Submission to the Financial System Inquiry 8. Payments System Issues

Published as Occasional Paper No. 14

Introduction

  1. This Chapter describes some important innovations in the payments system and the policy issues they raise. Australia's payments system is a critical part of the economic infrastructure. It is the ‘hidden plumbing’ through which financial values flow around the economy. An efficient and reliable payments system can make an important contribution to economic growth and to Australia's international competitiveness. The payments system is also the mechanism through which financial shocks can be transmitted more widely through the financial system and into the broader economy. International payment system linkages can carry shocks quickly across borders.
  2. Flowing from its concern for financial system stability, the RBA's main interests in the payments system relate to its soundness and reliability – ensuring that risks are well identified and controlled and that, if a problem arises, its spread is limited. It is now working with the industry on a system which will significantly reduce interbank settlement risk. The RBA is also keen to promote efficiency, competition and fairness in the payments system and has pursued these objectives in various ways, including through the Australian Payments System Council[10] and the Australian Payments Clearing Association[11].

Wholesale payments

Main developments and prospects

  1. The potential for financial system instability in the payments system lies primarily with wholesale payments, including high-value payments between financial institutions, net settlements from retail clearing streams and settlements from securities trading systems. The potential arises because of the large amounts involved, and because under current arrangements there can be up to a 24-hour delay between the incurring of interbank liabilities and their extinguishment (settlement) across Exchange Settlement Accounts (ESAs) at the RBA. Failure to make a settlement payment will create a major disruption because the bank due to receive funds will have entered into various other transactions on the expectation that funds will arrive. If this expectation is disappointed, the subsequent transactions would be virtually impossible to unwind.

Real-time gross settlement (RTGS)

  1. In mid 1995, following consultation with the banking industry, the RBA announced plans to introduce a RTGS system for high-value payments by the end of 1997. Under RTGS, high-value interbank payments will be settled across ESAs as they are exchanged between banks during the course of the day. This will replace the existing practice of clearing high-value payments and netting interbank obligations, under which final settlement does not take place until the morning of the following business day. The RTGS system will be built on the RITS [12] securities transfer and settlement platform operated by the RBA. Payments will also feed into this from the settlement system operated by Austraclear, and from a delivery system whose operations will be co-ordinated by APCA.
  2. The introduction of RTGS will substantially lessen risk in the domestic payments system because over two-thirds of the total value of daily payments activity will be settled during the course of the day, sharply reducing overnight credit exposures between banks. By requiring each high-value payment to be pre-funded, RTGS will eliminate the potential for one bank to cause liquidity (or solvency) problems for other banks by failing to settle for its high-value payments.
  3. Not all interbank settlement risk will be eliminated by RTGS because retail payment systems will continue to settle on a deferred net basis. However, the amounts at stake are relatively small and much of this risk is covered by loss-sharing agreements among the main participants in those systems.
  4. Further, the RTGS system will not remove normal credit risks between banks and their customers. But it will focus attention more sharply on those credit exposures, many of which are not clearly identified under current arrangements. The immediacy of an RTGS payments environment will heighten the need for customer credit exposures to be well understood and controlled; a bank making a payment on behalf of a customer will know that its instruction to the central bank will be acted on as soon as it has funds in its ESA available and will be irrevocable. Thus it must take an explicit credit decision about its own customer before issuing the instruction – will it provide credit, if so how much and on what terms, or must the customer have cleared funds before the bank will initiate the transaction on its behalf? Banks are responding to the need to more tightly control their credit exposures in an RTGS environment. Many have substantial back-office development projects underway.

Securities settlements

  1. RTGS will allow all securities settlements in Australia to be made on a full delivery-versus-payment basis. This ensures that final transfers of securities will occur if, and only if, the payment side of the transaction is performed simultaneously. This applies to all Commonwealth Government securities settled using RITS, as well as to all other debt instruments settled through Austraclear. Settlements made through the ASX's equities clearing system will also settle on this basis, but as an entire batch of transactions once a day, not as individual items as they occur.

