Key concepts

3.2 Payments system concepts as used by the Committee on Payment and Settlement Systems (CPSS) have evolved over time. These concepts have been addressed in documents such as the Report on Netting Schemes (the Angell Report), the Report of the Committee on Interbank Netting Schemes (the Lamfalussy Report) and, most recently, the Report on Delivery Versus Payment in Securities Settlement Systems (the DVP Report). In addition, an effort has been made by the CPSS to compile a glossary of terms for use by G-10 central banks. EC central banks have also created a glossary of terms and concepts in recent work analysing payments systems in the Community. This report builds on these earlier documents.

3.3 From the point of view of analysing credit, liquidity and systemic risks in payments systems, the most important concept is finality. As stated in the glossary of the DVP Report, finality or a final transfer is a concept that defines when payment, settlement and related obligations are discharged. Thus the DVP Report defines a final transfer as "an irrevocable and unconditional transfer which effects a discharge of the obligation to make the transfer". This is the definition of finality adopted in this report. The report also discusses the idea of an intraday final transfer capability at central banks of issue. An intraday final transfer capability is defined as the ability to initiate - and to receive timely confirmation of - transfers between accounts at the central bank of issue that become final within a brief period of time.

3.4 Finality is important because when it occurs - which depends upon applicable rules and laws - the interbank obligations generated in the interbank payment, clearing and settlement process are discharged. Thus, the credit, liquidity and systemic risks generated in this process, particularly interbank risks, may similarly be extinguished. Furthermore, from a broad perspective, finality is the point at which a money transfer process is completed.

3.5 One of the major roles of central banks is to provide a monetary asset free of default risk that can be used for making interbank transfers and settling interbank obligations. Central banks also typically provide accounts to qualified financial institutions in which balances of central bank money may be held. Arrangements differ across countries as regards whether central banks also provide, or possibly administer, electronic systems for executing payment instructions that effect transfers of central bank money. As discussed below, operational and legal arrangements also differ as regards when transfers of central bank money take place and are final (i.e. irrevocable and unconditional).

3.6 Interbank funds transfers can be made by transfer of commercial bank deposit money as well as by transfer of central bank money. Correspondent banks, for example, typically provide this service. Unlike transfers of central bank money, transfers of commercial bank deposit money are not transfers of a risk-free monetary asset.

3.7 As noted in the Angell Report, settlement risk involves a combination of credit and liquidity risks that arise in the interval of time between entering into a financial (or other) transaction that involves an obligation to pay an amount of money and the discharge of the obligation to pay money by the final transfer of the required sum. Systemic risk may accompany such situations, particularly if large numbers of payments between and among financial and other firms in an economy have been made on the assumption that all such payments will lead to, or are, final transfers. If this assumption proves false, significant unforeseen reallocations of monetary and other assets may take place between and among such firms, with potentially serious consequences for the liquidity and even solvency of these institutions. Furthermore, underlying obligations thought to have been discharged may, in fact, not have been discharged at all.

3.8 In the case of multi-currency payments the situation is even more complex. Major financial institutions and other sophisticated organisations may, in the normal course of business, enter into significant numbers of interdependent financial transactions in two or more currencies for settlement on a particular value date. In such cases, the final transfers of money needed to settle transactions denominated in different currencies, and, in particular, needed to settle exchanges of one currency for another through foreign exchange transactions, are usually dependent on the characteristics of two or more national payments and banking systems for the relevant currencies. In such circumstances, liquidity, credit and systemic risks can become quite difficult to manage precisely.

3.9 Cross-border issues further complicate the risks involved in transactions because, at the very least, potential conflicts and other problems may arise involving the application of different countries' laws to different aspects of payment and settlement. Furthermore, more than one country's laws may apply to the financial institutions through which payments and settlements are made. This is especially true in the case of foreign branches of these institutions. Some cross-border issues are also closely related to multi-currency issues. Thus the existence of differing national payments systems is also, in a sense, a cross-border "issue". Problems created by payments between counterparties in different time zones are also typically, although not necessarily, associated with cross-border issues.

3.10 At present, the sequential settlement of the various payment legs in foreign exchange transactions is the norm in the banking industry. Transfers of one currency are typically initiated and even become final before transfers of another currency or currrencies are initiated and become final. As a result, if transfers and settlements in later-settling currencies do not take place as scheduled, significant risks of loss of the principal value of one or more of the payments in a sequence may arise. Such risk is also called Herstatt risk. ^2,3

3.11 Another aspect of sequential settlement is the potential liquidity risk that may be generated in circumstances of financial stress and market uncertainty, if counterparties refuse to use customary sequential settlement methods out of fear that large credit losses might result. Payments may be withheld or their timing and sequencing changed. In these cases, the anticipated distribution of liquidity in the financial sector, both within a day and at the end of a day, may be disrupted, with potentially serious consequences for markets and clearing arrangements.

