Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Payment and Settlement Systems

I wrote a column in today’s Financial Express
about payment and settlement systems in India in the context of the
vision statement released by the Reserve bank of India

RBI recently released a vision statement for the payment systems in
India for the next three years. The mission is “to ensure that
all the payment and settlement systems operating in the country are
safe, secure, sound, efficient, accessible and authorised.”

It is true that the payment system in India has made considerable
progress in the last few years with the emergence of Real Time Gross
Settlement (RTGS) system, National Electronic Fund Transfer (NEFT)
system, implementation of core banking software in most large banks
and rapid spread of the ATM network. With these developments, India is
gradually moving away from antiquated paper-based payments to a modern
payment system. The progress is slower than one would like, but it is
progress all the same.

However, the global financial crisis in 2007 and 2008 has changed
the way we look at the safety and soundness of payment systems, and
the RBI vision statement does not reflect these new concerns and
priorities at all. In fact, the document is characterised by a
pre-crisis world view that makes it largely complacent about
settlement system risks.

The first lesson from the crisis is that any payment or settlement
system that settles in commercial bank money is simply unacceptable as
a ‘safe, secure and sound’ system. During the crisis,
credit default swap spreads on some of the largest banks in the
developed world as well as in India rose to levels indicating serious
concerns about their solvency.

This immediately brings up the horror scenario of every payment or
settlement system: pay-ins take place into the settlement banks of
these systems just before the settlement bank fails. In other words,
the settlement bank fails after receiving the pay-in but before making
the pay-outs.

Since the major securities and derivative settlement systems in
India settle in commercial bank money, this horror scenario should be
giving sleepless nights to the securities regulator and to the central
bank. Unfortunately, the vision statement does not betray any such
concern.

I think urgent steps should be taken to allow major settlement
agencies like the clearing corporations of the stock exchanges,
derivative exchanges, commodity exchanges, the Clearing Corporation of
India and similar entities to make settlements in central bank
money. Whether this takes the form of giving them a limited banking
licence or of opening up the RBI’s payment system to
systemically important non-bank entities is a matter of detail that
need not bother us here.

The point is that we do not have a true delivery-versus-payment
(DVP) system unless the payment happens irrevocably in central bank
money. Before the crisis, it was possible to pretend that large banks
are safe enough to allow settlement to happen in their books. After
the crisis, the regulators would be irresponsible and delusional to
accept this idea.

An even bigger problem exists in the settlement of foreign currency
transactions where time zone differences preclude any true
payment-versus-payment (PVP) settlement of these
transactions. Herstatt Risk has really not been solved several decades
after Herstatt Bank in Germany failed after receiving payments in its
currency but before making payments in foreign currency.

The international community has come up with the idea of having a
private bank (CLS Bank) handle the global settlement of foreign
currency trades. This avoids banks having to take exposure on each
other, but requires them to take exposure on CLS Bank and sometimes on
a participant bank that provides access to CLS Bank.

The thinking was that a settlement and custody bank like CLS Bank
cannot fail, but this is a delusion. During the 2008 global crisis,
questions were raised about some US banks that were largely settlement
and custody banks rather than lending banks. Moreover, even settlement
and custody banks can suffer from acute operational risk as was
demonstrated in a famous episode two decades ago in the US. As a
member of the G20, India has an opportunity to argue for putting
foreign exchange settlement on a sounder footing.

Many alternatives can be thought of. First is that the IMF could
take on the responsibility of running foreign currency settlement not
only because it holds all the currencies of the world, but also
because it enjoys multilateral guarantees that would make settlement
in IMF books a true PVP. The second possibility is that the
world’s major reserve currencies (and currencies of invoicing)
can be persuaded to run a 24/7 RTGS that eliminates the time zone
problem.

The third solution, closer in line with the post-crisis philosophy
of each country taking responsibility for risks within its territory,
is for RBI to run a US dollar RTGS in Mumbai by taking advantage of
its huge dollar reserves. In short, a lot needs to happen before we
can say that “all the payment and settlement systems operating
in the country are safe, secure and sound.”

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One response to “Payment and Settlement Systems

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