Foreign exchange settlement risk

  1. The international banking industry is now examining how to apply similar principles to reduce the risks associated with settlement of foreign exchange transactions, where the commodity being delivered is not a security but an amount of foreign currency. As payments are made in two different countries, with different participants and often during different business hours, achieving payment-versus-payment by synchronising the two settlement legs becomes much more difficult. With the encouragement of central banks, a number of large international banks are seeking to establish systems to link the payment in one currency to the receipt in another, thus reducing the risk that one party to a transaction will pay out but not be paid by its counterparty. Establishing either direct or indirect linkages between national RTGS systems will be critical to the success of such endeavours.

Policy issues: access to the wholesale payments system

  1. Until 1994, the RBA granted ESAs only to institutions which it supervised and which were considered unlikely to expose other institutions (including the RBA) to credit risk through failure to settle. Since then, in addition to the banks, two Special Service Providers (SSPs), one representing permanent building societies and one representing credit unions, have been given settlement facilities after the RBA was satisfied with the quality of their supervision by AFIC. They are permitted to settle only a limited range of low-risk transactions.
  2. Policy on access to ESAs reflects their central role in the payments clearing and settlement system. Historically, settlement accounts were established as a convenient way for providers of payment services to discharge their liabilities to each other. Entries to accounts at a trusted third party were cheaper and more convenient than exchanging gold or banknotes. The main role of ESAs continues to be the extinguishing of obligations which banks incur to each other through their specialised role as providers of payment services. Payment providers transfer customers' balances held on their balance sheets to customers of other institutions. In the process, they incur liabilities one to the other. By settling these clearing system obligations using settlement accounts with the central bank, creditor banks exchange claims on other commercial banks for a risk-free claim on the central bank. RTGS will prevent the build-up of settlement exposures by settling each high-value payment at the central bank continuously throughout the day.
  3. Banks are the main providers of payment services in Australia, in part because they hold the bulk of customers' deposit accounts from which payments are made. In recent years building societies and credit unions have successfully competed for a share of retail payments. These are the only types of institutions which currently have ESAs – either directly as do banks or indirectly in the case of building societies and credit unions.
  4. The prospective introduction of RTGS has led some to question whether access to ESAs could be broadened beyond banks and SSPs because, with the removal of settlement risk between ESA institutions – at least for high-value payments – new players would not expose existing participants to losses. It is true that unsettled payment system exposures will be less of a problem with RTGS. However, the RBA does not accept that the introduction of RTGS would justify giving ESAs to commercial organisations which might make large numbers of payments on their own account, but which are not providers of payment services generally to others. To do so would change the essential nature of one of the RBA's core central bank functions as supplier of settlement services to commercial payments providers. It would also mean that the RBA was providing a banking service to private sector users of the payments system in competition with the commercial banks.
  5. In principle, institutions other than the existing members of the payments system could become large-scale providers of payment services to customers holding transaction balances with them and thereby generate settlement exposures to other payment providers. If this happened, it could be appropriate for the RBA to help extinguish these risks and prevent them creating exposures for other participants by giving the new providers access to ESAs. Each case would need to be considered on its merits, in light of the business being transacted and the potential exposures being generated. Of course, such institutions would need to have customers prepared to hold significant transaction balances with them; if they were to develop this business to any significant size they would almost certainly have to become a bank or other supervised deposit-taker.

Retail payments

Main developments and prospects

  1. The vast bulk of retail payments pass through well-established retail payment systems – cash, cheques, direct entry, credit cards, debit cards and EFTPOS. These systems have evolved over many years. While each has features that need improving – such as cheque clearance times – all are well accepted by the public and do not raise new prudential or system stability issues.

Emerging systems

  1. A number of technological innovations have attracted considerable attention, including payments over the Internet and stored-value cards (SVCs). These create opportunities for firms supplying communications and computer software services to play a role in payments.
  2. This has excited assertions that the payments system as we know it is under challenge and that banks will become irrelevant. These claims are not at all well-founded. Many confuse the fundamental nature of payments – a transfer of value from payer to payee – with the operations of the payments process. Some of the common claims are discussed in the following paragraphs.

