Reforming Cross-Border Payments and
Forex Settlement Systems
Regional Workshop on
“Reforming Payment and Securities Settlement
Systems”
Manama, Bahrain, March 16, 2005
José Antonio García
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Contents
1.
Forex settlement systems
i.
ii.
iii.
iv.
Key Considerations
Risks
Current Situation
Reducing Forex Settlement Risk
2.
Cross-border retail payments
3.
International family remittances
2
Cross-border vs. Forex
• Large-value, cross-border payments generally (though not
necessarily) related to financial market transactions,
particularly foreign exchange (Forex).
• On the other hand, Forex market transactions need not to
imply a cross-border payment
• Non large-value cross-border payments more related to:
– International trade of goods and services
– Unilateral funds transfers from individuals residing in
country X to others in country Y (“Family remittances”)
3
Forex Settlement Systems
• Forex market is the most active financial market in
the world in terms of total amounts traded
– Approximately the equivalent of US$ 4 trillion was
settled each day worldwide by financial institutions by
year-end 2004 (gross value, spot markets only).
• Forex markets may entail risks that are relevant
from a systemic standpoint
– Credit risk
– Liquidity risk
– Legal and operational risks
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Forex Settlement Systems
• A sound Forex market settlement infrastructure is
thus key for several reasons:
– Systemic risk reduction
– Necessary in order to develop a deeper and more
dynamic (and, hence, more efficient) forex market
– The forex market can be regarded as the entry point of
foreign investors to all other domestic financial (and
non-financial) markets
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Credit Risk in Forex Transaction
• A bank that cannot make the payment of the currency it
sold conditional upon its final receipt of the currency it
bought (i.e. under a payment versus payment (PvP) basis),
faces the possibility of losing the full principal value of the
transaction.
– Actual exposure: when settling a forex trade, it is the full amount
of the currency purchased
– Duration of the exposure: the exposure lasts from the time a
payment instruction for the currency sold can no longer be
cancelled unilaterally until the time the currency purchased is
received with finality.
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Credit Risk
– This period may still be followed by an “uncertain
period”, which is the length of time after the bought
currency is due that a bank takes to identify whether of
not it has received the funds (e.g. when working
through correspondent banks).
– Durations are a function of market practices,
differences in time zones and in payment system
operating hours.
– Exposures can last from at least overnight and up to
several days. For trades in a number of major
currencies, the duration was greatly reduced with the
launch of CLS Bank.
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Credit Risk
Settled or
Revocable
Trading
Irrevocable
Deadline for
Unilateral
Cancellation
Uncertain
Final Settlement
of both currencies
Failed
Identification
of transactions
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Credit Risk
• Thus, considering all the above, banks should be
expected to apply a control process to FX
settlement exposures that is the same or equivalent
to the process they apply to credit exposures of the
same size and duration resulting from loans or
other formal counterparty credit extensions.
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Liquidity and Legal Risks
• Liquidity Risk
– Temporary delays in settlement can expose a receiving bank to
liquidity pressures if unsettled funds are needed to meet
obligations to other parties.
– The high dynamism of the Forex market also means that a bank
will face high opportunity costs if it does not receive the currency
bought on due time
• Legal Risk
– In the case of foreign exchange deals, legal risk can be complicated
by the fact settlement normally takes place in more than one
jurisdiction.
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The current situation
• Besides the case in which currency pairs are now settled
through CLS Bank (to be explained later), the current
situation and trends in most countries are the following:
– Low awareness of the settlement risks involved in Forex deals.
– In many cases, deals and settlement based purely on mutual
“trust”. Some banks, however, do establish controls as to who their
Forex counterparties may be, and also set limits on the amounts
that may be traded with such counterparties
– In some cases there is a centralized Forex trading platform.
However, in general such platforms have no direct links with a
settlement infrastructure
– In some countries, the Central Bank is the main player (buyer &
seller) in the Forex market.
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The current situation
• Lack of PvP:
– Forex trades among domestic institutions are generally over-thecounter (OTC) bilateral transactions. The domestic leg usually is
settled in central bank accounts, while the foreign currency leg is
generally settled through bank correspondents abroad (in most
cases in the country of origin of the foreign currency).
– In the vast majority of cases, the two legs of the transaction are
settled independently one from the other. The only “assurance” that
settlement will occur is trust in the counterparty.
