Context

An appropriate legal framework is needed to underpin a sound and efficient payment system. The legal environment should include the following: (1) laws and regulations of broad applicability that address issues such as insolvency and contractual relations between parties; (2) laws and regulations that have specific applicability to payment systems (such as legislation on electronic signature, validation of netting, and settlement finality); and (3) the rules, standards, and procedures agreed to by the participants of a payment system. The legal infrastructure should also cover other activities carried out by both public and private sector entities. For example, the legislative framework may establish clear responsibilities for the central bank or other regulatory bodies, such as oversight of the payment systems or the provision of liquidity to participants in these systems. Finally, relevant pieces of legislation that have an impact on the soundness of the legal framework on the payment system include a law on transparency and security of payment instruments, terms, and conditions; antitrust legislation for the supply of payment services; and legislation on privacy. Although laws are normally the appropriate means to enforce a general objective in the payments field, in some cases, regulations by the overseers may be an efficient way to react to a rapidly changing environment. In other cases, specific agreements among participants may be adequate. In such cases, a professional assessment of the enforceability of these arrangements is usually required. Finally, because the payment system typically includes participants incorporated in foreign jurisdictions or it might operate with multiple currencies or across borders, it may be necessary to address issues associated with foreign jurisdictions.

The operation of a securities settlement system (SSS) must be reliable and predictable. This depends on the laws, rules, and procedures that support the holding, transfer, pledging, and lending of securities and related payments, and how these work in practice—that is, whether system operators, participants, and their customers can enforce their rights. If the legal framework is inadequate or its application is uncertain, it can give rise to credit or liquidity risks for system participants and their customers or to systemic risks for financial markets as a whole.

A variety of laws and legal concepts can affect the performance of clearing and settlement systems. Weaknesses in contract laws, company laws, bankruptcy and insolvency laws, custody laws, and property laws may impede the performance of a clearing system. There is a need for an adequate legal basis that is able to accommodate technological advances. Key aspects of the settlement process that the legal framework should support include enforceability of transactions, protection of customer assets (particularly against insolvency of custodians), immobilization or dematerialization of securities, netting arrangements, securities lending (including repos and other economically equivalent transactions), finality of settlement, arrangements for achieving delivery versus payment, default rules, liquidation of assets pledged or transferred as collateral, and protection of the interests of beneficial owners. The rules and contracts related to the operation of the SSS should be enforceable in the event of insolvency of a system participant, irrespective of whether the participant is located in the jurisdiction whose laws govern the SSS or is in another jurisdiction.

An important emerging issue is the legal status of digital signatures. If digital signatures are to substitute for handwritten signatures, they must be legally binding. A critical need is to ensure that laws are both enforced and are enforceable in all relevant jurisdictions. In addition, disputes should become the subject of court proceedings only as a last resort. This can be achieved through the specification and acceptance of clear, comprehensive, and fair arbitration processes.

For further details on the legal framework’s status in the region, see Appendix Table A4.1.

Observations

There is no regulation in the six countries specifying how oversight is to be conducted, although central bank laws usually recognize that payment systems’ oversight is among the central bank’s functions (the exceptions being El Salvador and Panama).

There is a lack of provisions regarding acceptance, irrevocability, or settlement finality of an order to be processed by the system. These concepts are especially important in the event of an insolvency. In netting systems, the legal definition of these concepts would reduce uncertainties and limit systemic liquidity risk from unwinding procedures. Similarly, although in general there are no explicit zero hour rules, it is not clear if the countries’ courts could revoke pending or already executed operations made by the defaulting institution. Many legal frameworks fail to define specific triggers for the intervention of a financial institution, creating uncertainty about the system’s or central bank’s credit risk exposure (the latter in the case the central bank extends credit to the system’s participants).

In some of the Central American countries, the central bank law provisions have not translated into a specific regulation dealing with the operation of settlement systems. Not all the systems have detailed rules. Thus, participants may not be aware of the risks they incur. There is also a lack of clarity regarding penalties and the conditions and procedures for removing a participant from the system.

There is no explicit legal recognition in the six countries of multilateral netting arrangements, creating legal uncertainty in the event of an insolvency. Since netting is used on a broad scale for the settlement of stock exchange transactions and check and retail payments, this constitutes a serious legal risk. It might also hamper further development of financial instruments such as derivatives. It is important to protect netting schemes from potentially disruptive insolvency laws so that, even if a system participant fails during the day, a liquidator cannot unwind settlement occurring on a net basis at a later time in the day (see, for instance, the Finality Directive of the European Commission).

Most Central American countries have recently approved laws for electronic documents and signatures. These need to be complemented by changes in relevant rules and regulations to ensure that the legal basis is effective and clarify that the laws also apply to the electronic exchange of messages within the payment systems operated by the central bank.

In general, there is no public or private body responsible for the resolution of potential conflicts arising from the operation of the systems. There is no provision regarding the responsibility of the operator in case of malfunctioning of the system and, therefore, there is no rule dealing with a possible compensation in those cases.

The judiciary in the six countries lacks familiarity with the specific legal needs of the financial sector and the systemic implications of the application of certain laws. Focused training programs should be put in place as soon as an overall assessment of the legal framework for the payment system is completed.

Although securities markets legislation usually includes the legal basis for immobilization and dematerialization, in some cases (e.g., Guatemala) this law only applies to private securities. The legal framework for public debt securities is separate and does not include a definition of dematerialization and immobilization.

