt Bank had all paid their Deutsche marks to Herstatt Bank but never received their purchased USD. With the bankruptcy of Herstatt Bank, all the counterparties lost the total value of their FX trades with the Bank (see chapter 3 for more detail). Similarly, at a later date, some major banks suffered the huge losses when the Bank of Credit and Commerce International (BCCI) went into bankruptcy in 1991. This incident caused the banking community to consider again the gravity of the FX settlement risk. Since the FX market has grown strongly over fifty years, even if this settlement risk persists for only a short and limited time, the total exposure of the FX trades could be very large compared to the capital of the banks involved in the trade. Usually, the average value per FX transaction is large and can be enormous. The FX settlement risk is not the “Replacement Cost Risk” but the “Principal Risk,” which is a risk that a party will lose the full value of the trade. Therefore, the active banks in the FX market hold significant risk on a day-to-day basis. In some cases, the large banks may have almost three times more exposure to the FX settlement risk than to the credit risk which the banks hold as a whole. The daily settlement exposure reaches tens of billions of dollars constantly. In an extreme case, the exposure of a bank to a single counterparty goes beyond the entire capital of the bank. There were long discussions about how to cope with the Herstatt risk at the level of central banks, at industry group level, and in the individual banks,

respectively. The PVP concept of CLS Bank was derived from these discussions.

BACKGROUND OF CLS BANK Effort to Reduce FX Settlement Risk Concern of Central Banks From the mid-1990s, the central banks became increasingly concerned that the high level of the FX settlement risk could trigger a serious disruption of the global FX markets and cause a major damage to the financial stability. In 1996, the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) published a report titled “Settlement Risk in Foreign Exchange Transactions.” This report is sometimes referred to as the “Allsopp report,” after Mr. Peter Allsopp of Bank of England, the chairman of the working group which prepared the report.

Three-Track Strategy of Allsopp Report This report advocated the “Three-Track Strategy” to reduce the systemic risk associated with FX settlements. The strategy called for actions at three different levels. First, individual banks should take actions to control their FX settlement exposure. Second, the industry groups should develop the FX settlement risk-reducing multi-currency services. Third, the central banks should take actions to promote the prompt improvement in the FX settlement risk reduction in the private sector. Among these actions, the highest priority was given to the industry initiatives. In brief, the report gave a significant homework to the industry group.

Result of G20 Study In parallel with the preparation of the Allsopp report, the “Group of Twenty” (G20), which was

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comprised of the world’s 20 major banks, conducted a comprehensive study on the necessary multi-currency settlement service to eliminate the FX settlement risk. The result of this study was the “Continuous Linked Settlement” (CLS) concept, which was a simultaneous exchange of each of the two legs of an FX transaction, using a “Payment versus Payment” (PVP) mechanism. The source of the FX settlement risk lies in the fact that each currency leg of an FX transaction is being settled separately. Thus, the CLS concept is intended to settle two payment instructions relating to a FX transaction simultaneously to eliminate the time lag between the two legs.

Establishment of Organizations Along with the progress of the discussion on the settlement mechanism, the project to establish the organization to provide the multi-currency settlement service was also proceeded. First, “CLS Services Ltd” was established in London in July 1997. Later, “CLS Bank” was established as an Edge Act Corporation in New York in November 1999. After the development phase of the CLS system and an extensive test phase, CLS Bank started operations in September 2002. CLS Bank

went live with 39 Settlement Members and seven eligible currencies (Table 1).

True Nature of CLS Bank CLS Bank is a “special purpose bank” which is dedicated to eliminating the FX settlement risk by providing a special mechanism of settlement called the “Continuous Linked Settlement.”

PVP Mechanism CLS Bank adopts the method of the “Payment versus Payment” (PVP), which is a mechanism that ensures a final transfer of one currency occurs if, and only if, a final transfer of the other currency takes place simultaneously. With the PVP scheme, the payment of one currency always goes hand-in-hand with the payment of another currency. In sum, the PVP is an effective solution for eliminating settlement risk caused by the time lag of the two legs. In other words, the settlement through CLS Bank (the “CLS settlement”) effectively eliminates the FX settlement risk.

Table 1. Brief Sketch of Establishment and Development of CLS Bank Timing

Affair

March 1996

The BIS published the Allsopp report (“Settlement Risk in Foreign Exchange Transactions”).

July 1997

The CLS Services Ltd was established in London.

November 1999

The CLS Bank was established in New York.

April 2002

The CLS Group Holdings AG was established in Zurich.

September 2002

The CLS Bank started operations for 7 currencies.

September 2003

The eligible currencies were extended to 11.

December 2004

The eligible currencies were extended to 15.

November 2007

The CLS Bank started credit derivative settlement with DTCC.

December 2007

The CLS Bank started NDF service.

May 2008

The eligible currencies were extended to 17.

Source: CLS Group

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Support of Central Banks

OUTLINE OF CLS BANK

Even though CLS Bank was established as a private bank, establishing CLS Bank was not a pure private-sector-driven project. As mentioned above, the project was an assignment from the central banks to the industry group. With this background, the central banks have encouraged and supported the progress of the project towards achieving its goal. Some central banks even encouraged the major banks at home to join the project or become a Member of CLS Bank. In addition, the central banks contribute to the daily CLS settlements by allowing CLS Bank to have an account at each central bank and to become a direct member of the RTGS system in each country. This is a unique arrangement between the central banks and private sector. Therefore, it can be described that this was a project of public nature with the purpose of reducing the FX settlement risk. CLS Bank is an institution dedicated to the settlement service, and undertakes no other business such as the commercial lending or securities investment. And as CLS Bank never becomes counterparty to the FX transaction at any time, it does not bear any FX settlement risk.

Organization of CLS Bank

CLS Bank as a Payment System

CLS Bank International

CLS Bank is a global multi-currency payment bank that has the organizational form of a private bank. However, as the background for its creation shows, CLS Bank was intended to be a market infrastructure to deal with multi-currency settlements specifically for the FX transactions. For this reason, it is appropriate to recognize CLS Bank as a kind of payment system rather than an ordinary bank. Actually, the Federal Reserve Bank of New York regulates and supervises CLS Bank as a “Systemically Important Payment System” (SIPS).

CLS Bank (CLS Bank International) is a 100% subsidiary of the CLS UK Holding. It was established as an Edge Act Corporation in New York, which is a banking institution with a special charter from the Federal Reserve to specifically conduct international banking operations and does not accept retail deposits. It is directly supervised by the Federal Reserve. CLS Bank is also subject to a “cooperative oversight” arrangement, in which the central banks whose currencies are settled in CLS Bank participate. The Federal Reserve is the lead overseer of the cooperative oversight, and organizes and administers the “CLS Joint

CLS Group Holdings AG The CLS Group is composed of four institutions (see Figure 1). The “CLS Group Holdings AG” is the ultimate holding company, which has the wholly-owned subsidiary, the CLS UK Holding. The CLS Group Holdings AG fulfils the management function of the entire group and makes strategic decisions. It was established in Switzerland and regulated by the Federal Reserve as a US bank holding company. It is owned by 72 shareholders consisting of the world’s leading banks as of the end of 2010.

CLS UK Holding The CLS UK Holding is a private limited company in the UK, which has two wholly-owned subsidiaries, CLS Bank and CLS Services. Based in London and with a representative office in Tokyo, it acts as an intermediate holding company of the CLS Group. It provides the financial, personnel and audit services to the group companies.

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Figure 1. Organization of the CLS Group

Oversight Committee,” the primary forum for the participating central banks.

CLS Services Ltd CLS Services Ltd is a company organized under the UK law and located in London. It provides the technical and operational support to CLS Bank, including the operation of the system and back-office support.

Shareholders of CLS Group As noted above, 69 major banks in the world are shareholders of the CLS Group as of the end of 2009. These shareholders bore the system development cost and assume the corporate governance of the Group. The Board of the CLS Group Holdings AG is composed of 15 directors from the shareholders as well as the CEO and the deputy CEO. Each shareholder has an equal vote in the governance of the CLS Group Holdings. Only a shareholder bank can become a Settlement Member of CLS Bank.

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Eligible Currencies of CLS Bank When CLS Bank started operations in September 2002, there were only seven eligible currencies of the Bank: the US Dollar, the euro, the UK Pound, the Japanese Yen, the Swiss Franc, the Canadian Dollar, and the Australian Dollar. One year after the launch, CLS Bank added four currencies for settlement: the Swedish Krona, the Danish Krone, the Norwegian Krone, and the Singapore Dollar. As the third wave currencies, a further four currencies were added in 2004: the Hong Kong Dollar, the New Zealand Dollar, the Korean Won, and the South African Rand. Most recently, two currencies, the Israeli Shekel and the Mexican Peso, were added in 2008, which made the total eligible currencies 17 (Table 2). These 17 currencies account for 94% of the transaction value in the worldwide FX market. However, it does not mean that 94% of the transactions are settled through CLS Bank, as described below.

CLS Bank

Table 2. Expansion of Eligible Currencies in CLS Bank Wave

When introduced

Number of Currencies

Target currencies

First wave currencies

September 2002

7 currencies

US Dollar, Euro, UK Pound, Japanese Yen, Swiss Franc, Canadian Dollar, Australian Dollar

Second wave currencies

September 2003

4 currencies

Swedish Krona, Danish Krone, Norwegian Krone, the Singapore Dollar

Third wave currencies

December 2004

4 currencies

the Hong Kong Dollar, the New Zealand Dollar, the Korean Won, the South African Rand

Fourth wave currencies

May 2008

2 currencies

the Israeli Shekel, the Mexican Peso

Total

--

17 currencies

--

Targeted Transaction of CLS Bank The targeted transaction of CLS Bank covers a wide range of FX transactions as well as some derivatives transactions. CLS Bank settles payment instructions received for the following kinds of transactions: (i) FX spot, (ii) FX forwards, (iii) FX option exercises, (iv) FX swaps, (v) Non Deliverable Forwards (NDFs), and (vi) Credit derivatives (see Table 3). CLS settlement is possible only if two conditions are satisfied. First, both payment instructions should be the CLS eligible currencies. Second, both parties of the transaction should be able to settle at CLS Bank directly or indirectly.

