COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS

COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS SECRETARIAT January 2001 The Committee on Payment and Settlement Systems (CPSS) A. Introduction: the role and purpose of the CPSS. B. Areas of work: 1. Core principles for systemically important payment systems and other work in the area of large-value payment systems. 2. Securities settlement systems. 3. Foreign exchange settlement risk. 4. Clearing arrangements for derivatives transactions. 5. Retail payment instruments and systems. 6. Other topics under review. C. Concluding comments: history; summary. Annex. Contact information A. Introduction: the role and purpose of the CPSS The Committee on Payment and Settlement Systems (CPSS) serves as a forum for the central banks of the Group of Ten countries (G10) to monitor and analyse developments in domestic payment, settlement and clearing systems as well as in cross-border and multicurrency settlement schemes. It was created in 1990 (see "History" below). Since June 2000 Mr Padoa-Schioppa, Member of the Executive Board of the European Central Bank, has been Chairman of the Committee. The BIS hosts the Secretariat for the Committee. Increasingly, non-g10 central banks participate in the work of the CPSS. The Committee also provides a means of coordinating the oversight functions to be assumed by the G10 central banks with respect to payment systems. In addition to addressing general concerns regarding the efficiency and stability of payment, clearing, settlement and related arrangements, the Committee pays attention to the relationships between payment and settlement arrangements, central bank payment and settlement services and the major financial markets which are relevant for the conduct of monetary policy. The CPSS undertakes specific studies in the field of payment and settlement systems at its own discretion or at the request of the G10 Governors. Working groups are set up as required. Efforts are made to ensure that a wide range of expertise is brought to bear on the issues of concern to members of the Committee. Through the recent publication of the "Core principles for systemically important payment systems" and the joint CPSS/ISCO "Recommendations for Securities Settlement Systems", the Committee has contributed to the set of standards, codes and best practices that are deemed essential for strengthening the financial architecture worldwide. Since its creation, the Committee, under the auspices of the BIS, has published various reports covering large-value funds transfer systems, securities settlement systems, settlement mechanisms for foreign exchange transactions, clearing arrangements for exchange-traded derivatives and retail payment instruments, including electronic money (most publications are available via the Bank's website at http://www.bis.org). The Red Book on payment systems in the G10 countries is periodically revised and a statistical update of the data it contains is published each year. The CPSS has long been at the forefront of efforts to reduce risks in payment and settlement systems. This has been motivated by concerns that the credit and liquidity risks inherent in payment and settlement systems have the potential to contribute to systemic problems if not properly managed and controlled. In this connection, the CPSS has considered it important to cooperate with other groups, including the International Organization of Securities Commissions (IOSCO), the Basel Committee on Banking Supervision (the Basel Committee) and the G10 Deputies, to address issues of common concern. In the context of its activities the Committee maintains contact with many global payment system providers, industry associations and other regulatory authorities. 1

In recent years the Committee has developed relationships with other central banks, particularly those of emerging market economies, in order to extend its work outside the Group of Ten. In collaboration with the respective central banks and the BIS, it has published a number of reference studies (Red Books) on payment systems in countries outside the G10. The Committee provides, if so requested and whenever possible, organisational and substantive expertise (e.g. by providing speakers, or co-organsing seminars and workshops) on payment system issues to various regional central banking organisations; it works together, for instance, with CEMLA in Latin America, the GCC in the Gulf Region, the AMF in other Arab countries, SAARC in southern Asia, EMEAP and SEACEN in eastern and Southeast Asia, SADC and MEFMI in southern Africa, and the BCEAO in western Africa. (Conference papers for some of the more high-level workshops have been published as separate CPSS/BIS publications.) More recently, the CPSS has also cooperated with existing or supported emerging regional central bank groups focussing on payment systems, for instance in eastern and central Europe, in Asian EMEAP countries and in Latin America. In the latter region, the CPSS is a member, through its Secretariat, of the International Advisory Council for the World Bank's "Western Hemisphere Payments and Securities Clearance and Settlement "Initiative". B. Areas of work 1. Core principles for systemically important payment systems - and other work in the area of large-value payment systems The work of the CPSS has consistently emphasised the importance of payment systems that are "systemically important", i.e. 