A sound legal basis requires the legal definition of the depository function that the central bank often undertakes for public debt securities. However, the depository function is normally defined in securities markets legislation for joint stock companies, while central bank laws only cover the custody function: that is, central banks maintain the registry of the primary market but have not developed the ownership transfer functionality for the secondary market, even when another depository does not exist. This is a clear impediment to the development of the secondary market because its settlement rests on the exchange of physical certificates.

Transactions linked to securities settlement systems are not legally final, creating a potential for counterparty risk. Finality must be integrated into the legal framework. This is an important issue in all existing net settlement systems, especially those that have longer settlement cycles. Without this legal basis, it is uncertain whether in case of bankruptcy the transfer of securities to the counterparty or his custodian could take place, even if the counterparty has already paid for the securities (in some systems there is a time lag between the settlement of the cash leg and the settlement of the securities leg). Due to this uncertainty, an unwinding of the net settlement might be the only solution if the cash settlement process did not take place. If the cash settlement already took place, it might bring forward principal risk if the court did not grant the request to transfer the securities.

Even systems with more advanced legal frameworks are vulnerable to settlement finality risk because of bankruptcy procedures that cancel fraudulent transactions effective several days before the participant is declared failed. However, the impact in case of RTGS systems is likely to be negligible because of the gross nature of the system. Problems of interpretation might also arise since settlement finality is subject to regulations that have a lower hierarchy than the bankruptcy law. Initiatives to engage the judicial system in this debate are worth pursuing.

In general, protection of customer assets under custodian arrangements is not clearly established. Therefore, assets pledged as collateral by clearing members are not adequately covered by the law, thereby compromising the capacity to execute collateral. Sometimes, the protection of custody arrangements is provided for the depository and broker-dealers but not for other custodians, or vice versa. This limitation could bar potential settlement arrangements from taking place.⁸⁶ In the case of public securities, this could limit retail market development because beneficial owners are usually not identified in the accounts of the depository.

Custodian arrangements for government securities (which are often issued in physical form) do not have secure legal support because primary dealers keep the ownership in the registry of the ministry of finance or central bank. Thus, it is uncertain whether the certificate endorsements in subsequent repo operations can be legally considered a proof of ownership. In some cases, participants agree that the transferred certificate will be kept but not used to transfer ownership in the ministry of finance or central bank registry.

Although repo operations are legally defined, there is uncertainty about their use as guarantees for transactions to be processed in a system. The legal basis for the pledge is typically included in the civil code but the pledge, as a tool for collateralized operations, is not regulated. Furthermore, there are no rules on the execution of those guarantees in case of a default. This creates an important impediment in the granting of collateralized intraday credit by the central bank for the purpose of payment settlement.

The definition of repos covers only sell and buyback transactions, although the scope of a repo is much wider internationally. Repos are much used to collateralize cash or securities loans. If, during the collateralization period, due to market developments, the collateral offered no longer covers in full the obligation to pay back the loan or the value of the securities borrowed, additional collateral can normally be requested through a margin call. The definition used in the six countries leaves no room for this market practice and makes it difficult to use international standard contracts. Margin calls during the contract period might also give rise to legal risk if the court recharacterizes a repo agreement with interim margin calls as an improper pledge. It might be worth studying if there should be an explicit distinction between a repo in the form of a collateralized cash or securities loan and an explicit sell and buy-back transaction.

Laws are clear in terms of the segregation of accounts by the depository but not by the custodians (e.g., banks, broker-dealers), although this is often done in practice. This makes it unclear whether the customer assets will be protected against the insolvency of custodians. This issue is relevant in circumstances when the bulk of the market is represented by government securities (a common situation in Central America) that are issued in physical form and largely held by custodians.

The legal basis for securities lending does not exist in many cases or detailed regulations have not been developed. The current low volume of market trading is an opportunity to develop the legal and regulatory framework in preparation for an eventual recovery of past market volumes.

The fragmentation of laws and regulations related to securities and capital markets is common in the region. This creates uncertainty and confusion in the legal framework and may ultimately influence both the functioning of the markets and the activities of market participants. A unified payment systems law might help in resolving the potential conflicts of interpretation on issues such as finality and oversight.

Legal frameworks often do not contain explicit conflict of law rules. This could hamper the development of intraregional financial markets and international cooperation in the area of trading, custody, and clearing and settlement.

The lack of enforceability of the legal framework is hampering the development of securities settlement systems. Many countries have introduced an adequate legal and regulatory framework for the processing of electronic operations but poor enforcement is preventing the further development of financial markets.

To sum up, country authorities need to review the legal framework with particular attention to irrevocability of final settlement, adequate protection against bankruptcy effects, the legal basis for custody arrangements, legal definition of a repo operation, legal recognition of multilateral netting arrangements, legal definition of immobilization and dematerialization of securities (especially public securities), and legal definition and regulation of oversight powers of the central bank. Other legal issues considered from a developmental point of view include the legal basis for collateral pledge and securities lending. Due to the variety and importance of these legal aspects, some of the countries should determine whether the level of legal changes required justify a payment systems law.

