THE UNIVERSITY OF HONG KONG LIBRARIES. Hong Kong Collection

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2 THE UNIVERSITY OF HONG KONG LIBRARIES Hong Kong Collection

3 CONSULTATIVE PAPER ON HONG KONG'S INTERBANK PAYMENT SYSTEM INTRODUCTION " LTIT^IIII Hong Kong has an advanced banking environment. At the consumer banking level, the banking industry offers a wide array of payment instruments, from cheques to direct debits, credit cards and multi-currency bank accounts, many of which are professed electronically. At the wholesale level, Hong Kong's interbank clearing and settlement system processes over 600,000 transactions daily, valued at $130 billion. On a peak day, the system could process as much as half of Hong Kong's annual GDP in one day. 2. The basic building block of an economy's financial infrastructure is the interbank payment and settlement system. This has served the economy well and soundly throughout Hong Kong's rapid emergence as one of the most dynamic and vigorous international financial centres. 3. In recent years, with the emergence of global banking, rapid financial innovation and increasingly high telecommunications technology, central banks around the world have studied the importance of payment systems and have made numerous recommendations on their improvement and risk management issues. 4. Accordingly, a Working Party on Payment and Settlement System was established, with experts from the Hong Kong Monetary Authority (HKMA) and the banking industry, to study these issues and to make recommendations on the way forward. The objective is to build on Hong Kong's existing strong financial infrastructure and prepare the ground for securing Hong Kong's premier position as a leading international financial centre, as well as one of the most important electronic banking hubs in the world of global finance.

4 The Working Party has consulted various banking experts, including Mr Robert Lindley from the Bank of England. This Report has been issued as a Consultative Paper to solicit views and comments from the banking community and major users of the payment and settlement system. EXISTING SITUATION 6. The clearing system of the Clearing House in Hong Kong is provided by the Hong Kong Association of Banks (HKAB) and run by the Hongkong and Shanghai Banking Corporation Ltd (HSBC), which serves as the Management Bank of the clearing system pursuant to an agreement between the HKAB and HSBC entered into in January 1981 and subsequently amended in March 1982, August 1987 and July The Management Bank provides staff to the Clearing House as supervisors and clerks to receive, sort and balance articles presented. The Clearing House has 159 clearing members. 7. All Clearing House member banks maintain a clearing account with the Management Bank either directly or indirectly through another Settlement Bank. By debiting or crediting the clearing accounts of the member banks at the end of the clearing process, the Management Bank provides final settlement facilities. There are altogether ten Settlement Banks, including the HSBC which performs the dual role of a Settlement Bank as well as the Management Bank. All other 149 are Sub-Settlement Banks. 8. The interbank payment system offers a wide range of payment facilities but cheques, which are paper-based debit-transfer instruments, remain the most important in terms of volume. The interbank payment system consists of five components and their share of the total value and volume of payments are as follows:

5 - 3 - Average daily traffic (March 1993) Paving component $mns Value (%} Volume No. of items (%} Cheque 52, , CHATS* 73, , Electronic , Easy Pay , CCASS** 4, , , , Clearing House Automated Transfer System ** Central Clearing and Settlement System (for shares) 9. CHATS, cheques and CCASS are the three most important components in Hong Kong's payment system. They together account for practically the whole of the total value of payment. In all three major components, a significant percentage of the value (97% in CHATS, 68% in cheque clearing and 41% in CCASS) is accounted for by a relatively small number of large payments of over $10 million each. (The total number of such payments for all three systems combined is around 1600 each day). 10. Cheques currently account for some 40% or so of the average value of traffic through Hong Kong's payment system (as compared to 24% in the United Kingdom and less than 5% in Japan). It is common practice in Hong Kong to use large-value cheques to settle property and securities transactions. There is currently no incentive for banks or customers to move towards truncation (the transfer of paperbased data into electronic form), or paperless electronic fund transfer systems. Largevalue payments by means of CHATS or other electronic means are preferable because of the speed and reliability of processing. Large value credit-transfers also eliminate customer risk, making it easier to handle interbank risk. The problems associated with the use of such paper-based debit-transfer instruments as cheques are discussed in Annex A.

