Role of Payment System Oversight in Financial Stability/Financial Infrastructure

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1 Role of Payment System Oversight in Financial Stability/Financial Infrastructure by Paul O Brien 1 ABSTRACT The oversight of payment systems is an essential function of central banks, aiming to ensure the smooth functioning of payment systems and seeking to contribute to financial stability. The efficient and effective operation of payment systems is also a requirement for meeting both the business needs of the economy generally and the personal banking requirements of the public at large. This paper provides an overview of the workings of the payment system in Ireland and details the operation of the system in 2003, which is viewed to have continued to operate satisfactorily. Rationale The oversight of payment systems is an essential function of central banks, aiming to ensure the smooth functioning of payment systems and seeking to contribute to financial stability. The efficient and effective operation of payment systems is also a requirement for meeting both the business needs of the economy generally and the personal banking requirements of the public at large. The Central Bank & Financial Services Authority of Ireland (CBFSAI), in its capacity as a member of the European System of Central Banks (ESCB) and also under domestic legislation, is entrusted with responsibility for oversight of payment systems operating within the State. Oversight of payment systems is very much regarded as a central bank task, principally intended to promote the smooth functioning of payment systems and to protect the financial system from possible domino effects which may occur when one or more members in a payment system incur credit or liquidity problems. Payment systems oversight aims at a given system (e.g., funds transfer system) rather than individual participants 2. Central banks aim to minimize systemic risk in payment systems. This is the risk that the failure of one participant in the system will result in other participants being unable to meet their obligations, thereby leading to a chain reaction in the system. Moreover, a major malfunction in the payment system could, under certain circumstances, undermine the stability of financial institutions and markets. In large-value systems the amounts processed are such that a malfunction in the payment system may provoke consequences for the wider financial markets, given that modern technology has the capacity to facilitate the very quick transmission of disruptions throughout the financial sector. In addition, central banks are concerned with the efficiency of payment systems, which is an objective that complements that of minimising systemic risk. Moreover, it is important that the users of payment systems, and of payment instruments, have confidence in these mechanisms, as this ultimately impacts on maintaining confidence in the currency itself. Finally, as payment systems are an essential mechanism for the implementation of monetary policy, oversight also aims to protect the transmission channel for monetary policy. Legal Basis for Oversight Function The legal basis for this oversight of payment systems is set out in the Treaty establishing the European Community and the Statute of the European System of Central Banks and the European Central Bank (ECB): Article 105 (2) of the Treaty and Article 3 of the Statute state that... the basic tasks to be carried out through the ESCB shall be [...] to promote the smooth operation of payment systems. In addition, Article 22 of the Statute states that The ECB and the national central banks may provide facilities, and the ECB may make regulations, to ensure efficient and sound clearing and payment systems within the Community and with other countries. In domestic legislation the legal basis for the role of the CBFSAI in this field (in addition to the Eurosystemderived role) is set out in the Central Bank Act, 1997: Part II Regulation of Payment Systems. In addition, Section 7 of the Central Bank and Financial Services Authority of Ireland Act, 2003 includes the objective of promoting the efficient and effective operation of payment and settlement systems. 1 The author is Deputy Head of Payments & Securities Settlements Department. 2 Glossary of terms used in payment and settlement systems, Committee on Payments and Settlements, BIS, March Financial Stability Report

2 The provisions of the Act require all payment systems operating in the State to be approved, and have their rules vetted, by the CBFSAI. Under the Act, the CBFSAI may impose conditions on approval, revoke approval and issue directions to a payment system or to its members. In approving rules, the CBFSAI must have regard to the... interest of the proper and orderly regulation of the payment system concerned and of competition between payment systems.... At a domestic level, regulation (or oversight ) of payment systems is principally aimed at promoting the orderly functioning of such systems, thereby minimising systemic risk in order to protect the banking system as a whole from the possible domino effects that could occur if one or more of the credit institutions participating in a payment