Context

Large-value systems are the most significant component of the national payment system. This is because they can generate and transmit systemic disturbances to the financial sector. Several measures can be adopted to minimize these systemic risks. If the system is characterized by a deferred net settlement of payment transactions, risk control measures include the introduction of bilateral and multilateral caps, the implementation of loss-sharing agreements, and the pledging of collateral. The development of RTGS systems is one response to the growing awareness of the need for sound risk management in large-value funds transfer systems. RTGS systems can offer a powerful mechanism for limiting settlement and systemic risks in the interbank settlement process, because they can effect final settlement of individual fund transfers on a continuous basis during the processing day. In addition, RTGS systems can contribute to the reduction of settlement risk in securities and foreign exchange transactions by facilitating delivery versus payment and payment versus payment mechanisms. Variants of the basic RTGS system—the so-called hybrid systems—that take into account liquidity saving features in net settlement systems are being introduced in some countries.

Appendix Table A4.2 presents some data about the amount of cash and transferable (sight) deposits as a proxy for the use of cash and cashless payment instruments. Appendix Table A4.3 presents the main characteristics of the interbank settlement systems identified as systematically important payment systems (SIPS). Clearinghouses are included as they are systemically important, although there are also relevant retail payments (see next section).

Observations

Large-value and systemically important payment systems in Central America do not fully observe several of the Committee on Payment and Settlement System’s Core Principles for Systematically Important Payment Systems (CPSS-CPSIPS).⁸⁷ A number of central banks in Central American countries (El Salvador, Guatemala, Honduras) have initiated payment system reforms to improve the safety and efficiency of large-value systems, launch RTGS systems, and reduce the use of checks for large-value settlement. These efforts should be carried out as part of the overall strategy to reform the national payment system, of which large systems represent the backbone.

The high value of checks settled in the check clearinghouses throughout the region and their use in interbank payments confirm that these systems should be viewed as SIPS. Strengthening payment system stability requires that the discharge of obligations among financial intermediaries be executed through electronic payments settled in the RTGS system (when this is operational). The movement from checks to electronic payments is crucial to increase the efficiency of the payment system as a whole. Consequently, central banks should evaluate ways to provide intermediaries with incentives to use the RTGS system instead of checks for interbank transfers. Pricing policy should be used as an incentive for this transition.

There has been progress in launching RTGS systems in the region. Costa Rica already has a safe and efficient RTGS system, and new systems in line with the CPSIPS are being launched in El Salvador, Honduras, and Guatemala. In Nicaragua, an overhaul of the gross settlement system (Transferencia Telefónica Segura de Fondos, TTS) is under way. All countries in the region should count with an appropriately designed RTGS system. To this end, central banks should evaluate and discuss with market participants all aspects of the new system. In particular, central banks should prepare rules and procedures related to the use of the system, including tools for managing legal, financial, and operational risks. Tools to handle liquidity risks should include queuing and optimization mechanisms; efficient throughput mechanisms and adequate interconnections among the systems; routines for channeling government payments early in the operating day; the flexible use of reserve requirements; and intraday liquidity provision through repos with application of haircuts. Moreover, the design of the system should include (1) a robust and efficient communications network between the bank and system participants, which should reduce and eventually eliminate the use of manual and paper-based procedures; (2) strict security measures for physical and electronic access to the system; (3) contingency plans and disaster recovery mechanisms, including the setting-up of a secondary site; and (4) measures for business continuity and resilience. The design should include elements that could affect the system’s efficiency and practicality such as full integration of available systems, strictly enforced operating hours, and reduction and elimination of manual procedures. Pricing policies should be consistent with the overall objectives. Some form of cost recovery should be evaluated vis-à-vis other externalities stemming from a robust and efficient payment system. Access criteria (including exit and exclusion) should be defined more clearly and tiered arrangements should be reviewed and eventually favored to allow the reduction of manual procedures. In some cases, certain institutions (such as the stock exchange and retail system operators) might be allowed to hold settlement-only accounts within the system. The governance of the system inside the central bank should be streamlined and rationalized. User groups (i.e., groups of system participants to discuss system development issues) should be introduced.

The smooth functioning of the RTGS system requires sufficient reserves and the efficient distribution of liquidity among intermediaries during the operational hours of the day. To facilitate the optimum use of available liquidity, intermediaries should have complete and timely information on incoming and outgoing payments. It is the central bank’s responsibility to remove obstacles to the efficient use of liquidity and to facilitate cash management by intermediaries. To this end, the central bank should collect reliable statistics to be used to analyze the functioning of the RTGS system. This supports the decision to improve the functionality of the system. In determining how to improve the efficiency of the system, it is important that open discussion takes place among all parties involved. In particular, some central banks have found it useful to review the time schedule of settlement of payments in the RTGS system during the day and the critical times at which relevant sources of liquidity are injected into the system. In this regard, the evaluation of the treasury time schedule for settling its payments—one of the most important sources of liquidity for the financial system—is critical in order to avoid unforeseen injections or withdrawals of reserves that increase volatility in the availability of intraday liquidity.

The implementation of RTGS systems in Central America will not only serve the needs of domestic payment systems but also create conditions for future regional integration. The integration of payment systems should be based on the existence of common features in all relevant areas (including legal, risk control mechanisms, liquidity provision, access policies, governance, organizational arrangements, operational aspects, reliability, and business continuity).