Traffic of CLS Bank CLS Bank settles on average 589 thousand FX instructions with a total daily average value of $3.66 trillion per day in 2009. On a peak day (16 February 2010), CLS Bank settled more than 1.7 Table 3. Six categories of Targeted Transaction of CLS Bank €€€€€€€€€€€€(i) FX spot €€€€€€€€€€€€(ii) FX forwards €€€€€€€€€€€€(iii) FX option exercises €€€€€€€€€€€€(iv) FX swaps €€€€€€€€€€€€(v) Non Deliverable Forwards (NDFs) €€€€€€€€€€€€(vi) Credit derivatives

million instructions with a value of more than $6.1 trillion in a single day. We can recognize CLS Bank as the world’s largest FX settlement infrastructure. The shareholder banks actually use CLS Bank very extensively. That is, 95% of their trades with each other are settled at CLS Bank. In a global sense, it is estimated that approximately 58% of daily FX transactions are settled through CLS Bank in value. In sum, CLS Bank is a huge payment system which handles more than half of the FX transactions across the globe. It is obvious that CLS Bank makes an extremely significant contribution to reduce the FX settlement risk.

Membership of CLS Bank There are several types of participants in the CLS settlement service. First, the “Settlement Members” are the direct participants of CLS settlement and have an account at CLS Bank. Second, the “User Members” are the indirect participants of CLS settlement, and do not have an account with CLS Bank and outsource the CLS settlement to a Settlement Member. Third, the “Third parties” are the customers of the Settlement Members or User Members. The details of these memberships are as follows.

Source: CLS Group

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Settlement Members

Third Parties

A “Settlement Member” is a direct participant of CLS Bank and has a single multi-currency account with CLS Bank. The Settlement Members may submit the payment instructions directly to CLS Bank, which include their own FX transactions as well as their customers’ transactions. The requirements to become a Settlement Member1 are; (i) To be a shareholder of CLS Group Holdings AG, or a 100% subsidiary of the shareholder, and (ii) To have certain level of financial and operational capabilities (the capital, rating, financing capacity of liquidity, business processing capability, etc.). There are 61 Settlement Members as of the end of 2010.

A “Third party” is a customer of the Settlement Members or User Members. It does not have any relationship with CLS Bank, and is able to make CLS settlements through the Settlement Members or User Members. The relationship between the Third parties and Settlement Members (or User Members) is defined by a contract between them and CLS Bank is not involved in this relationship. There were 10,886 Third parties as of the end of 2010, which included 379 banks, 39 corporates and 143 non-bank financial institutions. More than 10 thousands of them were investment funds.

User Members

The “Third Party Service Providers” are the Settlement Members or User Members who offer the CLS settlement service to their customers. The customer may achieve the benefits of the CLS settlements as a Third party. There are 24 Members across the globe acting as a Third Party Service Provider.

A “User Member” may submit payment instructions directly, but it does not have an account with CLS Bank. Thus, the settlements of the User Member’s instructions are executed through the sponsoring Settlement Member. Stated differently, the “Designated Settlement Member” (DSM) is responsible for all the funding for the obligations relating the User Member’s instructions and for having these instructions processed through its account. For this reason, each instruction submitted by a User Member must be authorized by its DSM. A User Member’s instructions may include its own transactions as well as its customers’ transactions. The requirements to become a User Member are; (i) To be a shareholder of CLS Group Holdings AG, or an affiliated company of the shareholder, and (ii) To have certain level of financial resources and operational capabilities. The Settlement Members and User Members are collectively-referred to as the “CLS Members.” There were only 2 User Members as of the end of 2010.

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Third Party Service Providers

Accounts Used for CLS Settlement The account relationships of CLS Bank are twotiered. First, CLS Bank holds an account at each central bank of eligible currency. The funds are received and paid between CLS Bank and the Settlement Members through the Bank’s accounts at the central banks. Second, each Settlement Member holds a multi-currency account at CLS Bank. The CLS settlements are made across these accounts at CLS Bank.

CLS Bank Accounts at Each Central Bank As CLS Bank holds an account at the central bank for each eligible currency, CLS Bank therefore can participate directly in the Real-Time Gross

CLS Bank

Figure 2. CLS Bank’s Link to RTGS System and Central Bank Account

Settlement (RTGS) systems of the eligible currencies (Figure 2). When a Settlement Member makes a payment (Pay-In) to CLS Bank, the Member uses the RTGS system of the currency and transfers funds to the CLS Bank account at the central bank. In the same way, CLS Bank distributes funds (Pay-Out) to the Member’s accounts at the central bank using the RTGS system of the currency (Table 4).

Nostro Agent A Settlement Member can make a Pay-In to CLS Bank by itself. Alternatively, if the Member is not a direct participant of the RTGS system of the currency, they use an appointed “Nostro Agent” for the currency to either pay or receive on their behalf. The Nostro Agent takes care of funding and the Pay-In procedure on behalf of the Member. For example, when a Japanese bank asks a US bank to make Pay-Ins on its behalf in the USD via the Fedwire, the US bank is the Nostro Agent for the Japanese bank. In the opposite direction, a US bank may assign a Japanese bank as its Nostro Agent for the JPY.

Table 4. Eligible currencies and related RTGS systems Eligible currency

RTGS systems used for Pay-ins and Pay-outs

US Dollar (USD)

Fedwire

Euro (EUR)

TARGET2

Japanese Yen (JPY)

FXYCS/BOJ-NET

UK Pound Sterling (GBP)

CHAPS

Swiss Franc (CHF)

SIC

Canadian Dollar (CAD)

LVTS

Australian Dollar (AUD)

RITS

Swedish Krona (SEK)

RIX

Danish Krone (DKK)

KRONOS

Norwegian Krone (NOK)

NICS/NBO

Singapore Dollar (SGD)

MEPS+

Hong Kong Dollar (HKD)

CHATS

New Zealand Dollar (NZD)

ESAS

Korean Won (KRW)

BOK-Wire

South African Rand (ZAR)

SAMOS

Israeli Shekel (ILS)

ZAHAV System

Mexican Peso (MXN)

SPEI

Source: CLS Bank (2009a)

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Figure 3. Multi-currency Account at CLS Bank

Member Accounts at CLS Bank Settlement Members have a single account at CLS Bank. This single account is composed of the “sub-accounts” of the eligible currencies. That is a “multi-currency account” made of the subaccounts of 17 currencies (see Figure 3).

Finality of CLS Settlement The Settlement Members make Pay-Ins to the CLS Bank account, and CLS Bank makes PayOuts to the Settlement Members’ accounts at each central bank. These fund transfers are made with the “Central Bank Money” and have the real-time finality when processed. The settlement across the Members’accounts at CLS Bank is also final and irrevocable. The finality on the fund transfer at CLS Bank is secured by the common contract between CLS Bank and the Settlement Members under the New York state law.

Access to CLS System Each Member connects to the CLS system in one of two ways. One way is to use a “CLS gateway” 198

using a CLS Graphical User Interface (GUI). Another is to use an “Application Programming Interface” (API), which connects a Member’s in-house system with the CLS system. In each case, the messages and information are exchanged between CLS Bank and the Member over the SWIFT network. The SWIFTNet InterAct service is used as the messaging service. With these connections, the Settlement Members receive the real-time information on the status of all their payment instructions, and the related Pay-Ins and Pay-Outs in each currency.

FUNDING AND SETTLEMENT PROCEDURES OF CLS BANK Brief Overview of Funding and Settlement Procedures The relationship between the Settlement Members’ funding to CLS Bank and the settlements across the Member’s accounts at CLS Bank is rather complicated. Because the funding (Pay-In) process and the settlement process in the CLS system are executed separately. The settlement process takes

CLS Bank

place over a two-hour period (07:00- 09:00 CET), while the funding process takes place over a fivehour period (07:00-12:00 CET). The settlements are made individually on a gross basis, while the funding is made on a multilateral net basis. The settlement process utilizes the concept of “equivalent value” across each Member’s account. This means that the CLS system measures the positive values in some currencies against the negative values in the other currencies, all converted to the USD in real time. Each Member cannot go overdrawn as for an aggregate balance at any time as a result of settlements. There must always be enough “positive values” in the Member’s account to make each settlement. This is a highly dynamic process during each daily settlement cycle and is also a fundamental part of the risk management at CLS Bank. The following is a brief overview of the settlement procedures at CLS Bank.

Before Settlement Process Submitting Payment Instructions to CLS Bank First, the CLS Members (the Settlement Members or User Members) should submit the payment instructions to CLS Bank for CLS settlements within two hours after the trades are made. There are two ways to submit payment instructions to CLS Bank. One way is that the CLS members submit the instructions directly to CLS Bank via the “Gross Direct Input” (GDI) or MT3042 on the SWIFT network Another way is to send the copy of confirmation to CLS Bank. After the FX trade is made, both of the counterparties exchange the confirmation of the trade via MT3003 on the SWIFT network. The SWIFT provides a service that the copies of confirmations are sent to CLS Bank as a payment instruction (Figure 4).

Figure 4. Submit Payment Instructions to CLS Bank

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Validation of Payment Instructions

Settlement Process

Upon receipt of payment instruction, the CLS system authenticates and validates the certain field of payment instruction. If the payment instruction is not successfully authenticated or validated, it will be rejected by the CLS system.

Feature of CLS Settlement

Matching of Payment Instructions Once the payment instruction is successfully authenticated and validated, the CLS system matches the payment instructions from both parties of the transaction. If the contents (the counterparty, amount, currency, value date, etc.) of the instruction are confirmed to be matched, these instructions are recognized as the payment orders to CLS Bank. Then, the CLS members receive the matched trade status from CLS Bank. In addition, if the amount of a single instruction is too big, the PVP process does not work efficiently. Thus, any ultra-large payment instructions, the equivalent of $100 million or more, is automatically divided into several instructions of smaller amounts.

Pay-In Schedule At midnight in Central European Time (CET), CLS Bank calculates the “net positions” of each CLS member on a multilaterally netted basis for each currency and each value date. These net positions for each currency are noticed to each member as a “Pay-In Schedule” well before the starting time of settlement process, which was in order to provide enough time for each member to prepare its necessary funding. The amount of Pay-In is much smaller than the gross amount of transactions as a result of the netting. The netting effect is remarkable especially when many transactions (in both buying and selling) are made among the Members in the same currency pairs for the same value date.

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The features of the settlement process at CLS Bank are as follows. i.