3.12 A fundamental concept used in this report is multi-currency delivery-versus-payment (multi-currency DVP). Drawing on the DVP Report, when two or more currencies are involved, multi-currency DVP means that a final transfer in one currency occurs if and only if a final transfer of the other currency or currencies also takes place. The significance of this concept is that when transfers are made using a DVP mechanism, Herstatt (principal) risk does not arise, although other risks may still be present.

3.13 The term simultaneous settlement is also used by the Working Group. Multi-currency settlements may take a form, whereby, either through a DVP arrangement or through a less structured arrangement, settlement in two or more currencies is coincident. In the less structured arrangement there is no DVP, and no physical mechanism exists to assure at all times that if one currency were settled all other currencies would also be settled.

3.14 In summary, multi-currency DVP can, in principle, eliminate Herstatt risk in the settlement of transactions involving the exchange of two or more currencies. Multi-currency DVP also provides an important yardstick against which to judge the settlement risks in non-DVP multi-currency settlements, in particular settlement risks in sequential settlements that are the current norm in the banking industry. As noted in the DVP Report, the overall risk characteristics, particularly liquidity risk characteristics, of any actual DVP mechanism will depend on the risk management features of that mechanism, along with market usage.

Current arrangements and risk implications

3.15 From the point of view of overall credit and liquidity risks in making and receiving cross-border and multi-currency payments and counter-payments, current national large-value transfer systems have two related characteristics that may inhibit the reduction of risks. The first is a constraint in some national systems on when during a payments system operating cycle transfers can be initiated and on when they are final. The second is a constraint on the hours of operation of payments systems themselves, which in turn implies a constraint on the times of day at which final transfers can be initiated and completed. Both of these restrictions limit the possibility of DVP (or simultaneous) exchanges of currencies through national payments systems. Given such constraints, the sequential settlement of most currencies is inevitable. The only issue from the standpoint of credit and liquidity risk is how to manage and reduce those risks.

3.16 There are a variety of operational and financial structures for large-value transfer systems in the G-10 countries. Significant changes are also under way. The structures, along with relevant payments and insolvency law, determine the timing of the finality of transfers effected using these systems.

3.17 Two major types of large-value transfer system can be distinguished that have very different characteristics with respect to the timing of finality. The first type is the gross real-time transfer system, in which payment messages are processed one at a time through an operating system or systems, with each message resulting in the transfer of central bank money as it is processed. Gross real-time transfer systems for central bank money potentially can provide finality for transfers on a payment-by-payment basis. This would require, however, that payments, insolvency and other relevant laws grant a discharge of any obligation to transfer money at the point transfers of central bank money take place. This may not be the case in some countries. Where these conditions are met, there is no constraint based on the structure of the payments system that prevents intraday final transfers of central bank funds.

3.18 Financial arrangements differ across central banks that operate gross real-time transfer systems with respect to the treatment of payments when a bank sending a transfer through such a system has insufficient covering balances or credit. In such circumstances, payments may be held in a queue pending the receipt of funds, or they may be rejected by the operating system. Thus central bank credit constraints placed on gross real-time transfer systems may limit the ability of banks to make final transfers of funds at the time of their choosing, given the level and distribution of central bank money and credit at a particular time during an operating day. However, such constraints are not necessarily part of the inherent design of a payments system and may arise from the financial or credit policy of a central bank as applied to its country's payments system.

3.19 By contrast, in the second major type of large-value transfer system, called multilateral netting systems, limitations on the timing of finality are an inherent feature. In such systems, final transfers of central bank money take place at specified times rather than on a continuous basis. Such systems are based on the multilateral netting of payments across members in the arrangement using principles similar to those employed in the classic bankers' clearing house for paper instruments. Settlements for such systems can take place at multiple times during the day. However, in current practice, settlements are typically made at the end of the processing day using transfers of central bank money between central bank accounts or, in at least one case, through the medium of a special settlement account at the central bank for the transfer system. At the time of the transfers of central bank money, payments and settlements are typically considered final. (Care needs to be taken that payments, insolvency and other laws actually support this assumption of finality, particularly in countries with so-called zero-hour bankruptcy rules. ⁴)

3.20 In any event, the structure of these netting arrangements with periodic settlement may make it difficult for transfers to be final, in the sense of an irrevocable and unconditional discharge of obligations to transfer money, during a processing day or, more accurately, between the periodic settlements. Various netting arrangements may employ more or less extensive risk management and loss-sharing arrangements designed to ensure that periodic settlements take place and thus that promised final transfers of central bank money are made.

