United Kingdom
Observance by CHAPS of CPSS Core Principles for Systemically Important Payment Systems Detailed Assessment of Observance

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

I. Summary, Key Findings, and Recommendations

1. The Clearing House Automated Payment System (CHAPS) is a safe, reliable, and efficient system for transferring large-value, time-sensitive payments. CHAPS payments benefit from a robust legal environment that ensures settlement finality can occur in real time. The system has comprehensive features that allow its members to properly manage their liquidity and operational risks. In normal operation, payments do not expose members to credit risk; however, if the system’s Bypass mode is needed as a contingency, members can be exposed to credit risk. In the unlikely event that a member in a net debit position were to default while in Bypass mode, there are no clear procedures to set forth how the losses would be allocated. Exposures to commercial settlement banks are concentrated, moving the management of credit risk outside the system (between CHAPS members and their bank clients). Membership in CHAPS is fair and open. Governance arrangements could be improved to reflect the fact that the operator of CHAPS is also the operator of the Faster Payment Service (FPS), which is at a much earlier stage of development. CHAPS Clearing Company Limited (CHAPSCo) needs to demonstrate that it has the resources and capacity to satisfy the needs of both schemes. It also needs to show improvements to succession planning following the retirement of the company manager. CHAPS is competently overseen by the Bank of England (BoE), which has a well-defined oversight role based in statute, as well as an operational role as operator of the underlying Real-Time Gross Settlement (RTGS) infrastructure. However, the BoE does not undertake a direct and unified assessment of the RTGS infrastructure against these Core Principles.

A. Introduction

2. This assessment was undertaken in the context of an IMF Financial Sector Assessment Program (FSAP) exercise for the United Kingdom over the period January-July 2011, which included, inter alia, the Core Principles for Systemically Important Payment Systems (Core Principles). The assessment covers the CHAPS system and the relevant operational services provided by the BoE in support of CHAPS.1

3. CHAPS is the United Kingdom’s large-value payment system, providing its members with real-time gross settlement for transfers denominated in pounds sterling. It is useful at this point to draw attention to the distinction made in the United Kingdom between a payment scheme and the operational infrastructure. The scheme comprises the arrangements to facilitate the transfer of money between institutions (e.g., scheme rules), while the operational infrastructure is the underlying technology that supports those arrangements. For the purposes of this assessment, we shall refer to the CHAPS payment system as the scheme and its underlying infrastructure. The CHAPS scheme is managed by CHAPSCo, while payments are processed by the RTGS infrastructure owned and operated by the BoE. The BoE (i) settles CHAPS payments through debits and credits to members’ settlement accounts held on its books; (ii) operates the Enquiry Link, which allows members to interact with the RTGS infrastructure, so they can monitor payments progress, manage payments in the centralized queue, and make certain funds transfers; and (iii) provides CHAPS members with collateralized intra-day liquidity to support CHAPS payments.2

B. Information and Methodology Used for Assessment

4. During the 2002 FSAP, a detailed assessment was made of CHAPS against the Core Principles. More recently, the BoE published an assessment of CHAPS against the Core Principles as an Annex to its 2008 Payments System Oversight Report. A new assessment was prepared by the BoE in 2010, which was not published, and this was updated for the FSAP mission. The BoE also provided a number of documents relevant for the assessment. Extensive meetings were held with the BoE and CHAPSCo, supplemented by discussions with several members and a bank that accesses the system indirectly through a CHAPS member.

5. The methodology for the assessments was derived from the Core Principles as well as from the IMF and World Bank’s Guidance Note for Assessing Observance of Core Principles for Systemically Important Payment Systems. The assignment of an assessment category is based on the current situation existing without regard to any proposed or ongoing actions.

6. No obstacles were faced in the work. The authorities and others were fully cooperative.

C. Institutional and Market Structure

7. The CHAPS system typically processes large-value payments, but there are no restrictions on the type or value of transactions. In 2009, the average size of payment transferred by the system was £1.76 million although the average is skewed by a small number of very large payments (approximately 94 percent of payment value is attributable to 5 percent of payment volume). Typical payments are large financial transactions, either between banks or between banks and corporations. Some retail transactions such as housing market purchases also go through CHAPS. CHAPS is also used for sterling pay-ins and pay-outs related to CLS transactions and for transfers to and from the concentration bank in relation to LCH margin payments.

