Chapter 15 Developments in Payment Systems

Robert Effros
Published Date:
June 1994
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In thinking about payment systems developments, consider an inverted triangle. The central bank is at the bottom. Resting on the central bank are the accounts of depository institutions, investment banks, securities firms, and perhaps others. At the top are participants in the financial markets. In the first part of this paper, I will discuss the transfer of securities and of funds. The second part is an overview of the risk-reduction program in the payment systems in the United States.


Extensive trade between countries creates the problem of exposure. In each of our countries, the law is probably different as to remedies available if a counterparty becomes bankrupt. Exposure will differ from country to country. Financial market participants are actively seeking to reduce those exposures. Transactions are conducted in the financial markets. Participants buy and sell securities or foreign exchange. In some of these over-the-counter markets, like the foreign exchange market, participants want more structure. One way of establishing structure is through a trade-matching system or through an intermediary. It might be a matching system and a confirmation system that would go back to both parties and confirm the transaction. It is not a legal concept as much as an information systems concept.

(1) Trade matching. In a trade-matching arrangement, the parties might send confirmation to each other or to a third party in a standard format. If the confirmations match, the parties will know that they have agreement on the terms of the trade. Such an arrangement will reduce the costs associated with errors in trade terms.

(2) Trade netting. Assume that the two counterparties want to net their trades. This can be done by each counterparty bilaterally or on a more organized, multilateral basis, such as through a clearing corporation.

(3) What happens on an exchange? Basically, the two parties will make a deal with each other on the floor of the exchange. Then they will take that trade to the clearing corporation, where, if the terms of the trade match, the contract is divided into two contracts, with the clearing corporation as the intermediary. Each of the parties has a back-to-back contract with the intermediary. They have eliminated the credit risk between themselves. Their credit risk now is the creditworthiness of the clearing corporation. Moreover, the two parties can both obtain netting benefit, because each of them has the same counterparty—the clearing corporation—for all its contracts of that type on the floor of the exchange.

(4) Gross settlement system. This may be illustrated by a securities-delivery-against-payments system: Each individual payment transaction is settled with the participating institutions’ accounts with the central bank. If Morgan sells a U.S. Government security to Chase, Morgan gives the central bank an instruction; the central bank debits Morgan’s securities account and credits its funds account while doing the opposite to Chase. It is a transaction-by-transaction payment and settlement. The transfer of the security is simultaneous with payment.

(5) Net settlement system or netting system. In a netting or clearing system involving a separate clearing house, only netted interbank positions developed over a period of time—usually a day—are settled in the participating institutions’ accounts with the central bank. There are two ways of settling a net basis.

One way, which is in use in the United States, is exemplified by the Participants Trust Company (PTC). Organized by groups of commercial banks and investment banking firms, it handles certain government-guaranteed mortgage-backed securities, referred to as Ginnie Maes. The PTC is the intermediary; it has a custodian that holds the paper or definitive securities, which are immobilized. The participants in the system (or its customers) trade these securities; the seller or its participant gives the intermediary, the PTC, the instruction to deliver the securities. Then the intermediary debits the seller with the amount of securities that it holds and credits it provisionally with funds. The PTC holds the securities during the day; it is the owner of the securities during the day. It sets up a “dummy” or memorandum account for the buyer.

The PTC does not deliver the securities to the buyer until settlement. The problem is that, if the securities are delivered to the buyer, and there is a customer who has paid the buyer for the securities, that person may get the securities but the intermediary may not be paid. These are risks in a tiering system. When there are two parties with credit risks and a participant fails, who is going to win or lose? Is it the failed receiving participant’s customer or the clearing corporation, or the delivering participant? Who is going to bear the risk of loss? Notwithstanding this dummy account arrangement, during the day the buyer participant can issue instructions to retransfer those securities on to a third participant. At the end of the day, the PTC strikes up the net amount of funds owed resulting from these securities transfers. Net debtors have to pay in funds to the PTC. If they pay in the funds, they obtain the securities. However, if they do not pay in the funds, the system must fund itself overnight. To fund itself overnight, the PTC employs the securities it took in during the day. The PTC has committed credit lines for overnight secured credit. Thus, it has an assured means of liquidity should one of the participants fail. In this way, the system can avoid the shock to the marketplace of not settling. This arrangement helps ensure settlement today and deals with the allocation of loss tomorrow.