– The risk of loss of the principal value of the transaction due to a
failure in settlement generally lasts for a few hours when deals
involve moreless the same time zone, or overnight and even a few
days if deals involve quite different time zones.
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The current situation
• Lack of PvP (cont..):
– In general, Central Banks are concerned about
managing settlement risks of their own Forex
transactions and do not pay much attention to deals
between financial intermediaries.
– In some countries, the Central Bank holds accounts for
financial intermediaries both in local currency and also
in one major foreign currency. This could open the
possibility to settle Forex trades among domestic
financial institutions under a PvP basis. However, in
most cases this possibility is not used.
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Reducing Forex Settlement Risk
• In 1996 the Governors of the central banks of the G-10
countries endorsed a comprehensive strategy to reduce
risks, particularly systemic risks, in settling Forex
transactions.
• A three-track strategy was agreed, providing for:
– action by individual banks to control foreign exchange settlement
exposures;
– action by industry groups to provide risk-reducing multi-currency
services; and
– action by central banks to induce rapid private sector progress.
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1. Action by individual banks
• Increase awareness of the risks
– Proper measurement and updating of Forex settlement exposure
(current and future)
• Establish clear senior level responsibility for measuring
and controlling Forex settlement risk
• Treat Forex settlement exposures like other credit
exposures of the same size and duration, and manage them
accordingly, for example:
– Establish bilateral exposure limits with each counterparty
– Establish limits (or sub-limits) for exposure duration
…….
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1. Action by individual banks
• ……
– Revising correspondent banking arrangements
– Improvements in back office payments processing, for
example, on-line statements of accounts with
correspondents
– Consider the possibility (and costs) of implementing
settlement assurance mechanisms, like pre-funding of
transactions or other forms of collateral
– Consider the possibility of implementing obligation
netting to reduce settlement flows
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2. Action by industry groups: CLS Bank
• In September 2002 the CLS Bank International (CLS
Bank) started its Continuous Linked Settlement service,
settling foreign exchange transactions in 7 currencies (the
Australian dollar, the Canadian dollar, the US dollar, the
Euro, the Swiss Franc, the Japanese Yen, and the British
pound)
• At the time of its launch, CLS had 66 of the world’s largest
financial institutions participating as shareholders
• It is estimated that CLS banks settles over 80 percent of the
world’s foreign exchange business by value.
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2. Action by industry groups: CLS Bank
• By December 2004 a total of 15 currencies (the former
plus Danish Krone, Norwegian Krone, Swedish Krona,
Hong Kong Dollar, Korean Won, Singapore Dollar, South
African Rand, New Zealand Dollar)
• By December 2004, a total of 58 Member Banks
(shareholders, with settlement accounts) and 191 “Member
customers” (third parties sponsored by a Member Bank).
• The CLS Bank is subject to the cooperative oversight of
central banks involved and it is under the direct oversight
of the US Federal Reserve.
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2. Action by industry groups: CLS Bank
• Counterparty risk is eliminated through a form of payment
versus payment (PvP). Liquidity risk is not eliminated.
• Settlement member accounts at CLS Bank
– Single, multi-currency account on CLS Bank’s books
– Individual currency balances calculated, monitored
• FX trades settle gross on CLS Bank’s books
– Final, simultaneous debits and credits to Settlement Member’s
accounts: Achieves “payment versus payment”
• Pay-in’s, pay-out’s via CLS Bank accounts/RTGS systems
– CLS Bank holds accounts at central bank of issue.
– Participants’ funding and defunding of these accounts is on the
basis of the net amounts in each currency of the trades they are
settling that day.
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3. Action by Central Banks
• Encourage timely, market-wide progress
– For example, cooperation and dialogue with private
sector to ensure that well-constructed multi-currency
services are developed
• Enhance national payment systems
– For example, extension of operating hours of payment
systems, to increase the overlap in system hours in
different currencies
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Cross-border Retail Payments
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Today’s Picture
• Customers expect a set of convenient, cheap,
reliable and predictable instruments to cover their
most important payments needs:
– face-to-face-payments, one-off and recurring remote
payments, ATM cash withdrawals
• While customer requirements are generally met in
many countries at a domestic level, performance
in most areas is poor for cross-border transactions
– As recent as two years ago, the average fee applicable
to retail cross-border transfers in the Euro zone was 100
times higher than that applicable to comparable
domestic transfers
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Today’s Inefficiency
• A “natural” explanation
– with few exceptions (e.g. payment cards), payment
infrastructures already in place are only domestic in terms
of their scope, this is, they were developed for a monetary
zone delimitated by national boundaries.
