Reforming Cross-Border Payments and Forex Settlement Systems

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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

• Forex settlement systems
• Key Considerations
• Risks
• Current Situation
• Reducing Forex Settlement Risk
• Cross-border retail payments
• 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
Settled or Failed
Revocable
Irrevocable
Uncertain
Final Settlement of both currencies
Identification of transactions
Deadline for Unilateral Cancellation
Trading
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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
  worlds largest financial institutions
  participating as shareholders
• It is estimated that CLS banks settles over 80
  percent of the worlds 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 Banks
  books
• Individual currency balances calculated,
  monitored
• FX trades settle gross on CLS Banks books
• Final, simultaneous debits and credits to
  Settlement Members accounts Achieves payment
  versus payment
• Pay-ins, pay-outs 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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Todays 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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Todays 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 individuals 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)
The Task Force shall pursue the following streams
of work

• 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.

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Mandate and scope (II)
The Task Force shall pursue the following streams
of work (cont.)

• 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.