The settlement process starts at 07:00 CET every business day (15:00 in Tokyo). Settlement is completed by 09:00 CET. Payments to fund negative positions in some currencies are split into three hourly amounts for the Asian currencies and five hourly amounts for the European, African and American currencies. ii. CLS Bank holds the payment orders in the settlement processing queue and processes them when there is enough value, across all currencies in each Member’s account to settle each individual transaction, as explained above. iii. At sub-account level, the intraday overdraft (O/D) is allowed within a certain limit. Stated differently, the balance of some sub-accounts could be negative (less than zero) until the end of settlement cycle. iv. CLS Bank executes the “Payment versus Payment” (PVP) settlement. More concretely, the payment of selling currency and the payment of buying currency is made simultaneously. In the event of a failure by one side of a transaction, the principle amount paid by the other is immediately returned to their account and by this action the FX settlement risk is eliminated. Figure 5 shows the simple example, in which Bank A sold the USD to Bank B against JPY, and vice versa. In this case, the payment of the USD from Bank A to Bank B and the payment of JPY from Bank B to Bank A are made simultaneously in the CLS system.

CLS Bank

Figure 5. PVP Settlement at CLS Bank

Net Funding and Gross Settlement As Figure 5 shows, the PVP settlement at CLS Bank is executed on a gross basis, while the funding or Pay-In to CLS Bank is made on a net basis.

After Settlement Process CLS Bank makes the Pay-Out to the Members’ account at each central bank through each RTGS system for the long position (the balance is more than zero) currencies. Pay-Out is made in accordance with a Pay-Out algorithm, which ensures that CLS Bank holds the necessary liquidity. When the settlement process is completed, the balance of each Member’s account at CLS Bank becomes zero.

Pay-In Schedule Notice of Pay-In Schedule As mentioned above, the Settlement Members submit payment instructions to the CLS system for matching on a trade date. Instructions of the standard trades4 (T+2) can be submitted up to 00:00

CET5 on the settlement date. Then, the “Initial PayIn schedule” is sent to each Settlement Member. From 00:00 to 06:30 CET, the instructions relating to the same-day swaps between Members who participate in the In/Out swap trades are submitted. At 06:30 CET, each Settlement Member receives its “Revised Pay-In schedule” for the day. The Pay-In schedule indicates the net positions for each currency and the required Pay-In amount for the fixed hours (see Table 5).

Funding Period The Pay-In time is defined in CET. As for the European and North American currencies, the funding period is 07:00-12:00 CET, which is equivalent to 01:00-06:00 in the Eastern Standard Time (EST) in the US. This time zone for funding is called a “five-hour window.” For the Asia-Pacific currencies, the Pay-In time is over three hours of 07:00- 10:00 CET, equivalent to 15:00-18:00 in Japan Standard Time (JST). Approximately 80% of total Pay-In obligations are required to be paid to CLS Bank by 10:00 CET, while the remaining 20% should be paid by 12:00 CET.

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Table 5. Pay-In Schedule (Example) Currency

Net position

Required Pay-in (cumulative amount until each deadline) until 8:00

until 9:00

until 10:00

until 11:00

until 12:00

416

500

USD

+1000

Euro

-500

125

250

333

JPY

-900

400

800

900

GBP

+900

CHF

+460

AUD

-600

200

400

600

SGD

-300

100

200

300

HKD

-60

20

20

20

Note: Time is CET.

These Pay-In time windows were defined to coincide with the operating hours of the relevant RTGS systems, such as the Fedwire, TARGET2 and FXYCS/BOJ-NET.

out Pay-Ins according to the Pay-In schedule, approximately 99% of payment instructions will be settled by 08:00 CET, with the remaining 1% of payment instructions settling by 09:00 CET.

Operational Timeline of CLS Bank6

Pay-In and Pay-Out Process

Funding and Settlement

Between 07:00 and 09:00 CET of every business day, each Settlement Member makes its funding to the multi-currency account at CLS Bank by making payments (“Pay-Ins”) to CLS Bank. CLS Bank then settles payment instructions with the received funds between the Members’ accounts at CLS Bank. Then CLS Bank makes payments (“Pay-Outs”) to the Settlement Members’ account7 from CLS Bank’s central bank accounts through the applicable RTGS systems. CLS Bank repeats this process (the Pay-In, settlement and Pay-Out), continuously every few minutes (Figure 6). All fund transfers occur during a five-hour period. For the Asia Pacific currencies, the PayIn and Pay-Out process occurs over a three-hour period until 10:00 CET and for the European and North American currencies the process occurs over a five-hour period until 12:00 CET. Between 9:00 and 12:00 CET, the Pay-Ins and Pay-Outs are completed. All funds will be paidout, i.e. disbursed back to the relevant Settlement

Settlement Members makes Pay-Ins based on the Pay-In schedule to the CLS Bank account at the relevant central bank. The Pay-Ins are executed using the relevant RTGS systems: the Fedwire for the USD, the TARGET2 for euro, the FXYCS/ BOJ-NET for JPY, the CHAPS for Pounds Sterling (GBP), the SIC for CHF and so on. Upon receiving the funds at the CLS Bank account at the relevant central bank, CLS Bank credits the same amount to the Member’s account at CLS Bank. CLS Bank settles each pair of matched payment instructions within the range of the aggregate available balance in the Member’s account. The settlements are made trade-by-trade on a gross basis, and the settlements become final when processed. Payment instructions that cannot immediately settle remain in the queue and are continually revisited. The funding and settlement procedures begin at 07:00 CET. And if all Settlement Members carry

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Figure 6. Operational Timeline of CLS Bank

Members by 12:00 CET, which allows the Member to manage liquidity requirements efficiently.

Multi-Currency Account at CLS Bank Each Settlement Member has a single account at CLS Bank. The single account is composed of sub-accounts of all CLS eligible currencies. During the settlement cycle (7:00-12:00 CET), the balances of each sub-account are constantly changing from moment to moment (see Figure 7). At this stage, some sub-accounts have a credit balance, while the other sub-accounts have a nega-

tive balance, since the intraday O/D is allowed at the sub-account level. In normal circumstances where the settlements of all payment instructions are completed, CLS Bank completes Pay-Outs of the long balances in its central bank accounts to Settlement Members before the close of each RTGS system. As a result of these procedures, Settlement Members will have a zero balance in its account at CLS Bank. On the other hand, CLS Bank will have no funds in its central bank accounts at the end of each business day.

Figure 7. Balances of Sub-accounts during Settlement Cycle (Example)

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Table 6. Three Risk Management Measures of CLS Bank Risk management measures

Contents

Positive Adjusted Account Balance

Net Account Balance is calculated by adding up the dollar-based amount of all the sub-accounts of a Member. The Balance should be positive (more than zero) all the time.

Short Position Limit (SPL)

SPL is set for each currency, which is common to all Members. The negative balance of each subaccount cannot exceed the SPL of the currency.

Aggregate Short Position Limit (ASPL)

Aggregate Short Position is calculated by adding up the dollar-based amount of negative sub-accounts of a Member. This Position should not exceed the ASPL that is fixed for each Member.

RISK MANAGEMENT OF CLS BANK Three Risk Management Tests According to the provision of the CLS settlement service, CLS Bank applies three risk management tests to each payment instruction which mitigate the credit, market and liquidity risk. These are: (i) Positive Adjusted Account Balance, (ii) Short Position Limit (SPL) and (iii) Aggregate Short Position Limit (ASPL), (see Table 6). These risk management tests are designed to ensure that CLS Bank has sufficient funds for settlements and Pay-Outs, even if the Settlement Member with the largest Pay-In obligation fails to satisfy its funding requirements. The following three tests are applied to each payment instruction, regardless of the type of underlying transaction involved.

Positive Adjusted Account Balance8 CLS Bank never settles a payment instruction when such settlement will cause the sum of all the currency balances in the Settlement Member’s Account, (the “Account Balance,” expressed in USD equivalent), to be less than zero. This means that the short positions of a Member should be fully covered by the long positions of the other currencies. Stated differently, CLS Bank is ensured to have more than equivalent value in the USD than the short positions in some currencies. Thus, CLS Bank does not bear the net credit risk as a whole to any Member, even if it

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allows Members to have the short positions in some currencies. For the exchange rates used for the currency conversion to the USD, the “haircuts” are applied. CLS Bank applies a currency specific haircut to each currency balance in the Settlement Member’s Account. The haircut percentages are decided according to the historical volatility of each currency. The “haircuts” provide a cushion against the adverse FX rate movements; they have the effect of increasing the value of each short position and reducing the value of each long position to ensure the adjusted Account Balance does not fall below zero even during periods of the extreme FX market volatility. It does not mean that the Settlement Members are required to fund their respective Accounts for additional amounts to cover haircuts. The haircuts only affect a Settlement Member by withholding value in its Account through the reduced Pay-Outs until a Settlement Member covers the entire amount of the relevant short positions by its Pay-Ins to CLS Bank.

Short Position Limits (SPL) At no time may the Settlement Members Account have a short position (the negative balance) that exceeds the “Short Position Limit” (SPL) established by CLS Bank for the relevant currency. The SPL for each currency is unique and is determined from time to time by CLS Bank for all Settlement Members based on the committed amount of Liquidity Facilities (to be described below). The

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SPL is set in order to complete the CLS settlement in a timely manner. CLS Bank permits each Settlement Member to incur the short positions in a currency to facilitate settlements. It is beneficial for participants to have the allowed short positions, which allows settlements to occur even if the Member does not have enough liquidity in its sub-account of the currency. If a Member with a short position in a currency is unable to make a Pay-In, the “Liquidity Providers” of the currency are obliged to provide the funds to complete the CLS settlement (to be described below).

Aggregate Short Position Limit (ASPL) At no time may the Settlement Member’s Account Balance exceed the “Aggregate Short Position Limit” (ASPL). The ASPL represents the maximum amount of all short positions (expressed in USD equivalent) in the Account and is determined from time to time by CLS Bank based on the specific criteria relating to the Settlement Member. The ASPL is set for each Member taking into consideration of the capital, rating and other financial conditions. In contrast to the SPL, which is the same amount for all the Settlement Members, the ASPL is unique to each Member depending on its financial condition. For example, a Member with the high level of capital and safety rating will have a larger ASPL. On the other hand, a Settlement Member with the rating of non-investment grade maybe given a zero ASPL. Additionally, the ASPL of each Member cannot exceed US $1.5 billion.

Risk Management Tests for Queued Payments Upon receipt of the payment instructions, CLS Bank put them in the queue of the system. Once the queued payments pass all the risk management tests, these payments are picked up from the queue and processed for settlement. The risk management tests (the Positive Adjusted Account

Balance, SPL and ASPL) are applied to both sides of the transaction, namely the selling Member and the buying Member.