• Additional issues:
–
–
–
–
–
Payment instruments being used
Involvement of a Foreign Exchange Transaction
“Different” risks
Supply factors (diversity of service providers)
Regulation (including customer protection) and Oversight
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Payment Instruments
• All over the world, cash continues to be the most
relevant instrument for cross-border payments in
terms of volume
• As for cashless transactions, payment cards are the
most relevant instrument in terms of volume
– In the EU, cards account for 83 percent of total cashless
transactions. In many cases, however, cards are not
used as payment instruments but rather for ATM cash
withdrawals
– Using cards for remote payments?
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Payment Instruments
• Cheques still relevant for remote payments,
especially in less “bancarized” countries
• With the payment system technology currently
available, electronic credit transfers and direct
debits would appear to be the natural instrument
for remote payments
– Until recently, only available through cumbersome and
costly correspondent arrangements
– Only in recent years, with the spreading of processing
and messaging technologies, they are starting to
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become accessible to the average individual
Involvement of a FX transaction
• Not necessarily the case
– Cross-border payments in the Euro area, or payments
between a dollarized country (e.g. Ecuador) and the US
• In some cases, more than one FX transaction,
meaning more intermediaries
• Usually, large exchange rate spreads
• Interestingly, however, at present cross-border
transactions between countries that use the same
currency are not very different in terms of overall
inefficiency (i.e. high cost) from transactions
involving two or more currencies
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“Different” Risks
• The risks are actually the same than for domestic
transactions, although the mix can be quite
different
• Increased legal risk
• Increased operational risk due to intensive manual
procedures (i.e. lack of interoperability)
• However, fraud and other security concerns (e.g.
identity theft) are regarded as the main risks
– In the case of cards, cross-border fraud is
approximately 20 times higher than domestic fraud.
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Supply Factors
• Increasing demand for cross-border payment
services with enhanced flexibility, speed and
geographical outreach
• Banks have not been able to cope with this
– Banks strong in urban areas, where they have generally
well-developed infrastructures and where payments
involve “bancarized” sectors
• Thus, non-banking (or even non-financial)
institutions have gained an important market share
– Proprietary messaging systems
– Large distribution networks covering remote locations
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Regulation and Customer
Protection
• Transparency standards are particularly low for
cross-border payments
– Several implicit charges that are not disclosed to
customers (e.g., exchange rate spreads, charges
applicable to the receiver, etc.)
– Minimum service levels, which, for example, give
certainty on the time of accreditation of funds to the
beneficiary, are practically non-existent
– It is still costly for customers to foster competition
through customer research and comparisons
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Oversight
• Still no consensus that retail systems should fall
under the direct control of the overseer
• Additional problems in the case of retail crossborder payments:
– Overseeing non-financial payment services providers
– Overseeing the full flow of a transaction would
necessarily involve two or more national authorities
A broader and more activist agenda in the particular
area of retail cross-border payments?
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What can be done?
• Improvements through:
– The “natural” or inertial evolution of crossborder payment systems as a result of increased
economic and political integration
– The systematic and conscious effort to
improve/reform retail cross-border payment
systems
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A look at the SEPA
• In theory, with the adoption of the Euro domestic
payments and payments between the countries of
the Euro zone ought to be identical
• Up to 2002, however, this was not the case:
–
–
–
–
–
High costs when compared to domestic transactions
Relatively low STP rates
Lack of transparency
Poor performance for customers (cost, quality and time)
For cards, seamless domestic and cross-border
processing, but significant price differences between
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domestic and cross-border
A look at the SEPA
• The European Commission decided that a drastic
political solution was necessary. In December
2001 the European Parliament adopted the
“Regulation on cross-border payments in euros”
• Main features:
– All fees applicable to card and ATM cross-border
transactions in euros, up to Euro 12,500, must be
identical to those being applied to domestic transactions
– This same regime would apply to credit transfers
starting on July 1, 2003
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A look at the SEPA
• To comply with this Regulation, the European
Payments Council approved two key market
conventions:
• The CREDEURO Convention
– Establishes a basic bank-to-bank pan-European credit
transfer that allows banks to give guarantees to their
customers as regards information requirements,
execution time and remittance information transmitted
• The Interbank Charging Principles Convention
– A standard procedure for achieving end-to-end certainty
in charging methods, and allowing for the instructed
amount to be credit to the beneficiary in full
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A look at the SEPA
• Commercial banks have decided on a panEuropean architecture, the Pan-European Clearing
House (PE-ACH) as the preferred model for credit
and debit transfers.
