Modernisation of National Payment System

Dr. Ranee Jayamaha, Deputy Governor Central Bank of Sri Lanka

PAYMENT INFRASTRUCTURES: The payment system is the mechanism through which money is transferred between savers and borrowers, buyers and sellers or from one party to another party. The term "National Payment System" covers payment instruments, payment infrastructures like, clearing and settlement systems and institutional frameworks.

Reforming payment systems for financial stability and its impact on the financial system, institutional arrangements and payment practices of banks and the public are not well researched nor considered as critical to economic transactions. Most stakeholders take the national payment system as given, while currency shortages and delays in cheque clearance are being highlighted as isolated incidents.

Although cash remains an important form of payment in all transactions, non-cash payments by commercial banks and the use of Central bank money from a significant component of the payment system. The main elements of a national payments system include:

* Payment instruments used to initiate and direct the transfer of funds between the accounts of payers and payees at financial institutions;

* Payment infrastructures for transacting and clearing payment instruments, processing and communicating payment information and transferring the funds between the paying and receiving institutions;

* Financial institutions that provide payment accounts, instruments and services to consumers, and businesses and organisations that operate payment transaction, clearing and settlement service networks for those financial institutions;

* Market arrangements such as conventions, regulations and contracts for producing, pricing, delivering and acquiring the various payment instruments and services;

* Legal and regulatory framework which include standards, rules and procedures set by legislators, courts and regulators that define and govern the mechanics of the payment transfer process and the conduct of payment service markets.

The payment infrastructures include all the specific individual payment transactions, clearing and settlement systems operating in a country, while some infrastructure are designed specifically around particular types of payment instruments.

The institutional arrangements include the market arrangements for various types of payment services and the financial institutions and other organisations that provide payment services to users.

They also include a legal and regulatory framework for market organisations and conduct and mechanisms for consultation and co-ordination among the principal stakeholders. The institutional structure links infrastructure arrangements and stakeholder together functionally in the national payment system.

The national payment system is the backbone of the monetary and financial system and it plays a critical role in a country's economic development. Developing a national payment system is an ongoing process.

By reforming and developing the national payment system, it is possible to reduce the overall transaction costs and expand opportunities for commercial and financial transactions in an economy. In recent years, there has been a rapid acceleration in fundamental reforms to national payment systems worldwide, although the pace of implementation of reforms in different countries has been uneven.

All illustrated by the general guidelines for National Payment System Development Report by the Bank for International Settlements (BIS) in December 2006, generally, the reforms in the national payment system are triggered by: (i) new developments in the financial and non-financial sectors that present new needs and opportunities for cost-efficient payment instruments and services; (ii) an increasing awareness of payment system risks and concerns about financial system stability; (iii) internal and external pressures for reform and a policy decision to comply with relevant international standards; or (iv) political-economic developments sometimes related to a country's entry into regional or global trade and financial markets.

Accordingly the recent trends in the national payment system development indicate that initiatives have been taken to:

* Broaden the range of payment instruments and services;

* Improve cost efficiency, particularly in terms of operating costs and access to, and usage of liquidity;

* Enhance the interoperability and resiliency of banking, payment and securities infrastructures;

* Better contain legal, operational, financial and systemic risks in payment infrastructures;

* Create more suitable oversight and regulatory regimes for the national payment system; and

* Enhance the efficiency and stability of payment service markets.

However, experience indicates that the development process for a national payment system is not always a smooth and efficient one. Planned outcomes have not always been achieved in terms of expected use, benefits or costs of payment system reform projects and many planned reforms have been unexpectedly slow to complete. The most common problems for effective development are:

* Inadequate knowledge about the overall breadth of the national payment system and limited vision and leadership;

* Limited information about emerging payment needs and system capabilities;

* Weak support and commitment from stakeholders due to inadequate consultation;

* Limited development resources and

* Legal, regulatory, public policy and market barriers to ongoing development of the national payment system.

That is why many Central Banks in particular have taken the lead to modernise the national payment systems in their countries.

Payment system reforms in Sri Lanka

In the modernisation programme which commenced in 2001, the Central Bank of Sri Lanka refocused on its core objectives, i.e. economic and price stability and the financial system stability and recognised the complementarity between them.

The financial system stability objective encompasses a wide range of subjects of which, the establishment of a safe and sound payment system is seen crucial for the development of the financial sector.

In this context, the Central Bank examined the adequacy and the efficiency of the payment system to satisfy the needs of an evolving economy and decided to undertake comprehensive payment reforms. The broader objectives of the reforms were to reduce transaction costs, increase efficiency, ensure safety and reduce credit, liquidity and systemic risks. The reforms were also in line with the Government's and regulatory authorities' public policy objectives.