The second way of settling on a net basis is exemplified by the Depository Trust Company (DTC)1 arrangement for securities that clear on stock exchanges. In the DTC, all transactions during the day are “dummy” or memorandum transactions. If a thousand IBM shares are transferred, they are not transferred between participants until settlement. At the end of the day, the net funds and securities positions of participants are struck. If a net debtor is unable to settle, the DTC determines what portion of the securities that party wanted to transfer will not be transferred that day. In Europe, there are two international clearing and settlement systems for Eurobonds: Euroclear (based in Brussels) and CEDEL (Centre de Livraison de Valeurs Mobilieres) based in Luxembourg. Both institutions operate in a manner similar to that of the DTC. Nothing moves in the system until settlement time, even though the system is constantly calculating what securities will be transferred against payment in those systems. Those systems are also set up so that, if a party does not have funds or cannot obtain liquidity, the securities stay with the sending participant.

(6) Funds transfers. A wire transfer of funds system can also settle on a net basis. In London, CHAPS (Clearing House Automated Payment System) is such a system. In New York, CHIPS (Clearinghouse Interbank Payments System) is such a system. These are true multilateral payment systems with no intermediaries. Systems like the PTC have an intermediary (a limited-purpose trust company) between participants. In CHAPS and CHIPS, the person that runs the system is not a party to the payment transaction. In CHIPS, the payments go back and forth on a multilateral basis among more than 140 participants, and the “system” constantly calculates on a net-net basis how much each party owes or is owed. But this amount is not owed to or by any particular party. That is one problem in the common law that had to be dealt with through legislation. It is easy to have set-off in a bilateral situation. If I owe you $5, and you owe me $3, it is simple to conclude that I owe you, net, $2. In a multilateral system, one cannot identify a particular party to whom funds are owed. The better legal view considers that the figure produced in that kind of multilateral settlement is valid and binding. But the law is not perfectly clear on that point.

Regulations and Risk Reductions

What are the developments in the United States? One major development is the new Article 4A of the Uniform Commercial Code.2 Commercial law in the United States tends to be state law. The Uniform Commercial Code was a voluntary attempt by the states to enact a common commercial law among the 50 states (although it is not completely uniform in each state).

The Uniform Commercial Code governs such transactions as sales, leases, transfers of paper, transfers of securities, securities interests, letters of credit, and collection of instruments. It did not, however, deal with credit transfers of funds—the types of payments that go through CHIPS or over Fedwire. A debit transfer system is like a checking system, where a party depositing that instrument in the system tries to pull money back. It can be a check; it can be a draft with securities attached. By contrast, in a credit system, the money is pushed by the party to pay; for example, on Fedwire, the payor wants to get money—bank balances—to a transferee for ultimate credit to a beneficiary’s account. It will be pushed through the banking system. In the absence of a statute law in the United States governing wire transfer funds, common law would apply.

Why is there a commercial code in the United States? Because common law does not seem to be efficient in certain areas, particularly in commercial transactions, where merchants have developed special rules to facilitate business. Why is there a British Bills of Exchange Act3 incorporating Price v. Ncal4 with its doctrine requiring a drawee to identify the signature of the drawer of a check? Because the principles under common law were inadequate, a specialized law in England was needed to deal with it comprehensively. That is the same conclusion that we came to in the United States.

CHIPS has, each day, close to a trillion dollars moving across the system. Such a system should be governed by a clear law so the parties have a precise view of their rights, obligations, and risks. That is what Article 4A does. Article 4A has been effective in New York since 1991.5 Generally, Article 4A governs wholesale payments, not consumer payments.