When Risk Checks are Not Passed When a payment instruction cannot pass one or more risk management tests, it is not processed and remains in the queue. However, this does not mean that the payment is rejected, or a default takes place. This situation only means that the payment instruction is unable to settle immediately. The system will try the instrument again and again in later stages of the settlement cycle. If CLS Bank is unable to settle a payment instruction by the relevant currency just before the deadline, since the applicable risk management tests for the two relevant Settlement Members are not satisfied, the payment instruction will be rejected by the CLS Bank system.

When Risk Checks are Passed When a payment instruction passes all the risk management tests, it is picked up from the queue and processed for settlement. At this stage, two matched payment instructions involving two currency payments (buy and sell) are settled simultaneously and individually, which means that the PVP settlement is executed on a gross basis. With the sound legal basis, these settlements are final and irrevocable when processed.

Pay-Out CLS Bank makes the Pay-Outs from its central bank accounts to the Settlement Member’s account at the central bank, in accordance with a Pay-Out algorithm. As a result of the Pay-Outs, the balances of both the Member’s account at CLS Bank and the CLS Bank accounts at the relevant central banks become zero when all the CLS settlements are completed. Normally, the Pay-Outs are completed by 12:00 CET.

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LIQUIDITY FOR CLS SETTLEMENT Reduced Liquidity Since the required funding amount is calculated on a multilateral netted basis, the funding burden for Pay-In is significantly reduced compared to the gross amount of the FX trades. This becomes possible because CLS settles payment instructions by circulating the liquidity of each currency within CLS Bank. Thus the required liquidity for the CLS settlement is much less than that necessary for the gross settlement on a bilateral basis. For those payment instructions which have been qualified as the “settlement eligible instructions,” the settlements are made on a sequential basis. For instance, after the liquidity is transferred from Bank A’s account to Bank B’s account, the same liquidity can then be used for the settlement from Bank B to Bank C. The Pay-In amount is less than 2% of the gross amount of FX transactions because of the effects of netting and liquidity circulation. In other words, the required liquidity is reduced by more than 98% compared to the ordinary gross settlement value. On peak days, the netting efficiency exceeds 99%. For example on 16 February 2010, the total value settled was $6,181 billion with a net funding (Pay-In amount) of $44.8 billion. It was the most recent record volume day when more than 1.7 million trades were settled, and the ratio of the net funding to total settlement value was only 0.7% on the day.

In/Out Swap Between 00:00 CET and 06:30 CET, CLS Bank identifies and calculates any intraday swap opportunities between different members – “In/ Out Swaps.” By implementing In/Out Swaps, CLS Bank reduces Members’ overall liquidity requirements, while leaving their FX positions unchanged.

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An In/Out Swap consists of two equal and opposite FX transactions that are agreed as an intraday swap. One leg of the transaction is settled at CLS Bank and the other leg is settled outside CLS Bank. This transaction is referred to as an “In/Out Swap” or an “I/O Swap.” The I/O Swaps are used by Members to reduce their positions in CLS Bank – leading to a reduction in the Pay-In amount. For example, Member A has a significant short position in euro and a significant long position in the USD and Member B has the opposite position (the significant long position in euro and significant short position in the USD). In this case, the two Members would agree the Swap transaction between euro and the USD. More concretely, Member A would like to buy euro and sell the USD which are settled at CLS Bank (in-leg), and would like to sell euro and buy the USD which are settled outside CLS Bank (out-leg). The overall FX positions of the two Members are unchanged by these transactions. However, Member A is able to reduce the short position of euro at CLS Bank, and Member B can reduce the short position of the USD. Therefore, two Members can reduce the intraday funding requirements for Pay-In to CLS Bank. The advantage of I/O Swap is to reduce the “In-CLS” cash positions, which enables Members to manage liquidity more easily. However, the disadvantage is that the I/O Swap generates the out-leg transactions which are settled outside of CLS Bank, thus re-introducing settlement risk. However, the re-introduced settlement risk via I/O Swap is much smaller than the original settlement risk. According to the CLS data for the first three quarters of 2009, the settlement risk re-introduced by the I/O Swap was approximately 3.9% of the total gross settlement value.

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COUNTER-MEASURES FOR PAY-IN FAILURE Pay-In Failure In CLS settlements, there is a possibility that a Member might miss the deadline of the Pay-In schedule because of the operational or credit issues. This situation is called the “Pay-In failure.” CLS Bank prepares the counter-measures to ensure the smooth settlement, even if a Pay-In failure occurs.

Pay-In Call CLS Bank will stop the Pay-Out to the relevant Member, when it realizes the incident of a PayIn failure. Then CLS Bank sends a request for an additional Pay-In to the failed Member9 (the “primary member”) and the counterparty of the failed transaction (the “secondary member”). This is referred to as the “Pay-In Call” – a process implemented to complete the settlement process in a timely manner. It is the first means of raising additional liquidity in response to a Settlement Member’s failure to satisfy its funding requirements. It is important to note that the Pay-In Calls are only issued to the failed Member and its counterparty; the other Settlement Members (the “distant members”) are not notified. If the relevant Member completes the additional Pay-Ins in response to the Pay-In Call, all the involved settlements and Pay-Outs will be completed within the assigned timetable.

Liquidity Facilities CLS Bank maintains the committed “Liquidity Facilities10” in each eligible currency. If the reaction by the failing members to the Pay-In call is inadequate, CLS Bank withholds the Pay-Outs to the involved Members until such time as its funding obligations to CLS Bank are satisfied. If this failure situation continues, CLS Bank will

access its committed liquidity facilities in order to satisfy its Pay-Out obligations to other Settlement Members. Under these liquidity facilities, CLS Bank may call upon its “Liquidity Providers” to enter into the FX currency swaps or outright transactions intra-day, which in turn allows CLS Bank to raise the liquidity in the currency it needs in exchange for currency in which it has balances on its central bank accounts. These balances effectively represent the long positions in the failing Settlement Member’s Account, the funds which CLS Bank would otherwise have paid to the Settlement Member in the absence of its failure to cover its short position(s). The currency haircuts applied to the currency balances in the Settlement Members’ Accounts and the withholding of Pay-Outs to the failing Settlement Members together ensure that the value of these central bank balances are more than sufficient to equal the value of the currency that is to be acquired through the liquidity facility. Without a Pay-In failure, the liquidity facilities are never used to facilitate the daily settlement of payment instructions.

Extremely Exceptional Cases CLS Bank is well prepared for the extremely exceptional cases.

Pay-In Failure of Liquidity Provider It is usually the case that the main player of a currency is also the Liquidity Provider of that currency. CLS Bank is prepared for the worstcase scenario - that the largest Liquidity Provider of a particular currency is also the largest short position Member at the same time leading to a Pay-In failure on that currency. CLS Bank determines the maximum Short Position Limit (SPL) of each currency based on the available liquidity commitment amounts (less the largest commitment amount from any single liquidity provider). With this cautious design, CLS

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Bank maintains the sufficient liquidity facilities in each currency to satisfy its Pay-Out obligations in the correct currency if there is a Pay-In failure by the Settlement Member with the largest short position in that currency (even if the failed Member is also the largest Liquidity Provider in that currency).

Multiple Pay-In Failures If, by any remote chance, major multiple Pay-in failures of more than one member would occur in the same day, it would not be improbable that the sum of short positions of the failed Members is larger than the sum of the committed liquidity facilities of Liquidity Providers of the currency. In several currencies, CLS Bank has the committed liquidity facilities that allow it to satisfy its Pay-Out obligations in the correct currency if there are Pay-In failures by the Settlement Members with the two largest short positions in the currency. However, if the major multiple Pay-In failures of more than one member occur and the sum of short positions of failed Members is larger than the sum of the committed liquidity facilities of Liquidity Providers of the currency, then CLS Bank can make Pay-Outs to the Members in a “third currency,” an alternative currency to the currencies involved in the transaction. In this extreme case, the Members would receive an unexpected currency. Although the Pay-Outs of an “alternate currency” could cause a liquidity impact on the relevant Members, they would not bear Principal Risk that a party will lose the full value of a transaction.

Loss-Sharing Rule CLS Bank does not guarantee the settlement of any payment instruction or become counterparty to any FX transaction of payment instruction, which means that the credit risk of the non-paying Settlement Member is ultimately borne by the Settlement Members. The CLS Bank Rules require

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a mandatory assessment of these FX market losses to the Settlement Members through a loss-sharing process. The conditions for the loss-sharing process are as follows: if there is a continued failure by a Settlement Member to satisfy funding requirements (for example, a permanent failure as a result of bankruptcy), coupled with the significant fluctuations in the FX rate around settlement date, in excess of the currency haircut percentages applied to the Accounts, a “mark to market loss” (or the “FX market loss”) will be incurred. In this case, even though most unlikely, each Member would bear the loss-share depending on the transaction value with the failed Member. This method is called the “combined loss allocation.”

IMPACT OF CLS BANK CLS Bank has had several significant impacts on the FX market and CLS Members as follows.

Reduction of FX Settlement Risk The primary aim of establishing CLS Bank was to reduce the FX settlement risk. It began operations in 2002 with 39 Settlement Members and seven currencies. Since then, another ten currencies have been added and today over 10 thousands funds, banks, and corporates use CLS Bank to eliminate the FX settlement risk and enjoy the benefits of greater operational efficiency and liquidity management. The estimated coverage of CLS Bank is about 58% of the total market value in 2010. This figure indicates that CLS Bank has eliminated 58% of the global FX settlement risk. It can be said that CLS Bank has achieved its objectives to a substantial extent. Especially, the Asia-Pacific currencies enjoy the considerable benefits, since they always have to be settled in advance of the USD and euro.

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Nevertheless, there are still some 42% of FX transactions settled outside of CLS Bank. Efforts are underway to extend the CLS Bank’s coverage more broad and further reduce the FX settlement risk.

Importance of Intraday Liquidity Management Each Settlement Member is responsible for managing the funding for their respective accounts, either directly or indirectly (through the Nostro Agents). Although the funding is calculated on a multilaterally netted basis, the Pay-In to CLS Bank is a time-sensitive payment (the “timed payments”). This may increase the importance of liquidity management for the Settlement Members. Traditionally, the liquidity management is undertaken on a day-to-day basis, but the CLS Members need to manage the liquidity more strictly to cope with the timed payments. Therefore, the management of intraday liquidity on an hourly basis becomes more and more important. In addition, the time zone of Pay-In differs according to area: in the morning in the EU, in the evening in the Asia-Pacific region, and before dawn in the US. To cope with this global-scale situation, each Member sets up a “control branch” which controls the liquidity in all CLS currencies. The European banks and the US banks tend to select London for the location of their control branches and most Japanese banks locate their control branches in Tokyo.

