Payments System Board Annual Report – 2007 Risk in the Payments System

Over the past year, the Board has re-examined the risks that payment systems might pose to financial stability, focusing on systems where large values of payments are settled. In addition, the International Monetary Fund (IMF) finalised its report on Australia's high-value payment system, the Reserve Bank Information and Transfer System (RITS), conducted under the Financial Sector Assessment Program (FSAP).

Financial Sector Assessment Program

In October 2006, the IMF released the results of its assessment of Australia's real-time gross settlement (RTGS) system, RITS, against the Core Principles for Systemically Important Payment Systems (the Core Principles) (Table 9). This assessment was undertaken as part of the IMF's FSAP, and followed an earlier self-assessment by the Bank. The IMF concluded that RITS is a sound and efficient payment system and that it fully complies with all the relevant international standards. It also concluded that the Bank meets all of its responsibilities in applying the Core Principles. The full FSAP assessment of RITS is available in Australia: Financial Sector Assessment Program – Detailed Assessment of Observance of Standards and Codes, which can be found on the IMF's website, or through the Bank's website.

As part of its assessment, the IMF also made a number of recommendations which it believed had the potential to further enhance Australia's compliance with the Core Principles. In particular, it recommended further consideration of issues related to legal risk, security, business continuity, pricing, consultation with participants, governance arrangements and oversight. The recommendations covered both policy and operational matters, and therefore were considered by both the Board and the relevant operational areas of the Bank. In some cases, changes were already in train at the time of the FSAP, while in others, changes to processes have been considered. The recommendations and the Bank's responses are summarised in Table 10.

In response to the IMF's recommendation that the Bank adopt more ‘formal methods and procedures’ for oversight of important payment systems, the Board undertook a broader evaluation of possible approaches to oversight and their appropriateness in the Australian setting. The more formal approach adopted in some countries typically involves assessment of the main payment systems against the Core Principles. The Board, however, concluded that there was limited value in such an approach in Australia. This conclusion partly reflects the fact that the Core Principles are designed specifically to assess risks in high-value payment systems. This reduces their applicability to other systems, although in some areas they provide useful guidance. The Board also recognised that a system-by-system evaluation is not always helpful, particularly if it leads to insufficient attention being paid to the interactions between the various systems. Further, the Core Principles focus mainly on risk issues, and deal only briefly with efficiency and competition issues, which are given prominence by Australia's payments legislation.

The Board's general approach to oversight is to consider the payments system as a whole, focusing on both stability and efficiency issues, including interactions between various payment systems. While assessments against international standards for high-value systems have an important role to play, much of the Board's work has focused on the economics of the individual payment systems, and how these systems compete with one another. In conducting this work, the Bank has consulted widely, both formally and informally, with payment system operators, financial institutions, users of payment services, consumer groups, and other domestic and international regulators. While the broader approach can pose additional challenges, the Board's view is it is both necessary and appropriate, particularly given the Board's broad responsibilities set out in legislation.

Residual Risks in the Payments System

As part of the Board's work, it periodically takes stock of the various risks in the payments system and the actions and processes that mitigate those risks. In doing so, it recognises the significant number of developments over the past decade that have enhanced the stability of the payments system. These developments include:

  • the introduction of RTGS in 1998, which greatly reduced the build-up of interbank credit exposures during the course of the payments day;
  • the granting of legal certainty to RTGS payments and obligations in multilateral netting arrangements through the introduction of the Payment Systems and Netting Act in 1998 and the subsequent approval of RTGS systems and key multilateral netting arrangements under the Act by the Bank;
  • changes in 2004 to APCA's ‘failure to settle’ rules, which specify how to deal with the failure of a participant in a deferred net settlement system;
  • the introduction of a standing facility in 1997 that allows institutions with Exchange Settlement Accounts to obtain overnight liquidity from the Bank at 25 basis points above the target cash rate, provided that they have eligible securities to undertake a repurchase agreement;
  • the move to real-time delivery versus payment (DvP) for settlement of debt securities in 1998; and
  • the introduction of CLS in 2002, which significantly reduced risks arising from the two sides of a foreign exchange transaction being settled at different times.

The result of these developments is that the system is much more robust than it was previously, and that problems in the payments system itself are much less likely to be the source of systemic disruption in the financial system.

Notwithstanding this positive assessment, over the past year the Board has considered a number of residual risks in the payments system. One of these risks is that settlement problems in deferred net settlement systems could have broader implications for the financial system.

Currently, around 90 per cent of interbank payments, by value, are settled through the RTGS system, which prevents the accrual of settlement risk during the day. The remaining 10 per cent of payments are settled on a deferred net basis, with payments being aggregated and settled at 9am the day after payment instructions are exchanged. These payments include cheque payments, consumer electronic payments (such as credit and debit card payments), and payments through the direct entry system. By far the largest component of deferred net settlement values originates from the direct entry system and, as a consequence, this was the Board's main focus.

Risks arise in the direct entry system because payments are typically credited to the receiving customer's account before settlement between banks occurs (as is the case for other deferred net arrangements). This means that the recipient's bank is exposed if the payer's bank fails prior to settlement, since it will not receive a covering payment for the credit to its customer's account. A system established today to process significant payment values might not be set up in this way, but there are significant costs of changing well-established systems. The industry has periodically examined these risks and has not seen a compelling case to change existing arrangements. APCA is, however, currently developing a road map for the evolution of Australia's low-value payment systems, and this will include the development of a work program for any industry cooperative effort required in a variety of areas, including risks. The Board will continue to monitor developments in this area.

A second issue that the Board considered was whether there are significant risks in netting arrangements that have not been protected under the Payment Systems and Netting Act. Where netting is not protected under the Act, the administrator of a failed participant may seek to have net obligations unwound to gross obligations, eliminating the risk reduction benefits of netting arrangements. At the time of the Board's discussion, the largest multilateral netting arrangement not protected under the Payment Systems and Netting Act was the equities settlement batch operated by ASX Settlement and Transfer Corporation. This was, however, granted protection under the Act during the year (see ‘Ongoing Regulatory Responsibilities’). The Bank is also seeking to ensure that the Payment Systems and Netting Act protections of elements of the ‘9 am Batch’ – where deferred net obligations are settled – are sufficiently robust.

A third possible source of risk to the payments system examined by the Board was operational risk. The focus on operational risk worldwide has increased dramatically since the terrorist attacks in the United States in 2001 and it is now expected that key elements of the financial system should be able to continue operations with minimal disruption when faced with a wide range of contingencies. Among the key elements considered specifically by the Board in the context of operational resilience were RITS and the SWIFT messaging system.

The Board concluded that the Bank's RITS system, which is at the core of the Australian payments system, has a high degree of resilience with several levels of backup. These arrangements were enhanced significantly in July 2007 when the Bank's new, dedicated business resumption facility became operational. The facility is staffed permanently and allows rapid recovery from any incidents affecting Head Office.

The Board also concluded that there are well developed business continuity arrangements in place for the SWIFT system. Given the importance of the SWIFT messaging system to the Australian foreign exchange market and RTGS system, however, the Board remains interested in SWIFT's resilience. In this context, the Board noted that SWIFT has voluntarily submitted to the oversight of the G10 central banks, led by the National Bank of Belgium, with operational resilience an important focus. It also noted that the Executives' Meeting of East Asia-Pacific Central Banks (EMEAP) grouping of Asian central banks (including Australia) has been working with the National Bank of Belgium to obtain greater access to SWIFT oversight information. The Board supported the development of these new information-sharing procedures.