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. Systemic importance is determined mainly by the size or nature of the individual payments or their aggregate value. Systems handling specifically large-value payments - mostly interbank transactions - would normally be considered systemically important. Estimates compiled by the CPSS indicate that these systems transfer the equivalent of several trillion dollars per day in the G10 countries, a large portion of which is related to the settlement of financial market transactions. These systems and their risk management arrangements have often been a focus of the Committee's discussions, and over time it has compiled substantial information on their main characteristics both in G10 and non-g10 countries. The Red Book series of publications provides market participants with a large amount of information on these important systems that is not readily available from other sources. Most recently, a set of Core principles for systemically important payment systems, together with an explanatory report, has been elaborated and made available for public consultation by the CPSS Task Force on Payment System Principles and Practices. The CPSS Task Force comprises the G10 central banks and an equal number of other institutions (central banks from emerging markets as well as the ECB, the IMF and the World Bank). The report of the Task Force, containing the Core Principles and related clauses on the responsibilities of central banks in applying the principles, was first published in December 1999, after approval by the G10 Governors. A revised version was published in July 2000, taking into account comments received from interested parties. The second round of public consultations ended in September 2000; the final report will most likely be published by the end of this year. The Core Principles provide guidance for central banks as well as for international organisations such as the IMF and the World Bank in efforts to improve the design and efficiency of payment systems on a global basis. The Core Principles are part of a set of minimum standards and principles that the international community considers essential to strengthen and maintain financial stability (see the "compendium of standards" published by the Financial Stability Forum, http://www.fsforum.org). As such, the Core Principles are also used by the joint IMF/World Bank "Financial Sector Assessment Programme" (FSAP) and the "Reports on the Observance of Standards and Codes" (ROSC). The work of the CPSS in this area has contributed to a growing awareness of the need for sound risk management in large-value funds transfer systems. These interbank funds transfer systems can be classified broadly into gross settlement systems and net CPSS - Background Information (2001) 2

settlement systems. In a gross settlement system, the final settlement of funds occurs transaction by transaction, usually on a continuous or real-time basis. Systems that can effect final settlement on a continuous, transaction-by-transaction basis throughout the processing day are generally known as real-time gross settlement (RTGS) systems. In a net settlement system, on the other hand, the final settlement of funds transfers occurs on a net basis according to the rules and procedures of the system at specific designated times. During the past ten years a number of countries have decided to introduce RTGS systems to help limit settlement risks in the interbank payments process. Nearly all G10 countries have RTGS systems in operation and many non-g10 countries have also been developing RTGS systems. In view of the growing importance of such systems, the CPSS published the report Real-Time Gross Settlement Systems in March 1997. The RTGS report examines the key concepts and risks involved in large-value payment systems, the principles and design features of RTGS systems and some general issues relating to the development of RTGS systems. It describes the major differences between RTGS systems already implemented or being planned in G10 countries, the management of liquidity in RTGS systems and the procedures used to queue payment instructions. The report also considers the differences between RTGS and net settlement systems. The CPSS expects the publication of the report to familiarise market participants with a number of aspects of the development of RTGS. This should be particularly helpful to the many countries currently in the process of introducing RTGS systems as no other analytical studies of this kind are publicly available. 