Concentration of Payment Business CLS Members can also offer the settlement service to their customers – the “Third party service,” i.e. small banks, corporate and funds. By providing the multi-currency service to its customers, the Members can earn fee revenues and further strengthen their customer relationships. In addition, the more the third parties use the service, the

greater the benefits of the “netting effect” among the Third parties’ positions become. However, the Members do need to invest in the system development and secure the adequate number of personnel to provide the Third party service. For this reason, the Third party service providers tend to be the larger banks, which would promote the concentration of the world’s payment business.

Role of CLS Bank During Crisis Lehman Bankruptcy Lehman Brothers Holdings Inc. filed for the US bankruptcy protection under Chapter 11 on 15 September 2008. Some reports11 highlighted the role of CLS Bank during the financial crisis after the Lehman shock. According to these reports, the situations were as follows. The filing for Chapter 11 of Lehman Brothers was a dramatic event that pushed the banking world into the crisis situation. And the inter-bank lending market dried up immediately after the event, as all banks took the protective measures. Prior to the bankruptcy, Lehman Brothers was a User Member of CLS Bank, using Citigroup as a Designated Settlement Member to settle its FX transactions. Lehman Brothers was a top quartile participant both by value and volume.

CLS Settlement under Lehman Shock Crisis During the week of 15 September (so-called “Lehman’s week”), the CLS system handled and settled more than $150 billion of transactions, in which Lehman Brothers was a counterparty. The volume in the FX market grew considerably due to the increased volatility in exchange rates. As a consequence, CLS Bank settled a total of $26.5 trillion and 4.4 million instructions during that week. Despite the failure of one of its larger participants and a historically high level

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of transactions, CLS Bank did not suffer severe disruption and all the settlements and Pay-Outs were carried out without any incident. On the other hand, there were some complications and disruptions for market participants not using the CLS settlement. The bottom line is that CLS Bank played a vital role during the Lehman shock crisis. It was proved that the CLS settlement system worked effectively, even when a major market participant failed. It is a general recognition after the Lehman shock that CLS Bank is an effective and robust measure to mitigate the FX settlement risk. As mentioned previously, there are still some 42% of FX transactions that are settled outside of CLS Bank and further efforts are underway to expand the portion of FX settlements settled through CLS Bank.

EXTENTION OF BUSINESS AREAS BY CLS BANK CLS Bank has been extending its business areas step by step. There are four new business areas so far.

CLS Aettlement for NonDeliverable Forwards (NDFs) In December 2007, CLS Bank extended the settlement service to include the Non-Deliverable Forward (NDF) FX transactions. An NDF is a cash-settled, short-term forward contract on a thinly traded or non-convertible foreign currency. In NDFs, the traded currencies are not physically delivered for settlements, and instead the contract is settled by calculating the difference between the agreed exchange rate and the spot rate at the time of settlement for the notional amount of funds. One party in the agreement will make a payment to the other party on the basis of the profit or loss on the contract. The

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NDF contracts are mostly, but not exclusively, quoted and settled in the US dollars. The “CLS NDF service” includes capturing the various instructions (e.g., the opening and valuations) for the entire life of the NDF contract, providing the matching and reporting, and settling the net amount in one of the 17 CLS eligible currencies. The post-trade processing of NDFs has traditionally been manually intensive, due to lack of standardization and the use of long-form confirmations. The CLS NDF service provides Straight Through Processing (STP) on the post-execution process, which leads to a significant reduction of both cost and operational risk. It is worth pointing out that the settlement of NDF is a one-way settlement (a single currency payment) and not a PVP settlement. This is the first service CLS Bank provides which is outside the framework of PVP settlement. Until now, the settlement volume of NDFs has been small and cash flow on NDFs has not disrupted the normal balance of PVP settlement.

CLS Aettlement for OTC Credit Derivatives In January 2008, CLS Bank launched the settlement service for the over-the-counter (OTC) credit derivative transactions. This service is provided in partnership with the Depository Trust & Clearing Corporation (DTCC). More concretely, the CLS settlement service is made available by linking the “Trade Information Warehouse” (TIW) of the DTCC Deriv/SERV and CLS Bank. The DTCC Deriv/SERV provides the posttrade processing for OTC derivatives, and most OTC credit derivatives transactions are now matched and confirmed electronically through this service. However, the settlements were still made bilaterally over the life of each contract in a fragmented and non-standardized manner. With the CLS Bank’s service, the TIW automates and centralizes the most up-to-date information about

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a derivatives contract, and sends this data to CLS Bank for settlement, so that payments take place automatically, resulting in more efficient and accurate payment processing. To be more precise, the TIW generates bilaterally netted payment instructions and sends them to CLS Bank early in the morning on the settlement day. Then, CLS Bank automatically notifies its Settlement Members, and settlement will be made as a part of CLS settlement on a multilateral netted basis. Payments through this service are possible in five currencies: the US dollar (USD), euro (EUR), Japanese Yen (JPY), British pound (GBP) and Swiss franc (CHF). By using this service, the number of payment instructions is reduced by more than 99.99%. This is another service that is a single currency payment and outside the framework of PVP settlement.

CLS Settlement for FX Option Premiums CLS Bank has also extended the settlement service to FX Option Premium transactions. An FX Option is a derivative instrument where the Option owner has the right, but not the obligation, to exchange one currency with another currency at a pre-agreed exchange rate. The Option owner can execute the right only on a specified date (“European Option”) or at any time before the maturity date (“American Option”). The FX Options are used to hedge the future cash flows in a foreign currency, or to take a speculative position for the fluctuation of an exchange rate. The FX Option Premium is the price that the buyer of the Options pays to the seller in compensation for the right. The CLS Option Premium service consists of a matching service of the economic terms of the trade and an automated settlement service of premium. By using this service, the main players in the FX Option market have streamlined the confirmation and premium payment processes,

and reduced the underling settlement risk if also settled in CLS Bank when the option is exercised. The CLS Option Premium service supports both deliverable and non-deliverable Options for Vanilla options.

CLS Aggregation More recently, CLS has also extended its service to provide “trade aggregation” to participants through the “CLS Aggregation” service. The development of this service addresses the rapid increase in foreign exchange trading as an asset class by a widening group of hedge funds, algorithmic traders, retail and institutional market participants which has brought substantially higher volumes to the foreign exchange industry. Many of these participants are the prime brokerage clients of CLS settlement Member banks and this increase in volume has led to capacity, cost and operational challenges for them. The aggregation service provides these Settlement Members with a solution to these challenges.

REFERENCES CLS Bank. (2009a, December). Assessment of Compliance with the Core Principles for Systemically Important Payment Systems. CLS Bank. (2009b, September). Briefing on the Global FX Market and the Role of CLS Bank. Bank for International Settlements. (1993, September). Central Bank Payment and Settlement Services with Respect to Cross-Border and MultiCurrency Transaction (the Noël Report). Bank for International Settlements. (1996, March). Settlement Risk in Foreign Exchange Transactions (the Allsopp Report). Bank for International Settlements. (1998, July). Reducing Foreign Exchange Settlement Risk: A Progress Report.

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Bank for International Settlements. (2007, July). Progress in Reducing Foreign Exchange Settlement Risk. GroupC. L. S.http://www.cls-group.com/Pages/ default.aspx

ENDNOTES 1



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A central bank who issues or, if applicable, otherwise circulates a currency that is settled in CLS Bank is also eligible to become a contractual Member. MT304 is a Message Type of SWIFT to send advice/instruction of a third party deal. MT300 is a Message Type of SWIFT to send foreign exchange confirmation. In FX market, the settlement date of standard trade is two days after the trade date (T). Central European Time. This operational timeline is only applicable to Settlement Members. User Members and Third parties can set up different timeline by mutual agreement with their Settlement Member.



7

8



9





10

11



When a Settlement Member uses a Nostro Agent, the Pay-Outs are transferred to the account of Settlement Member’s Nostro Agent at the central bank. This is also called the “Net Positive Value Test.” The Pay-In call to the failed Member might be made in other currencies than the failed currency. CLS Bank maintains a “Foreign Exchange Liquidity Agreement” with each Liquidity Provider that provides the committed liquidity facilities in a particular currency to CLS Bank. These reports include the followings: “Report on Operational Lessons from the Demise of Lehman Brothers in Autumn 2008,” ECB, March 2009, “FXJSC Paper on the Foreign Exchange Market,” the Foreign Exchange Joint Standing Committee (FXJSC), September 2009, and “The Functioning and Resilience of Cross-border Funding Markets,” Committee on the Global Financial System and Markets Committee, BIS, March 2010.

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About the Author

Masashi Nakajima is a professor of Faculty of Economics and Business Administration at Reitaku University, Japan. He had a long career at the Bank of Japan (BOJ) after graduating from Hitotsubashi University. During his career at the BOJ, 1981-2006, he gained a wide range of experience as a central banker holding senior positions in various departments including Research and Statistics Department, Institute for Monetary and Economic Studies, International Department, and Financial Systems and Bank Examination Department. He also had experience working for the Bank for International Settlements (BIS) 2003-2005 and the Center for Financial Industry Information System (FISC) 1999-2001. He distinguishes himself as a coauthor of All about Payment Systems (2000, 2nd edition 2005)(in Japanese) and All about Securities Settlement Systems (2002, 2nd edition 2008)(in Japanese). These two books cover a wide-range of payment and settlement system issues and are regarded in Japan as must-read books on the subject of payment and settlement systems. He is also the author of All about SWIFT (2009) (in Japanese), which is the first book in the world in any language to give a comprehensive presentation of SWIFT that is the essential global provider of secure financial messaging services. As a key figure in the payment and settlement arena, he has been on several committees of public institutions, which include the Financial Services Agency (FSA) of Japan, Ministry of Economy, Trade and Industry (METI) of Japan, Tokyo Financial Exchange (TFX) and Japanese Banks’ Payment Clearing Network (Zenginnet).

