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Financial Sector Legal and Regulatory Toolkit : Part Two: Preconditions and Infrastructure for Financial Sector Development
D. Payment and Settlement
A payment system defines the procedures, rules, standards, and instruments used to exchange financial value between two parties discharging an obligation. Payment transactions have two parts: the flow of payment instructions and the flow of funds. These two flows are always related, but may follow different paths and have different timings. Payment methods are the instruments, procedures, and institutions which enable users to meet payment obligations. Traditionally, payment methods have been classified as credit or debit transfers depending on whether the payor's payment instructions are given direct to its bank (credit transfer) or pass via the payee (a debit transfer). Payment methods are paper- based, electronic or a combination of both. An additional classification divides payment systems into small and large-value systems. A 1996 study [ PDF ] concludes that five attributes determine a country's payment structure and illustrate the critical areas that will affect emerging market economies as they seek to modernize their own payment systems:
Ineffective payment, settlement, and custody arrangements undermine the proper functioning of financial markets. As early as 1992, a report [ PDF ] concluded that effective, efficient payment systems are vital for the economic development of emerging economies (Listfield & Montes-Negret, 1994). Efficient payment systems help promote the development of commerce, enhance economic policy oversight, control the risk inherent in moving large values, and reduce the financial, capital, and human resources devoted to the transfer of payments. The authors recommended that a new payment system should be kept simple because many such countries lack the infrastructure and banking sophistication to leapfrog from basic to state-of-the-art payment systems. The first task is therefore to fix the most serious problems. The second is to upgrade the current systems incrementally, to meet basic standards of timeliness, security, and reliability. Development of the system should follow a disciplined plan for defining the needs of users and for organizing the project team and project goals.
In the area of payments and settlements, two organizations have been active. The first, the Committee on Payment and Settlement Systems (CPSS), which operates under the aegis of the G-10 central bank governors at the BIS, addresses issues related to the development of practices fostering efficient and viable payment and settlement systems and has established a set of core principles for payment systems. The second, IOSCO's Emerging Markets Committee, in which regulators from 64 emerging market countries participate, has released a report [ PDF ] proposing the basis for the development of a legal framework for clearance and settlement in emerging markets. The report highlights the main legal concerns, which must be addressed in order to achieve an efficient clearance and settlement system for securities in emerging markets. Released in January 2001, the CPSS "Core Principles for Systemically Important Payment and Settlement Systems" [ PDF ] is the key standard in the area of payment and settlement. According to the FSF, the document sets out core principles for the design and operation of systemically-important payment systems. The Core Principles are general principles that do not represent a blueprint for the design or operation of any single system, but suggest the key characteristics that all systemically important payment systems should satisfy. They delineate ten principles to achieve the policy objective of safety and efficiency in systemically important payment systems: The central bank's four responsibilities in applying the Core Principles are also established. It should IOSCO released in January 2001 a report that identifies minimum requirements that securities settlement systems should meet and the best practices for which systems should strive. These encompass the legal framework for securities settlement, risk management, access, governance, efficiency, transparency, and regulation and oversight. The recommendations are designed to cover all systems for securities, including equities, corporate and government bonds and money market instruments, and securities issued in both industrialized and developing countries. They also aim to cover settlement of both domestic and cross-border trades. In relation to legal risk, securities settlement systems should have a well-founded, clear, and transparent legal basis. In relation to pre-settlement risk, trade confirmation should occur no later than the trade date, with rolling settlement occurring no later than three days after trading. Central counterparties (CCPs) should be considered and securities lending and borrowing should be encouraged. In relation to settlement risk, central securities depositories (CSDs) are encouraged and should implement appropriate risk controls, along delivery versus payment settlement. Final settlement should occur not later than the end of the settlement day with real-time settlement preferred and should be secure. Appropriate systems and contingency plans should be developed to reduce operational risk and custodians should employ appropriate procedures to protect customer assets to reduce custody risk, including protection from claims by custodian creditors. In addition, CCPs and CSDs should have appropriate objectives and governance structures, along with objective and transparent criteria for participation permitting fair and open access as well as transparency in their operations. Further, securities settlement systems, in addition to safety and soundness, should also be cost-effective and efficient, use appropriate communication procedures, and be subject to effective regulation, with central banks and securities regulators working together. Finally, CSDs with cross-border links should design and operate such systems so as to reduce cross-border settlement risks. In addition to the two key standards, the FSF Compendium also includes a number of other standards under the subheadings of banking and securities. Payment and settlement standards for banking address real time gross settlement systems [ PDF ] (RTGS), foreign exchange settlement risks [ PDF ], and interbank netting [ PDF ]. Payment and settlement standards relating to securities address OTC derivatives settlement [ PDF ], clearing of exchange-traded derivatives, and delivery versus payment systems [ PDF ]. In addition to the considerable body of guidance which has been developed for payment and settlement systems, as a result of the global financial crisis, much attention is currently being paid to settlement arrangements for OTC derivatives, especially credit default swaps (CDS), with the G-20 and the FSF committing to the establishment of central counterparty settlement arrangements to underpin these markets. At the same time, to date, payment and settlement systems outside of the OTC derivatives context have not been an issue in the global financial crisis. At the end of 2002, the IMF and the World Bank conducted a review of FSAP/ROSC experiences [ PDF ] to date. The assessment revealed a number of weaknesses, with many systems failings to meet a number of standards, especially in relation to legal basis. As a result of these identified issues, the World Bank and the IMF with the CPSS developed additional guidance in the area. Office of the General Counsel
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