The Federal Reserve Board (Fed) has a payment-system risk-reduction program that deals with intraday or daylight credit risk. Before we had computers, the Fed had what I call a “dribble-posting” system. Transactions were posted periodically during the day. We had an idea of what our customer’s account balance was. When the high-speed computerized Fedwire system was implemented, the control that we had over the customer’s account balance was not maintained. This situation has been rectified. Most banks do not have on-line, real-time, integrated accounting systems that can calculate the balance in the customer’s account at any moment; perhaps only a handful of commercial banks can do that. Instead, the operations that go on during the day in various parts of the bank periodically flow to the main computer that will post the bank’s books. At some time early in the morning of the next day, someone pushes the button, all the entries are processed, and the account balances are struck.

What is the value of a dollar for one hour? So far there is no intraday funds market. Today, no banks want to buy funds for an hour, because the ability of parties to have overdrafts over the Fedwire system is limited. In order to obtain such intraday overdrafts, each bank that participates in Fedwire evaluates itself. How good is its operation? How good is its liquidity—the ability to fund itself in the marketplace? Using criteria set out by the Federal Reserve Board, the bank gives itself a rating. Based on that rating, it is permitted to have daylight overdrafts equal to some multiple of its capital and surplus. This is a voluntary program, but if the bank is unwilling to participate in this process, it will not be allowed to have an intraday (“daylight”) overdraft.

But the Federal Reserve does impose a cap that institutions are expected not to exceed. Overdrafts related to the wire transfer of securities had not been included in the calculation in the early aspects of this policy but were added to the program after a study concluded that this would not have a materially adverse impact on the government securities market. A zero-based review of the risk-reduction program was made and the conclusion was that there was room for improvement.

Some would argue that the ultimate objective should be to have no daylight overdrafts over Fedwire. That is the way the Swiss system works. In the Swiss system, the opening balance of every bank’s account at the central bank is put into the Swiss Interbank Clearing (SIC) system. Banks can transfer that amount out, plus amounts received from other banks. No daylight overdrafts are permitted in that system during the day. So a queue forms, and payments cannot be made until the covering funds are transferred in. Will that system face gridlock because of insufficient liquidity? That remains to be seen. The answer might be that, whenever parties need liquidity, they can buy it in the marketplace. Other depository institutions could sell their excess of funds. Such transactions have not yet been necessary, and they probably will not arise for a few years in the United States or elsewhere.

This should cause you to think about interest rates. In the Federal funds market in the United States, a day’s interest is paid for borrowing funds overnight. The purchasing bank obtains the funds at 4 p.m. or later and the convention is that the money is due back around 10 a.m. the following business day, with interest payment for a full day. Someone might say: “A day is 24 hours. If the funds are obtained at 4 p.m., why aren’t they paid back at 4 p.m.?” The answer might be that, unless there is a cost for intraday funds and overdrafts, there is little incentive for market participants to devote attention to this issue. It seems that, one way or the other, pricing of daylight exposures eventually will occur. The Fed has said that it would price intraday overdrafts. The Federal Reserve Board adopted a pricing proposal6 in 1992; daylight overdraft pricing will be effective on April 14, 1994, six months after the October 14, 1993 effective date of the Board’s new overdraft measurement procedures.7

The fee will apply to combined funds and book-entry securities-related funds intraday overdrafts in accounts at the Federal Reserve. While studying the proposal,8 the Fed looked at the exposure that it had from the larger clearing banks. These institutions have sizable daylight overdrafts because of the amount of securities transferred in the U.S. Government securities market, the largest securities market in the world. Securities are delivered to these clearing banks during the day for the account of their dealer customers. If the dealer’s computer fails and is unable to give the bank instructions to transfer the securities out later in the day, that dealer must finance the position overnight. The dealer sold the securities with the interest rate calculated on the basis of the securities being delivered today. Therefore, a dealer has an incentive to keep failures to a minimum. Dealers will deliver their largest positions first. If it had ten transactions and the largest one was $100 million and the smallest one was $1 million, the dealer is not going to look for the $1 million security and deliver it first. It will wait until it is able to transfer that $100 million out.

When the securities are transferred to a clearing bank for the account of a dealer, securities go “in the box.” This goes back to the days when there was literally a box. When the messenger delivered the physical securities to the dealer’s clearing bank, they were put in the box. Every delivery of a security gave rise to a loan, and the security was taken as collateral for the loan. The same thing is done electronically today.

