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Payment Systems

Payment Systems. Why is it important? Wire transfers are the dominant system of payment in the United States More than US$3,200,000,000,000.00 per day (that’s $3.2 trillion!) through the system in US alone This is 85% of payments made each day

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Payment Systems

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  1. Payment Systems • Why is it important? • Wire transfers are the dominant system of payment in the United States • More than US$3,200,000,000,000.00 per day (that’s $3.2 trillion!) through the system in US alone • This is 85% of payments made each day • Internationally important because of dominant role of US dollar as global reserve currency (If you want oil, you need dollars, they don’t take American Express!)

  2. Payment Systems • Advantages of Wire Transfers • Can handle very large sums • Can do so quickly - within hours, usually never more than a day • Funds are made immediately available to the beneficiary - unlike a check or credit card • Cost is relatively low • Traditionally available for business to business transactions

  3. Payment Systems • The basic law of wire transfers • Governed by Article 4A of the Uniform Commercial Code (UCC) • (What is the UCC?) • 1989: Article 4A, Funds Transfers, adopted, to handle growing complexity and size of transfers • Further evidence of era of financialization unleashed in late 70s.

  4. Payment Systems • Article 4A • Adopted by all 50 states • Incorporated into Regulation J, which governs activities of the Federal Reserve Bank, so now part of federal law, too. • It is a push system not a pull system: payment orders originate with an entity with resources (or right to resources) to insure payment to a beneficiary • So it is not possible to give the beneficiary the right to come and get the money - debtor initiates a “credit transfer” to creditor, not other way round

  5. Payment Systems • An example of how a wire transfer may be used: • Bay Bridge Manufacturing Co. needs to order $5 mn of steel to repair the bridge from Sonoma Steel • BBMCo sends a payment order to Wells Fargo, where it has an account, to initiate a funds transfer to Sonoma Steel • If Sonoma Steel has an account at WF, WF will debit BBMCo and credit Sonoma - an In House Transfer • If Sonoma, though, has an account at BoA, WF will send a payment order to BoA which in turn will in turn credit the account of Sonoma. • But this only works if WF has an account with BoA • If not, an intermediary of some sort is needed

  6. Payment Systems • Bay Bridge to Sonoma Steel • The intermediary can be another bank where both WF and BoA have accounts • If so, the IB will debit the WF account and credit the BoA account for 5 mn (less fees) • BoA will, in turn, credit Sonoma Steel’s account • WF will, in turn, debit BBMCo’s account

  7. Payment Systems • In theory, there can be several intermediary banks • To increase efficiency, settlement systems have emerged • The two most important: Fedwire and CHIPS • Fedwire is a combined message and gross payment system: “the message is the money” • CHIPS is a message system but with an intraday* “net settlement” system *Used to be “end of day”

  8. Payment Systems • Let’s get a bit more formal • UCC 4A defines: • “Funds Transfer” means the series of transactions, beginning with the originator’spayment order, made for the purpose of making payment to the beneficiary of the order • So, in our simple example, • BBMCo is the “originator” • WF is the “originator’s bank” • Sonoma Steel is the “beneficiary” • And BoA is the “beneficiary’s bank” • How many payment orders are there in this example?

  9. Payment Systems • Payment Orders • Defined by UCC4A-103(a)(1): “an instruction of a sender to a receiving bank, transmitted orally, electronically, or in writing to pay, or to cause another to pay, a fixed amount of money to a beneficiary” • Each step requires a separate payment order • So answer depends on the system used • If it is just WF to BoA then two payment orders • BBMCo to WF and WF to BoA • If an intermediary is used then that means another P.O.