2. Securities settlement systems The Committee has undertaken an active work programme concerning the arrangements for the settlement of securities transactions. The most recent joint initiative of the CPSS and the Technical Committee of IOSCO aims at improving the efficiency and security of securities settlement systems worldwide, including cross-border securities settlement arrangements. In January 2001, both Committees published the consultative report on the Recommendations for Securities Settlement Systems. Comments from all interested parties are invited until 9 April 2001, and it is expected to finalise the Recommendations by the end of this year. The objective of this project is to promote the implementation by securities settlement systems of measures that can reduce risks, increase efficiency, and provide adequate safeguards for investors by developing recommendations for the design, operation, and oversight of such systems. The recommendations cover both individual systems and the cross-border linkages between systems, but, given the diversity of institutional arrangements internationally, the focus is on the functions to be performed and not individual systems. As with the Core Principles for Systemically Important Payment System, this project contributes to the international efforts to address vulnerabilities in the international financial system, and are included in the body of relevant standards and codes identified by the Financial Stability Forum. In order to achieve a wide consensus on the Recommendations, CPSS and IOSCO have set up a joint task force on securities settlement systems, comprising about 20 central banks and securities regulators, in addition to the co-chairmen, from both industrialised and emerging market economies. A first international consultative meeting with more than 50 public institutions was held at the BIS on 19 January 2000 and the Recommendations are now in the public domain for comment by all interested parties in the public and private sectors. A previous joint effort with IOSCO concerned issues related to securities lending. Following an analysis of the underlying procedures (including repo transactions) and their implications for securities settlement systems, CPSS and IOSCO published the Report on Securities Lending (July 1999). It provides an overview of the dynamics of the securities lending market, including the underlying motivations for securities lending and legal, regulatory, tax and accounting issues. It also addresses the risks present in these transactions and the practices and procedures used by market participants to manage and reduce them. The report discusses a number of implications for market participants, infrastructure providers and market authorities, in particular securities regulators and central banks. CPSS - Background Information (2001) 3

Building on earlier work by IOSCO, the CPSS and IOSCO decided that it would be beneficial to develop jointly a disclosure framework that could be used by settlement system operators and their participants to gain a clearer understanding of the rights, obligations and exposures associated with securities settlement systems. A working group comprising representatives from the CPSS and IOSCO, as well as private sector and emerging market settlement system operators, carried out this work in the course of 1996. The Disclosure Framework, which is in the form of a questionnaire, was published in early 1997 and regulatory and supervisory bodies worldwide have been encouraged to ask system operators in their jurisdictions to complete the questionnaire and make the responses available to market participants. The CPSS and IOSCO Secretariats serve as clearing houses for the responses. References to publicly available responses can be found on the respective BIS and IOSCO websites. The report on Cross-Border Securities Settlements (1995) extends the analysis contained in the DVP report and studies in more detail the channels that market participants use to complete cross-border securities transactions. It identifies the different risks that may be present in these particular arrangements and stresses the importance of understanding the procedures used to effect cross-system settlements. The report concludes that the complexity of and lack of transparency in cross-border securities settlement arrangements pose challenges for market participants in assessing the risks they face through their participation in these systems. The 1992 CPSS report on Delivery Versus Payment in Securities Settlement Systems defines and analyses the types and sources of risk associated with settlements between direct participants in a single securities settlement system. The report clarifies the meaning of delivery-versus-payment (DVP) mechanisms and describes three common approaches to achieving DVP, each of which entails different risks to market participants. The report also provides a framework for evaluating the implications of the design and operation of DVP systems for financial stability. 