3.21 Netting arrangements can be designed to guard against the unwinding ⁵of payments and to provide for "certainty of settlement" ⁶This is the certainty that, when the netting cycle and the associated settlement procedures have been completed, there will be an appropriate transfer of central bank money to effect settlement. Legal considerations, particularly in situations involving the crossborder participation in a payments system by branches of multinational financial institutions, may also affect the certainty attached to the settlement of netting systems.

3.22 There are variations of both major types of payments system model along with hybrid systems. The table provides summary information on the large-value transfer systems in the G-10 countries. In addition to indicating whether a system is a gross real-time transfer system or a netting system, the table shows the hours of operation of the systems, the timing of settlement finality and the cut-off times for third-party transfers. It appears from the table that, in a few countries, it is not possible at the present time to obtain intraday finality of payments via those countries' large-value transfer systems.

3.23 The chart highlights for a given value date the operating times of selected G-10 large value transfer systems typically used to settle foreign exchange transactions. Several important points should be noted. Firstly, there is little or no overlap in the operating hours of key transfer systems used for settling foreign exchange transactions in several of the major currencies. Thus it would be difficult if not impossible to conduct simultaneous or DVP settlements for several major currencies over national large-value systems under present conditions.

3.24 Secondly, if suggested rules governing cut-off times for international correspondent transfers are followed, the apparent overlap in operating hours between some European and North American large-value transfer systems would disappear for the purposes of processing correspondent payments. DVP or similar processing would be impossible for most foreign exchange settlements requiring payments via international correspondents. Even if suggested rules governing cut-off times for international correspondent payments are not followed in practice, cut-off times for all third-party transfers on some systems are likely to limit further the effective degree of overlap in processing hours among key transfer systems.

3.25 Thirdly, although a number of central banks operate gross real-time transfer systems, these are often not extensively used to settle foreign exchange transactions. Instead, large-value systems relying on net settlement appear to be used quite extensively. Providing for multi-currency DVP settlements of foreign exchange transactions over these existing large-value netting systems, with intraday finality, would require among other things significant coordinated changes in settlement times or in interbank settlement practices.

Footnotes:

2 . The term "Herstatt risk" denves from the episode in 1974 in which the Bankhaus Herstatt was closed at the end of the German banking day, but before the end of the banking day in North Amenca. One result was that the Deutsche Mark leg of some of Herstatt's foreign exchange contracts for value on the day of closure had been settled before the closure of the bank, but the dollar legs of those contracts had not yet been finally paid. Note that sequential settlements can be disrupted for operational or other reasons, as well as problems associated with the creditworthiness of a counterparty to a contract.

3. The Lamfalussy Report also refers to Herstatt risk as "cross-currency settlement risk". That Report states that "during the interval between the settlement of each leg [of a foreign exchange transaction], the party that has made the first payment risks losing the full value of the second in the event that the counterparty were to default on its obligation. This credit nsk at settlement - or cross-currency settlement risk - is generally known as Herstatt risk" (Lamfalussy Report, Part C, paragraph 2.7). Similarly, in the DVP Report principal risk is defined as the "risk of loss of the full value of securities or funds . . . transferred to the defaulting counterparty" (DVP Report, paragraph 2.9).

4. In general, under a zero-hour bankruptcy rule, a bankruptcy that occurs during the day may be deemed to have occurred at 0:00 hours for the purpose of deterrnining whether transactions entered into by the bankrupt on the day of bankruptcy will be binding on the estate in bankruptcy. A court hearing is usually required to deterrnine whether each individual transaction will have to be reversed.

5. An unwinding of payments is a procedure allowed in certain multilateral netting arrangements, whereby the funds transfers to and from a participant that fails to complete a net settlement are to be deleted and net settlement positions are to be recalculated to reflect those deletions.

6. For example, it may be the case that netting arrangements with explicit and robust loss-sharing formulas, net debit caps and fai l-safe liquidity backstop facilities, involving the full col lateralisation of all net debit positions by appropriately discounted government securities, would provide for the virtual assurance of settlement at the end of a netting cycle.

Table and Graphs associated with this page:

Operating hours of selected large-value interband funds transfer systems ¹

Global time zone relationships: Opening hours of selected large-value interbank transfer systems