Supplementary Submission to the Financial System Inquiry 2. Innovation and Technological Change in Financial Intermediation and the Payments System


38. This Chapter takes up the point in the Inquiry's Discussion Paper about the need for ‘flexibility to take the greatest possible advantage from the potential that new technologies unleash’ (p.xvi). It discusses innovation in financial intermediation and payments, with a focus on technology and electronic commerce. It considers, in particular whether current regulatory arrangements are inhibiting the application of new technology in the financial system by existing and potential suppliers.[6] This question is especially important in the payments system where technological innovation is particularly rapid.

39. On the way through, the discussion also touches on the related issue of whether – and how – payments innovations are changing risk for consumers, institutions and the financial system as a whole.

40. The next two sections survey the use of technology across the broad range of intermediaries' operations, and in the payments system. The following section addresses questions of entry and competition. The final section summarises the conclusions.

Technological Innovation in Financial Intermediation

41. Diagram 4 illustrates the major functions and business relationships of financial intermediaries.

(a) Customer interface

42. The customer interface is the most visible aspect of a financial intermediary. In the past, customers of intermediaries such as banks, building societies and credit unions dealt with them principally through their offices and branches. Retail customers (refer (1) on Diagram 4) had to visit branches to apply for loans, make deposits and withdraw cash. The interface with wholesale customers (2) was little different.

43. Technology is changing this interface between intermediaries and their customers. Traditional bank branch networks are shrinking, replaced by electronic access points through the telephone, mobile lenders with laptop computers and modems, and ATMs and EFTPOS terminals located away from bank branches. Where branches remain, they are being radically transformed. Rather than waiting for personal service, customers will make transactions and access information through terminals, and sales staff will sell a wide range of services with the aid of technology-assisted information systems. Some loans will be approved using electronic point-scoring.

44. Retail customers are beginning to use home banking and the Internet. Most Australian banks have Internet home pages, and some are providing interactive services which, inter alia, allow customers to compare loan repayment options. Software and communication suppliers, such as Intuit (with Quicken) and Microsoft (with Money), together with their Internet access facilities and browser software, provide another means by which banks and customers communicate.

45. These innovations are weakening the direct relationships between banks and their customers – posing marketing challenges to banks. But consumers benefit through wider choice and lower costs of searching and of switching between service providers.

46. Both retail and wholesale customers can also access a rapidly widening range of remote electronic payments facilities. Direct credits to accounts have already largely replaced cash payrolls and pay cheques. During 1997 Australians will be able to buy mobile telephones that will allow them to download funds from their bank accounts onto reloadable stored-value cards (SVCs) at any time. ‘Cash’ will be available over the telephone. Cardholders will be able to transfer the value on a card to a merchant or to another card.

47. Two general features are notable about these innovations. The first is that change relates mainly to how financial services are delivered to customers. The basic nature of the financial services themselves is not much altered, although a wider array of options has become available.

48. The second feature is that these innovations are being exploited by all players. Internationally, the major Australian banks are near the forefront in retail banking innovation. Yet, in some areas the smaller Australian banks and non-bank institutions have been quicker to adopt new technology.

(b) Management

49. The second panel of Diagram 4 shows the main management functions involved in the running of a financial intermediary.

50. Intermediation requires the maintenance of extensive records of transactions and elaborate accounting systems (3). This work used to be very labour intensive, and dispersed, with records kept by hand and systems paper-based. As a result of advances in data processing technology these functions are now automated and, increasingly, being kept in ‘real time’ in central locations.

51. As well as maintaining formal records of transactions to accounts, financial intermediaries must have extensive processing systems (4). These tasks were also largely manual only a few years ago, but most are now largely automated. Many intermediaries, especially smaller ones, have been able to achieve further savings by outsourcing (5) routine processing to industry co-operatives or independent specialist service providers who can exploit scale economies. Foreign-owned banks draw on the resources of their parent bank using real-time communications links. Common examples of outsourcing are the processing of cheques and foreign exchange transactions.

52. Balance sheet and risk management (6) is critical for all financial intermediaries, which need to deal with many risks – credit, market, maturity, liquidity, operational, legal and so on. Technology has provided the tools for financial institutions to develop complex risk management systems and products, including derivatives. The mathematics underlying these products is not new, but modern computing power and information services have facilitated their pricing and management. Balance sheet risk management is also being assisted by wider use of securitisation. However, the future growth of securitisation will depend more on the evolution of markets than on technological innovation.