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List of Abbreviations

A2A: Account-to-Account A2A: Application-to-Application A2R: Account-to-Receiver ACH: Automated Clearing House ACHA: American Clearing House Association API: Application Programming Interface AS: Ancillary System ASI: Ancillary System Interface ASO: Additional Settlement Obligation ASPL: Aggregate Short Position Limit B2B: Business-to-Business B2C: Business-to-Consumer BCBS: Basel Committee on Banking Supervision BCEAO: Banque Centrale des Etats de l’Afrique de l’Ouest (Central Bank of West African States) BCP: Business Contingency Plan BIC: Bank Identifier Code BIREL: Banca d’Italia Regolamento Lordo BIS: Bank for International Settlements BOE: Bank of England BOJ: Bank of Japan BOJ-NET: Bank of Japan Financial Network System C2C: Consumer-to-Consumer CACHA: Calwestern Automated Clearing House Association CBF: Clearstream Banking Frankfurt CBL: Clearstream Banking Luxembourg CCASS: Central Clearing and Settlement System CCD+: Cash Concentration or Distribution+ CCP: Central Counterparty CET: Central European Time CGFS: Committee on the Global Financial System CHAPS: Clearing House Automated Payments System CHATS: Clearing House Automated Transfer System CHIPCo: Clearing House Interbank Payments Company LLC

List of Abbreviations

CHIPS: Clearing House Interbank Payments System CLS: Continuous Linked Settlement CM: Contingency Module CMU: Central Moneymarkets Unit CNS: Continuous Net Settlement CP: Commercial Paper CPSS: Committee on Payment and Settlement Systems CRI: Centrale des Règlements Interbancaires CSD: Central Securities Depository CSM: Clearing and Settlement Mechanism CTP: Customer Transfer Plus CTX: Corporate Trade Exchange DORPS: Daylight Overdraft Reporting and Pricing System DSL: Daily Settlement Limit DTCC: Depository Trust & Clearing Corporation DTNS: Designated-Time Net Settlement DVP: Delivery versus Payment EACB: European Association of Co-operative Banks EACHA: European Automated Clearing House Association EACT: European Associations of Corporate Treasures EAF: Euro Access Frankfurt EAF: Electronischen Abrechnung Frankfurt EBA: Euro Banking Association EBF: European Banking Federation ECB: European Central Bank ECCB: Eastern Caribbean Central Bank ECS: Electronic Clearing Services ECU: European Currency Unit EDI: Electronic Data Interchange EEA: European Economic Area ELLIPS: Electronic Large Value Interbank Payment System ELS: Euro Link System EMU: Economic and Monetary Union EMZ: Elektronischer Massenzahlungsverkehr EPC: European Payments Council EPM: ECB Payment Mechanism EPN: Electronic Payments Network ESBG: European Savings Banks Group EST: Eastern Standard Time FAFO: First-Available, First-Out FF: Fixed-to-Fixed Fedwire: Federal Reserve’s wire transfer system FGO: Foreign Gateway Operator FIFO: First-In, First-Out

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List of Abbreviations

FRBNY: Federal Reserve Bank of New York FSAP: Financial Sector Assessment Programme FSB: Financial Stability Board FV: Fixed-to-Variable FX: Foreign Exchange FXJSC: Foreign Exchange Joint Standing Committee FXYCS: Foreign Exchange Yen Clearing System G10: Group of Ten G20: Group of Twenty G30: Group of Thirty GDI: Gross Direct Input GO: Gateway Operator GSE: Government-Sponsored Enterprises GUI: Graphical User Interface HAM: Home Accounting Module HKAB: Hong Kong Association of Banks HKICL: Hong Kong Interbank Clearing Limited IAT: International ACH Transaction IBAN: International Bank Account Number ICM: Information and Control Module ICSD: International Central Securities Depository ICT: Italian Credit Transfer IOSCO: International Organization of Securities Commissions IPF: Input Payment File IP-VPN: Internet Protocol-Virtual Private Network ISO: International Organization for Standardization ISSA: International Securities Services Association IT: Information Technology JBA: Japanese Bankers Association JGB: Japanese Government Bond JST: Japan Standard Time LLR: Lender of Last Resort LSF: Liquidity-Saving Features LVPS: Large-Value Payment System LVTS: Large Value Transfer System MAS: Monetary Authority of Singapore MEPS: MAS Electronic Payment System MT: Message Type NACHA: National Automated Clearing House Association NCB: National Central Bank NCE: National Check Exchange NCSD: National Central Securities Depository NDF: Non Deliverable Forward NPVT: Net Positive Value Test

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List of Abbreviations

NSS: National Settlement Service NYACH: New York Automated Clearing House NYCH: New York Clearing House O/D: Overdraft ODFI: Originating Depository Financial Institution OTC: Over-the-counter PEACH: Pan-European Automated Clearing House PHA: Proprietary Home Accounting PIS: Paris Integrated System PM: Payments Module PNB: Potential Net Balance PNS: Paris Net Settlement POPS: Pankkien On-line Pikasiirrot ja Sekit PSR: Payment System Risk PVP: Payment versus Payment RDFI: Receiving Depository Financial Institution RITS: Reserve Bank Information and Transfer System RM: Reserve Management ROSC: Reports on the Observance of Standards and Codes RSSS: Recommendations for Securities Settlement Systems RTGS: Real-Time Gross Settlement RTGS-XG: Next Generation RTGS SCT: SEPA Credit Transfer SD: Static Data SDD: SEPA Direct Debit SEC: Standard Entry Class SECB: Swiss Euro Clearing Bank SEPA: Single Euro Payments Area SEPI: Servicio Espanõl de Pagos Interbancarios SF: Standing Facilities SFD: Settlement Finality Directive SIC: Swiss Interbank Clearing SIPS: Systemically Important Payment System SNP: Système Net Protégé SOS: Single Obligation Structure SPF: Settled Payment File SPL: Short Position Limit SSP: Single Shared Platform SSS: Securities Settlement System STP: Straight Through Processing SVPCo: Small Value Payments Company LLC SWIFT: Society for Worldwide Interbank Financial Telecommunication T2S: TARGET2-Securities TARGET: Trans-European Automated Real-time Gross settlement Express Transfer system

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List of Abbreviations

TBA: Tokyo Bankers Association TBF: Transferts Banque de France TC: Technical Committee TCH: The Clearing House TCP/IP: Transmission Control Protocol / Internet Protocol TDC: Tokyo Dollar Clearing TIW: Trade Information Warehouse U2A: User-to-Application XML: eXtensible Markup Language

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219

Index

A Account-to-Account (A2A) 126, 143 Account-to-Receiver (A2R) 126 Additional Settlement Obligation (ASO) 108 A European Automated Clearing House Association (EACH) 5, 7-9, 12-13, 20, 24-25, 30-35, 39, 44, 47-48, 50, 52-53, 57-58, 62-64, 66-68, 74-77, 79-80, 83-85, 88, 90-93, 96-97, 99-102, 104, 107-115, 120, 125, 127-128, 130-132, 135-137, 141-144, 147-149, 151, 153, 155-156, 159, 162-166, 169, 171-172, 175-176, 180, 182, 184-187, 192-196, 198-210, 212 Aggregate Short Position Limit (ASPL) 204-205 American Clearing House Association (ACHA) 129 Ancillary System (AS) 1-12, 14-15, 17-28, 30-40, 42, 44-53, 57-64, 66-68, 71-72, 74-87, 90-93, 96-97, 99-107, 109-110, 112, 114-120, 122125, 129-132, 134-147, 149-167, 169-173, 176-184, 186, 188-211 Ancillary System Interface (ASI) 143 Application Programming Interface (API) 198 Application-to-Application (A2A) 126, 143 Automated Clearing House (ACH) 12, 14-15, 73, 96-97, 101, 117-129, 151, 154-163, 183 Available Balance 44, 63, 109-113, 115, 202

B BAHTNET 59 balanced release engine 44, 63, 111 Banca d’Italia Regolamento Lordo (BIREL) 64, 85-86, 130 Bank for International Settlements (BIS) 2, 9-10, 14-16, 19-20, 23, 27, 51-52, 75-78, 81, 83, 88, 90, 92, 173, 191, 212 Bank Identifier Code (BIC) 135, 138, 154-156 banknotes 1, 3, 7, 170 Bank of England (BOE) 143

Bank of Japan (BOJ) 48, 60, 71, 168-174, 177, 181182, 189 Bank of Japan Financial Network System (BOJNET) 6, 12, 14, 48, 53, 56, 60, 64, 71, 168175, 177-179, 181-185, 189, 202 bank-related settlement 3 Banque Centrale des Etats de l’Afrique de l’Ouest (BCEAO) 73 Basel Committee on Banking Supervision (BCBS) 77, 88 BCCI incident 17, 22, 76 Bearing incident 17 bell-shaped curve 60-61 bilateral net balance 112-113 bilateral net credit limit 33, 40, 108, 116, 182 bilateral netting 13, 23-24, 49, 84, 113 bilateral offsetting 50, 53, 175-176 bilateral partial netting 49 bilateral release 44, 63, 112-113 BOK-Wire 59 book transfer 5, 68-69 Business Contingency Plan (BCP) 20, 92 Business-to-Business (B2B) 2, 14, 156, 158, 165 Business-to-Consumer (B2C) 14 bypass FIFO 51-52, 141, 148

C calcuating net positions 15 Calwestern Automated Clearing House Association (CACHA) 118 cascade effect 58 Cash Concentration or Distribution+ (CCD+) 128 cash position manager 20, 32 cash settlement 3 CCD+ (Corporate Credit or Debit +) 128 central bank money 5, 7, 11, 15-16, 31, 37, 82, 88, 102, 142-143, 198 Central Bank of West African States 73

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Index

central bank payment system 5, 12, 31, 96, 100 central banks 1-2, 4-5, 7-9, 11-12, 15-16, 19, 28, 30-32, 35-41, 48, 54, 56-62, 64, 66, 71-73, 7577, 79, 82, 87-90, 93, 96, 98-100, 102, 118-119, 130-133, 135-137, 139, 142-144, 153, 166-167, 169, 171-172, 182, 191, 193-194, 196-198, 201-203, 205, 207, 211-212 Central Clearing and Settlement System (CCASS) 67 Central Counterparty (CCP) 24, 142 Centrale des Règlements Interbancaires (CRI) 46, 146 Central European Time (CET) 135, 143, 147-148, 150-151, 164-166, 199-203, 205-206 Central Moneymarkets Unit (CMU) 67 central queue 40, 47 Central Securities Depository (CSD) 9, 70-71 CHIPS Finality 86, 96, 103, 106, 109, 111-112, 114, 116 CHIPS Online Cash Management Tool 111 Clearing and Settlement Mechanism (CSM) 156 clearing bank 6, 22, 68, 163-164 clearing house 12, 22, 44, 66, 73, 96-97, 101, 103, 117-119, 129, 146, 151, 153, 156-157, 159, 165-166, 183 Clearing House Automated Payments System (CHAPS) 6, 14, 22, 74, 78, 143, 202 Clearing House Automated Transfer System (CHATS) 59, 66-67, 74 Clearing House Interbank Payments Company LLC (CHIPCo) 103, 129 Clearing House Interbank Payments System (CHIPS) 12, 14, 22, 44, 53-54, 62, 73, 81, 86, 96-97, 102-112, 114-118, 120, 123, 129, 168 clearing process 7, 12, 15 Clearstream Banking Luxembourg (CBL) 71 close-out netting 24-25 CLS Bank International 190, 193 CLS UK Holding 193 Collateral Scheme 81, 108, 116, 182 commercial bank money 11, 15, 67 Commercial Paper (CP) 172 commercial trade 3 commerical banks 2, 4, 6, 11, 15, 67, 105, 170, 183 commitment line 35 Committee on Payment and Settlement Systems (CPSS) 77, 79-81, 90, 173, 191 Committee on the Global Financial System (CGFS) 88 Consumer-to-Consumer (C2C) 14 contagious default 58

