Prof. Jayanth R. Varma's Financial Markets Blog

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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.”

Posted at 11:05 am IST on Wed, 2 Dec 2009         permanent link