This practice raises the question of tiering, which gives rise to certain anxieties. In fact, the movement to book entry will make some individuals nervous. For securities in the TRADES program, the Fed will list one of its depositors, say a commercial bank, as the owner. The U.S. Treasury is the issuer; the Fed maintains ownership records for the Treasury. That commercial bank might hold the security for a securities dealer who, in turn, holds it for an individual. Of course, there can be additional tiers. If the commercial bank fails or the securities dealer fails and the individual has paid the dealer for the security, who ends up with the security if the Fed or commercial bank, respectively, has a security interest in the security?

There are ways to deal with such a situation in the securities law in the United States. The securities firm has an obligation to segregate those securities and to put them in a separate account for the owner, but that is a next-day responsibility, not a same-day responsibility. Under the Securities and Exchange Commission segregation rules, the dealer has to segregate the fully paid for security in the individual’s account tomorrow.

Institutional investors are as sophisticated financially as the securities firms and the banks with which they deal. I believe that the Fed, commercial banks, and dealers will over the next several years be expected to have the capability to segregate on-line, in real time, during the day so that the bottom tier owner will be assured that it has received what it has paid for.

The book entry system is based on a custodian—say a bank or a stockbroker—who holds the security. The issuer of the security, be it General Motors or the U.S. Government, does not know who owns the security; the issuer sees only the next party up in the tier. The U.S. rules governing insolvency differ according to the type of custodian. When a bank goes insolvent, a tracing rule governs. If you bought the security before someone else and it is in the bank, you have rights to that security. If there are not enough securities, the last one in loses. By contrast, for the liquidation of a stockbroker with customers, any loss is shared by all customers holding that security. Losses are shared pro rata.

The Group of Thirty has an effort under way to move equities securities clearing and settlement to a “T plus three” basis—in which parties trade today and settle for that trade in same-day funds on the third day from today. In the United States, we now operate on a “T plus five” basis. The way to get globalization of securities markets will be facilitated if trades could be made and settled on the same day worldwide. The only way to get to “T plus three” in the United States is through book entry.

One issue to consider is coordinated clearing. The problem to be dealt with is that, when a shock hits the financial markets, firms come under liquidity stress. These firms participate in a number of different markets. A firm might have money coming from one system, and have to pay money to another system. If the firm does pay within one hour, the system will close out the firm’s position. It has been suggested that the answer to this is a single clearing and settlement system. Another way of getting there might be by coordinating the clearing. Why do systems close and settle at different times? Cannot all systems settle at the same time? In this case, a bridge could be designed to ensure that the funds can flow from one system to the other unimpeded. Another approach is to allow excess collateral in one system to be pledged to secure an exposure in another system.

The United Nations Commission on International Trade Law has developed international credit transfer funds rules.9 The basic question was, When is there an international transfer of funds? If two payments are going through the United States—one domestic and one international—can different laws apply? How do we make these distinctions? What will such a statute govern?

Mention should be made of the efforts carried out under the auspices of the Group of Ten Central Bank Governors. This started with a report of the payment experts, which raised some questions about the payment netting. This was the first time any group had surveyed the effects and structure of these clearing payment settlement systems. The report’s observations attracted the Group of Ten Governors, who then decided that this work should go a step further. They set up a committee on netting schemes, and under it four working parties: the lawyers’ working party, a bilateral netting party, a multilateral netting party, and an offshore payments party. This effort started in April of 1989, and the final report was published in November 1990.10

The first part of the report is an introduction with a summary of analysis and policy recommendations. The second part is an analysis of the policy objectives and the implications of netting on credit, liquidity, and systemic risks; it also emphasizes the broader implications of netting such as the several effects on foreign exchange markets and the monetary policy and systemic disturbances. The third part sets minimum standards for the design and operation of cross-border and multicurrency netting and settlement schemes. The fourth part sets the principles for cooperative central bank oversight of cross-border and multicurrency netting and settlement schemes.