6 All the five components of the payment system settle as a single process which takes place at 10:15 a.m. of the next day (Day D+l). Dishonoured cheques will be returned in the afternoon of that day and the settlement of the returned amounts takes place on the following day (Day D+2). If a Settlement Bank is overdrawn in its clearing account and the Management Bank is unwilling to provide enough credit, the Settlement Bank will be declared to be in default and the clearings will be unwound i.e. the net position of each of the surviving Settlement Banks will be recalculated excluding all transactions to and from the failed Settlement Bank. Similarly, if a Settlement Bank declares that it is unwilling to settle a Sub-Settlement Bank's position, and the Sub-Settlement Bank is unable to cover its position by other means, the clearing will again be unwouiid and recalculated excluding transactions to and from the Sub-Settlement Bank. A chart describing the timing of the various components in the payment system is at Annex B. 12. The existing interbank payment system has so far served Hong Kong well It provides a convenient facility for interbank payment and settlement at reasonable cost. The flow of payments has increased very rapidly from an average daily value of $130 bn in March 1993 to $216 bn in December On a peak day, the value reached $400 bn. The existing system has been able to cope with this increased turnover with little difficulties. 13. In most payment systems, there are a number of settlement risks involved. These risks are : principal risk, funding risk and systemic risk (see Annex C). They can be reduced by shortening the settlement period (i.e. improving the efficiency of the settlement process) or reducing the amount to be settled. The two are actually inter-related since more frequent settlement will result in fewer items being left in the waitlist for settlement. REAL TIME GROSS SETTLEMENT (RTGS^ 14. * Settlement risk can be eliminated by moving onto a RTGS system. RTGS tackles the root of the problem i.e. the time gap between the receipt of the payment instruction and settlement. Each payment is processed continuously and finality of settlement is instantaneous. In effect, individual payment instructions

7 - 5 - would be settled before they were passed to the receiving banks. So there is no problem of anticipation. By the time when the bank receives the payment instruction, it has already had the funds credited to its settlement account. Thus the beneficiary bank receives final funds, by way an irrevocable credit to its clearing account; and it can immediately pass good value to its customer, or use the funds to meet its own obligations elsewhere, without any exposure to the sending bank. 15. RTGS has been adopted by a number of financial centres for large-value electronic payments. At present, Switzerland's Swiss Interbank Clearing (SIC) and the US Fedwire are examples of RTGS. Japan's BOJ-NET also allows its participants to choose between RTGS and designated time settlement. The United Kingdom intends to implement RTGS by Annex D is a comparison of the US Fedwire and the Switzerland's SIC systems. 16. As RTGS allows for instantaneous finality of settlement, it provides a necessary condition for real time Delivery Versus Payment (DVP) or Payment ag'ainst Payment (PVP), which will increasingly become the minimum standard for the basic infrastructure for the developed financial markets. 17. Settlement risk in Hong Kong's existing payment system can best be eliminated by RTGS. In the course of moving towards RTGS, the introduction of limits is in many ways the biggest behavioural change involved: under RTGS, banks will have to keep within a limit determined by the funds available on their settlement account (including any credit facility available). Such a limit could be accommodated within the existing system by introducing "sender caps" on the net debit position each bank was allowed to run during the day. By introducing the limits at a high level and gradually reducing them, banks could gain experience of working with an intra-day constraint and it would be less likely that disruption to the normal payment flow would occur when RTGS was introduced. PRACTICAL ISSUES OF IMPLEMENTING RTGS 18. While RTGS has clear theoretical superiority over the other systems, there are still a number of practical issues, such as costs, management of payment