3. Foreign exchange settlement risk Current settlement practices for foreign exchange (FX) transactions generally expose market participants to the risk that they could pay the funds they owe on a trade but not receive the funds due to them from their counterparty. Given the roughly $1.5 trillion in daily FX trades, the potential consequences of a disruption in the FX settlement process are considerable. Although the probability of a major disruption in the foreign exchange settlement process is low, the G10 central banks have been concerned about the effects of large settlement exposures on the safety and soundness of banks, the adequacy of market liquidity, market efficiency and overall financial stability. In early 1996 the G10 Governors endorsed a report prepared by the CPSS entitled Settlement Risk in Foreign Exchange Transactions (also known as the Allsopp Report) which provided a clear definition of settlement risk in foreign exchange transactions and a corresponding method to measure it properly. The report set out a strategy to reduce FX settlement risk based on action by individual banks to measure and control their own exposures and by banking industry groups to develop well-constructed multicurrency services, including netting schemes, that would con tribute to the risk reduction efforts of individual banks. As part of the strategy, individual central banks would work, where appropriate with supervisory authorities, to foster private sector action in their domestic markets. In addition, where appropriate and feasible, individual central banks would consider enhancements to national payment systems. The report set a two-year horizon for the implementation of the strategy and during this period the CPSS closely monitored the action being taken. As a result, the CPSS concluded that encouraging progress had been made but more needed to be done. Many individual institutions had significantly enhanced the way they managed their FX settlement exposures, groups of institutions were working constructively on risk-reducing multicurrency services and a number of key payment systems had benefited from useful improvements. However, many banks were still not managing their exposures appropriately and industry efforts had still not realised their full risk-reducing potential. In the light of this, the G10 central banks decided to reaffirm and strengthen the strategy as set out in the July 1998 follow-up report Reducing Foreign Exchange Settlement Risk: A CPSS - Background Information (2001) 4

Progress Report. Amongst other things, the G10 central banks invited the Basel Committee on Banking Supervision to develop international supervisory guidance for banks on the prudential management and control of FX settlement risk. This guidance was published in September 2000 and is available on the BIS website. The CPSS sub-group on foreign-exchange settlement risk that produced the relevant reports was set-up by its parent committee to take forward the work of implementing the central bank strategy to reduce FX settlement risk that was set out in the 1996 Allsopp Report. At the moment a key aspect of the sub-group's work is the regulatory oversight of the CLS project. The sub-group consists of representatives of the central banks of all the first-wave and most of the proposed second-wave CLS currencies. The current efforts of the CPSS concerning FX settlement risk build on the considerable work that the G10 central banks have carried out in this area over the years. The 1989 Report on Netting Schemes and the 1990 Report of the Committee on Interbank Netting Schemes identified issues that may be raised by cross-border and multicurrency netting arrangements, and established minimum standards and an oversight regime for cross-border netting schemes. The 1993 report on Central Bank Payment and Settlement Services with respect to Cross-Border and Multi-Currency Transactions examined possible central bank service options that might decrease risk in the settlement of FX trades. 4. Clearing arrangements for derivatives transactions Following the Barings failure, the CPSS undertook a systematic review and analysis of risks in clearing arrangements for derivatives in the G10 countries. In March 1997 it published a report which describes the structure of the clearing arrangements for exchange-traded derivatives and which identifies possible weaknesses in such arrangements. These include the potential inadequacy of the resources of clearing organisations in the event of member defaults following large price movements, a lack of intraday controls on members' positions and the use of payment systems that do not ensure timely intraday settlement. The report suggests a number of possible ways to deal with system weaknesses, including the use of stress testing by clearing organisations, more timely trade matching for the calculation of margin requirements and the strengthening of the internal payment arrangements, for instance through the use of RTGS or similar systems that can ensure intraday finality. In addition to the analysis and recommendations it contains, the report provides a large amount of information on the design and operation of selected individual clearing houses in the G10 countries that is otherwise difficult to obtain. As regards over-the-counter derivatives, the Committee, together with the Committee on the Global Financial System (at the time called Euro-currency Standing Committee ), undertook a study of the practices and procedures that participants in the over-the-counter (OTC) derivatives markets use to manage their counterparty risk. In September 1998 the report OTC Derivatives: Settlement Procedures and Counterparty Risk Management was published. The report identified a potential weakness in practices, namely the