Statistical information regarding CHAPS

Daily Average Volumes (thousands) and Values of Transactions (£ billions), 2007-2010

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8. CHAPS is a highly-tiered payment system. There are 16 direct members of CHAPS as well as the BoE and CLS Bank. In turn, the members act as correspondent banks for other banks, processing payments on their behalf. Payment flows are highly concentrated, with the five most active members accounting for approximately 80 percent of payment value, and the two most active accounting for half of the total value.

9. Prior to 2008, CHAPSCo operated a separate scheme for processing euro payments, called CHAPS Euro. CHAPS Euro was decommissioned in 2008 following the launch of TARGET2. Previous CHAPS Euro members and their customers now effect their TARGET payments in euro via another country’s system, and the BoE makes and receives its euro payments through access to TARGET2 via De Nederlandsche Bank. A liquidity bridge remains between the RTGS infrastructure and TARGET2, which allows CHAPS members to transfer euro payments between their TARGET2 accounts and their CHAPS accounts. This enables euro funds to act as collateral for the provision of intra-day liquidity in sterling.

10. In addition to CHAPS, CHAPSCo manages the Faster Payment Service (FPS), which was launched in May 2008. FPS is a deferred multilateral net settlement system for retail electronic payments in the United Kingdom, which uses the RTGS infrastructure for final settlement during the day. The FPS service accommodates telephone and internet payments of three main types: single immediate, forward-dated, and standing order payments. From January-September 2010, the FPS settled a daily average value of £643 million and daily average volume of 1.7 million payments.

11. The CHAPSCo Board usually meets on a quarterly basis, and although the Board covers both CHAPS and FPS, system specific issues are voted on separately. Each member is entitled to appoint one Director regardless of whether they are active in either one or both of CHAPS and FPS. The BoE attends CHAPSCo Board meetings with “observer status.”

12. CHAPSCo has a contractual relationship with the U.K. Payments Council, which is the strategic governance body for the U.K. payments industry. Under the terms of the contract, CHAPSCo has agreed to comply with directions given by the Board of the Payments Council in pursuit of the Council’s objectives. These objectives are to deliver innovation; ensure that payment systems are open and accountable; and maintain the integrity of the payment systems. Nonetheless, CHAPSCo remains responsible for the day-to-day management of the CHAPS systems, including risk management. Additionally, the U.K. Payments Administration provides staff and other services to U.K. payment systems. In March 2007, the Payments Council and Payments Administration replaced The Association for Payment Clearing Services (APACS).

13. In 2000, CHAPS was designated under the Financial Markets and Insolvency Regulations 1999, which implements the EU Settlement Finality Directive in the United Kingdom. This designation provides CHAPS with protection against the normal operation of insolvency law, ensuring finality and irrevocability of payments and enforceability of collateral security. On January 5, 2010, HM Treasury (HMT) recognized CHAPS as an interbank payment system under Part 5 of the Banking Act 2009, giving the BoE statutory responsibility for overseeing it.

D. Main Findings

14. Legal framework (CP I): CHAPS operates under a well-founded legal basis that is reinforced by its designation under the Financial Markets and Insolvency Regulations (FMIR 1999), which implements the EU Settlement Finality Directive in the United Kingdom. The legal basis for the BoE’s oversight of CHAPS is established in statute under Part 5 of the Banking Act 2009, which also provides the BoE with statutory tools to assist its oversight function. All CHAPS members agree to the CHAPS Rules, which incorporate by reference other relevant documents. There is a clear contractual relationship between CHAPS members and the BoE as provider of the underlying RTGS infrastructure for CHAPS and intra-day credit within the system. There is a Memorandum of Understanding (MoU) between CHAPSCo and the BoE setting forth detailed service level expectations in key areas. While the MoU is not a binding legal contract, incentives are well-aligned between the BoE and CHAPSCo, and thus the potential for misunderstanding or an irresolvable dispute between the two parties, requiring resort to legal action, remains small. However, the BoE should undertake a legal review of the consequences of the nonbinding nature of the MOU, either internally via the BoE’s Legal Department, or externally.