The matter is further complicated by considerations of branch banking. The Basle Concordat addresses the supervision of multinational banks with foreign branches. The Concordat says that the chartering or home-country authority is responsible for solvency. The host-country authority where the branch is located is responsible for supervising the branch’s liquidity. It is, however, difficult to determine the difference between solvency and liquidity. There are two kinds of insolvency: balance-sheet insolvency and liquidity insolvency. If there is a liquidity problem, there is a question of solvency—the ability to pay debts as they come due.

In terms of payment systems, when we consider branches of foreign banks, a new element appears that has not yet been addressed. What is the responsibility of the branch if that branch cannot meet its obligations? In the United States, a branch is treated as a separate bank for a number of purposes. In the United States, we would liquidate the assets of the branch, pay off the branch’s creditors, and anything left would be handed over to the home-country liquidator. The U.S. requirement under the bankruptcy law is to make sure that the home country has a bankruptcy law that treats all creditors fairly, and if it does (and many of the laws of many foreign countries have been found to be fair), then the court will approve this process rather than ending up with multiple litigation in the United States. Clearly then it would appear that it is necessary to work on defining what is a branch and what is a bank in order to progress in the analysis of these matters.



One of the statutes referred to by Mr. Patrikis is an amendment to the United States Uniform Commercial Code, designated Article 4A, which is designed to deal with electronic funds transfers. Millions, billions, and trillions of dollars move among banks in the United States. Several years ago it was deemed to be desirable that these banks should understand where the various risks were instead of waiting for a problem to arise and for a judge to sit down and figure out how the system should work. A group was formed to write a statute on electronic funds transfers in the United States.1 This group, after laboring for three years, produced Article 4A of the Uniform Commercial Code. It is state law and must be adopted by the states. Forty-five states have already adopted Article 4A of the UCC.

In the drafting process, a great effort was made to get all the experts on this subject in the United States in the same room at the same time. We dredged people out of the back offices of banks. We got people who know how funds were communicated, what risks were undertaken, where risks should lie, when payments should be made, when an order should be given, and so on. An innovative, modern, workable statute was created.

It had as its fundamental direction the transfer of large funds—the kinds of transfers that go through the Federal Reserve System. These transfers go through the Clearinghouse Interbank Payments System (CHIPS), and they have common features. They are large in amount. The parties expect them to get where they are going quickly. The parties expect to be charged a modest amount. You can send $1 billion over CHIPS and pay something like $15 for the transfer; senders of funds now expect to be given that kind of treatment.

Simultaneously with the drafting of Article 4A the need was realized for an international law of funds transfer, because when funds are transferred from Bern to Zurich to Tokyo to Rome to Nairobi, there is no clearly identifiable statutory law in place. The United Nations, through its Commission on International Trade Law (UNCITRAL), drafted such a law.2

For this purpose, a rather different group appeared. Delegations to missions to the United Nations, academics, government officials, even people who were instructed by their local banks but did not have, in general, hands-on experience—all contributed in various ways to the initial drafting. In contrast to the statute we worked on in the United States, which had large-volume, high-speed, low-cost funds transfers in mind, the statute written by UNCITRAL addressed other concerns as well.3 For example, it covered paper transfers (as well as electronic transfers). Soon there may be two laws governing electronic funds transfers, one here in the United States and another developed by UNCITRAL.

From a U.S. bank point of view, if Citibank in New York transfers funds to a bank in San Francisco, the domestic law should govern. If Citibank in New York were transferring the same funds to a bank in London, the UNCITRAL draft may apply. Now, it is clearly a nuisance to Citibank to have one set of laws, one set of risks, one set of procedures, one set of governing ideas for the transfer that goes west and another set of laws, another set of procedures, another set of risk allocation for the transfer that goes east.

The real problem, however, is that the rest of the world may be governed by the UNCITRAL statute, which is not specifically devoted to the aims of low cost, high volume, and speed. For example, if Citibank sends to Zurich, and to get to Zurich, goes through London and through Paris, the UNCITRAL Model law places the duty to monitor that transfer on each bank in the chain, and if anything looks peculiar, the bank must reject and return it. So there must be mechanisms in place at each bank to scrutinize and potentially reject every message received. This slows the process—the goal of speed (now part of our domestic law) is lost. This system deficiency would increase the cost.

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