existence of significant backlogs of unsigned master agreements and outstanding confirmations. It was recommended that both derivatives counterparties and prudential supervisors review these backlogs, assess the risks entailed and take appropriate steps to ensure that the risks are adequately controlled. The report went on to conclude that, firstly, the rapidly expanding use of collateral could significantly mitigate risks in OTC derivatives transactions, and, secondly, that the expansion of clearing houses for OTC derivatives could reduce counterparty risk. 5. Retail payment instruments and systems As concerns retail payment systems in general, the CPSS has set up a Working Group that is looking into such systems in order to identify and analyse recent trends in this area (not restricted to the development of electronic money) and any particular policy concerns that may arise in this context. In September 1999, the Working Group published its first report on Retail Payments in selected countries: A comparative study that compares CPSS - Background Information (2001) 5

information in particular on retail payment instruments from G10 countries as well as Australia. As a next step, the Working Group analysed the particularities of systems that are used to effect and settle payments initiated with particular retail payment instruments and in September 2000 published the report Clearing and settlement arrangements for retail payments in selected countries. With regard to "electronic money", the G10 Governors have asked the BIS, in cooperation with the CPSS, to closely monitor global developments of electronic money products and their potential impact on policy issues. The term electronic money is used to cover a number of new or proposed electronic payment products generally designed for retail use, including both card schemes (so-called electronic purses or multipurpose prepaid cards) and computer-network or software-based schemes (in particular, various proposals to offer non-standard payment services on computer networks such as the internet). A survey of e-money developments has been carried out regularly since 1996 with a large number of central banks around the world, and the results shared among the contributing institutions. A public version of the latest Survey of electronic money developments was published in May 2000. This report provides information on electronic money products that are in use or being planned in 68 countries or territories. The information relates to late 1999 or early 2000. The report also includes some information on the policy stance adopted by the various authorities concerned, including central banks. The interest of the CPSS in such developments dates back a number of years. In the course of 1996 the CPSS played a central role in the work carried out by the G10 central banks on electronic money issues. Various reports were prepared, covering the security of electronic money products, implications for monetary policy and seignorage, legal and law enforcement questions and regulatory approaches to issuers of e-money value. The analysis carried out by the G10 central banks has provided useful input to the work of other international groups dealing with e-money issues, including the G10 Deputies and the Financial Action Task Force. In August 1996 the CPSS and the G10 Group of Computer Experts jointly published a report on the Security of Electronic Money in the expectation that the information it contains on the range of security measures that can be taken to protect electronic money products will contribute towards improving public discussion of these topics. Drawing on the work done by the CPSS and by G10 monetary policy experts, in October 1996 the BIS published Implications for Central Banks of the Development of Electronic Money, which summarises many of the key issues that may be raised by the emergence of electronic money schemes. 6. Other topics under review The Committee has carried out internal studies on the role of collateral in payment and settlement systems. The use of collateral to secure transactions is becoming more widespread in a number of areas, including many payment systems. The Committee has therefore looked at some of the issues that arise from the use of collateral to protect against counterparty risk. The objective of this work has been to foster central banks' understanding of such matters as how market participants might react if the cost of providing collateral were to rise, how collateral usage may itself involve certain risks and why cross-border collateral transactions can be particularly complex. The CPSS is keeping these issues under review. Attention is being paid to linkages between wholesale payment systems and the implications these may have for risk management policies. The development of new payment system services by various providers, both domestic and international, is also being monitored and examined carefully. In this connection, the CPSS, together with the Group of Computer Experts, has also undertaken an internal survey on certification authorities (CAs) and Public Key Infrastructure (PKI). The CPSS also closely cooperated with the Basel Committee on Banking Supervision and the Group of Computer Experts to raise the market's awareness of the importance of the Year 2000 issues and thus contributed to the smooth transition into the year 2000 of computer systems, in particular those used in payment and settlement procedures. For instance, the Chairman of the CPSS was an ex officio member of the Joint Year 2000 Council which was sponsored by the Basel Committee, the CPSS, IOSCO and IAIS. CPSS - Background Information (2001) 6