8 - 6 - flows and behavioural changes of customers, which need to be further studied. These issues include : (a) (b) (c) Liquidity to fund the clearing accounts : A RTGS system may be cash funded or collateralised or both. The operating cost of the batiks may become higher arising from the need to set aside a larger clearing balance to ensure smooth flow of payment instructions than under the present system. Alternatively, they may be required to hold a significant amount of liquid assets, which are likely to be of low yield, to be used as collaterals to support the overdraft limits of banks' clearing accounts. The cost of collateralised overdraft limits may not necessarily be high. The Bank of England is considering introducing same-day Repo to reduce the cost to banks. This is an idea deserving further consideration in Hong Kong's context. Problem of Queuing : Queuing is considered undesirable because it may induce inefficiency and uncertainty in the payment system. There is a need to devise an effective mechanism to reduce the chance of payment being blocked and delayed for unduly long periods of time. At the same time, banks would need to develop skills to manage the intraday payment flows. Need to change the computer systems of the Clearing House and members of the CHATS : Under CHATS it is possible to set a debit limit per transaction and daily net debit limit for each Sub-Settlement Bank. Warning signals can be sent to the Settlement Bank if any of its Sub-Settlement Banks exceeds the limits. While this serves only as a warning system because the related fund transfers which caused the excess can still go through the system, it should be relatively simple to extend this system to the Settlement Bank and to install a stop device to reject those transactions above limits. However, some further changes to the existing hardware and software may be needed to generate additional information on the pattern of intra-day fund flows among banks. This is needed for making an assessment on the feasibility of setting up multilateral limits and caps for interbank exposures.

9 - 7 - RECOMMENDATION : RTGS AS THE TARGET 19. It is recommended that Hong Kong should move towards RTGS for the following reasons: a) legally RTGS is more robust than any form of netting as the transactions are settled on a gross basis; b) since individual payment instructions would be settled before they were passed to the receiving banks, there is no problem of anticipation and settlement risk can be minimized or even eliminated; and c) as RTGS allows instantaneous finality of settlement, it provides the necessary conditions for real time DVP or PVP. 20. Although RTGS is superior to other systems, it is unlikely that the banking sector would agree to its implementation without knowing its costs and practical consequences for banks. It is therefore recommended that more detailed studies should be undertaken to assess the costs and other practical issues involved in introducing RTGS in Hong Kong (paragraphs 18). Further study on RTGS should focus on the following issues: (a) (b) (c) (d) (e) analysis of the existing payment flows and the scale of existing and potential risks; whether collaterals are needed and if so the best form of collateral arrangements; the likely amount and costs of collaterals needed by the banks to fund their clearing accounts under RTGS; the legal implications of introducing RTGS; the system changes needed in terms of new software and/or hardware to enable the monitoring of the intra-day limits and to carry out real time settlement; and

10 - 8 - (f) the development of DVP system for Hong Kong's financial markets and PVP for cross border and multi-currency transactions with reference to internationally acceptable standards. RECOMMENDATION : INTERIM REFORM MEASURES 21. While Hong Kong should move to RTGS in order to reduce and eliminate risk, it takes time to assess the costs and other practical issues (paragraphs 18). It is therefore necessary and desirable to implement some interim reform measures, particularly those which are conducive to the move towards RTGS. The following interim reform measures are recommended: (a) (b) (c) (d) same day settlement: the final settlement for CHATS and large-value cheques over $10 million should be brought forward to Day D (say 6:00 p.m.) and thus the operating hours of the Liquidity Adjustment Facility, currently from 4:00 p.m. to 5:00 p.m., may need to be postponed; reduction of large-value cheque payments: the value of cheque payments, which accounts for 40% of total value of payments, can be reduced by encouraging corporate and retail customers to use CHATS, imposing charge on the drawers of large value cheques of over $10 million, setting an earlier cut-off time (say 2:00 p.m.) for the presentation of large-value cheques of over HK$10 million to the Clearing House for clearing and value the same day; setting up a real time cheque information tracking system: an electronic cheque data capturing and transferring system such as that introduced in Singapore should be set up; and consideration be given to set an earlier cut-off time for the presentation of CCASS items to the Clearing House to facilitate same day settlement;

