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Reforming Cross-Border Payments and Forex Settlement Systems

Regional Workshop on “Reforming Payment and Securities Settlement

Systems”

Manama, Bahrain, March 16, 2005

José Antonio García

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Contents

1. Forex settlement systemsi. Key Considerationsii. Risksiii. Current Situationiv. Reducing Forex Settlement Risk

2. Cross-border retail payments

3. International family remittances

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Cross-border vs. Forex

• Large-value, cross-border payments generally (though not necessarily) related to financial market transactions, particularly foreign exchange (Forex).

• On the other hand, Forex market transactions need not to imply a cross-border payment

• Non large-value cross-border payments more related to:– International trade of goods and services– Unilateral funds transfers from individuals residing in

country X to others in country Y (“Family remittances”)

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Forex Settlement Systems

• Forex market is the most active financial market in the world in terms of total amounts traded– Approximately the equivalent of US$ 4 trillion was

settled each day worldwide by financial institutions by year-end 2004 (gross value, spot markets only).

• Forex markets may entail risks that are relevant from a systemic standpoint– Credit risk – Liquidity risk– Legal and operational risks

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Forex Settlement Systems

• A sound Forex market settlement infrastructure is thus key for several reasons:

– Systemic risk reduction

– Necessary in order to develop a deeper and more dynamic (and, hence, more efficient) forex market

– The forex market can be regarded as the entry point of foreign investors to all other domestic financial (and non-financial) markets

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Credit Risk in Forex Transaction

• A bank that cannot make the payment of the currency it sold conditional upon its final receipt of the currency it bought (i.e. under a payment versus payment (PvP) basis), faces the possibility of losing the full principal value of the transaction.

– Actual exposure: when settling a forex trade, it is the full amount of the currency purchased

– Duration of the exposure: the exposure lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally until the time the currency purchased is received with finality.

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Credit Risk

– This period may still be followed by an “uncertain period”, which is the length of time after the bought currency is due that a bank takes to identify whether of not it has received the funds (e.g. when working through correspondent banks).

– Durations are a function of market practices, differences in time zones and in payment system operating hours.

– Exposures can last from at least overnight and up to several days. For trades in a number of major currencies, the duration was greatly reduced with the launch of CLS Bank.

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Credit Risk

Trading

Deadline for Unilateral Cancellation

Final Settlementof both currencies

Identificationof transactions

Revocable Irrevocable Uncertain

Settled or

Failed

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Credit Risk

• Thus, considering all the above, banks should be expected to apply a control process to FX settlement exposures that is the same or equivalent to the process they apply to credit exposures of the same size and duration resulting from loans or other formal counterparty credit extensions.

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Liquidity and Legal Risks

• Liquidity Risk– Temporary delays in settlement can expose a receiving bank to

liquidity pressures if unsettled funds are needed to meet obligations to other parties.

– The high dynamism of the Forex market also means that a bank will face high opportunity costs if it does not receive the currency bought on due time

• Legal Risk– In the case of foreign exchange deals, legal risk can be

complicated by the fact settlement normally takes place in more than one jurisdiction.

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The current situation

• Besides the case in which currency pairs are now settled through CLS Bank (to be explained later), the current situation and trends in most countries are the following:– Low awareness of the settlement risks involved in Forex deals.– In many cases, deals and settlement based purely on mutual

“trust”. Some banks, however, do establish controls as to who their Forex counterparties may be, and also set limits on the amounts that may be traded with such counterparties

– In some cases there is a centralized Forex trading platform. However, in general such platforms have no direct links with a settlement infrastructure

– In some countries, the Central Bank is the main player (buyer & seller) in the Forex market.

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The current situation

• Lack of PvP:– Forex trades among domestic institutions are generally over-the-counter

(OTC) bilateral transactions. The domestic leg usually is settled in central bank accounts, while the foreign currency leg is generally settled through bank correspondents abroad (in most cases in the country of origin of the foreign currency).

– In the vast majority of cases, the two legs of the transaction are settled independently one from the other. The only “assurance” that settlement will occur is trust in the counterparty.