system were to encounter credit or liquidity problems. The emphasis in the 1997 Act is on systems. The focus of this type of regulation is on the systems themselves, rather than on the individual participating credit institutions, all of which are fully supervised entities. In exercising its regulatory function, the CBFSAI seeks to ensure that payment systems in the State are safe, effective and efficient, and that all credit institutions with a requirement to do so can access these systems on a fair and equitable basis. The CBFSAI further seeks to ensure that Ireland s payment systems themselves do not cause, or add to, instability in the operation of the country s financial markets. The CBFSAI is also empowered under the 1997 Act to regulate securities settlement systems. In December 2000, however, the settlement function for Irish Government Bonds was transferred from the Bankoperated Central Bank of Ireland Securities Settlements Office (CBISSO) to Euroclear Bank in Belgium (though the CBFSAI continues to maintain the Register for Irish Government Bonds). The National Bank of Belgium carries out oversight of Euroclear. A Memorandum of Understanding between the CBFSAI and the National Bank of Belgium on their respective roles in relation to the co-operative oversight of Euroclear has been agreed, and the CBFSAI attends a bilateral review meeting each year. Risk Reduction in Payment Systems The mechanism preferred by central banks for the settlement of large-value payments, both interbank and customer, is the real-time gross settlement (RTGS) system. In such a system, where settlement is via settlement accounts at the central bank and, therefore, in central bank money a risk-free asset payments are settled in real time, on an individual basis (i.e., without netting), instantaneously and continuously throughout the operating day. In such a system a receiving bank may re-invest funds received, and/or give value to a customer, etc., as soon as the funds are credited to its settlement account at the central bank in the RTGS system, as these funds are in final money. In order for RTGS systems to function smoothly participants need to have sufficient liquidity (i.e., funds) in their settlement account to ensure that payments settle and gridlocks are avoided. In most RTGS systems participants may use their mandatory reserve balances (and any additional balances) in their settlement accounts with the central bank on an intraday basis for payment system purposes. In addition, they can obtain intraday, and overnight and longer, liquidity from the central bank. In the Eurosystem all such credit must be fully collateralised to protect the Eurosystem from loss. The Eurosystem requires that all monetary policy and credit/liquidity providing operations be settled via RTGS systems. In some countries, including some of those in the EU, RTGS systems operate in parallel to deferred net settlement systems. The latter are also used to settle large-value payments, though increasingly the largest payments are settled in RTGS systems. In a deferred net settlement system participants communicate payment messages to each other throughout the day but these messages, really promises to pay, are not settled until a fixed point, or points, in the day. The obligations to be paid are then aggregated and netted on a multilateral basis for settlement. Such deferred net settlement systems can be less demanding in terms of liquidity needs, as the final net obligations will be much smaller than the underlying gross obligations. However, payment system policy makers prefer settlement of largevalue payments in the economy via RTGS mechanisms. This is because there is a greater risk of systemic consequences arising from, for example, a failure to settle in a deferred net settlement system, where obligations may need to be unwound and re-calculated and/or revert to gross obligations. Notwithstanding this, deferred net settlement systems can be designed to diminish significantly systemic risk concerns by the implementation of risk-reduction measures such as loss-sharing arrangements, posting of collateral, and debit and credit caps. In recent years, hybrid systems that combine characteristics of RTGS systems and netting systems have been developed. In such systems a chosen part of the payments, usually the smaller and less urgent payments, are settled on a net basis several times during 154 Financial Stability Report 2004

3 the day while the remainder, large-value and urgent (and the settlement of ancillary systems, e.g., cash settlement of securities settlement systems, settlement of retail payments clearing systems), are settled on an RTGS basis. In Ireland the large-value payment system is on an RTGS basis since March 1997 see below. Prior to that it operated as an end-of-day gross system. Most retail payments clearing systems, where the aggregate value of payments is vastly smaller than the value passing through large-value systems, settle on a multilateral netting basis, with the resulting net obligations settled via the RTGS system. Operation of the Payment System in 2003 In the context of its oversight role, the CBFSAI attends, in an observer capacity, the board meetings of the Irish Payment Services