Sri Lanka's payment instruments and their clearing and settlement processes are wide ranging. Cash is the common mode of payment, because it has a finality in settlement of a transaction and is readily and legally acceptable as a medium of exchange.

However, the inconvenience of carrying cash and increased security threats has encouraged the use of other payment instruments. Non-cash payment instruments are considered to be more secure, but paper-based instruments like cheques, drafts and travellers cheques are not so convenient or efficient instruments.

In modern times, card and electronic payments are treated as the most convenient and safer instruments, although they too are subject to certain risk, card frauds in particular and technology related issues.

There are three systemically important payment systems in Sri Lanka. They are (i) the high value and time critical payments and settlement system used by banks, primary dealers, the Central Bank for inter-bank and inter-market transactions. (ii) the cheque-based retail payment system used by all segments of the population; and (iii) the Automated Trading System operated by the Colombo Stock Exchange (CSE) which settles stocks and shares, i.e. private equities. Any disruptions to these three payment systems can result in financial system-wide impacts leading to financial system instability.

These critical payment clearing and settlement systems that are in operation today are backed by a strong institutional, legal and regulatory framework. The key elements include; (i) the payment and settlement services, (ii) legal and regulatory framework, (iii) mechanisms for consultation with stakeholders; and (iv) catalyst and oversight roles of the payment system.

(i) Payment and settlement systems and services high value and time critical transactions: RTGS/SSS system

The implementation of the Real Time Gross Settlement System (RTGS) and the Scruples Securities Settlement Systems (SSSS) with a SWIFT link was the most significant reform effected in recent times.

The RTGS was implemented in September 2003, and the system facilitates large value and time critical fund transfers and settlements electronically and on real time. During April 2007, the number of daily average RTGS transactions stood at 816 (Rs. 104 billion invalue).

In February 2004, the SSSS module was integrated to the RTGS System. To facilitate the operations of these systems, government securities are issued in scruples form and the system facilitates simultaneous transfer of government securities and settlement of funds through the RTGS on a delivery versus payment basis.

The SSS System has eliminated the need for issuing treasury bills and bonds in paper form and manual authorisation of same when they are transferred. In April 2007, the daily average number of SSS transactions amounted to 923 (valued at Rs. 59 billion).

The system has also facilitated the recent issue of Treasury Bonds to foreign investors in scruples form and their trading through the Scruples Securities Depository System.

The Central Bank continues to upgrade and enhance facilities in these two systems and in December 2005, the Internet based facility called LankaSecureNet enabled the account holders of the Scruples Securities Depository System to obtain upto date details of their investments through the Internet.

To facilitate smooth operations the RTGS/SSS systems, the Central Bank provides intra-day liquidity free of charge (subject to availability of collateral) to the banks and primary dealers. In essence, all settlements on the RTGS system are done using Central Bank money during each business day, which is returnable at the end of the day.

The Central Bank is the owner and operator of both the RTGS and SSS systems. Reflecting the public policy responsibilities, the Government funded the initial expenditure of the modernisation programme, while the Central Bank met the cost of all interfaces, upgrades and support services in the system.

The service is charged for cost recovery purposes which is spread over a long period of time. Some banks and financial institutions recover the service charge from customers often at rates far in excess of the charge by the Central Bank.

(ii) Retail payment clearing infrastructure: The cheque imaging and truncation system in Sri Lanka (CITS)

This is the second systemically important payment system which involves the clearing of cheques on an islandwide basis.

The service provider of the retial payment system is LankaClear (Pvt) Ltd (LCPL) which is owned jointly by the Central Bank and commercial banks. In mid 2006, LCPL introduced the CITS replacing the Sri Lanka Automated Clearing House operated by the Central Bank.

The CITS is designed to ensure that cheques deposited in any part of the country is cleared and settled within two days (after reaching LCPL Colombo Centre or regional offices), except in uncleared areas.

The CITS eliminates regional time disparities in cheque clearing and establishes a common clearing schedule. The LCPLN also clears payments made through the Sri Lanka Inter Bank Payment System (SLIPS).

The US dollar cheques drawn within the country are settled by a commercial bank and the other banks have agreed to maintain accounts with the clearing bank for settlement purposes. This is not a systematically important payment system.

The LCPL is the retail cheque clearing house which collates, distributes and clears cheques on a country-wide basis. In addition to its Colombo Main Processing Centre, it operates with 11 regional centres.

Invalue terms, LCPL handles a total value of about Rs. 18 billion cheques per day. When cheques are deposited by customers, the collecting bank sends them to Colombo or to the nearest regional centre at which the relevant information of the cheque is imaged by the imaging machines.

The regional centres send imaged information on -line to the main processing centre in Colombo for clearance.

LCPL using the MICR technique, clears cheques of all banks and sends net clearing balances to the RTGS system for settlement and informs the relevant banks of their obligations.