– The risk of loss of the principal value of the transaction due to a failure in settlement generally lasts for a few hours when deals involve moreless the same time zone, or overnight and even a few days if deals involve quite different time zones.

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The current situation

• Lack of PvP (cont..):– In general, Central Banks are concerned about

managing settlement risks of their own Forex transactions and do not pay much attention to deals between financial intermediaries.

– In some countries, the Central Bank holds accounts for financial intermediaries both in local currency and also in one major foreign currency. This could open the possibility to settle Forex trades among domestic financial institutions under a PvP basis. However, in most cases this possibility is not used.

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Reducing Forex Settlement Risk

• In 1996 the Governors of the central banks of the G-10 countries endorsed a comprehensive strategy to reduce risks, particularly systemic risks, in settling Forex transactions.

• A three-track strategy was agreed, providing for:– action by individual banks to control foreign exchange settlement

exposures;– action by industry groups to provide risk-reducing multi-currency

services; and– action by central banks to induce rapid private sector progress.

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1. Action by individual banks

• Increase awareness of the risks– Proper measurement and updating of Forex settlement exposure (current

and future)

• Establish clear senior level responsibility for measuring and controlling Forex settlement risk

• Treat Forex settlement exposures like other credit exposures of the same size and duration, and manage them accordingly, for example:– Establish bilateral exposure limits with each counterparty– Establish limits (or sub-limits) for exposure duration…….

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1. Action by individual banks

• ……– Revising correspondent banking arrangements

– Improvements in back office payments processing, for example, on-line statements of accounts with correspondents

– Consider the possibility (and costs) of implementing settlement assurance mechanisms, like pre-funding of transactions or other forms of collateral

– Consider the possibility of implementing obligation netting to reduce settlement flows

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2. Action by industry groups: CLS Bank

• In September 2002 the CLS Bank International (CLS Bank) started its Continuous Linked Settlement service, settling foreign exchange transactions in 7 currencies (the Australian dollar, the Canadian dollar, the US dollar, the Euro, the Swiss Franc, the Japanese Yen, and the British pound)

• At the time of its launch, CLS had 66 of the world’s largest financial institutions participating as shareholders

• It is estimated that CLS banks settles over 80 percent of the world’s foreign exchange business by value.

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2. Action by industry groups: CLS Bank

• By December 2004 a total of 15 currencies (the former plus Danish Krone, Norwegian Krone, Swedish Krona, Hong Kong Dollar, Korean Won, Singapore Dollar, South African Rand, New Zealand Dollar)

• By December 2004, a total of 58 Member Banks (shareholders, with settlement accounts) and 191 “Member customers” (third parties sponsored by a Member Bank).

• The CLS Bank is subject to the cooperative oversight of central banks involved and it is under the direct oversight of the US Federal Reserve.

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2. Action by industry groups: CLS Bank

• Counterparty risk is eliminated through a form of payment versus payment (PvP). Liquidity risk is not eliminated.

• Settlement member accounts at CLS Bank– Single, multi-currency account on CLS Bank’s books– Individual currency balances calculated, monitored

• FX trades settle gross on CLS Bank’s books– Final, simultaneous debits and credits to Settlement Member’s

accounts: Achieves “payment versus payment”

• Pay-in’s, pay-out’s via CLS Bank accounts/RTGS systems– CLS Bank holds accounts at central bank of issue. – Participants’ funding and defunding of these accounts is on the basis of

the net amounts in each currency of the trades they are settling that day.

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3. Action by Central Banks

• Encourage timely, market-wide progress– For example, cooperation and dialogue with private

sector to ensure that well-constructed multi-currency services are developed

• Enhance national payment systems– For example, extension of operating hours of payment

systems, to increase the overlap in system hours in different currencies

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Cross-border Retail Payments

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Today’s Picture

• Customers expect a set of convenient, cheap, reliable and predictable instruments to cover their most important payments needs:– face-to-face-payments, one-off and recurring remote

payments, ATM cash withdrawals

• While customer requirements are generally met in many countries at a domestic level, performance in most areas is poor for cross-border transactions– As recent as two years ago, the average fee applicable to

retail cross-border transfers in the Euro zone was 100 times higher than that applicable to comparable domestic transfers

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Today’s Inefficiency

• A “natural” explanation– with few exceptions (e.g. payment cards), payment

infrastructures already in place are only domestic in terms of their scope, this is, they were developed for a monetary zone delimitated by national boundaries.