Organisation (IPSO), IRISCo (the owner of the domestic RTGS system) and the paper and electronic clearing companies (IPCC and IRECC see below), in order to monitor payment system developments. Regular bilateral review meetings are held with IPSO on payment systems issues. IPSO was incorporated in 1997 to act as the representative body of the payments industry in Ireland; in this regard, the company provides a framework within which the country s various payment systems operate, its role being mainly consultative and advisory in nature. (a) Large-Value Payment System Due to its systemic importance, the domestic real-time gross settlement system (IRIS) continues to be the CBFSAI s primary concern from a regulatory perspective. There are 19 credit institutions participating in the system, plus the National Treasury Management Agency (NTMA) and the CBFSAI. The settlements facilitated by the system include interbank payments on own behalf, and on behalf of customers largely corporate; transactions with the authorities (e.g., tax receipts, Government spending); settlement of the retail clearings, and transactions with the CBFSAI, i.e., monetary policy operations, intraday credit operations, currency issue and withdrawal. IRIS helps to minimise overall systemic risk in the country s payment systems by providing a mechanism for participants to effect all large-value interbank payments in Ireland. In an RTGS system payments are settled on an individual basis, in central bank funds, continuously throughout the day. Eurosystem monetary policy operations are also settled via the IRIS system, with funds only being advanced on the transfer of ownership of sufficient collateral to the CBFSAI. For making and settling cross-border payments in euro, the IRIS system is linked to the TARGET system. TARGET is the Trans-European Automated Real-time Gross Settlement Express Transfer system, which is a mechanism to effect cross-border payments in euro on a real-time gross settlement basis. The 15 RTGS systems of the (pre-1 May 2004) EU and the Euro Payment Mechanism (EPM) of the ECB are linked to form the TARGET system. The TARGET system operated smoothly in 2003 and provided a reliable and safe mechanism for the efficient settlement of large-value payments in euro in real-time. The system is subject to regular ESCB risk analysis and its security features are also reviewed on a regular basis. A revised method for the calculation of availability of domestic RTGS systems, and of the TARGET system, was agreed at ESCB level and introduced during The average monthly availability of the IRIS system in 2003 was per cent, exceeding the ECB minimum availability requirement of per cent. In 10 of the months of 2003, the availability of the IRIS system was 100 per cent. The overall availability of TARGET in 2003 was per cent. The TARGET system handles payments of a significantly greater value than those processed through the domestic retail clearing system, although the corresponding number of transactions is much lower. In 2003, TARGET as a whole processed a total of 66.4 million payments with a total value of \420 trillion. This corresponds to a daily average of 261,200 payments with a value of \1.7 trillion. A total of over 800,000 payments were processed through IRIS during 2003 with the value of those payments amounting to approximately \5.5 trillion. Domestic and cross-border payments represented approximately 58 per cent and 42 per cent, respectively, of all payments processed by IRIS in The average daily volume and value of domestic and cross-border transactions effected by IRIS participants are shown in Table 1. Table 1: Average Daily Transactions via IRIS Number of transactions per day Value of transactions per day (\billion) Domestic 1,231 1, Cross-border 1,052 1, Total 2,283 3, The average daily number of domestic and cross-border transactions processed by IRIS during 2003 was 3,148. Financial Stability Report

4 This is an increase of 38 per cent on the 2002 figure and reflects the abolition of the previous minimum transaction threshold. The average daily value of \21.6 billion processed in 2003 is an increase of 12.5 per cent on 2002 values. In TARGET as a whole, the growth in the volume of transactions was mainly due to an increased number of customer payments, reflecting a further migration of commercial payments to interbank systems such as TARGET. Transactions processed by IRIS represented 1.3 per cent by value and 1.2 per cent by volume of total transactions processed by the TARGET system in Comparable figures for 2002 were 1.2 and 0.9 per cent. All liquidity provided to banks participating in IRIS is fully collateralised as required by ECB regulations. All such monetary policy and intraday liquidity transactions are governed by the terms of a Master Repurchase Agreement signed by the CBFSAI and each of its counterparties, and all credit institution participants in the RTGS system may use their reserve requirement balances for making payments in the system. (The reserve requirement system is on an averaging basis.) There is no upper limit to the amount of credit/liquidity that can be provided by the CBFSAI to participating credit institutions but all credit must be fully collateralised. At the