11 Probably with the exception for (c), the above measures do not involve major system changes and should not be too difficult to implement. It is recommended that they should be implemented as soon as practicable. 23. If the measures in paragraph 21 are implemented, the overall clearing commitment of the Member Banks should be known by the close of play on Day D. CHATS, large-value cheques and the CCASS items could then be settled on the same day. But the finality of settlement for small-value cheques would still be on Day D+l. Nevertheless, the total value of small-value cheques is likely to be small relative to the overall clearing commitment. Such conditional finality of settlement is adequate to serve the purpose of assessing the credit exposures of the Management Bank to any Settlement Bank and of any Settlement Bank to their Sub-Settlement Bank or vice versa. In case the Management Bank is not comfortable with the debit position of a bank and the latter is unable to borrow from the money market to cover its debit position, the Management Bank should bring this matter to the attention of the Secretary of HKAB and possibly the HKMA immediately. In this way, the parties concerned can have the whole evening to assess the problem and consider what should be done. The deadline for the Secretary of HKAB to announce the suspension of clearing facility to a bank, which has the same effect of declaring the bank concerned to be in default, should preferably be advanced to before the start of the next business day. In other words, if the entries have to be reversed, it would take place well before the market starts on Day D+l. 24. To impose an earlier cut-off time for the presentation of large-value cheques and CCASS items to the Clearing House may involve behavioural changes on the part of the bank customers and changes in the existing practices in the Stock Exchange and CCASS. But these changes should not be difficult to accommodate. Annex E assesses the implications of these measures. CONCLUSION 25. Apart from improving the robustness and risk management of the interbank payment system, the recommended measures, if implemented, would bring useful benefits to the bank customers. By making good funds available to the

12 receiving party at an earlier time, same day settlement can improve the efficiency of the use of money. For example, a customer would be able to freely draw on the funds in the morning instead of late afternoon of Day D+l. RTGS would further improve the efficiency. 26. Intra-day finality of settlement is now considered an important "foundation stone upon which risk reduction measures can be developed". As Hong Kong's financial markets develop, the value of the payments handled by the system will grow, thereby increasing the risks. At the same time, there is likely to be growing competitive pressure for the system to provide same day funds. There will also be a growing demand for the system to offer real time DVP in the securities and debt markets and real time settlement in foreign exchange markets (PVP). Annex F describes different versions of DVP as identified by the Bank for International Settlements. 27. Intra-day finality of settlement will naturally lead to RTGS. In respect of both risk management and efficiency enhancement, RTGS is undoubtedly the best option. Payment systems are only a means of moving funds between bank accounts and as such are not intrinsically risky - at least not in the sense of necessarily involving interbank exposures. RTGS restores payment systems to that relatively simple state by removing all credit from within them so that they are merely a money transmission mechanism. Because of this, RTGS systems are the best placed to withstand crises and to deal with any future growth in traffic. Moreover, RTGS is the building block for real time DVP and PVP. Lately, the European Community (EC) Report has recommended that RTGS should be the minimum common feature for domestic payment systems for EC Countries (Annex G). 28. RTGS is both desirable and practicable in Hong Kong f s context. This view is confirmed in the consultancy study by the Bank of England expert. If Hong Kong wishes to maintain its status as an international financial centre and remain competitive, it needs to have an efficient, safe, and robust payment system such as RTGS which complies with all the main standards adopted by other major international financial centres.

13 Given the lead time it would take to study the costs and other related practical issues of implementing RTGS, it is recommended that the interim reform measures, designed to achieve same day settlement and reduce the value of cheque payments, be implemented as soon as practicable. Hong Kong Monetary Authority January 1994

14 Annex A The problem of cheques as a means of interbank payment (i) (ii) (iii) Settlement cannot take place until the cheque has been passed from the payee bank through the Clearing House to the paying bank and confirmed by the latter. It is difficult for a bank to keep track of the number and value of cheques its customers have issued. The information about the value of cheques drawn on a bank during the day is not known until mid-night of that day. Cheque payments involve both interbank risk and customer risk; interbank risk disappears at 10:15 a.m. when settlement takes place but the customer risk remains until 2:15 p.m. at which time the Clearing House will provide information about cheques that have been returned. Cheque payment is inherently an inefficient system because it involves the physical delivery of the cheques from the payee bank to the Clearing House, from the Clearing House to the paying bank, and from the paying bank back to the payee bank through the Clearing House in respect of returned items. (iv) Debit-transfers such as cheques are never ideal because they encourage anticipation. With credit-transfers it is possible to cure the problem by arranging for settlement to take place before the payment instruction is delivered to the receiving bank (as in real time gross settlement, for example); in such an arrangement the receiving bank cannot anticipate the funds - by the time it receives the instruction, it has also received the related funds. But with a debit-transfer, the information flow is, in a sense, the wrong way round : the receiving bank is the first to know of the payment instruction (i.e. when it is paid into that bank) and settlement cannot take place until the instruction has been passed on to the paying bank.

