The Financial System: Introduction

Transcription

1 The Financial System: Introduction Financial system consist of financial institutions, markets and instruments that together provide financial services for the economy The financial system is important as it performs a number of financial functions Financial functions help us in our everyday life as businesses and individuals Financial functions Major task performed by financial systems are: 1. Settlement of transactions 2. The flow of funds 3. Risk management 4. Overcome information asymmetry 5. Resolve incentive problems 6. Pool funds Settlement function The arrangements that can be used to settle commercial transactions Settlement occurs when a buyer exchanges money for a purchased item Money includes cash and electronic methods (often used today) The payment system performs the settlement function Overview of the payment system A transaction is an agreement between a buyer and a seller to exchange an item or service for payment Most consumer transactions are settled immediately Transactions in financial markets are made in two stages: 1. An agreement is made between the buyer and seller that specifies the terms of the trade 2. Settlement occurs a specified number of days after when the payment is made and ownership of the asset is transferred e.g. in the bond market trades are settled 3 days later (T+3) T+3 is shorthand for requirement that trades in a financial market are settled three business days later Barter, the trading where goods and services are exchanged for each other is not as efficient as payments systems as barter only occurs when a coincidence of wants are met, meaning the two people want what the other has to offer Payment orders

2 Most transactions are between households and businesses, or between businesses, and many are settled with payment orders which require a processing system to complete the movement of funds from the buyer Payment orders are instructions to an ADI to pay the stated amount to the nominated party When the drawer and recipient of a payment order use different ADI, system is required for the drawers ADI to pay the funds to the recipient Exchange settlement accounts ESA s are funds that financial institutions hold with the RBA to settle the payments they make to each other and with the RBA The balances in ESA s belong to the account holders and are known as ES funds The benefits of ESA s are: they enable ADI s to provide payment services to their customers, they re safe and the RBA pays interest on the end of day balance (the interest rate on these balances are set below the rate of interest paid by the RBA to discourage ADIs holding excessive balances in their ESA) However, the accounts cannot be overdrawn Interbank payment order Interbank payment orders require: 1. Clearing- where the ADI s agree on their payment obligations to be settled using ES funds 2. Settlement- the actual transfer of ES funds from the paying to the receiving ADI (handled by the reserve banks information and transfer system- RITS) Settlement systems The two long-standing settlement systems have been: 1. The wholesale system which uses real-time gross settlement o The individual settlement of payments immediately upon clearing o Instructions are received from the debt market s clearinghouse (Austraclear) and FX market (SWIFT) 2. The retail system which uses deferred net settlement o Retail payment orders are net cleared and settled as a batch periodically and at 9am next business day The batch process enables specific payments to be net cleared (such as payments to settle share transactions) with the amounts involved settled in real time In 2011, the payment system board (PSB) proposed new system be developed by 2016 to replace deferred net settlement with real-time settlement Paymentsfrom SWIFT and Austraclear are place in a queue and RTGS settles each payment individually one after the other during the business day Firstly RTGS ensures sufficient ES funds by the paying bank and if they do, the payment is cleared immediately between the ESA accoutns of the paying and receiving bank The RBA informs SWIFT and Austraclear after payments are settled so they can transfer ownership of the traded security or currency

3 Batch feeder facility The batch feeder facility is the facility for settling a group of interbank payment obligations that have been multilaterally netted and submitted to RITS for settlement o This is available to settle specific groups of interbank payment obligations such as those that settle trades in the share market The facility combines the net clearing feature of DNS with the real time settlement capability of RTGS and thus provides a method for faster settlement of the payment orders (period between deposit of the payment orders, their clearing and settlement) DNS system will be history if 2016 industry expectations are met Structure of the payment settlement system scan 2.1 pg 32 scan 2.1 g 32- table The structure of the payment system shown is RTGS are initiated by instructions from Austclear (clearing house for the debt security market) and SWIFT (for foreign exchange trades). The DNS system net payment obligations are submitted through the batch feeder facility. Note all ES funds are processed through RITS whether they re RTGS or DNS During 2012, the payment system settled over $200 billion worth of payments per business day in the DNS and RTGS system, showing the importance of the reliability of the payment system to the economy Approximately 70% of this amount was settled through RTGS, although it only processes a fraction of of the number of payment orders handled by the retail system Payment System Board In 1998, the RBA was formally made responsible for the payment system through the PSB, which o Controls risk in the payment system o Promotes the efficiency of the payment system o Promotes competition in the market for payment services, consistent with the overall stability of the financial system The PSB and hence RBA, is pursuing reforms to reduce risk and improve efficiency and competitiveness of the payment systems The Retail Payment System Settles the vast majority of payment orders, even thought their total value is much smaller than the total value of wholesale payments The main retail payment instruments are direct entries, which are automatic debit or credit charges to an account, payment cards (debit and credit cards) and cheques, which are cleared and settled in the DNS system Retail payment orders require authorization by the payer, this can be done through a signature or personalized identification number (PIN), they must also be verified, when the ADI ensures the instructions are that of the drawer. Authorization and verification is important to reduce the incidence of fraudulent payment orders. PIN provides both verification and authorization while signature only provides authorization and can be verified by the merchant (checking it against the persons card at point of sale), or in the case of a cheque, it requires the physical transportation back to the drawers bank for inspection