• Additional issues:– Payment instruments being used– Involvement of a Foreign Exchange Transaction– “Different” risks– Supply factors (diversity of service providers)– Regulation (including customer protection) and Oversight

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Payment Instruments

• All over the world, cash continues to be the most relevant instrument for cross-border payments in terms of volume

• As for cashless transactions, payment cards are the most relevant instrument in terms of volume– In the EU, cards account for 83 percent of total cashless

transactions. In many cases, however, cards are not used as payment instruments but rather for ATM cash withdrawals

– Using cards for remote payments?

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Payment Instruments

• Cheques still relevant for remote payments, especially in less “bancarized” countries

• With the payment system technology currently available, electronic credit transfers and direct debits would appear to be the natural instrument for remote payments– Until recently, only available through cumbersome and costly

correspondent arrangements– Only in recent years, with the spreading of processing and

messaging technologies, they are starting to become accessible to the average individual

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Involvement of a FX transaction

• Not necessarily the case– Cross-border payments in the Euro area, or payments

between a dollarized country (e.g. Ecuador) and the US

• In some cases, more than one FX transaction, meaning more intermediaries

• Usually, large exchange rate spreads • Interestingly, however, at present cross-border

transactions between countries that use the same currency are not very different in terms of overall inefficiency (i.e. high cost) from transactions involving two or more currencies

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“Different” Risks

• The risks are actually the same than for domestic transactions, although the mix can be quite different

• Increased legal risk• Increased operational risk due to intensive manual

procedures (i.e. lack of interoperability)• However, fraud and other security concerns (e.g.

identity theft) are regarded as the main risks– In the case of cards, cross-border fraud is

approximately 20 times higher than domestic fraud.

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Supply Factors

• Increasing demand for cross-border payment services with enhanced flexibility, speed and geographical outreach

• Banks have not been able to cope with this– Banks strong in urban areas, where they have generally

well-developed infrastructures and where payments involve “bancarized” sectors

• Thus, non-banking (or even non-financial) institutions have gained an important market share– Proprietary messaging systems– Large distribution networks covering remote locations

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Regulation and Customer Protection

• Transparency standards are particularly low for cross-border payments– Several implicit charges that are not disclosed to

customers (e.g., exchange rate spreads, charges applicable to the receiver, etc.)

– Minimum service levels, which, for example, give certainty on the time of accreditation of funds to the beneficiary, are practically non-existent

– It is still costly for customers to foster competition through customer research and comparisons

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Oversight

• Still no consensus that retail systems should fall under the direct control of the overseer

• Additional problems in the case of retail cross-border payments:– Overseeing non-financial payment services providers– Overseeing the full flow of a transaction would necessarily

involve two or more national authorities

A broader and more activist agenda in the particular area of retail cross-border payments?

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What can be done?

• Improvements through:

– The “natural” or inertial evolution of cross-border payment systems as a result of increased economic and political integration

– The systematic and conscious effort to improve/reform retail cross-border payment systems

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A look at the SEPA

• In theory, with the adoption of the Euro domestic payments and payments between the countries of the Euro zone ought to be identical

• Up to 2002, however, this was not the case:– High costs when compared to domestic transactions– Relatively low STP rates– Lack of transparency– Poor performance for customers (cost, quality and time)– For cards, seamless domestic and cross-border processing, but

significant price differences between domestic and cross-border

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A look at the SEPA

• The European Commission decided that a drastic political solution was necessary. In December 2001 the European Parliament adopted the “Regulation on cross-border payments in euros”

• Main features:– All fees applicable to card and ATM cross-border

transactions in euros, up to Euro 12,500, must be identical to those being applied to domestic transactions

– This same regime would apply to credit transfers starting on July 1, 2003

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A look at the SEPA

• To comply with this Regulation, the European Payments Council approved two key market conventions:

• The CREDEURO Convention– Establishes a basic bank-to-bank pan-European credit transfer

that allows banks to give guarantees to their customers as regards information requirements, execution time and remittance information transmitted

• The Interbank Charging Principles Convention– A standard procedure for achieving end-to-end certainty in

charging methods, and allowing for the instructed amount to be credit to the beneficiary in full

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A look at the SEPA

• Commercial banks have decided on a pan-European architecture, the Pan-European Clearing House (PE-ACH) as the preferred model for credit and debit transfers.