Unsupervised non-banks are competing unfairly with banks

  1. One common complaint is that non-bank companies, not subject to banking regulation, are unfairly eroding banks' credit card business. The case of GE Capital, an internationally operating finance company, is often cited. GE Capital has purchased the inhouse credit account business of the Coles Myer Group to give it a card base of around 2 million in Australia. Many department stores have provided similar store card services for many years, funding themselves on the wholesale market and advancing credit to their customers. GE Capital operates many similar specialist businesses which it has purchased from department store chains around the world. It appears to be successful mainly because it is very efficient. It is difficult to see that it has a regulatory advantage – the company has a capital ratio of 15 per cent, well in excess of most banks, and it is not a significant retail deposit-taking institution.
  2. GE Capital's card competes directly with those offered by banks every time a customer makes a choice about which card to use in a Coles Myer store. There is no evidence that it has either a new or privileged position in that competitive environment. The structure of the business is similar in many respects to that of the long-established charge card companies, American Express and Diners Club, which offer their cardholders a means of payment at participating merchants, and credit until the monthly account falls due. At this stage, the merchants covered by GE Capital's Australian operations are all stores in the Coles Myer Group. Ultimate settlement of obligations incurred on these cards takes place through the banking system.

The Internet is making banks irrelevant

  1. Another claim is that by breaking geographic boundaries, the Internet is making conventional banking and payments irrelevant. An example quoted is someone with Internet access logging on to a Web site for a bookshop in the US, selecting a book and paying for it using his/her credit card without leaving home. But banks are involved in this transaction. The Internet is being used principally as an efficient ‘search engine’. Ordering and paying for goods remotely has been possible for many years, using mail order catalogues, fax machines and the telephone. Credit card payment is convenient because the customer simply cites his credit card number to make the payment (the merchant and his banker have arrangements covering losses due to fraud). Most Internet payment works in the same way – it is simply another way of authorising a conventional credit card payment. The payment is processed through the credit card clearing and settlement system as are cards authorised by signature in a shop. The same will apply to debit card transactions when Internet security is satisfactory.
  2. Many other Internet-based banking products are also merely a more efficient means of access. A ‘home page’ with details of a bank's products is an electronic brochure. One Australian bank already allows customers to move funds between their accounts by issuing instructions over the Internet, rather than over the counter. Security considerations have so far prevented banks from accepting instructions over the Internet to debit a client's account and make payment to another party. When security problems are overcome, the debit will be a conventional banking operation and the covering credit will be processed through a conventional payments system, such as the direct entry system used to make salary payments. In all these transactions, banks or other financial institutions or credit or charge companies, carrying out conventional payments business, are directly involved. The only new element is the means of issuing instructions to them, which will probably be cheaper for banks and more convenient for customers.
  3. There is, however, an emerging class of Internet facilities which could reduce the role of banks. Some companies (such as Digicash) are promoting the use of Internet ‘tokens’. Tokens are purchased from the issuing company using conventional payment means – a debit to a bank account or credit card account – and then used to make payments to third parties. Under some scheme designs the tokens have to be returned directly to the bank or the issuer to be redeemed, while in others they could be passed from one holder to another over the Internet, just as currency notes are passed from hand to hand. It remains to be seen whether consumers will be prepared to hold significant balances in this form. It is more likely that only supervised financial institutions with a track record in payments (such as banks) will have the standing and credibility to become large players.

The telecoms, network and software suppliers are taking over

  1. There is a concern that the companies providing telecommunication, network and software facilities to banks and their customers – such as AT&T, Telstra and Microsoft – will somehow take over banks' payment business. Banks clearly depend on outside suppliers for a range of services they need to conduct their payments activities. When the technology was simple, specialised and relatively inexpensive it was controlled by individual banks, but this is no longer possible. Competition among banks might force them to outsource processing and communications to the specialised service providers. But this does not mean outsourcing the basic financial services of holding balances and arranging for their transfer on request.
  2. Banks fear that they will lose their direct relationship with their customers. As an example, as home banking becomes more popular, customers may choose banks that can be accessed using the software with which they are familiar (such as that provided by Microsoft) rather than first choosing their bank. With the next generation of bank customers more familiar with keyboards and the Internet than bank services and prudential standings, banks might well find they need to approach their customers through third parties. Software and network suppliers might become the gateways to banks – as the doors of a bank branch used to be. These are indeed difficult issues for banks to grapple with. But they are commercial issues, not issues of public policy as those fearful of change often claim.

