Basics of Payment Systems

The economic natures of payment systems, such as the network externalities, natural monopoly and interdependencies of payment systems are also discussed in this chapter.

Classifications of Payment System

These classifications are not mutually exclusive. Rather, one can use a combination of these classifications in order to describe the feature of a payment system. For example, a payment system may be managed by a central bank, make settlements on a gross and real-time basis, and be mainly used for large-value payments.

CLS Bank

This chapter focuses on the CLS Bank. CLS Bank International (hereinafter referred to as “CLS Bank”) was established in 1999 to eliminate settlement risk associated with settling foreign exchange (FX) transactions in different time zones. It provides the unique multi-currency Payment versus Payment (“PVP”) settlement service for the major players in the FX market. Although CLS Bank was established as a private bank in the US, the main purpose of the Bank is neither to accept deposits nor to make loans. Its function is dedicated to providing a multi-currency settlement service. Thus it is more appropriate to regard CLS Bank as a kind of payment system, or market infrastructure than just a private bank. This chapter elaborates on the mechanism of CLS Bank, which includes the organization, the shareholders, the eligible currencies, and the accounts used for CLS settlement. The funding and settlement procedures and risk management schemes of CLS Bank are discussed in greater detail. In addition, the impact of CLS Bank to FX settlements and the FX market is also analyzed.

Payment Systems in EU

The reforms of retail payment systems were also sought in response to the introduction of the euro. However, the retail payment systems in the EU are still fragmented, which means that each country has its own retail payment system. In order to overcome such a situation, the European Central Bank (ECB) and European Commission have promoted the project of “Single Euro Payments Area” (SEPA). The aim and situation of the SEPA project is described in detail. The cross-border retail payment systems, i.e. the “STEP1” and “STEP2,” are also discussed in this chapter.

Driving Forces for Innovations in Payment Systems

Fourth, the progress of Information Technology (IT) also played a critical role. Enhanced computer capacity, improved communication networks and reduced technology cost contributed greatly to the innovation of payment systems.

Evolutionary Trends of Payment Systems

This chapter also reviews another line of evolutionary trends, including the “Multi-Currency Payment Systems” and “Offshore Payment Systems,” and the linkage between payment system and “Securities Settlement System” (SSS). It also gives an explanation about the adoption of “Financial EDI” capability, which is the scheme that enables the processing of remittance information with payment instructions in the payment system.

Hybrid System and Integrated System

These advanced payment systems became possible through the progress of Information Technology (IT). The progress of IT enabled to achieve several mechanisms to support the sophisticated payment systems. This chapter gives the explanation of such mechanisms, which include (i) the frequent netting and continuous processing, (ii) partial netting, (iii) offsetting, (iv) searching and matching facility, (v) queue management function, (vi) pre-funding account, and (vii) multiple functions in a single payment system.

DTNS System and RTGS System

The DTNS system and RTGS system have their own advantages and drawbacks. The RTGS system is superior in reducing settlement risk. On the other hand, the DTNS system has an advantage on the level of liquidity required for settlement. This means that there is a trade-off between the two systems in terms of risk and efficiency. With knowledge of the pros and cons of the two systems, the most appropriate system should be adopted according to the feature of payments which are processed in the system.

Critical Issues on Payment Systems

Fourth, the efficiency of payment systems is discussed. Since a payment system provides a service with public nature, the operator should take the cost-effective way to manage the system. The cost of a payment system includes the processing cost of the system and the internal processing costs of the participants. It also includes the liquidity cost of participants, which means how much liquidity the participants should hold in order to process payments.

Settlement Risk

First, the source of settlement risk is identified in two kinds of settlements; the “simple settlement” and “exchange-for-value settlement.” Second, the differences are clarified between “settlement risk” and “pre-settlement risk.” Third, the classifications of settlement risk is explained, which include “credit risk,” “liquidity risk,” “systemic risk,” “legal risk” and “operational risk.” Fourth, the differences are made clear between “principal risk” and “replacement cost risk.” Fifth, the actual examples are described, in which settlement risk turned into reality. They include the famous “Herstatt Bank incident,” “BCCI incident” and “Bearing incident.” Finally, the measures how to reduce settlement risk are discussed after identifying the exposures of settlement risk. Several mechanisms to reduce the risk, such as the netting, Payment versus Payment (PVP), and Delivery versus Payment (DVP), are described in detail.