53. Risk management depends crucially on access to real-time information flows (7) through widely available services such as Reuters, Telerate and Bloomberg.

(c) Relationships with professional counterparties

54. The third panel of Diagram 4 shows financial intermediaries' relationships with their counterparties, the other financial institutions with which they deal. Technology has had major impacts on both the efficiency and security of these relationships, which are outlined in the following paragraphs.

55. Intermediaries dealing in financial markets (8) depend on a number of specialised communication and support systems to confirm and settle their trades. Most foreign exchange (and some domestic securities) trades are confirmed and settled on the basis of messages sent over the SWIFT network which links financial institutions around the world. This system has replaced less secure and less reliable telephone and telex linkages. Most developed financial markets have also seen the benefits of technology in the form of centralised electronic securities depositories. In Australia these systems include Austraclear (for public and private sector debt securities), CHESS (for equities) and RITS (for Commonwealth Government securities). They have accommodated marked increases in trading volumes and are allowing the introduction of delivery-versus-payment in some markets.

56. Brokers (9) are frequently used by intermediaries for traded financial products, such as foreign exchange. New communications technology has increased the efficiency of brokered transactions, while also providing information directly to counterparties and thereby allowing the by-passing of brokers. Consequently, broking has become more competitive.

57. Clearing houses (10) are central locations/mechanisms through which intermediaries exchange financial obligations. Traders of many financial instruments use the trading, clearing and settlement services of clearing houses such as the Sydney Futures Exchange. Foreign exchange traders are making increasing use of netting schemes operated by specialised clearing houses in Europe and North America (such as FXNet, ECHO and Multinet) to reduce their settlement exposures. These clearing houses have extensive data processing facilities, and they monitor the positions of clients in real time to ensure close control of exposures.

58. In payments clearing systems (11), direct computer-to-computer links are replacing the physical exchange of paper or magnetic tapes. Meanwhile, central banks (12) in many countries, including Australia, are drawing on advances in communication and data processing to introduce real-time gross settlement to reduce risk in payments systems. Such changes in clearing and settling are discussed in the following section.

Innovations in the Payments System

59. It is on the payments system that changes in technology and communications have had the greatest impact. This has been most visible at the retail level, but it is more widespread than that.

(a) The components of payments services

60. To appreciate where regulations are relevant, and where risks to customers, institutions and the financial system may arise, it is necessary to separate the payments process into its main components. A ‘start-to-finish payments service’ comprises a set of quite separable, but linked, elements. As illustrated in Diagram 5, these are:

  • maintenance of a transaction account which acts as a source of value for a payer wishing to transfer funds to a beneficiary – such accounts can either hold deposit balances, or may provide credit to a customer;
  • issue of a payment instrument which a payer uses to instruct a financial institution to access a nominated account (or other source of value) and transfer funds to the beneficiary;
  • the clearing, or exchange, of payment instructions between financial institutions acting on behalf of the payer and the beneficiary; and
  • settlement of the obligations generated between financial institutions as a result of clearing their customers' payment instructions.

(b) Innovation

61. Prior to 1970, cheques accounted for almost all of the number and value of non-cash payments. Because legislation limited cheque issuance to banks, they had a virtual monopoly in the payments system. Other institutions, such as building societies, credit unions and merchant banks, offered ‘store of value’ facilities (savings or investment accounts) but their inability to link a widely-accepted payment instrument to such accounts meant they could not readily compete for transaction business.

62. There were some early examples of non-banks competing for payments business, such as the issuance of charge cards by American Express and Diners Club and credit cards by retail stores, but these accounted for a very small proportion of non-cash payments.

63. Over the past two decades, however, the range of instruments and participants in the payments system has expanded dramatically and competition has become much more intense. This has been largely due to technological innovation. Examples of change include new payment instruments beginning with Bankcard in 1974, then debit cards and direct entry in the late 1970s, MasterCard in 1979, and Visa in 1981. The past 20 years have also seen developments in authentication and information-capturing devices, such as ATM and EFTPOS terminals, which require heavy investment in technology. The latest innovations are stored-value cards (SVCs), based on advances in computer chip technology, and electronic payment tokens for use on the Internet, based on new communication and encryption technology.