Policy issues

  1. The emergence of new payment instruments, such as Internet services and SVCs, do raise various new issues for public policy. Most of these are about consumer protection, prevention of money laundering, potential erosion of tax bases and privacy protection and so fall outside the RBA's main area of responsibility. Even the potential loss of seigniorage from SVCs is ultimately more a matter for the Government than for the RBA.
  2. Systems involving the issue of electronic tokens will allow payments to take place on the Internet. Consumer regulators may wish to establish standards for security and for disclosure, the latter so that consumers know with whom they are dealing. Should the use of such tokens become widespread there may be a need to increase public protection, in part by establishing sound and reliable clearing and settlement arrangements. To date, with only a few exemptions, banks remain the source of the value being transferred and the point of redemption. This position may be challenged in the future, but issuers who cannot guarantee integrity of the source of funds are unlikely to find widespread public acceptance, especially for high-value payments.
  3. While the Australian authorities can apply standards to issuing institutions based in Australia, a major attraction of the Internet is the access it gives to organisations based abroad. Australian agencies cannot control who issues tokens or establishes systems abroad, nor could they realistically prevent residents from opening accounts abroad and accessing them via the Internet. These issues will be faced by all countries. The RBA is liaising on these issues with other central banks, particularly through the Bank for International Settlements.
  4. SVCs aim to replace currency for consumer payments, both domestically and in foreign currencies for travellers. Achievement of this aim would pose concerns for central banks and other agencies, because any loss of confidence in the soundness and security of this new payments instrument would be very disruptive to business activity. The regulatory environment to be applied to SVC products internationally is still to be decided. The US Federal Reserve has taken the view that it does not want to impede development by premature regulation. It has identified the matters which potential issuers need to address, and stressed their obligations to disclose fully to potential cardholders the risks they bear. In contrast, the European Monetary Institute has recommended that only authorised ‘credit institutions’ (banks, building societies and credit unions in Australian terminology) should be able to issue SVCs in European Union member states.
  5. The RBA has drawn a distinction between development projects and full-scale introduction of SVC products. Its approach has been to monitor closely international developments and the domestic trials of SVC products. Two have involved banks directly and two have been operated by non-financial companies. All have involved only a small number of cardholders and merchants and relatively small exposures for cardholders.
  6. Arrangements might be made for unsupervised institutions issuing SVCs to provide a degree of assurance that card holders could redeem value in cards. However, failure of a major broadly-based scheme could have damaging effects on consumers and merchants and on general confidence in other similar products. Given this risk, the RBA is inclined to the view that SVCs which are likely to be widely issued and accepted, and whose use generates significant liabilities which must be cleared and settled, should be issued only by supervised financial institutions.
  7. In discussions with banks about SVCs, the RBA has sought not to stifle innovation, but has identified issues which scheme designers need to address, and invited them to demonstrate how they would do so. For instance, institutions issuing SVCs need to demonstrate that they have the financial resources to match the risks and claims that could arise if the card security is compromised. This could include adverse affects on the bank's reputation in other markets, raising the possibility of flow-on effects. The schemes will also need to address adequately the concerns of the law enforcement agencies and consumer interests.

Footnotes

The RBA chairs and provides the secretariat for the Australian Payments System Council (APSC) which was formed in 1984 by the Federal Treasurer to encourage efficiency and stability in the Australian payment system and advise the Treasurer on relevant matters. It has no operational role in the payments system. [10]

The Australian Payments Clearing Association (APCA) is the industry body with responsibility for managing payments clearing arrangements between members. The RBA currently provides the Chairman and a voting Board member to APCA. [11]

RITS is an electronic registry, transfer and settlement system for Commonwealth Government securities. A similar facility, FINTRACS, is operated by Austraclear Ltd for semi-government and private sector debt securities. [12]