The Integrity of Central Bank Payment Systems

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Feature
24 Apr, 2017

Given its historic assessments of cash and settlement questions, Thomas Murray works closely with central banks in the field of payment systems.  It has recently been looking into new requirements in this area, the implications of which are worth sharing with the capital markets public.

The Bank of England (BoE) has recently released two consultation papers[1] exploring how UK-licensed banks use intermediaries to access the services of a domestic interbank payment system in another jurisdiction.  The BoE contrasts this with direct membership participation of these same UK banks in those other central bank payment systems. These consultation papers built upon an earlier text from October 2014[2], which proposed a policy of ring-fencing for core activities of banks. That policy was subsequently expanded to include the use of high-value payment systems.

The current papers talk to the Financial Services and Markets Act[3], detailing firstly the exceptions under which a UK bank may use an intermediary when accessing an interbank payment system; and secondly, the requirements of banks when using an intermediary for indirect access to a payment system[4].  Legislation specifically prohibits ring-fenced bodies (RFBs) from having exposures to other financial institutions[5]; however, it does set out exemptions for exposures arising for certain financial institutions or in certain circumstances. The implication here may be that the BoE is concerned for the safety of regulated UK banks, and views the removal of links in the chain for international payments as a way to enhance the resilience of an RFB by protecting it from risks arising in the global financial system and from other group entities.[6]

For capital market professionals, the questions that need to be asked are:

·         Why might this now be an important area of focus?

·         What is the best approach to interbank payment system access for UK banks active in multiple jurisdictions?

·         Is it actually beneficial for UK banks to act as a direct participant of an interbank payment system, and if so how?

‘Exceptional Circumstances’ are defined as follows:

·         Where acting as a direct participant in a particular payment system would result in a level of cost, risk or burden for an RFB, its customers or the payment system that is disproportionate to the degree to which direct participation would contribute to the PRA’s achievement of its general safety and soundness objective in relation to ring-fencing; and

·         Where an RFB is not already a direct participant in a particular payment system and joining that system during a particular period would result in a level of cost, risk or burden for the RFB, its customers or the payment system significantly greater than establishing direct participation at some later specified date.

Thomas Murray has done considerable work on global interbank payment systems.  The risks and benefits of direct versus indirect access to multiple jurisdictions’ payment systems have become apparent over time.  

Firstly, there are numerous operational and logistical obstacles that must be overcome, if a bank were to access central bank payment systems directly outside its home market.  Each central bank has its own specific requirements, which usually include minimum levels of capital, ownership and shareholder specifications, collateral obligations, and country-specific systems and other technological requirements – none of which may be needed if that same bank were to make payments via a local intermediary.  All together and spread over numerous markets, direct participation may result in a real strain on resources to ensure on-going compliance in each country. When it comes to meeting requirements for central bank payment system access, there is no “one-size-fits-all” preparation.   The overall burden of joining a foreign interbank payment system may outweigh projected benefits, and in any case merits evaluation.   If business activity remains below a certain threshold, it might well consider withdrawing.

Yet there are benefits to direct participation that may outweigh the costs and risks highlighted above.  In almost all cases, high-value interbank payment systems are owned and run by the nation’s central bank.  Central banks are almost invariably considered risk-free counterparties.  Should a commercial bank choose to effect payments in a given currency via an intermediary, it would be subject to the credit risk of holding funds with a private entity instead.  Those are not usually considered to be “safe havens.”  

Direct participation in foreign payment systems may also remove liquidity constraints on the commercial bank member for two reasons.  First, the bank would have to meet the market deadlines of the central bank, rather than the internal deadlines of the intermediary, which, depending on the market and the particular intermediary, would result in tighter funding schedules by the UK bank. Second, there would be a greater dependency on the intermediary’s provision of liquidity to make payments when due.

In any markets, barriers to direct participation are simply cases where membership is restricted to banks with a local presence, or those that are fully licensed by the central bank in question.  This is understandable given the sensitivity of payments.  Further, direct participation often entails additional commitments, such as membership of local associations or other local market settlement systems. In these cases, the exceptions to ring-fencing are clear enough; it may, however, be more of a challenge to justify the use of an intermediary in markets where these restrictions are not in place.  Or, alternatively, are these requirements alerting banks to the possibility of direct participation, where the option had not previously been considered?

It is not entirely clear what may be prompting the BoE to be visiting this aspect of payments for the banks it supervises.  It is noteworthy that all UK-licensed banks will need show that they can justify their decision on how they organise payments in multiple currencies.




[1] CP37/15 – The implementation of ring-fencing: prudential requirements, intragroup arrangements and use of financial market infrastructure – October 2015, and CP25/16 – The implementation of ring fencing: reporting and residual matters – July 2016

[2] CP19/14 – The implementation of ring-fencing: consultation on legal structure, governance and the continuity of services and facilities – October 2014.

[3] Financial Services and Markets Act, Part 3, article 13.

[4] Sections 6.9 and 6.10 of CP25/16 detail these requirements, which include a Ring Fenced Bank (RFB) having to report on any intermediaries used as well as identifying the exceptions it is exercising to be an indirect member.

[5] Section 5.18 of CP19/14 states that legislation specifically prohibits Ring-fenced bodies (RFBs) from having exposures to other financial institutions

[6] Section 5.18 of CP19/14.

 

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