Context

A wide range of payment instruments is essential for supporting customer needs. A less than optimal supply of payment instruments may ultimately have an impact on economic development and growth. The safe and efficient use of money as a medium of exchange in retail transactions is particularly important for the stability of the currency and a foundation of the trust people have in it. As CPSS publications have shown, the use of retail payment instruments differs both within and among developed countries.⁸⁸ This is because of a variety of reasons, including cultural, historical, economic, and legal factors. Common trends can be observed, however, namely, the continued primacy of cash (in volume terms) for face-to-face payments; growth in payment cards use; increased use of direct funds transfers, especially debit transfers, for remote payments; and changes in market arrangements for providing and pricing the retail payment instruments and services delivered to end-users. This evolution is likely to continue in the future and is expected to influence traditional (especially paper-based) instruments. Over the long term, some of the observed market developments may well alter traditional payment practices and contribute to increased efficiency of and convenience in using retail payment systems. In an increasing number of countries, more and more attention is devoted by authorities and market participants to the efficiency and efficacy of production and distribution of payment instruments (including cash).

Central banks are involved in retail payments in an operational capacity, as payment system over-seers and/or as facilitators of market and regulatory evolution. Even though the involvement of central banks in retail payments varies from country to country, a 2003 CPSS report argues that each central bank should examine market developments periodically with a focus on clearly identified policy issues (Box 4.1).⁸⁹ Where such issues are judged to arise, relevant public authorities (including central banks) may decide to take action aimed at establishing or re-establishing an acceptable balance of the various aspects of safety and efficiency. The public policy goals, central bank minimum actions, and the range of possible additional actions identified in the CPSS report are summarized in(Box 4.1.)The CPSS report has been prepared in light of the trends in retail payment markets in the G-10 countries and Australia. It is likely that, in developing countries, central banks and other private and public entities need to take a proactive role and carefully explore the possibility of taking the additional action.

Appendix Table A4.4 includes data on the use of cashless instruments for retail payments. However, many countries still use checks as means of payment for large-value transactions, though it is a diminishing trend. The main features of the clearinghouses were presented in the previous section.

Observations

In many cases, new applications to process retail electronic credit and debit instruments have been a major element of efforts to modernize national payment systems. ACHs have been launched in some countries—Costa Rica, El Salvador, Guatemala, and Honduras. In most Central American countries, however, ACH projects are either too slow to keep pace with costumer needs or too limited in scope (e.g., the project focuses only on improving check clearing procedures). Central banks should actively support the full deployment of efficient applications to process electronic retail payment instruments. Specifically, central banks should take a leadership role to ensure that banks and other participants reach the necessary agreements. They should also coordinate efforts to achieve a single system encompassing all banks and other major participants, and processing as many payment and collection services as possible (see next section on government payments), so as to avoid duplications and misuse of infrastructure.

Central banks and commercial banks should consider extending payment instruments and services offered by the ACHs. The introduction of new means of payments (such as electronic transfers and direct debits) has good potential for cost reduction. Strategies for modernizing the payment system based solely on improvements in the check clearing system are inadequate and counterproductive. Improvements in checks clearing produces efficiency gains in the short term because checks are the main cashless payments media used in all countries. However, a strategy that includes the development of other means of payments could have a major impact in the medium and long term. New instruments such as electronic transfers and direct debits will directly benefit the urban and major rural areas, and indirectly benefit remote rural areas through the reduction of operational costs in financial institutions and, therefore, less expensive financing.

The region relies heavily on use of checks, which is far from optimal from the point of view of efficiency and risk control. Central American central banks and all stakeholders in the retail arena must work together in a clear strategy to promote the intensive use of retail electronic payment instruments and reduce the importance of checks. Customers change their choice of payment service as a response to the price and convenience of the services provided. Thus, central banks might use moral suasion to persuade participants to make alternative retail payment instruments relatively more attractive at the end-user level, including a relative higher cost for checks than that for electronic payment services. It should be noted that such a pricing strategy must be agreed on and applied at the system level (e.g., binding interbank agreements), because individual competitive strategies may derail efforts in this direction. To avoid oligopolistic practices, the interbank agreements would be based on an analysis of processing costs for the different payment instruments. Also, a minimum fee structure could be set in such a way that there will still be incentives for banks to reduce costs and promote efficiency, for instance, by basing the minimum fee for the different payment instruments on the processing costs of the bank that has the lowest internal processing costs.

In all countries, checks are used for large-value payments and check clearinghouses are systemically important payment systems. Central banks should be proactively pursuing the removal of all large-value items from the check clearinghouse. In parallel, the introduction of some risk control measures (such as guarantee funds and loss-sharing agreements) should be considered.

Some efficiency gains could also be implemented in the check clearing system, such as full or partial truncation (for checks under a given value). Investments required for these efficiency gains should not create an obstacle for the development of modern payment instruments (e.g., electronic transfers, direct debits), by giving system participants the illusion that check processing can be less costly than processing of other instruments.

Retail circuits are characterized by very low interoperability (e.g., automated teller machines (ATMs) and electronic funds transfers at point of sale (EFTPOS)), resulting in the inefficient use of the current infrastructure. Many of the positive effects of a payment cards system for increased efficiency are not being captured because of the lack of electronic payment instruments for retail transactions. For example, ATMs of any network can be used only by the customers of the banks belonging to that network. As a result, the volume of transactions needed to amortize the investment in the ATM is slow to be achieved, creating disincentives for the deployment of more ATMs. Although ATMs are not payment instruments on their own, they are an effective means to reduce the use of “on us” checks and are a useful infrastructure through which electronic payments and other services may be channeled. In the case of EFTPOS, lack of interoperability translates into merchants having three terminals (one for each card processor) on their premises, which increases overall costs and may translate into merchants giving customers incentives to pay in cash or by checks. Finally, the lack of retail electronic payment instruments makes the card system more cumbersome and costly as card processors pay merchants with checks, or merchants need to have an account at many banks in order to receive credits from every card processor they work with.