4 Deferred Net settlement process Settlement risk, the possibility that an ADI will not meet its payment system obligations, this arises in the DNS when net clearing has determined the obligations. Settlement risk arises because ADI s may have insufficient ES funds at 9 am the next business day to meet their DNS obligations Netting the amounts owed mean only firms owed are at risk and the amount they are owed the amount owing is the amount they have at risk. Hence less firms are at risk and less money is at risk Payment Orders- Cheques Cheques are paper based payment orders drawn on funds held in an ADI deposit account They used to be the principal payment order. They require the user to have a cheque account which no interest was paid on the balance Banks didn t charge a fee on cheques being written/drawn, hence they could write cheques without payment in lieu of interest ADIs now provide cheque facilities on a range of their deposit accounts and may pay a low rate of interest on the funds in the account A cheque is dated, paper-based instructions by the drawer s ADI to pay the stated party the stated sum with the drawers authorizing signature, address of ADI on which it is drawn at, BSB number that identifies the bank and branch, account numbers of both drawer and recipient (to help processing of cheque) Cheques are cleared and settled by DNS on the assumption that each is a valid payment order. This means the amount is credited to the depositors account immediately, however access to the funds is delayed (usually three business days) to allow for the cheque to be verified to protect the depositors ADI The verification of cheques are expensive, hence higher charges apply to processing cheques and there use has declined relative to electronic payment orders The merchant accepting a cheque is exposed to the risk of failed verification meaning the deposit amount is reversed by the merchants bank In addition to drawn by depositor, bank cheques are drawn by banks on the funds in their customer s account and for which a customer is charged a fee. This cheque is common to settle real estate transactions. Financial institutions also draw cheques on themselves and on deposits they have with other financial institutions Debit and credit cards Debits cards are issues by ADI s to their depositors to enable them to access the funds in their deposit accounts, whether the access is through an ATM, an EFTPOS terminal or over the counter at a branch of the ADI. Eftpos terminals are used to settle transactions, banks charge an annual fee for their debit cards and may charge a small transaction fee, depending on the account A credit card company in association with an ADI issues credit cards. The two main credit card companies are MasterCard and Visa. They are used to settle payments; the merchant deposits the credit card instruction and is paid by the card company s bank the next day (DNS). The customer isn t billed for purchases by the card company s bank until the customer s monthly

5 billing date. When the amount is fully paid by the cardholder, the process is completed. If the holder doesn t repay the full amount due, they incur interest from the date of purchase. Note the rate varies but are generally high for credit cards Usage pattern of retail payment orders Direct credits and direct debit have the greatest money value respectively in comparison to other payment orders. Debit cards and credit cards are the most commonly used payment order although the value of the orders are small. Other payment orders are cheques and BPAY which have a small value and number of times used compared to others Payment system board Reforms o Rules of the international credit card companies (Visa and Mastercard) that encouraged cardholders to pay with their credit card to the detriment of payments by other instruments. o The board challenged the fee structure that credit card companies put in place to prevent merchants charging a surcharge to customers to recover cost their costs when accepting payment by credit card, they made fees lower and more explicit to card users o The bpard ensured merchant surcharges were inline with charges on them by credit card companies o ATM reform of the foreign ATM fee to usage fee which is disclosed to ATM users prior to the transaction, ensuring customers could decide on using foreign ATM and encouraging competition o Eftpos reform to wider the payment processes o Ensure stability of settlement process through setting standards for clearing and settlement. Ensuring no financial collapse o Aims to replace DNS with a faster and more efficient system settling most retail transactions, they proposed direct entry payments be settled in batches at specified times throughout the day (done in 2013) and enhance the RTGS of retail payment system orders on a 2/7 basis Wholesale payment systems RTGS removes settlement risk through its after hours session which enables settlements in AUD leg of foreign exchange transactions simultaneously with the settlement of the foreign currency leg in the UK and Europe RTGS puts liquidity pressure on ADI s that make wholesale payments because the payments are settled in a queue which may require a series of payments before receiving payments. Hence if ES funds are exhausted, the ADI wouldn t be able to settle further payments even though the bank may have a credit balance in its ESA Intraday Repos Interest free loan of ES funds by the RBA to ADIs, arranged by RBA agreeing to buy eligble securities from an ADI on the basis of the ADI repurchasing them for the same price at the end of the day The purpose is to help ADIs pay theyre RTGS payments throughout the day Intraday repos were worth $15 billion by mid 2013 and these funds together with the end of day ES balance represents around 10% of the value of RTGS payments

6 Flow of funds function The supply of funds for a period usually on the basis that the users compensate the suppliers for the use of their funds Funds are supplied by surplus units mostly as bank deposits and superannuation contributions o They require compensation for forgoing the immediate use of funds and for the risk of funds will not be returned o Hence, the flow of funds has a price (interest), if the return on the funds are higher than the interest, both the supplier and the user of the funds are better of as a result The deficit units that require funds include households (for housing loans), business and the government The funds are supplied either: 1. Directly (financial markets)- deficit units raise funds directly from surplus units through the issue of securities in the financial markets. Securities are contracts issued by deficit units to raise funds- they specify the promised payments by the deficit unit and can be traded in the financial markets. Securities are liabilities for the issuers and are assets for their owners. The proceeds raised from securities depend on the price of at which the security is issued. 2. Indirectly (financial institutions)- where funds are supplied as deposits to financial institutions, which in turn supply funds as loans to deficit units. The financial institution acts as an intermediary, borrowing from surplus and supplying deficit units. This form of financing has two contracts- one with the surplus unit and one with the deficit unit Risk transfer function Risk is the possibility that returns will be lower than expected, which includes the possibility of a loss Default risk is the chance that financial obligations will not be met Market risk is the possibility of a loss arising from an unexpected movement in market variables such as interest rates, exchange rates or share price The risk transfer function is so named, as risk cannot be made to disappear by the financial system. The risk for a trader is only eliminated if another trader takes on the risk.