220

Contingency Module (CM) 136 Continuous Linked Settlement (CLS) 9, 65-66, 79, 139, 170, 178, 182, 190-212 Continuous Net Settlement (CNS) 44, 62 continuous settlement system 13, 15, 25 Corporate Trade Exchange (CTX) 128-129 credit limit 25, 33-35, 40, 50, 87, 108, 116, 164, 182 credit obligations 24 credit risk 16-17, 19-20, 28, 32, 34, 38, 57, 99, 108, 110, 191, 204, 208 credit transfer order 7 Customer Transfer Plus (CTP) 116-117

D Daily Settlement Limit (DSL) 25 Daylight Overdraft Reporting and Pricing System (DORPS) 99 debit cap 25, 33-34, 40, 80, 87, 99, 108-109, 116, 147, 150, 164, 182 debit transfer order 7 debt obligations 24 defaulters pay 34-35 Delivery versus Payment (DVP) 9, 17-18, 26-27, 36, 67, 71-72, 102, 143, 180-181 deposit balance 7, 15, 37 Depository Trust & Clearing Corporation (DTCC) 210 Designated-Time Net Settlement (DTNS) 30-36, 40, 42-46, 49, 53, 56-58, 60, 62, 64-65, 74, 76, 79, 82, 84-86, 96, 103, 106-107, 116, 131, 145146, 168-173, 178-179, 182, 184 designated-time settlement system 13, 25, 31, 57 diffusion of innovations 60, 73 Direct Deposit 123, 184 direct participants 6, 134, 137-140, 143, 147, 158, 163, 165, 182, 195-197 Direct Payment 123 distributed queue 40 DN inquiry and transfer system 58 DVP settlement 72, 102, 143

E Eastern Caribbean Central Bank (ECCB) 73 Eastern Standard Time (EST) 100-102, 106, 110, 201 ECB Payment Mechanism (EPM) 132 Economic and Monetary Union (EMU) 59, 131, 135 Electronic Clearing Services (ECS) 129

Index

Electronic Data Interchange (EDI) 56-57, 72-73, 96, 117, 127-129, 188-189 Electronic Payments Network (EPN) 117, 119, 129 electronic payment system 3-4, 182 Electronischen Abrechnung Frankfurt (EAF) 44, 62, 81, 84-85, 145-146, 180 Elektronischer Massenzahlungsverkehr (EMZ) 68, 74 end-of-day settlement system 13, 25 Enhanced Computer Capacity 75, 86 environmental interdependencies 10 Euro Access Frankfurt (EAF) 44, 62, 81, 84-85, 145-146, 180 Euro Banking Association (EBA) 130, 146-147, 149-150, 153, 158, 163-167 Euro Link System (ELS) 84-85 European Association of Co-operative Banks (EACB) 167 European Associations of Corporate Treasures (EACT) 153 European Banking Federation (EBF) 167 European Central Bank (ECB) 48, 54, 71, 77, 130138, 144, 148-149, 153, 167, 212 European Currency Unit (ECU) 22-23, 28 European Economic Area (EEA) 134, 138, 152, 165, 167 European Savings Banks Group (ESBG) 167 exchange-for-value settlement 17-18, 20, 23, 26, 100 EX payment mode 47, 51, 64 eXtensible Markup Language (XML) 73, 117, 154, 156, 165, 188

F Federal Reserve 3, 5, 12, 21-22, 38, 54, 59, 61, 73, 96-102, 108-110, 117-119, 121, 123-127, 129, 193 Federal Reserve Bank of New York (FRBNY) 54, 109, 115 Federal Reserve Banks 21-22, 54, 59, 73, 97-99, 101-102, 108-110, 117-119, 123-127, 129, 193 Federal Reserve’s wire transfer system (Fedwire) 3, 12, 14, 21-22, 38, 58, 71, 73, 86, 96-98, 100-104, 106, 110, 114-118, 123-124, 129, 134, 168, 170, 197, 202 FedGlobal ACH 96, 125-127 FEDNET 98 Fedwire Funds Service 97, 100, 102 final settlement 8, 18, 22, 31-32, 43, 49, 57, 62, 71, 81-82, 86, 148, 169, 173, 185

Financial EDI 56-57, 72-73, 96, 117, 127-129 financial markets 2-3, 8, 14, 19, 21-22, 36-37, 57, 82, 92, 97, 100, 131, 144, 173 Financial Sector Assessment Programme (FSAP) 83 Financial Stability Board (FSB) 77, 83, 88 financial system 2-3, 88, 94, 212 First-Available, First-Out (FAFO) 52-53 First-In, First-Out (FIFO) 51-53, 140-141, 148 first-tier participant 6 Fixed-to-Fixed (FF) 125-126 Fixed-to-Variable (FV) 125 foreign currency 3, 19-20, 67-68, 126, 210-211 Foreign Exchange (FX) 3, 5, 9, 18-19, 21-23, 26, 36-37, 65-66, 92, 96, 100, 104, 117, 125, 131, 142, 172, 183, 190-196, 199-200, 204, 206-212 foreign exchange (FX) settlement 3, 18, 23, 65-66, 100 foreign exchange (FX) settlement risk 65-66, 100 Foreign Exchange Joint Standing Committee (FXJSC) 212 Foreign Exchange Yen Clearing System (FXYCS) 22, 81, 168-170, 172-174, 177-179, 181-184, 202 Foreign Gateway Operator (FGO) 125-126 frequent netting 42, 49, 86-87 full duplication 92 full netting 49, 87 fund settlement 3-4, 71, 102, 142, 169-170, 182 funds transfer system 4, 7, 12, 14, 169, 189 FX market 5, 19, 21, 96, 190-191, 194, 204, 208209, 211-212

G Gateway Operator (GO) 13-14, 20, 33, 125, 157158, 178, 180, 183, 199 gentlemen’s agreement 39 Global Standard 79, 90, 173, 182 government bond market 19, 96 Government-Sponsored Enterprises (GSE) 102 Graphical User Interface (GUI) 198 gridlock 39-40, 50, 53, 181-182 gross basis 11, 13, 24-25, 27, 31, 50, 57, 97, 140, 146, 149, 171, 175-176, 181, 199, 201-202, 205 Gross Direct Input (GDI) 199 gross-gross type DVP 27 gross-net type DVP 27 gross settlement system 12-13, 23, 31, 36, 132 Group of Ten (G10) 48, 77 Group of Thirty (G30) 27 Group of Twenty (G20) 191

221

Index

H Herstatt Bank incident 17, 21, 76 Herstatt risk 21-22, 66, 100, 190-191 Home Accounting Module (HAM) 137, 142 Hong Kong Association of Banks (HKAB) 74 Hong Kong Interbank Clearing Limited (HKICL) 74 hybrid mode 42-43, 45-46, 65, 180 hybrid system 42-46, 49, 56, 62-65, 76, 82, 84-85, 87, 96, 103, 130, 145-146

I illiquidity 38 immediate finality 43 incentive pricing policy 40 indifference curve 45 indirect participants 6, 134, 138, 158, 165, 182, 195 Individual release 44, 63, 111-113 Information and Control Module (ICM) 136, 143 Information Technology (IT) 1-2, 4-5, 7-8, 10-17, 19-26, 28, 30-38, 40-46, 48-50, 52-54, 56-59, 61-62, 64-66, 69-71, 73-76, 81-82, 84-87, 8993, 97-103, 108, 111, 114-115, 117-121, 123, 130-131, 135-136, 144-147, 149, 153, 155-160, 162-163, 165, 167-168, 170, 172-174, 176, 178, 180-183, 186, 188-190, 193-196, 200, 204-208, 210 Input Payment File (IPF) 165 Institution-based Interdependencies 9 Integrated systems 42-43, 45-49, 53-54, 56-57, 6365, 76, 82, 85, 87, 130, 146, 168-169, 179-180 interbank payments 5, 18, 21-22, 44, 53, 68, 96, 98, 100, 103, 129, 134-135, 169-170, 172, 179, 191 internal settlement 3-5 International ACH Transaction (IAT) 125 International Bank Account Number (IBAN) 154156 International Central Securities Depository (ICSD) 71 International Organization for Standardization (ISO) 117, 154, 156, 188 International Organization of Securities Commissions (IOSCO) 77, 93 International Securities Services Association (ISSA) 27 Internet Protocol-Virtual Private Network (IP-VPN) 188 intraday liquidity 5, 8, 28, 32, 37-41, 58, 66, 93, 98100, 135, 172, 181, 209

222

intraday overdraft (intraday O/D) 37-38, 172, 177, 203 intraday repo transaction 8, 37-38, 99, 135 in-transit collateral 72 Italian Credit Transfer (ICT) 158, 165

J Japanese Bankers Association (JBA) 173 Japanese Government Bond (JGB) 169 Japan Standard Time (JST) 170, 201