Some banks are starting to offer retail payment instruments and services in multiple countries in the region. These efforts should be monitored and supported by central banks and banking supervisors. However, there is no project to develop a common regional infrastructure in the retail sector. Consideration should be given to fostering the standardization and harmonization in this area to allow for the creation of some form of regional ACH in the future.

In sum, central banks and commercial banks have a role to play to ensure that retail circuits support customer needs and that such arrangements are safe, convenient, and efficient for the economy as a whole. The central bank, as the entity leading the efforts to improve the country’s financial infrastructure, should promote agreements among banks to facilitate increased interoperability. Central banks should examine developments in the market periodically in the light of public policy goals and take action as necessary. In particular, the central bank should (1) review the legal and regulatory framework to identify barriers to efficiency and/or safety, and cooperate with relevant public and private entities to ensure that such a framework keeps pace with market developments; (2) monitor market conditions and behaviors, and ensure they are competitive; and (3) support the development of effective standards and infrastructure arrangements. Central banks could engage participants in a dialogue on national payment systems with a view to agreeing on necessary improvements. Once conditions are ready (e.g., when agreements on interoperability are reached and/or when an ACH is deployed that would produce interbank obligations that need to be cleared and settled somewhere), central banks could adapt their provision of settlement services for systems operated by other entities to contribute to efficient and safe outcomes, allowing all such systems to settle in central bank money.

Context

The public sector is a heavy user of payment systems. The government receives and remits many payments (tax collection, salaries, purchase of goods and services, and so on). In several countries, the public sector has lagged behind the private sector in terms of efficient use of payment instruments and has failed to make effective use of the banking sector. In recent years, increasing attention has been devoted to this issue and, in some countries, the government has been able to use efficiently the options offered by new technologies, such as ACHs, smart cards, and so on, significantly reducing its processing costs.

For the status of government payments in the region, see Appendix Table A4.5.

Observations

Costa Rica, Guatemala, and Panama have implemented or are in the process of implementing projects to integrate the public sector in the national payment system. In one case (Costa Rica), the integration has been particularly successful. In others, these projects are stand-alone and are not fully consistent with a long-term strategic vision of the payment system.

Central banks and relevant government agencies should foster coordination and communication to ensure that collections and disbursements of public institutions that are major players in the payment system be processed electronically and timely through an appropriate system, such as an ACH for retail electronic payment instruments. In many cases, gains in efficiency and cost reduction for government payments have resulted from the reform effort. Such a strategy can also ensure that all sectors can benefit from new payment alternatives, for example, by increasing the banking services used by the public. Moreover, government payments provide an opportunity to channel a high volume of transactions, thereby making the ACH project for electronic payment instruments more attractive for potential investors.

Government payments are also a major source of liquidity for the banking system. If coordinated effectively, they can facilitate the smooth functioning of the RTGS system being implemented in the region and increase its appeal to participants.

Context

Foreign exchange markets present relevant risks. The foreign exchange settlement risk clearly has a credit risk dimension. If a bank cannot make the payment of the currency it sold conditional upon its final receipt of the currency it bought (as is usually the case under current market practices), it faces the possibility of losing the full principal value of the transaction. Foreign exchange settlement risk also has an important liquidity risk dimension. Even temporary delays in settlement can expose a receiving bank to liquidity pressures if unsettled funds are needed to meet obligations to other parties. Foreign exchange settlement risk has other dimensions as well, for example, legal risk. In the case of foreign exchange deals, legal risk can be complicated by the fact that settlement normally takes place in more than one jurisdiction. In a 1996 CPSS report, the G-10 central banks agreed to a three-track strategy providing for⁹⁰

• action by individual banks to control foreign exchange settlement exposures;

• action by industry groups to provide risk reducing multicurrency services; and

• action by central banks to induce rapid private sector progress.

The report also states that “the G-10 central banks encourage existing and prospective industry groups to develop and offer services that would contribute to the risk-reducing efforts of individual banks.”⁹¹

Also as a result of the recommendations included in the 1996 CPSS report, the continuous linked settlement (CLS) service was launched in September 2002. The CLS, provided by CLS Bank International, settles foreign exchange transactions in fifteen currencies—U.S. dollar, euro, British pound, Japanese yen, Swiss franc, Canadian dollar, Australian dollar, Swedish krona, Danish krone, Norwegian krone, Singapore dollar, Hong Kong dollar, New Zealand dollar, Korean won, and South African rand—on a payment-versus-payment (PvP) basis on the books of the respective central banks. The CLS Bank is supported by over 70 of the world’s largest financial institutions, accounting for a large share of cross-currency transactions across the world. Transactions in other currencies are likely to be settled by the CLS Bank in the future. The CLS Bank is subject to the cooperative oversight of the central banks that are involved and it is under the direct oversight of the U.S. Federal Reserve.

For the status of foreign exchange and cross-border settlements in the region, see Appendix Table A4.6.

Observations

Foreign exchange transactions are not settled on a PvP basis. Central banks should investigate the possibility of introducing measures to mitigate the risks associated with these operations when PvP is not possible. Risks in this market can be evaluated by taking as a reference the reports and questionnaires published by the CPSS. For domestic foreign exchange transactions, that is, those that involve only domestic counterparties, the central banks that allow holding reserve accounts both in local currency and in U.S. dollars need to ensure, as matter of urgency, that wholesale foreign exchange trades are settled in central bank money on a PvP basis (not necessarily RTGS, but always maintaining PvP). In this direction, these central banks could eventually consider the provision of a settlement only account to other major players in the foreign exchange market such as the casas de cambio.