end of 2003 the value of fully collateralised credit operations, other than intraday, outstanding to the banking sector was \17.5 billion. On 31 December 2003 the 19 participating credit institutions had positive opening balances of \15.75 billion, which included fully collateralised intraday credit totalling almost \3 billion and reserve balances mobilised intraday for payment system purposes. There is no evidence of liquidity, or collateral, constraints in the IRIS RTGS system, or in the operations of domestic participants in the TARGET system. An assessment of the individual TARGET component RTGS systems against the Core Principles for Systemically Important Payment Systems (as published by the BIS Committee on Payment and Settlement Systems, and adopted by the Governing Council of the ECB as the minimum standards for the Eurosystem s common oversight policy on systemically important payment systems) was finalised in The Core Principles promote safe and efficient payment systems and set standards that apply to all systemically important payment systems (SIPSs) worldwide. According to the Core Principles report, a payment system is considered to be systemically important if it is capable of triggering disruptions or transmitting shocks across the financial system domestically or even internationally. The main determinants in this respect are the value and the nature of the payments that the system processes. A system is likely to be of systemic importance if at least one of the following is true: (i) it is the only payment system in a country, or the principal system in terms of the aggregate value of payments; (ii) it handles mainly payments of high individual value; or (iii) it is used for the settlement of financial market transactions or the settlement of other payment systems. Each SIPS has to comply with all ten Core Principles. All large-value payment systems in the euro area are considered to be systemically important. In this regard the CBFSAI carried out the assessment of the IRIS system. The major issue highlighted was the need to develop further the off-site back-up arrangements for the RTGS system. Work on this was carried over to During 2003 the TARGET system was the subject of a further detailed security review because of its key importance. The purpose of this review was to protect TARGET from external and/or internal threats, whether deliberate or accidental and to minimise the possibility of disruption arising from such threats. Each NCB was required to complete a questionnaire in respect of its local RTGS, covering personnel security, physical security, operations management, access control, systems development, etc. The results are to be benchmarked against an ESCB-developed benchmark and may result in a need for change in some local arrangements. Any follow-up actions will be completed during Eurosystem proposals were articulated in 2003 to replace individual national TARGET platforms with a single common platform system, known as TARGET2. However, the interface between the Eurosystem and the domestic banks following introduction of the new system will continue to be managed by the CBFSAI. The implementation date for TARGET2 is expected to be January (b) Retail Payment Systems The retail payment clearing system comprises the Irish Paper Clearing Company Limited (IPCC), which clears paper instruments (i.e., cheques and credit transfers), 156 Financial Stability Report 2004

5 and the Irish Retail Electronic Payments Clearing Company Limited (IRECC), which clears retail electronic payments, both debit and credit. The average number of payments processed through the clearing system each day is in the region of 580,000, the average daily aggregate value of the payments processed being just under \1 billion. The CBFSAI also continued in 2003 to administer the daily interbank settlement process for the clearing companies. Cheques continued to be a significant payment instrument with almost 74 million cheques going through the clearing system in 2003 a small (1.1 per cent) reduction on 2002 with an aggregate value of \188 billion. (The overall issuance and usage of cheques would be much higher as there is also a large additional volume of cheques in-branch and intrabranch the data for which are not available.) Electronic credit transfers and direct debits showed growth, in both volume and value, in 2003 over Tabel 2 shows data on the Irish clearing system for Table 2: Irish Clearing System Statistics Volume (millions) Value (\billion) Type of payment Cheques Paper credit transfers Electronic credit transfers Direct debits As already mentioned above, the IPCC and the IRECC operate the Irish clearing system. Work continued throughout 2003 in relation to the general legal and organisational arrangements of these companies. As mentioned above, all large-value payment systems in the euro area are considered to be systemically important. In addition some retail payment systems may also be of systemic importance and will thus have to fulfil the entire set of Core Principles. Although the Core Principles were devised originally to apply to systemically important payment systems (usually interpreted as being systems that settle large-value payments), the ECB and the