64. Technological change has also permitted more efficient processing of both cheques and new payment instruments. For example, the introduction of Magnetic Ink Character Recognition (MICR) lines on cheques allowed both the sorting and the posting of cheque transactions to customer accounts to be automated. Elaborate communication and processing technology is essential for switching (real-time transfer of instructions between banks) and authorisation of credit and debit card transactions both within and outside Australia. During the 1970s and 1980s institutions also began to outsource the processing and clearing of payments to industry-owned companies in pursuit of economies of scale. Examples included the Central Magnetic Tape Exchange (CEMTEX), set up by banks in the 1970s to process their direct entry payments, and CashCard (initially set up by permanent building societies) to process direct entry, ATM and EFTPOS exchanges. A number of independent service providers such as First Data Resources (FDR) also provide extensive switching and processing facilities for ATM and EFTPOS networks.

65. Competition from non-bank financial institutions has increased in several segments of the payments system. Since 1986 building societies and credit unions have been able to offer cheque facilities through agency arrangements with banks and to issue payment orders. They are also active with newer payment instruments such as direct entry (which, inter alia, allows customers to have their salary paid directly into any financial institution). Technology-dependent enhancements to credit and debit cards have allowed non-bank financial institutions to link payment services to their customers' transaction accounts.

66. Software and communications suppliers such as Intuit, Microsoft and Telstra are now providing alternative ways of initiating payments using the instruments issued by financial institutions. Telstra, for example, is planning to offer a system for use by merchants on Internet Web sites. This would offer choices in the form of a menu – e.g. National Australia Bank Visa Card, Westpac MasterCard, Commonwealth Bank KeyCard – and provide switching, authorisation and processing facilities between merchants and the acquiring and issuing institutions.

67. It is worth noting that, while innovation has produced a more efficient and diverse payments system, the basic elements of providing a store of value, issuing instructions and clearing and settling have not been changed in any fundamental way.

Regulation and Innovation

(a) Financial intermediation

68. This section looks at how regulations bear on innovation in the activities described in Diagram 4.

69. By and large, there are few regulatory restrictions on the application of new technology and other innovations to financial intermediation. For example, the main constraints on institutions' relationships with wholesale customers ((2) in Diagram 4) are the Corporations Law and the Trade Practices Act which cover market conduct and like matters which apply to all corporations. The output of accounting systems (3) must conform with accounting standards, but there are no constraints on the technology which firms may use to maintain records and generate accounting reports. Similarly, there are no limitations on institutions' ability to outsource (5) processing such as payroll, account maintenance or product delivery systems. (Prudential supervision does, however, restrict the outsourcing of strategic decision-making and risk controls which would dilute managerial responsibility and accountability.) The market for electronic information services (7) is not specifically regulated, with competition being the main discipline on service quality. Information systems and communications have revolutionised broking (9). Industry practice determines standards of behaviour. Since it does not involve risk (apart from fraud or similar improper practices), broking between financial intermediaries is not subject to any prudential regulation.

70. Innovations, including new technology, can help intermediaries to manage their risks (6). For example, technology supplies the tools by which managers aggregate interest rate risk, measure open positions on foreign exchange business, hedge the risk on an options book and perform scenario analysis on carrying existing risk into the future. As noted above, securitisation will help intermediaries to manage their balance sheet positions and their liquidity.

71. Such innovations have not, of course, removed risks from intermediation and in inexpert or imprudent hands they may actually lead to greater risk. Prudential supervision aims to help management contain the various risks in financing and has had to take into account the new risk-management technology. Banks and other supervised institutions need to assure supervisors that they are capable of handling the more sophisticated risk management products and that their systems are appropriate to the risks in their business. Within wide limits, however, financial institutions can use the risk-management technology they judge best-suited to their activities. And the use of techniques such as securitisation is not restricted, as long as capital is held against residual risk.

72. In the wide range of counterparty relationships which intermediaries have in financial markets (8) the terms are usually determined by market convention. There are licensing requirements for foreign exchange dealers, but these do not prescribe the way in which business between counterparties should be carried out. This is a matter for participants themselves to decide; in the foreign exchange market, practice is codified in the ACI Code of Conduct. In securities markets, the development of industry standard contracts such as AFMA ISDA Standard Documentation for instruments such as swaps, foreign exchange, options and repos has formalised the basis on which most counterparties deal, but they may agree to different terms.