Central banks and banking supervisors should introduce measures to mitigate the associated risks. Attention should also be given to correspondent arrangements abroad of domestic banks to ensure that risk profiles and operating procedures of correspondents are constantly reviewed and do not generate any relevant risks in the country.

Proprietary mechanisms of commercial banks for cross-border payments can turn into a less costly and convenient alternative for customers. Another possible benefit is that remittances from other Central American countries can now be channeled all the way through banks instead of unregulated specialized companies, so that, among other things, remittances need not be paid in cash. Central banks, in cooperation with banking supervisors and among themselves, should carefully monitor these mechanisms and other developments in this area and decide whether regulations are necessary to ensure that they do not increase risks for the domestic banks that are involved.

On the other hand, a large share of remittances are still channeled through unregulated specialized institutions, for which there are no standards for aspects such as transparency of fees and other charges or the timing of accreditation of funds to end beneficiaries. In the latter cases, the regulatory perspective should be widened from the traditional areas of balance of payments and money laundering to include payment system issues, in particular issues related to efficiency, transparency, and risks.

In sum, Central American central banks should carefully monitor trading and settlement platforms and procedures for foreign exchange and cross-border transactions, especially remittances, to ensure that they can apply the principles of safety and efficiency to the clearance and settlement.

Context

The adequate functioning of an interbank money market goes beyond clearance and settlement considerations. An efficient mechanism for trading and settlement of these transactions will allow for improved liquidity management and, thus, for increased safety and stability of the financial system. In addition it will help securities settlement through lower interest rates that will benefit the broker-dealers in the credit lines they negotiate with banks. Another important concern for the authorities is the smooth and effective functioning of the monetary policy because central banks normally use the interbank money market to give a clear signal to banks, which then is extended to the rest of the financial sector. If the operational procedures or the organizational and regulatory arrangements do not provide for an efficient system, the central bank can have difficulties in providing clear monetary policy signals.

Two key elements for the development of interbank money markets are a special purpose system for large-value payments to provide secure electronic interbank transfers with immediate settlement that can be interconnected to an electronic book-entry securities system to register and record changes in ownership of securities.

For the status of interbank money markets in the region, see Appendix Table A4.7.

Observations

The future evolution of securities markets needs to be discussed among responsible authorities and market participants. An adequate strategy that takes into account the national interest, leaving aside private interest, should be defined. Once the strategy has been agreed, a neutral securities clearance and settlement system can be implemented to allow fair competition in the financial sector. Authorities and market participants should openly discuss the likely future of securities markets and agree on organizational and regulatory arrangements that allow for adequately developing the interbank money market, on the one hand, and the securities market, on the other. This will be a difficult process because several private interests will be affected, but the only alternative is to develop safe and efficient securities markets that can take a lead in a potential regionalization process.

In sum, the adequate functioning of an interbank money market is crucial for the smooth functioning of payments and securities settlement. An efficient mechanism for trading and settlement will improve the system’s liquidity management. Another important concern for the authorities is the smooth and effective functioning of monetary policy because the interbank money market is the backbone of monetary transmission. Two key elements for the development of interbank money markets are a special purpose system for large-value payments to provide secure electronic interbank transfers with immediate settlement that can be interconnected to an electronic book-entry securities system to register and record changes in ownership of securities.

Clearing and Settlement Processes

Settlement Risks

Operational Issues

Custody Risk

Regulatory and Oversight Issues

Organizational Arrangements of Central Securities Depositories

Cross-Border Settlement

The settlement of cross-border securities transactions is more complicated and involves more risk than that of domestic transactions. Links among CSDs permit participants from multiple jurisdictions to settle trades in securities through a simple gateway operated by either the domestic or an international CSD. However, CSDs need to design links carefully to ensure that risks are reduced. They must address legal and operational complexities. If links are not properly designed, risks can be exacerbated. Inefficiencies may arise because of variations in operating hours. Links may create significant credit and liquidity interdependencies between systems. A CSD should evaluate the financial integrity and operational reliability of any CSD with which it intends to establish a link. Any credit extensions between CSDs should be fully secured by securities, letters of credit, or other high-quality collateral, and should be subject to limits.

For more details on the status of cross-broker settlement in the region, see Appendix Table A4.14.

Context

Smooth and reliable money transfer mechanisms affect the efficiency of financial markets and the real economy; they also have an impact on the central bank’s lender-of-last-resort function, the conduct of monetary policy, and liquidity management. Market forces alone may not be able to achieve the objectives of efficiency and reliability of the payments system because participants and operators may not have adequate incentives to minimize the risk of their own failure, or the costs their failure may impose on other participants. In addition, the institutional structure of the payment system may not provide incentives or mechanisms for efficient design and operation.