15. Understanding and Management of Risks (CP II-III): The CHAPS rules enable the members to have a clear understanding of the risks they face through participation in the system. In normal and contingency operations, the points of irrevocability and finality are clearly defined. Members are aware of the controls in place to help them manage liquidity risk, such as throughput guidelines, offsetting algorithms for queued payments, and the Sterling Bank Liquidity Scheme, which can help with the recycling of trapped liquidity. Members are also aware of and regularly test the measures designed to help them manage operational risk, such as the ability to make payments via the Enquiry Link or authorized fax, or the RTGS Bypass mode, which can be invoked if the BoE’s primary and standby systems are unavailable to process settlement requests for an extended period of time. In normal operations, members do not face credit risk since payments are settled on a real-time gross basis. However, in Bypass mode, payments would settle on a multilateral net basis at the end of each settlement cycle, which could expose members to credit risk. To help members understand and manage the risks they face in Bypass mode, CHAPSCo should develop procedures to set forth how losses would be allocated in the extremely unlikely event that a participant in a net debit position were to default while in Bypass mode.

16. Settlement (CP IV-VI): Settlement finality occurs in real time on a gross basis and in central bank money, upon the debiting and simultaneous crediting of the relevant members’ settlement accounts at the BoE. In Bypass mode, settlement would occur on a multilateral net basis at the end of each settlement cycle. It is expected that two settlement cycles would be run in order to prevent the build-up of net debit positions (one in the middle of the afternoon and one at the end of the day), but more frequent settlement cycles could be run if it were thought necessary. As previously discussed, CHAPSCo should develop processes and procedures to ensure that final settlement can take place in Bypass mode, if there were a default of a participant in a net debit position. While CHAPS settles in central bank money, a significant amount of large-value payment activity in the United Kingdom settles in commercial bank money on the books of the most active CHAPS members. This is a potential source of vulnerability since, if a major clearer were to become unavailable, this would likely impose significant liquidity pressures. The BoE is well aware of the risks associated with tiering and has spent considerable effort raising the awareness of such risks and encouraging banks with significant activity in the second tier to become direct members. Direct participation in CHAPS has recently increased with J.P. Morgan and Bank of America both becoming CHAPS members in the second half of 2010, but settlement remains highly concentrated.

17. Operational Reliability and Efficiency (CP VII-VIII): CHAPS offers a high degree of security and operational reliability. CHAPS members and suppliers must comply with the CHAPS Security Policy and Security Code of Conduct, and there is a comprehensive process for confirming members’ compliance. As operation of the core operational infrastructure is outsourced to the BoE, the MOU between CHAPS and the BoE specifies important operational performance and reliability targets that the BoE has historically met. The BoE operates a hot back-up site, providing resilience to operational shocks. However, the two processing sites are only about 12 miles apart as the crow flies and therefore still exposed to the risk of a wide-area event. To buttress resilience further, CHAPSCo and the BoE are considering whether to subscribe to the SWIFT Market Infrastructure Resilience Service, which is a generic RTGS system. This service would replace the Bypass mode in the event both of the BoE’s operational sites were down. Contingency options are regularly tested, including with members. Discussions with members suggest that CHAPS provides an efficient solution for making large-value payments in a reliable and safe manner.

18. Access and Governance (CP IX-X): Membership in CHAPS is fair and open, with membership criteria publicly disclosed on the CHAPSCo website. Discussions with market participants suggest the main barrier to entry may be a lack of a business case. The CHAPSCo Board, which is comprised only of CHAPS and FPS members, has responsibility for managing the system, and Board decisions are made on a consensus basis. Member engagement also takes place through the member-led committees. The governance structure and fees could be made more transparent, which could help a prospective member develop a complete business case. CHAPSCo is also the operator of FPS, and this raises challenges with respect to governance and management, particularly given that the CHAPS and FPS are at entirely different stages of development. Therefore, CHAPSCo needs to demonstrate that it has the resources and capacity to satisfy the needs of both schemes. The BoE has already identified this as an issue, and the CHAPSCo governance structure is being revised.