73. Clearing houses (10) for financial instruments are typically owned and controlled by their members. In some cases they have explicit legislative backing, but this is usually limited to ensuring the enforceability of contracts they have with their members. Detailed regulations, including admission criteria and ongoing performance requirements, are usually set by the clearing house itself, under the oversight of the competition authorities such as the ACCC. Particularly where clearing houses are central counterparties to all transactions, rather than simply scorekeepers, they need to establish rules and procedures to manage their exposures. They are increasingly using sophisticated communications and processing systems for this purpose.

74. Prudential supervisors have been keen to ensure that participants in clearing systems understand the exposures they are undertaking and that these have a sound legal basis. The efforts of relevant central banks (including the RBA) and the developers of the foreign exchange netting schemes, ECHO in London and Multinet in New York, to see that they meet internationally-accepted prudential standards, is a good example of co-operation between regulators and market participants in ensuring that the introduction of new technology and associated business practices occurs on a sound basis.

75. Regulations probably have the greatest influence on relationships between financial intermediaries and their retail customers (1). In addition to the Trade Practices Act, the new Credit Code imposes extensive obligations on credit providers, particularly for disclosure and documentation. Such requirements might prevent lenders establishing purely electronic links with retail customers. Industry codes such as the Code of Banking Practice, the Electronic Funds Transfer Code and the Australian Payments System Council's Security Guidelines might also constrain institutions' options in introducing some new technology. (Certainly, institutions argue that the Code of Banking Practice has increased costs unnecessarily.) Some aspects of these ‘regulations’ may be worthy of liberalisation in the interests of both suppliers and users of retail financial services.

(b) The payments system

76. As noted earlier, the payments system has become much more diverse and competitive in the past decade or so. This is notwithstanding the fact that restrictions of various kinds impinge on participation at some levels of the payments system. These include legislation, central bank and government policy, formal and informal industry agreements and codes of conduct. The following discussion of these restrictions draws on the schema of Diagram 5.

(c) Source of value

77. Payments can be made using the payer's own source of value – usually deposits to accounts designed for transaction purposes – or by using credit, typically provided by a third party.


78. The regulations governing institutions' ability to accept deposits are:

  • the Corporations Law, which requires institutions other than banks, building societies and credit unions to issue a prospectus when seeking to accept deposits from the general public;
  • prudential supervision requirements of the RBA (for banks) and the AFIC framework (for building societies and credit unions); and
  • consumer protection provisions in the Trade Practices Act, which apply to all corporations, and the industry codes of conduct for banks, building societies and credit unions.

79. Bank deposits remain the principal source of value for most retail and commercial payments, although accounts with credit unions and building societies are also important. Banks are supervised by the RBA, while building societies and credit unions are subject to a national supervisory scheme, broadly based on that covering banks. That scheme's effectiveness is one reason for the Government's recent decision to amend the Cheques and Payment Orders Act so building societies and credit unions may issue cheques in their own right.

80. The Corporations Law provisions make it difficult for other institutions to compete for retail deposits. They may, however, offer deposit-based transaction facilities in conjunction with a bank (or building society or credit union). Longstanding examples include cash management trusts with linkages to bank accounts. Recently, a financial subsidiary of AMP began offering its customers deposits in conjunction with a bank, although no transaction services are currently attached. In the UK, supermarket chain Tesco offers deposit and payment facilities to customers, but in conjunction with a bank with which the customer and Tesco have contractual relationships; the supermarket Sainsburys plans to do likewise, but using a bank which it would part own with an existing bank. Similarly, in the US several money market funds, such as Merrill Lynch and Charles Schwab, offer cheque and credit card facilities which are ultimately provided by a bank.

81. Australia's current arrangements mean that all firms wishing to accept conventional deposits in their own right must meet similar prudential standards, and consequently compete on a broadly comparable footing. Decisions about the appropriate regulatory regime for deposit-takers (including the extent and type of protection given to depositors) are important for the shape of the payments system but, of course, involve considerations which are much broader than that.

Stored-value cards (SVCs) and electronic money (e-money)

82. SVCs and e-money tokens used on the Internet generate deposit-like claims on their issuers. These schemes are mostly still at the embryonic stage, and regulators have generally decided that regulation should not pre-empt their development. Some countries propose that these instruments will be issued only by supervised deposit-taking institutions, while others have chosen not to restrict who may issue them. In Australia, there are no specific legal restrictions, nor industry standards, to be met by potential issuers.

83. Developers and issuers have taken advantage of the relatively open environment in Australia and there are currently four SVC trials here – two where cards are issued by banks, and two where cards are issued by non-financial corporations. In addition, Advance Bank has announced plans to issue Digicash e-money for use on the Internet. A small non-financial corporation, Cybank, is issuing its own e-money for limited purposes.