For these reasons, central banks’ involvement in the payments system is an integral component of their overall mandate to ensure financial system stability and maintain confidence in the domestic currency. In this context, central banks perform a number of functions in their national clearing, settlement, and payment arrangements. These functions may include direct involvement in managing clearing and settlement systems and in overseeing the payments system by developing rules, principles, and best practices under which private payment arrangements operate. The oversight role of the central bank is at the heart of the current international debate and the function is emerging as a key facet of central bank activity.⁹⁷

The role of the central bank is particularly important when the country is engaged in a comprehensive reform of its payments system. In this case, the central bank has a leading role to play in developing a vision for the reformed system, in coordinating with all stakeholders, and in carrying out the reform plan. Direct involvement of the central bank in managing clearing and settlement systems has been the first step toward governing the overall structure and operation of a country’s payments system and ensuring that the desire to limit systemic risk, especially in the area of large-value payment systems, is adequately taken into account. In many cases, this role stems from the need to ensure a widespread adoption of more advanced technology in the fund transfer mechanisms and to avoid possible discriminations in access to payment services. In all cases, to pursue the public interest in the payments system, central banks should ensure that the systems that they operate comply with the principles and guidelines they establish and, as overseers, ensure the (financial and operational) reliability and efficiency of the clearing and settlement systems they do not operate. The central bank’s oversight role is more prominent when payments reform is complete and the central bank is called upon to ensure the ongoing monitoring of the reliability and efficiency of the domestic system.

In an increasing number of countries, payments system oversight is entrusted to the central bank by law. Specifying objectives in the law may be the most direct way of providing a well-founded legal basis for the central bank to implement its policies and make it accountable in pursuing its goal and mandate in the payment system. For countries that are reforming their payment systems, it is important for the central bank to have a well-founded legal framework that clearly defines its payment system role and objectives.

As for the scope of the oversight function, at the international level there is consensus that systems posing systemic risks should fall under the direct control of the overseer. Typical examples of these systems are those that handle transactions of a high value at both the individual and aggregate level. For example, the CPSS Task Force on Core Principles identified four responsibilities of the central bank in applying the CPSIPS (Box 4.2).

Increasing attention is being paid to securities clearance and settlement systems as relevant components of the overall payments system. The oversight of these systems might well be a cooperative effort of two or more regulatory agencies. In some countries, retail (low-value) systems also fall under control of the oversight agency because of their importance in the overall efficiency of the payments system, their potential impact on the public trust of money, and their relevance to the ultimate objective of economic growth.⁹⁸

The evolution toward a new central bank role in payment systems calls for a careful consideration of at least three issues:

• The adequacy of legal enforcement of central bank actions in the payments system should be evaluated. The central bank role in payment systems stems from its responsibility for financial market stability and monetary policy. In many countries, a clearly stated legal enforcement for the central bank’s activity as overseer of the payments system has facilitated the fulfillment of the central bank’s objectives.

• The internal organization of the central bank may also be worth evaluating. Experience in many central banks indicates that significant improvements can be derived by setting up a unit specifically devoted to payments policy issues. Typically, such a unit could develop a policy framework and tools (e.g., data collection and periodical inspections) for use in assessing the appropriateness of individual payment systems. This function could be undertaken in close coordination with the banking supervisor. The staff of this unit should have adequate skills. Typical aspects to be analyzed in administering the oversight functions include, inter alia, potential risks emerging from the clearinghouses, the adequacy of risk control measures, the potential implications of unwinding procedures, and efficiency issues.

• Effective cooperation must be achieved between the overseer and market players, among domestic regulators, and among international oversight agencies. In particular, central banks without bank supervisory powers may face considerable information limitations, especially in crisis management situations.⁹⁹ An effective way to overcome this problem is to stipulate formal rules for granting the overseer adequate access to supervisory information. The institutionalization of information- sharing arrangements may reduce the risk that the exchange of information might be hampered by frictions in cooperation between different institutions. Various solutions can be adopted for this purpose, from signing a memorandum of understanding that specifies the framework for cooperation, to assuring contacts between institutions through joint board membership, or the establishment of a comprehensive market regulatory/supervisory body where all the institutions with oversight responsibilities are represented and mandated to cooperate.¹⁰⁰ Cooperation must also be pursued between the overseer and the securities market regulators, as securities settlement is an integral part of the payments system, and problems in securities market clearing and settlement may easily spill over to the payments system and vice versa.

Effective cooperation among market participants, between regulators and market participants, and among regulators is essential for the development of a sound and efficient payments system. In particular, the systemic nature of the underlying operating procedures for the transfer of money makes the payments system an “institution” whose existence and smooth functioning requires effective cooperation between all participants. On the one hand, the use of payment instruments generates significant externalities on the demand side, because the usefulness of an instrument is strictly linked to the degree of its acceptance and use for transactions purposes. Consequently, widespread use of new payment instruments and services relies heavily on public confidence in them. On the other hand, within the payments system, the supply of services can be affected by coordination failures because of the existence of conflicts of interest (and information costs) as well as the intermediaries’ unwillingness to cooperate. This can lead to suboptimal equilibria in the organizational arrangements in terms of reliability and efficiency. The payments system overseer is therefore entrusted with making up for coordination failure in the market for payment services. Cooperation problems may be especially relevant within interbank clearing and settlement systems. In these systems, risk profiles—both at the system level and at the level of the individual intermediary—may not be fully assessed by participants. In addition, the concern with having to support less reliable intermediaries may lead larger participants to discriminate against smaller ones, even when the smaller ones are technically eligible to participate in the system. Finally, the payment system industry also depends on agreements between producers to ensure that different components of the system are compatible. Most recently, the emergence of new types of nonbank intermediaries and payment instruments has strengthened the need for a comprehensive level of cooperation in payment systems.