• In a first stage, the PE-ACH will process credit transfers in combination with existing clearing and settlement systems

Summit of the Americas Commitment to Reduce Remittance Costs by at least half by 2008

– An upcoming Pan-American Payments Clearinghouse?

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International Family Remittances

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International Family Remittances

• International remittances initiated by migrant workers are an important source of family income in many developing economies.

• In some cases, remittances represent a very relevant percentage of the GDP of the receiving countries.

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Integrating remittances in the reform of the National Payments System

• KEY IDEA: Remittance services are part of the broader retail payment system both domestic and cross-border

– Remittances are cross-border retail payments with particular access requirements (on both the demand and supply sides)

• An efficient development of the domestic payment system infrastructure is key to reduce costs of remittance services

• The development of payment system oversight is fundamental to enhance transparency and reduce costs in the retail payment sector

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Integrating remittances in the reform of the National Payments System

• KEY IDEA: Remittance services are part of the broader retail payment system both domestic and cross-border

• The World Bank is a leading institution in payment system development, in particular in Latin America through the Western Hemisphere Payments and Securities Settlement Forum (WHF). In the context of payment system reforms, the World Bank has recommended improvements in the remittance area since 1999

• Payment system development projects are a good vehicle to address the issue

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Additional Key Ideas

• Remittances are part of an individual’s access to financial services

• A good remittance product improves value to the user in the short term and access to other financial products in the long term

• A good remittance product increases competition and moves transactions to the formal sector, enabling the formal sector to provide superior service

• There are no standard solutions

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CPSS/WB Task Force on “General Principles for International Remittance Systems”

• As part of the Sea Island remittance initiative, the G7 Finance Ministers and Central Bank Governors called for work toward developing prudential standards/guidelines for remittance services.

• Some obstacles identified include:– Lack of physical access to financial institutions– Inadequate financial education– Inefficient and costly remittance services available at financial institutions– Regulatory barriers to the provision of remittances services– Inadequacy of data on remittance flows– Lack of guidance on what regulation/supervision of remittance service

providers is necessary to ensure safety and integrity of these services

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Composition of the Task Force

•The Task Force is co-chaired by the CPSS and the World Bank.

•Additional Members:

– Central banks of Italy, the United States, Brazil, Mexico, the

Philippines, Sri Lanka, Turkey, Germany, Hong Kong and the

European Central Bank, as well as the International Monetary Fund,

the Arab Monetary Fund, the Asian Development Bank and the Inter-

American Development Bank

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Mandate and scope (I)

•The Task Force is to develop general principles on remittances describing key features and functions that should be satisfied by remittance systems, providers and financial intermediaries.

• These principles must be clear and universally applicable international standards, its main focus being to identify the main characteristics of sending and receiving remittances an the related infrastructures with a view to improving them.

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Mandate and scope (II)

• To map and compare the remittance market in different countries, as well as the respective cross-border arrangements in these countries in the form of country reports. This analysis should allow the Task Force to define stylized structures of remittance systems, and to determine Principles that could be applied.

• To try to identify principles to ensure an appropriate level of consumer protection and transparency. In this context, the different pricing methodologies shall also be analysed.

The Task Force shall pursue the following streams of work:

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Mandate and scope (II)

• To discuss the appropriate level of access to payment systems infrastructure preserving the safety and integrity of the infrastructure. Appropriate mechanisms for educating the remittance agents and operators will also be considered.

• To discuss public policy issues related to the remittance market.

• To discuss the role of the central bank and other public authorities in the application of the principles.

The Task Force shall pursue the following streams of work (cont.):