(iii) Equity and corporate debt securities settlement at the Colombo Stock Exchange (CSE)

Equity shares and corporate debt securities listed on the CSE are traded on-line on the screen trading system operated by the CSE. The CSE owns and operates the Automated Trading System (ATS) for trading of equity and corporate debt securities and the debt securities trading system (DEX) for trading of beneficial interest of government securities.

Corporate debt and equities listed on the CSE which are issued in script form by the respective companies are subsequently lodged by the investors in the Central Depository Systems (CDS) in a dematerialised form. Lodging such securities in CDS is mandated for trading on the CSE.

The CDS facilitates trading and clearing of equities and debt securities transactions at CSE. The stock-brokers and trading members are the participants on the ATS and DEX. The CDS also allows indirect participation by licensed commercial banks as some of them function as custodian banks for account holders in the CDS.

Investors maintain securities accounts in the CDS through their respective participants. Payments are settled across accounts maintained at a settlement bank.

Legal and regulatory framework

To underpin the payment reforms undertaken by the Central Bank and enhance integrity and safety of such systems, a comprehensive legislation governing payment, clearing and settlement systems in general and to provide the Central Bank with oversight and regulatory powers over various payment systems and money transfer service providers has been enacted through the Payment and Settlement Systems Act of 2005.

The Act empowers the Central Bank to be the authority responsible for the National Payment System, which requires oversight and continuous surveillance of all payment systems to ensure its efficiency and effectiveness.

The systemically important payment systems will be reviewed periodically to ensure that the design and operation meet with international standards and best practice. In addition, the Monetary Law Act of 1949 also provides significant powers to the Central Bank to engage in payment and settlement related functions which is a key element in financial system stability.

National Payments Council

In 2006, the Central Bank established a National Payments Council (NPC) which is the highest decision making body with regard to payment and settlement systems. This committee, represented by all stakeholders, provides a forum to the industry for consultation and dialogue on payment issues.

NPC is responsible for developing the payment and settlements infrastructure in collaboration with all the relevant authorities and stakeholders. NPC has finalised a road map for the development of the national payment system for the next five years, which is in line with the vision of the financial sector.

Catalyst and oversight roles

In implementing the road map, it is vital that all stakeholders in the payment system understands the significance of payment systems, their impact on financial stability and take ownership and leadership.

Most central banks at some point or other have been owners, operators, catalysts, overseers and users of the payment system. Over the years, Central Banks have given up their ownership and operator's role and, in some cases, even the catalyst role.

Banks and financial institutions and also the corporates should play an important role in shaping the national payment system in Sri Lanka.

Unlike in many countries, the banks and financial institutions in Sri Lanka have not taken the lead in reforming and developing the payment and settlement system. With or without payment system reforms, banks and financial institutions should be able to meet their payment obligations. Payment reforms also help to adopt best practices by all stakeholders.

Some of the benefits enjoyed by banks and customers over the years are no longer available under the RTGS as well as the CIT systems. Each payment reform has provided opportunities to develop new products.

Financial Institutions and service providers should take advantage of the available platforms, reduce transaction cost to customers and enhance access to finance. Banks and primary dealers should market their new products in conformity with the rules and regulations set up these systems rather than looking ways and means to operate outside rules and regulations.

To reap full benefits of the CIT project, the public too has to make adjustments in their payment practices and ensure that there are funds in their accounts when cheques are issued. It is reported that a significant portion of the cheque returns are due to non-availability of funds in customer accounts.

Customers should not issue cheques without having funds in their accounts or making necessary funding arrangements with banks to meet their payment obligations.

Impact of the modernised payment and settlement system

Sri Lanka is the 16th country in the world, which has received BISF-Red Book status for modernised payments systems. It occupies the third place in Asia in terms of payment reforms and has been the first country to operate RTGS/SSS system with SWIFT link in the SAARC region.

The RTGS and SSS systems speedily transfer funds and make settlements of banks, primary dealers, financial institutions, investors, customers, the Government and the public. The CIT has facilitated the clearance of outstation cheques speedily, thus increasing access to finance by rural and small business.

These two systems bring about financial discipline among stakeholders as they have to maintain adequate cash and reserves in their accounts to meet payment obligations.

Similarly, the CDS system at the CSE also provide safer and speedy settlements to the stock market, which has been a critical factor in attracting both local and foreign investors.

These systems help to improve the liquidity management by banks as treasures and fund managers are required to manage their daily liquidity in a more efficient manner.

Repurchase markets have developed following the payment reforms which provide new short term investment opportunities.

While the authorities responsible should concentrate on the future payment and settlement needs of the growing economy, the markets, financial institutions and all other stakeholders should use these systems and explore potential benefits offered by them.