K knock-on effect 58

L large-value payments 3, 5, 7-9, 11, 14-16, 28, 31, 46, 54, 68, 73, 79, 82, 93, 96-97, 103-104, 120, 130-131, 133, 142, 146-147, 150-151, 163, 167-169, 172-173, 177-183 Large-Value Payment System (LVPS) 3, 14 Large Value Transfer System (LVTS) 35, 46, 54, 56, 63, 180 legal framework 91 legal risk 17, 19, 57, 91 Lender of Last Resort (LLR) 35 level of liquidity 30-32, 36, 93 limit payment mode 47, 64 liquidity 5, 7-9, 15, 17-19, 28, 30-33, 35-41, 43-51, 53-54, 57-58, 60, 62-63, 65-66, 73, 83-85, 89, 93, 98-100, 109-110, 114, 123, 135, 138-143, 146, 148, 150-151, 171-172, 174, 176-177, 180-182, 185, 187, 196, 201, 203-209, 212 liquidity costs 32, 39, 60, 62, 89, 93, 180-181 liquidity management 28, 36, 54, 85, 99, 138, 141, 150, 208-209 liquidity providers 9, 35-36, 182, 187, 205, 207208, 212 liquidity risk 17, 19, 28, 32, 36, 57, 204 Liquidity-Saving Features (LSF) 48, 64, 173-182, 189 liquidity-saving mode 46-49, 63-64, 85, 138, 140141, 146, 168, 173, 180 liquidity shortage 18, 36, 114 Loss-Share Rule 182, 187 loss-sharing agreement 34 loss-sharing rule 33-34, 81, 108, 116, 208

M market liquidity 36-37

Index

MAS Electronic Payment System (MEPS) 48, 5354, 56, 59, 64 Message Type (MT) 147, 165, 199, 212 Monetary Authority of Singapore (MAS) 53 monetary value 1 money market 5, 19, 37, 70, 96, 133, 142, 168-170, 172, 177 monobank system 3 multi-currency payment systems 56-57, 65 multilateral net balances 112, 114 multilateral net debit cap 34, 40, 182 multilateral netting 13, 23-24, 44, 49, 62, 82-84 multilateral offsetting 48, 50, 53, 175-176, 180, 189 multilateral partial netting 49 Multilateral Release 44, 63, 112-114

N National Automated Clearing House Association (NACHA) 118-119, 121-122, 125, 128-129 National Central Securities Depository (NCSD) 70 National Check Exchange (NCE) 129 National Settlement Service (NSS) 101-102, 124 natural monopoly 1, 8, 75, 84 net basis 11-12, 27, 57, 83, 109, 146, 149, 171, 176, 199, 201 net credit position 7, 13, 33, 107 net debit cap 33-34, 40, 80, 99, 108-109, 116, 182 net debit position 7, 12-13, 22, 32, 53, 58, 80-81, 107-109 net-net type DVP 27 net payment system 7 net position 7, 12-13, 22, 24-25, 31-33, 43, 49, 5758, 62, 107, 148, 151, 171, 182, 184-185 net positive position 32 net receiver limit 33, 182 net settlement position 13, 15 Net Settlement Systems 79-81, 110, 145, 147, 169, 171 netting by novation 24 network externalities 1, 8 New York Automated Clearing House (NYACH) 119 New York Clearing House (NYCH) 103, 119 next-day payment system 14-15 Next Generation RTGS (RTGS-XG) 48, 169, 172175, 177, 179-183 Non Deliverable Forward (NDF) 210

O obligation netting 24-25

offsetting 23, 40, 42, 47-51, 53, 64, 85-87, 140-141, 175-176, 179-182, 189 offshore payment systems 56-57, 65-67 operational reliability 82, 89-92 operational risk 17, 20, 57, 91, 210 operational security 89 opportunity cost 38, 93 Overdraft (O/D) 37-38, 172, 177, 200, 203 Over-the-counter (OTC) 210

P Pan-European Automated Clearing House (PEACH) 157-159, 165 Pankkien On-line Pikasiirrot ja Sekit (POPS) 145146, 167 Paper payment 4 Paris Integrated System (PIS) 46-48, 56, 63-64, 8586, 130, 146, 180 Paris Net Settlement (PNS) 44, 46, 54, 62-63, 81, 85, 130, 145-146, 180 partial netting 42, 49, 87 participation rules 89-90, 178 payment instruction 6, 13, 22-23, 44, 46, 57, 63, 199-200, 204-205, 208 payment message 6, 105, 110-111, 117, 125-126, 135, 147, 149, 154, 165, 186, 188 payment netting 24 payment obligation 31 payment order 3, 6, 12-14, 18, 25, 31-32, 36, 38-40, 44, 49, 52, 62, 84, 97, 101, 110-112, 114, 116117, 127, 138-139, 174-176 payment process 7, 15, 72 Payments Module (PM) 136-137, 142 payments received 12, 33, 106, 117 payments sent 13, 33-34, 178, 183 Payment System Risk (PSR) 99-100 payment systems 1-22, 25, 28, 30-37, 39-46, 48-54, 56-59, 62-68, 71, 73-93, 96-97, 99-100, 103104, 106, 109, 114, 118, 120, 127, 129-132, 134, 136, 138-139, 142-143, 145-147, 150-153, 156-158, 162-163, 167-169, 172-173, 175, 177184, 189-191, 193, 195, 211 Payment versus Payment (PVP) 9, 17-18, 26, 36, 66-67, 190-192, 200-201, 205, 210-211 Potential Net Balance (PNB) 164 preferred flag 111 pre-funding scheme 53 pre-settlement risk 18 principal risk 17, 20-21, 26, 191, 208 private payment system 4-5, 8, 12, 31, 65, 96, 104,

223

Index

130, 182 private sectors 11, 89 Proprietary Home Accounting (PHA) 142 pro-rata basis 35, 108 protected DTNS system 33-34 provisional settlement 71

Real-Time Gross Settlement (RTGS) 7-8, 15-16, 25, 28, 30-33, 36-38, 40-43, 45-48, 50-51, 5354, 56-68, 73-74, 76, 79, 82-87, 90, 96-98, 102, 111, 114, 130-132, 135-140, 142-143, 146, 149, 163, 168-173, 177-182, 189, 193, 197, 201-203 real-time settlement system 13, 31, 36, 132 Receiving Depository Financial Institution (RDFI) 120, 123-124 Recommendations for Securities Settlement Systems (RSSS) 92 replacement cost risk 17, 19-21, 191 Reports on the Observance of Standards and Codes (ROSC) 83 repo transaction 8, 37-38, 99, 135 repurchase agreement 38, 99 Reserve Bank Information and Transfer System (RITS) 59 Reserve Management (RM) 137 Retail payment systems 3, 5, 7-8, 14-15, 31, 41, 73-74, 96-97, 118, 130-131, 139, 142-143, 151153, 156-158, 162-163, 169, 178-179, 183-184 risk management 6, 9, 25, 28, 33-35, 53-54, 58, 77, 79, 89-91, 107-108, 116, 147, 150, 164, 178, 182, 185-186, 190, 199, 204-205 risk mitigation arrangement 53 rist management schemes 53, 89-90, 178, 182, 190 RTGS mode 42-43, 45-46, 48, 53, 60, 63-65, 74, 85, 138-140, 146, 168, 171, 177-180, 182

160, 169 Securities Settlement System (SSS) 56-57, 70-71, 74 self-collateralization 72 Sender Net Debit Cap 108-109, 116 SEPA Direct Debit (SDD) 153, 155-158, 165 Servicio Espanõl de Pagos Interbancarios (SEPI) 145-146 Settled Payment File (SPF) 166 settlement asset 7, 11-12, 15, 82 Settlement Finality 7, 28, 89, 101, 108, 138 Settlement Finality Directive (SFD) 138 settlement process 7, 12-13, 15, 18, 20-21, 26, 101, 145-146, 148-149, 198-201, 207 settlement risk 2, 5, 15, 17-21, 23, 25-26, 28, 30-34, 36, 44-45, 54, 57-58, 64-66, 71, 75-76, 79, 8688, 100-101, 116, 160, 172, 181, 186, 190-193, 195, 200, 206, 208-212 settlement system 7, 9, 12-15, 23-25, 31, 36, 41, 43, 56-57, 67, 70-71, 80-81, 88, 93, 102, 107, 118, 132, 145-147, 169-171, 185-186, 189, 210 Short Position Limit (SPL) 204-205, 207 simple settlement 17-18, 23 Single Euro Payments Area (SEPA) 73, 130, 152159, 162, 165-167 Single Obligation Structure (SOS) 149 Single Shared Platform (SSP) 48, 64, 136, 142 small-value payments 11, 14, 179, 183 Small Value Payments Company LLC (SVPCo) 119, 129 S-shaped diffusion curve 61 Standard Entry Class (SEC) 92, 94, 125 Static Data (SD) 136 Straight Through Processing (STP) 117, 210 survivors pay 34-35 Swiss banks 68 Swiss Euro Clearing Bank (SECB) 68, 161 Swiss Interbank Clearing (SIC) 58, 68, 202 synchronous settlement 26 systemically important payment systems (SIPSs) 15, 81-82, 89 systemic risk 17, 19, 28, 32, 36, 43, 45, 57-58, 92, 148, 164, 171-172, 191 system-wide liquidity 39

S

T

same-day payment system 14-15, 31 second-tier participant 6 securities settlement 3-4, 10, 18, 20, 26-27, 36, 41, 56-57, 70-71, 79, 87, 92-93, 102, 139, 142-143,

TARGET2-Securities (T2S) 163 Targeted Transaction 195 TCH Payments Co. 96, 103, 114, 118-119, 124-125, 129

Q quasi payment system 6 queue 14, 32, 40, 42, 47, 49-53, 87, 105, 111, 114115, 139-141, 143, 147-148, 164, 174-175, 200, 202, 205 queue management 40, 42, 49, 51-52, 87, 139, 175

R

224

Index

Technical Committee (TC) 117 telecommunication networks 89 telecommunications 10, 89, 92, 168, 183 the bank for banks 5 The Clearing House (TCH) 96, 103-106, 114, 117119, 124-125, 129 third parties pay 34-35 throughput guideline 39 tiered membership 6 tiered structure 6 timing-based fee structure 40 Tokyo Bankers Association (TBA) 182 Tokyo Dollar Clearing (TDC) 68-70 Trade Information Warehouse (TIW) 210-211 trade-off curve 45 Trans-European Automated Real-time Gross settlement Express Transfer system (TARGET) 12, 14, 48, 50-52, 56, 58-59, 64, 68, 71, 85-86, 130-146, 148-152, 160, 163, 166-168, 170, 172, 180-181, 202 Transferts Banque de France (TBF) 46, 63, 85, 146, 180

Transmission Control Protocol / Internet Protocol (TCP/IP) 188 two-week average cap 99

U urgent flag 111 US dollar (USD) 3, 22, 66-71, 97, 100, 104-106, 125-126, 190-191, 197, 199-200, 202, 204-206, 208, 211 User-to-Application (U2A) 143

V voluntary collateral regime 99

Z Zengin System 12, 14-15, 73, 81, 168-169, 171174, 177-179, 181-189 zero-hour rules 20, 28, 91

225