More generally, the CPSS is cooperating with the Basel Committee to identify and analyse issues of common concern. Finally, the CPSS is working with non-g10 central banks, particularly those from emerging markets, to examine the process of change in payment and settlement systems and to identify priorities in managing change in these systems. C. Concluding comments History In 1980 the Governors of the central banks of the Group of Ten (G10) countries set up a Group of Experts on Payment Systems. The purpose of this group was to take forward the work on payment system issues which had been identified at that time by the G10 Group of Computer Experts - for example, issues concerning the development of electronic funds transfer systems and the question of competition vs. cooperation in payment systems. One of the Group's first projects was a detailed analytical review of payment system developments in the G10 countries. The result of this work was published by the BIS in 1985 in the first of a series that has become known as Red Books. The Group of Experts on Payment Systems also studied the characteristics of newly developing types of interbank netting scheme, on which the Bank for International Settlements published a report in 1989. The Group of Experts on Payment Systems was chaired successively by Mr Blunden of the Bank of England (1980-82), Mr Meyer of the Swiss National Bank (1983-88) and Mr Angell of the Board of Governors of the Federal Reserve System (1988-90). In 1989 the G10 Governors set up an ad hoc Committee on Interbank Netting Schemes (chaired by Mr Lamfalussy, then General Manager of the BIS) to study in more detail the policy issues relating to cross-border and multicurrency interbank netting schemes. The report prepared by this committee was published in 1990. It contains a set of minimum standards for the operation of bilateral and multilateral netting schemes and sets out the G10 central banks' agreed approach for the joint oversight of such systems. As a follow-up to the work of the Committee on Interbank Netting Schemes, and more generally to take over and extend the activities of the Group of Experts on Payment Systems, in 1990 the G10 Governors established the Committee on Payment and Settlement Systems (CPSS). The CPSS is one of the permanent G10 central bank committees reporting to the G10 Governors (the other main committees being the Basel Committee on Banking Supervision and the Committee on the Global Financial System). Since June 2000 Mr Padoa-Schioppa, Member of the Executive Board of the European Central Bank, has been Chairman of the CPSS. Mr Angell chaired the Committee from 1990 until the beginning of 1994 when Mr McDonough, President of the Federal Reserve Bank of New York, succeeded him. From July 1998 until June 2000 Mr Hartmann, member of the Board of the Deutsche Bundesbank was Chairman. Currently, the Chairman is Mr Tommaso Pado a-schioppa. Summary Through their collective efforts to analyse and promote awareness of risks and to develop minimum standards or best practices, the G10 central banks and the CPSS have played leading roles in promoting efficient and robust payment and settlement arrangements. Their continuing work in this area, with the increasing involvement of central banks outside the Group of Ten, reflects the need to continuously monitor and improve risk management in these systems, which are essential to the stability of financial markets and the global economy. * * * * * ANNEX: CONTACT INFORMATION Secretariat The CPSS Secretariat is currently made up of the following staff in the BIS Monetary and Economic Department (as from 1.2.2001): CPSS - Background Information (2001) 7

Mr Gregor Heinrich Head of Secretariat Tel. + 41-61-280 8730; fax + 41-61-280 9100 e-mail: gregor.heinrich@bis.org Mr Robert Lindley Deputy Head of Secretariat Tel. + 41-61-280 8292; fax + 41-61-280 9100 e-mail: robert.lindley@bis.org Mr Marc Hollanders (on secondment from the National Bank of Belgium) Tel. + 41-61-280 8070; fax + 41-61-280 9100 e-mail: marc.hollanders@bis.org Mr Tomoyuki Shimoda (on secondment from the Bank of Japan) Tel. + 41-61-280 8171; fax + 41-61-280 9100 e-mail: masayuki.mizuno@bis.org Mr Gynedi Srinivas (on secondment from the Reserve Bank of India) Tel. + 41-61-280 8426; fax + 41-61-280 9100 e-mail: gynedi.srinivas@bis.org Miss Kathie Jackson Administrative Secretary Tel. + 41-61-280 8705; fax + 41-61-280 9100 e-mail: kathie.jackson@bis.org For the purpososes of compiling "Red Book" statistics, Mr Gerhard Randecker [Tel: +41-61-280 8324] provides additional assistance to the Secretariat Postal address: CPSS Secretariat, BIS, CH-4002 Basel, Switzerland e-mail: cpss@bis.org website: http://www.bis.org CPSS - Background Information (2001) 8