19. Central Bank Responsibilities (A-D): The BoE has clearly defined objectives with regard to payment system oversight. Under Part 5 of the Banking Act 2009, interbank payment systems can be recognized by the Treasury and brought under the BoE’s oversight regime. The recognized systems are: CHAPS; CLS; Bacs; FPS; and the inter-bank payment systems operated as part of of CREST, LCH, and ICE. Operators of recognized payment systems must have regard for principles set forth by the BoE, and the BoE uses the 10 CPs plus four additional principles covering business risk, interdependencies, indirect participants, and outsourcing. The BoE follows a program of risk reviews for each of the recognized systems, the outcome of which is used to set the BoE’s expectations for actions to be taken by the operator. In discharging its oversight obligations, the BoE effectively cooperates with domestic authorities, such as the Financial Services Authority (FSA) and foreign authorities, such as other central banks. In addition to its oversight role, the BoE operates the RTGS infrastructure, which provides real-time gross settlement for CHAPS and CREST, as well as settlement of other payment schemes (FPS, Bacs, Cheque and Credit Clearing, LINK). The RTGS also facilitates intra-day liquidity transfers, reserve account transfers, transfers in respect of the note circulation system, and transfers that can occur outside of CHAPS operating hours. The BoE assesses the RTGS infrastructure against the Core Principles in an indirect and fragmented manner through its oversight of recognized systems that rely on the RTGS for settlement. Given that not all RTGS activity relates to these overseen schemes, and the importance of the RTGS to the U.K. financial system, the BoE should undertake a direct, unified assessment of the RTGS, systemically evaluating it against the core principles. This should include an assessment of the finality of RTGS movements made outside the context of schemes designated under the Settlement Finality Regulations.

20. Table 1 offers a principle-by-principle a summary of assessment results.

Table 1.

United Kingdom: Summary Observance of the CPSIPS and Central Bank Responsibilities in Applying the CPs

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Recommended actions and authorities’ response

Recommended action plan

21. Table 2 offers suggested steps for achieving observance.

Table 2.

United Kingdom: Recommended Action Plan to Improve Observance of the CPSIPS and Central Bank Responsibilities in Applying the CPs

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22. Table 3 offers additional recommendations.

Table 3.

United Kingdom: Additional Recommendations

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Authorities’ response to the assessment

23. The U.K. authorities welcome this assessment of the CHAPS payment system against the CPSS Core Principles for Systemically Important Payment Systems and of the Bank of England (the Bank) against the Central Bank Responsibilities in Applying the Core Principles.

24. The assessment identifies actions which would improve observance and also makes additional recommendations. The U.K. authorities will consider and review the assessors’ recommendations and additional actions. As noted in the assessment, work on many is already in train.

25. The IMF recommends that the Bank should “formally assess the RTGS infrastructure’s compliance with the Core Principles in a unified manner, given that not all activity in the RTGS infrastructure relates to systems that the Bank oversees, and given the importance of the RTGS infrastructure to the U.K. financial system.” As noted in the report, RTGS is not an interbank payment system but an accounting infrastructure that supports some payment systems. It would therefore not be appropriate to assess RTGS against the CPSS Core Principles as they apply to Payment Systems. The Bank will, however, this year conduct a unified assessment of RTGS based on its existing internal risk assessment, monitoring and management framework. That will be done at arms length as well as by line management.

II. Detailed Assessment

26. The assessment of CHAPS against each core principle (CP) was made on a qualitative basis using the following five categories: observed, broadly observed, partly observed, non-observed, and not applicable.

  • A CP will be considered observed whenever all assessment criteria are generally met without any significant deficiencies.

  • A CP will be considered broadly observed whenever only minor shortcomings are observed, which do not raise major concerns and when corrective actions to achieve full observance with the CP are scheduled and realistically achievable within a prescribed period of time.

  • A CP will be considered partly observed whenever the shortcomings are sufficient to raise doubts about the system’s ability to achieve observance within a reasonable time frame.

  • A CP will be considered non-observed whenever major shortcomings are found in observing the assessment criteria.

  • A CP will be considered not applicable whenever it does not apply given the structural, legal and institutional conditions.

27. In addition to assessing the observance of CHAPS, an assessment was made of the four Central Bank Responsibilities. For each Responsibility, the assessor undertook a qualitative assessment of the degree of observance using the same general framework as for the assessment of the CPs.

Table 4.

United Kingdom: Detailed Assessment of Observance of the CPSIPSS and Central Bank Responsibilities in Applying the CPs

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1

The assessor was Nikil Chande, Principal Researcher in the Department of Financial Stability at Bank of Canada, in collaboration with Christine Sampic, IMF Senior Financial Sector Expert.

2

See detailed assessment of CP I for the description of the respective responsibilities of CHAPSCo and the BoE in relation to CHAPS.

United Kingdom: Observance by CHAPS of CPSS Core Principles for Systemically Important Payment Systems Detailed Assessment of Observance
Author: International Monetary Fund