NCBs, as part of their oversight function, established a common methodology in 2003 for the classification of euro retail payment systems and the application thereto of relevant standards. Euro retail payment systems will have to comply with a harmonised set of oversight standards depending on the degree of disruption that these systems pose to the financial markets and/or the economy in general. If it is judged that the disruption of a retail payment system would threaten the stability of financial markets, the Eurosystem requires that these systems comply with the entire set of Core Principles. Should the disruption of a retail system not be judged to cause systemic implications but still be considered to have the potential for a severe impact because the system is of prominent importance for the functioning of the real economy, such a system would have to observe a sub-set of the Core Principles. In addition, there can be other retail payment systems that would be judged not to belong to any of the two previous categories and so would not have to comply with such oversight standards. The CBFSAI considers the two retail payment systems here to be of national importance, and without alternatives. Taking this view, the CBFSAI, as part of its Eurosystem mandate, is assessing these systems against all ten Core Principles. (c) Retail Payment Instruments Debit Cards, Credit Cards and ATMs The LASER debit card scheme was introduced by two of the clearing banks in 1996 and has since expanded to include a total of 10 credit institutions. The number of debit cards in issue at end-2003 was 1.1 million. In 2003 these cards were used for some 60 million transactions with a total value of \3.7 billion. Since they first became available in Ireland in the late 1970s, credit cards have continued to grow in popularity as a non-cash method of payment for goods and services. There were almost 2 million credit cards in issue in Ireland at end-2003, which were used in 2003 for some 86 million transactions with a total value of \7.6 billion. The ATM network in Ireland, like the retail clearing system, is not operated using a centralised technical infrastructure in common ownership, but is instead based on a series of bi-lateral arrangements between participating credit institutions. The number of ATMs in operation at end-2003 was almost 1,600, with 2.9 million cards in issue. In 2003 the number of transactions via ATMs was 206 million, with a total value of \18.2 billion. Table 3 gives data on the debit card scheme, credit cards and ATMs. Table 3: ATM and Payment Cards Year ended 31 December 2003 ATM Laser Credit cards Number of cards in circulation (millions) Number of terminals/outlets (actual) 1,508 37,000 nav Volume of transactions (millions) Value of transactions (\billions) Financial Stability Report

6 (d) Developments at the European Level in Retail Payments Promoting the development of a common euro-area clearing system for retail payments is a major policy objective of both the ECB/Eurosystem and the EU Commission in order to facilitate a genuine single market in financial services. To this end, European banks have established a forum (known as the European Payments Council, or EPC) in which both current payment systems issues and the direction of future payment systems developments are discussed and agreed. The Irish banks, through the Irish Payment Services Organisation (IPSO), participate in the work of the EPC on the plan for the Single Euro Payments Area (SEPA). The work of the EPC is closely monitored and evaluated by the ECB. For the EPC, and its constituent banks, achieving a true SEPA will require significant input from them for the rest of this decade. (e) Securities Settlement Systems As mentioned above, since December 2000 the settlement of Irish Government Bonds is carried out in Euroclear Bank in Belgium (though the CBFSAI continues to maintain the Register for Irish Government Bonds). In 2003 Euroclear announced that it would merge with the securities settlement systems in the UK (CREST in which Irish equities are settled), France (RGV), Belgium (CIK) and the Netherlands (Necigef). This merger will not affect the settlement arrangements for Irish Government Bonds. As a result of the announcement of this merger, during 2003 the CBFSAI attended meetings of those NCBs whose securities settlement systems had merged to form the enlarged Euroclear system. The meetings addressed the issue of the possible provision of settlement of cross-border securities transactions within the Euroclear system in central bank money. The Irish Market Advisory Committee (in relation to the settlement of Irish equities) which was formed by Euroclear to facilitate input from local participants on the Euroclear consolidation process is considering, inter alia, this issue. The CBFSAI participates in this Committee. View of 2003 Outcome The overall assessment of the payment and settlement system in Ireland from the financial stability perspective is that it continued to operate satisfactorily in As mentioned above, there is no evidence of liquidity or collateral constraints in the IRIS RTGS system, or in the operations of domestic participants in the TARGET system. 158 Financial Stability Report 2004