The safety and efficiency objectives of payment and securities settlement systems may be pursued by other public sector authorities in addition to the central bank and the securities commission. Examples include legislative authorities, ministries of finance, and competition authorities. There are also complementary relationships between oversight, banking supervision, and market surveillance. Appropriate cooperation among supervisors can be achieved in a variety of ways, for example, exchanges of views and information between relevant authorities may be conducted by holding regular or ad hoc meetings. Agreements on the sharing of information may be useful for such exchanges.

For further details on the status of transparency, oversight, and cooperation in payment systems in the region, see Appendix Table A4.15.

Observations

In most Central American countries, except El Salvador and Panama, the law gives some authority to the central bank over the payment system. However, the legal foundation of oversight of clearance and settlement systems is not always solid. For example, the law is often not clear about the scope of application of the function and the relative roles of the central bank and other authorities. To overcome these problems, it is important that central banks prepare and encourage approval of primary or secondary legislation to complete the legal framework and ensure the secure foundation of payment mechanisms that effectively contributes to the integrity, efficiency, and safety of all financial markets and the operation of monetary policy, especially in the area of securities settlement systems. Legislation should clarify in detail the empowerment and enforcement of the central bank as the payment system overseer.

In the context of establishing the oversight function, central banks should disclose publicly their objectives and implementation strategies relating to payment system matters. To this end, central banks should develop a comprehensive policy statement providing guidance to the private sector on matters relating to payment system governance, day-to-day management, risk mitigation, and on the policies that must be satisfied by all transactions that are ultimately settled on its books.

Central banks should broaden the set of policy objectives from efficiency and reliability of payment systems to including competition in the payment services market and consumer protection. These objectives might be pursued by central banks, especially where they are not included in other regulators’ mandates. With regard to their oversight role, central banks should apply their authority over all payment and securities settlement systems in the country, both the systemically important ones and retail systems, since the latter have a role in supporting economic activity and the public trust in money.

Central American central banks should be able to carry out their oversight role effectively. To this end, central banks should (1) establish appropriate organizational arrangements and staffing;¹⁰¹ (2) ensure that an adequate degree of participant cooperation exists and is sufficient to promote and realize the desired organizational and operational arrangements; (3) verify that individual payment systems satisfy user needs as well as risk and efficiency requirements through appropriate interventions both at the development stage and during the ongoing system implementation and operational phases; (4) define and implement appropriate actions should participants not comply with published rules and regulations (e.g., the application of predetermined penalties and sanctions for compliance failures); and (5) collect and distribute relevant statistical information to demonstrate how each system is being used and the extent to which the systems are satisfying end-user and other market needs. Information on substantial payment system matters should be disclosed in a manner that assures wide dissemination among payment system stakeholders and the general public.

Central American central banks should move toward compliance of their systemically important payment systems with international standards. In particular, central banks will continue to be direct providers—owners and operators—of clearing and settlement services. In this regard, care should be taken to ensure that appropriate service and performance levels are routinely achieved and adequately cover all critical safety and efficiency requirements. To this end, central banks should continuously review and seek to improve the design and operation of the systems they operate (e.g., along the lines that the CPSS Core Principles envisage for payment systems operated by private entities).

In performing the oversight function, central banks should ensure that policies and conditions for payment services offered are transparent. In each country, the central bank, banks, and other financial institutions should be encouraged to provide information to the public on the services they offer in the payment system. Moreover, arrangements for the resolution of conflicts should be disclosed and understood by providers, users, and regulators of payment systems and services. The general public should be able to resort to consumer protection agencies (e.g., a bank ombudsman) for resolution of conflicts related to payment services. The central bank should cooperate with the banking supervisor and other relevant authorities to ensure that payment services and instruments are appropriately covered by the new arrangements.

Cooperation among regulators is weak in Central America. The payment system overseer (central bank), the ministry of finance, the banking supervisor, the securities commission, and other relevant authorities should identify and implement procedure and process changes to address any weaknesses or inconsistencies in the regulatory arrangements and assure a high level of cooperation in the way that policies are implemented. Consideration should be given to establishing joint task forces to address problems of common interest and/or the preparation of appropriate memoranda of understanding. At the international level, central banks should get involved in the efforts of harmonization at the subregional level in Central America and in the activities of the WHF Working Group on Payment System Issues of Latin America and the Caribbean.

Cooperation among regulators and stakeholders should also be strengthened. No formal cooperative arrangement for the payment system as a whole exists in Central America. In each country, the central bank should establish a formal national payment system council. The new body should include representatives from all major stakeholders with an interest in improving payment and securities clearance and settlement systems and should also be used as the main tool to secure a constructive dialogue between regulators and market participants. The central bank should provide strong leadership and the secretariat. Payment system councils in Central American countries could establish forms of interaction with a view to moving forward the harmonization and integration agenda.

Binding interbank agreements are equally important to enhance cooperation within the banking sector. Cooperation at the interbank level has not always been satisfactory in Central America. Evidence can be seen in the area of retail payment circuits, the development of the interbank market, and the slowness to reduce dependency on checks. In light of possible market concerns about the potential loss of competitive advantages, which are however lower than the social benefit of taking these actions, the central bank and the banks are urged to work together toward the implementation of some agreements in the area of payment systems, which could enhance efficiency for the banking sector as a whole.

In sum, there is a need to establish the oversight function over the payments system. Regarding the oversight function and its transparency, Central American central banks should strive to fully observe the key responsibilities assigned to them by the CPSIPS (see Box 4.2). Cooperative arrangements in payment systems among all stakeholders should also be enhanced.