84. It should be noted that, despite the curiosity and excitement they tend to generate, SVCs and Internet tokens are fundamentally no different from travellers cheques which have been issued by banks and non-banks for many years. They are a ‘portable transaction account’ whose acceptance will depend a good deal on the confidence which purchasers and merchants have in the issuers.

85. There is a widespread misconception that the developers and promoters of these schemes will also be the issuers. In fact, the non-bank promoters of the best known examples – Mondex, Digicash and CyberCash – do not plan to be issuers in Australia. These corporations are offering relationships with banks, similar to those of Visa and MasterCard, neither of which issues cards in its own right. The financial institutions which are members of these schemes are the issuers, having financial relationships with cardholders and merchants accepting the cards. With the proposed Australian Mondex operation, it is envisaged that the store of value would be held with a special purpose bank but the cardholder's direct relationship would be with the issuing bank. Similar distinctions and considerations apply to the issue of electronic tokens for use on the Internet. The issue of Digicash tokens by Advance Bank is analogous to the issue of a Mondex SVC by Westpac. The issuer is a bank, not a system software or hardware supplier, and the token-holder's exposure is to the bank, just as with an ordinary deposit.

86. In contrast, with SVCs issued by Transcard and Quicklink, the cardholder has an exposure to a non-financial, unsupervised organisation. Similarly, the purchase of a Cybank Internet token leaves the holder exposed to an unsupervised organisation.

87. Whether the authorities should, at some point, restrict the issue of SVCs or e-money depends on the likely consequences of the failure of an unsupervised issuer. Should this happen, holders of its cards or tokens could suffer losses but, in total and individually, they are likely to be relatively small. As the various SVC schemes are currently designed (with interest not being paid on balances held), it seems likely that consumers will hold the bulk of their balances in conventional interest-bearing deposit accounts with financial institutions, downloading relatively small amounts to SVCs as needed. That likelihood is reinforced by the ease with which it will be possible to download funds (including over specially-equipped telephones), and by the fact that there will be no reimbursement for lost cards. Similar considerations apply to the various electronic money schemes.

88. The failure of an unsupervised issuer could also harm the commercial viability of other schemes, at least in the short run, but such adverse confidence effects for supervised financial institutions issuing stored-value cards would probably be very slight.

89. These considerations suggest the need for some consumer protection in the form of standards for disclosure of the identity and credentials of stored-value issuers, so that potential holders can choose between alternative issuers. But there seems to be little case for restricting SVC issue to supervised entities.

90. In the case of Internet tokens, Australian holders could face difficulty redeeming tokens issued abroad, whether or not the issuer were a supervised institution. Similar considerations already face Australian residents who conduct accounts with financial institutions located overseas. Increased Internet access will provide opportunities for more consumers, including many with little exposure to the variety of international banking regulations and practices. Again, the question is one of consumer protection. Holders of tokens issued abroad need to be aware of the exposures they are undertaking and the associated redemption risk; it is very rare for countries to extend deposit insurance or other protection beyond their borders and it is far from clear that these would, anyway, apply to claims from holders of SVC balances or electronic tokens. The failure of a foreign issuer of such tokens seems unlikely in itself to have a systemic effect on Australian issuers, although it might damage general perceptions of tokens as a reliable payment instrument.


91. The requirements on institutions providing credit as a source of value are:

  • those applying to all credit providers under the Uniform Consumer Credit Code;
  • the consumer protection provisions of the Trade Practices Act; and
  • where relevant, the provisions of voluntary industry codes of conduct, such as the Code of Banking Practice.

These apply to providers of credit regardless of whether it is intended as a source of value for payments. As with deposits, there are no specific restrictions on offering credit in direct association with a payment instrument.

92. Where credit is the source of value for payments, cardholders do not incur exposures to card issuers, and questions analogous to those about deposit protection do not arise. (Issuers of credit cards in Australia include substantial non-supervised institutions such as GE Capital, and retailers.) Credit cards can, however, generate exposures for merchants and other institutions issuing cards and acquiring card transactions. These issues are discussed in the section on clearing.