• In a first stage, the PE-ACH will process credit
transfers in combination with existing clearing and
settlement systems
Summit of the Americas Commitment to Reduce
Remittance Costs by at least half by 2008
– An upcoming Pan-American Payments Clearinghouse?35
International Family Remittances
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International Family Remittances
• International remittances initiated by migrant workers are
an important source of family income in many developing
economies.
• In some cases, remittances represent a very relevant
percentage of the GDP of the receiving countries.
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Integrating remittances in the reform
of the National Payments System
• KEY IDEA: Remittance services are part of the broader
retail payment system both domestic and cross-border
– Remittances are cross-border retail payments with particular access
requirements (on both the demand and supply sides)
• An efficient development of the domestic payment system
infrastructure is key to reduce costs of remittance services
• The development of payment system oversight is
fundamental to enhance transparency and reduce costs in
the retail payment sector
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Integrating remittances in the reform
of the National Payments System
• KEY IDEA: Remittance services are part of the broader
retail payment system both domestic and cross-border
•
The World Bank is a leading institution in payment system
development, in particular in Latin America through the
Western Hemisphere Payments and Securities Settlement
Forum (WHF). In the context of payment system reforms,
the World Bank has recommended improvements in the
remittance area since 1999
• Payment system development projects are a good vehicle
to address the issue
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Additional Key Ideas
• Remittances are part of an individual’s access to financial
services
• A good remittance product improves value to the user in
the short term and access to other financial products in the
long term
• A good remittance product increases competition and
moves transactions to the formal sector, enabling the
formal sector to provide superior service
• There are no standard solutions
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CPSS/WB Task Force on “General Principles
for International Remittance Systems”
• As part of the Sea Island remittance initiative, the G7
Finance Ministers and Central Bank Governors called for
work toward developing prudential standards/guidelines
for remittance services.
• Some obstacles identified include:
– Lack of physical access to financial institutions
– Inadequate financial education
– Inefficient and costly remittance services available at financial
institutions
– Regulatory barriers to the provision of remittances services
– Inadequacy of data on remittance flows
– Lack of guidance on what regulation/supervision of remittance service
providers is necessary to ensure safety and integrity of these services
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Composition of the Task Force
•The Task Force is co-chaired by the CPSS and
the World Bank.
•Additional Members:
– Central banks of Italy, the United States, Brazil,
Mexico, the Philippines, Sri Lanka, Turkey,
Germany, Hong Kong and the European Central
Bank, as well as the International Monetary Fund,
the Arab Monetary Fund, the Asian Development
Bank and the Inter-American Development Bank
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Mandate and scope (I)
•The Task Force is to develop general principles
on remittances describing key features and
functions that should be satisfied by remittance
systems, providers and financial intermediaries.
• These principles must be clear and universally
applicable international standards, its main focus
being to identify the main characteristics of
sending and receiving remittances an the related
infrastructures with a view to improving them. 43
Mandate and scope (II)
The Task Force shall pursue the following streams of work:
• To map and compare the remittance market in different
countries, as well as the respective cross-border
arrangements in these countries in the form of country
reports. This analysis should allow the Task Force to define
stylized structures of remittance systems, and to determine
Principles that could be applied.
• To try to identify principles to ensure an appropriate level of
consumer protection and transparency. In this context, the
different pricing methodologies shall also be analysed.
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Mandate and scope (II)
The Task Force shall pursue the following streams of work (cont.):
• To discuss the appropriate level of access to payment
systems infrastructure preserving the safety and integrity of
the infrastructure. Appropriate mechanisms for educating
the remittance agents and operators will also be considered.
• To discuss public policy issues related to the remittance
market.
• To discuss the role of the central bank and other public
authorities in the application of the principles.
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