15 PayMent and settlenent systems in Hong Kong Annex B Cheques Electronic Clearing Clearing CHATS EPS CCASS

16 Annex C Types of Settlement risk (a) Principal risk - (b) Funding risk (c) Systemic risk - This arises if, before a bank is known to be in default, a surviving bank has already acted on payment instructions received from the bank i.e. the surviving bank may have already made funds available to its customers, the beneficiary of the payment instructions. This arises if a bank defaults before settlement has taken place and hence under the current Clearing House Rules, the clearing has to be unwound to remove all transactions to and from the defaulting bank. The surviving banks will therefore face recalculated net positions that are likely to be larger deficits (or smaller surpluses) than they were expecting. At short notice, and at a time of market uncertainty caused by the original bank failure, it may be difficult for some surviving banks to raise the funds necessary to cover the difference between their original position in the Clearing and the new position they face as a result of the unwinding. The risk that the failure of one participant in an interbank funds transfer system to meet his required obligations will cause other participants to be unable to meet their obligations when due, notwithstanding that some of these other participants are not involved in the transactions with the problem bank concerned In short, systemic risk is the principal risk and/or funding risk permeating in the payment system as a whole.

17 Annex D Comparison between the US Fedwire and Switzerland's SIC systems There are some important differences between SIC and Fedwire. First. Fedwire allows daylight overdrafts on reserve accounts and the US Federal Reserve has to assume some of the risk in the period before final settlement, but SIC does not Instead, a queuing facility automatically holds an uncovered payment order until sufficient balances are available to process it without an overdraft and then automatically releases it for settlement Second, while Fedwire operation are limited to normal business hours, SIC operates around the clock on bank business days. Third, since January 1988 SIC has operated in an environment that imposes negligible reserve requirements on banks. Reserve account balances are now for all practical purposes excess reserve held for settlement purposes.

18 Annex E Implications of setting an earlier cut-off time for oresentation of large-value cheaues and CCASS items to the Clearing House To impose an earlier cut off time for presentation of large-value cheques may have a bearing on general business behaviour. If these cheques were to be presented to the Clearing House before 2:00 p.m., they would have to be accepted over-the-counter at bank branches before 12 noon. Currently, banks tend to accommodate the needs of their customers, particularly corporate and large individual customers, by accepting large-value cheques for clearance late in the afternoon. If such an earlier cut-off time is imposed, commercial activities which are presently settled by large-value cheques like property transactions will have to be completed in the morning to enable cheques to be presented for same day clearing. Nevertheless the apparent inconvenience to the general public has to be weighed against the benefits brought by same day settlement, one of which being that the payee of the large-value cheques can make use of the incoming funds in the early morning of Day D +1 (the existing practice is in the late afternoon of Day D + l or in the morning of Day D-f2) since these cheques have already been settled on Day D. Moreover, customers wishing to make payment in the afternoon may still use CHATS, which remain open until 4:30 p.m. To impose an earlier cut-off time for presentation of the CCASS items may necessitate changes in some existing practices in the Stock Exchange and CCASS. But this certainly deserves serious consideration. The Working Party notes that there is a gap of 45 minutes between the transfer of securities in CCASS and the final settlement of interbank payments. This is also an area in which further study in conjunction with CCASS is required.

19 Annex F Three models of Delivery Versus Payment (DVP) Model 1: Systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment). Model 2: Systems that settle securities transfer instructions on a gross basis with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle. Model 3: Systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle. Source: Delivery Versus Payment in Securities Settlement Systems, Basle, September 1992.

20 XQ [HKP]33212C72 XQ31757S1 Annex G Principles for large-value interbank funds transfer systems (IFTS) in EC Countries I. Harmorised access conditions to interbank fund transfer system capable of international interfacing. II. III. IV. Risk minimization or elimination by adopting Real Time Gross Settlement system. Well-founded legal basis. Reliable technical system. V. Fair pricing policy to be charged by the central banks. VI. Greater overlap of operating hours in different EC Countries. Source: "Report to the Committee of Governors of the Central Banks of the Member States of the European Economic Community" November 1993

21 HKP C72 C*rvr\c Til -f o -f -I i Date Due NO TOG

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