(d) Instruments

93. The issue of payment instruments is governed by:

  • the Cheques and Payment Orders Act which currently limits the issuance of cheques to banks, but which is about to be extended to building societies and credit unions;
  • scheme operators, such as Visa and MasterCard (and potentially Mondex and Digicash), which impose entry requirements on institutions wishing to join their schemes and issue instruments carrying their logos; and
  • the expectation of Governments and others that issuers will voluntarily conform to industry codes of conduct, such as the EFT Code, and other technical standards.

94. The Cheques and Payment Orders Act codified long-standing legislation and case law on the issue of cheques. There is no specific legislation governing non-cheque payment instruments. These have not, of course, developed in a legal vacuum, but have been based on enforceable contractual agreements, designed to meet business needs and adapted to the underlying technology. This approach needs to be complemented by appropriate disclosure standards if competition among institutions and instruments is to be effective. Otherwise, specific legislation should remain unnecessary, except possibly to give clarity to the efficacy of digital signatures. If this is deemed to be required, legislation should not be tied to any particular technology, but merely give clarity to parties' ability to contract on an agreed basis.

95. Payment instruments have traditionally provided a personal link between banks and their customers. For instance, banks issue cheque books and ATM cards directly to account holders. As discussed earlier, remote computer banking and the use of the Internet for commerce and payments are now interposing other organisations between banks and customers. They are also loosening banks' control over the design and operation of some newer payment instruments and the means of issuing payment instructions. As an example, when home banking and remote commercial banking were first introduced, banks provided their own software and communication facilities to customers, who could use them to communicate only with one bank. More recently, Intuit and Microsoft have provided comprehensive financial management facilities as well as communication interfaces that have the potential to be used at any bank. This has dramatically shifted competitive balances: banks must now build interfaces to products sold by PC software developers if they want to attract customers; customers can choose to shift between banks without having to change their software or business practices; and other banks can provide remote access to customers without having to develop their own software.

96. Although consumers will need previously established relationships with banks and to be registered with Telstra to use its proposed Internet facility described earlier, Telstra's system should also increase competition in payments by widening customers' options at the Internet point of sale.

97. These innovations have increased contestability in the supply of payment instruments, and their delivery to customers, by changing the way in which customers issue payment instructions to their financial institutions. But they raise no new prudential issues of any significance, since the underlying payment instruments and the process of issuing an instruction to debit one account and credit another is unaltered.

98. Should Telstra, Australia Post or computer software organisations wish also to provide store of value facilities in the form of credit and link them to their own payment instruments, they would be able to do so, subject to compliance with credit laws. However, as discussed above, if they wished to offer payments linked to deposits, these would need to be offered either through an agent bank (or a building society or credit union), or by seeking to acquire or form a bank which would be covered by the same prudential standards as other deposit-takers. It is likely that partnerships with existing financial institutions – which allow companies to concentrate on their own fields of expertise – will be the more commercially attractive arrangement.

(e) Clearing

99. Clearing involves a range of transportation, processing and accounting operations. Issuers of payment instruments may use an agent to clear for them, or they may clear in their own right. Generally speaking, only institutions with high volumes of transactions will find it attractive to do the latter.

100. Restrictions on participation in the clearing of payment instructions include:

  • provisions of the Cheques and Payment Orders Act which impose procedural requirements, but do not restrict which organisations can provide the physical processes for clearing cheques;
  • regulations and procedures specified by the Australian Payments Clearing Association (APCA), which set a range of requirements for the clearing of payment instruments (including entry fees), but do not specify which organisations may undertake this business; and
  • trade practices requirements, which can mean that some clearing arrangements need ACCC authorisation.

101. There are two key competitive issues. The first is the ability of new issuers of payment instruments to access existing arrangements to clear transactions. There is a need to balance the desire of existing participants to protect their investment in clearing networks and to exercise their own judgments about risk management, against the benefits to the community of greater competition from new providers. The nature of such judgments will always make them difficult. Prospective members will generally argue that the entry hurdles are excessive, while existing members will be inclined to overestimate the value of their investment and perhaps to exaggerate risk concerns.

102. Risk management questions relate to the ability of paying institutions to settle their obligations with receiving institutions. Under the rules of some clearing systems (such as the international credit card schemes), participants have to accept instruments of all members without question. Existing participants, therefore, have a legitimate interest in the standing of new issuers with whom they would be obliged to clear, because they are taking on a credit exposure in so doing. There is therefore a case for industry to require new participants in clearing systems to meet minimum prudential standards, but it is important to guard against the use of such standards to exclude new competitors unreasonably. For these reasons APCA seeks ACCC approval of its clearing system regulations and procedures. The RBA has taken the view that these regulations and procedures should be publicly available unless this would threaten the security of clearing arrangements.

103. The second competitive issue relates to the ability of third parties to offer clearing services to issuers of payment instruments. There are no regulatory restrictions on such activities, with decisions based purely on commercial calculations. Increasingly, the trend is towards outsourcing clearing to specialised operators like Austrapay, CashCard and FDR who can achieve economies of scale.

(f) Settlement

104. Ultimate settlement among intermediaries gives rise to a role for central banks (including the RBA) which provide settlement accounts to extinguish the obligations generated from the clearing of payments. It is in the interest of financial system stability that institutions are able to do so using a means that eliminates settlement risk and does not allow it to accrue. Central banks are uniquely suited for this role. Deposits (in the domestic currency) with the central bank are riskless; a deposit with any other financial institution carries an element of credit risk. Only the central bank can ensure that the system as a whole is capable of finalising settlement obligations, because only it can meet the liquidity needs of the system at all times and provide ‘lender of last resort’ facilities to individual institutions.

105. In Australia, net settlement obligations arising from the previous day's clearings are extinguished across Exchange Settlement Accounts (ESAs) at the start of each business day. A major project is under way to move high-value electronic payments to a real-time gross settlement (RTGS) basis, by which payments would be settled across ESAs as they occur. Such systems require substantial communication and real-time processing capacity if they are to reduce settlement risks without unduly compromising the efficiency of the system.

106. In Australia ESAs have automatically been provided to all new banks.[7] In 1994 the RBA opened settlement accounts for Special Service Providers (SSPs) to operate on behalf of the building society and credit union industries. This decision reflected two factors – the volume of customer payments business being done by building societies and credit unions, and the improved prudential supervision arrangements to which they had become subject under AFIC.

107. The prudential standing of ESA holders is important because the central bank can be exposed to settlement risk by conducting such accounts; the extent of this risk depends on the design of the settlement system and the terms on which accounts are operated. Under deferred net settlement systems, the central bank must bear in mind the potentially disruptive consequences to the financial system of an ESA holder's inability to meet its settlement obligations to others. In such circumstances, the central bank could refuse to accept any responsibility for the settlement and simply require the private sector participants to resolve the difficulty. This could, of course, precipitate the unwinding of a whole day's transactions with a high probability of disruption and possible instability. At the other extreme, the central bank could allow settlement to proceed by extending credit to the participant which cannot settle. Either way, there is a risk that the central bank would end up with a credit exposure to an ESA holder.

108. It has been argued that the planned introduction of RTGS should allow the RBA to give ESAs to a wider range of institutions, presumably on the basis that it would no longer be at risk of credit exposure to participants. It is certainly true that such exposures cannot arise with accounts conducted on a strictly prefunded RTGS basis (as is planned for Australia). The considerations described in the previous paragraph would, however, still apply if the ESA holder were a participant in the retail clearing streams which will continue to settle as they do now.

109. A distinction also needs to be made between the RBA's providing settlement facilities to commercial providers of payment services (as it does now) and offering such facilities to other organisations which are principally users of payments services. For the RBA to provide ESAs to commercial organisations which were not in the business of clearing and settling third party (customer) payments would take it well beyond its role as ultimate settlement facilitator, and into competition with the banks and other suppliers of payment services. The RBA does not believe this would be an appropriate role; nor has it been asked to make ESAs more widely available for this purpose.

110. When considering future requests for ESAs, the RBA would look closely at whether the institution concerned was a significant provider of payments services. It would also assess the extent to which the institution could cause the RBA to take on potential credit exposures indirectly on behalf of taxpayers.


111. Innovation, including the use of new technology, is continuing apace in the Australian financial system – particularly in payments. This is making for a more efficient and competitive system.

112. There is no evidence that regulation, including the various restrictions directed at prudent risk management, is inhibiting this process in any significant way. New entrants, either financial institutions or specialist suppliers of computer software and communications services, are major contributors to the innovation and are leading the way in some areas.


In discussing financial innovations this Chapter necessarily draws on examples of particular commercial applications. These are illustrative, not exhaustive. [6]

Not all banks have significant customer payments business, but they need ESAs for direct transactions with the RBA. Until the RBA discontinued its trading relationships with authorised dealers in the short-term money market in 1996, these had ESAs for similar purposes. [7]