  10. Payment Systems • The final step does not require a P.O. • Why? • UCC 4A-104(a): “A funds transfer is completed by acceptance by the beneficiary’s bank of a payment order for the benefit of the originator’s payment order.” • So, the final P.O. is the order sent by the final intermediary to the beneficiary’s bank

  11. Payment Systems • Final Steps • When the beneficiary’s bank accepts that P.O. the originator’s initial obligation to the beneficiary is extinguished. Payment has been made. • In place of the beneficiary’s right against the originator under the K, is a right against the bank • UCC 4A-406(a): originator pays beneficiary (1) at time a P.O. for benefit of beneficiary is accepted by the beneficiary’s bank and (2) in an amount equal to the order accepted by the beneficiary’s bank, but not more than the amount of the originator’s order

  12. Payment Systems • Financial Intermediaries • Fedwire • CHIPS • Available when there is no correspondent bank or for a non in house transfer • UCC allows a P.O. to be transmitted by a sender through a “funds transfer system” (defined in UCC 4A 105(a)(5)) • Fedwire • Communication and Gross Settlement • “Message is the Money”

  13. Fedwire • Owned by the 12 US Federal Reserve Banks • Transfers $1.85 trillion per business day (2004), average transaction $3.8 million [US GDP, $12.5 trillion] • What are the Federal Reserve Banks? • Quasi-governmental system managed jointly by USG and large commercial banks • Federal Reserve system consists of the board of governors, headed by Ben Bernanke and the member banks • Set discount rate, control money supply, regulate banking industry, set margin requirements for securities trading

  14. Fedwire • a real-time gross settlement system • more than 9,500 participants initiate funds transfers that are immediate, final, and irrevocable when processed. • Participants that maintain a reserve or clearing account with a Federal Reserve Bank may use Fedwire to send payments to, or receive payments from, other account holders directly. • Used to handle large-value, time-critical payments, such as payments for the settlement of interbank purchases and sales of federal funds; the purchase, sale, and financing of securities transactions; the disbursement or repayment of loans; and the settlement of real estate transactions.

  15. Fedwire Transfer

  16. Fedwire Risks • The risk to Fed from good funds and daylight overdrafts: originating banks fail to cover daylight overdrafts • Fed allows over drafts by participating banks • Peak in 2002 between $70 and 90 bn • If a bank fails with an open position, money stays with RB • Why not take the money back from RB if OB does not cover its overdraft? • Why not just prohibit overdrafts (Swiss version of Fedwire does so)?

  17. Fedwire risk management • Risk Reduction: Daylight Overdraft Ceilings • Maximum is 2.25 x capital per day and 1.50 x capital as a two week average • Self-assessment of (1) bank credit worthiness; (2) operational controls to control risk in payment systems and from customers; (3) credit policies and procedures; and (4) systems/contingency procedure • Ex-post monitoring (no automatic cutoff if exceed cap) • Special rules for branches of foreign banks • Home country subscribes to Basel: capital base is 10% of worldwide capital • Home country does not subscribe to Basel: capital base is 5% of the branch’s liabilities for unsecured overdrafts or 10% of worldwide capital for secured overdrafts

  18. Fedwire Risk Management • Overdraft Fees • Current price is 27 BP (.0027) annual rate for an 18 hour day—with a a deduction of 10% of capital • Assume a U.S. bank has $10 billion in capital and $6 billion in daily average overdrafts over an 18 hour operating day. Price per day will be: • .0027/360 x [6 - (.10 x 10 billion dollars)] = $37,500

  19. Hello, Mr. CHIPS • A private alternative to Fedwire • Until 1998 owned and operated by NYCHA (10 NYC banks: Bank of New York, Chase, Citibank, Morgan Guaranty, Bankers Trust, Marine Midland, U.S. Trust Company of New York, Fleet Bank N.A., European American, Republic National) • As of September 2005 owned by CHIPCo. which is indirectly owned by 22 large banks, three of which are foreign: Bank of Tokyo-Mitsubishi, HSBC, Deutsche Bank (NYCH is operator) • 47 participants, majority foreign, 19 countries • US$1.4 tn per day; avg. trans. = US$5 mn • CHIPS dominates international transactions but lags domestically

  20. CHIPS

  21. CHIPS Pre-2001 DNS • Bank A’s Position • Funds owed to others (sends): 25 to B and 50 to C = 75 (Vertical) • Funds owed to it (receives): 50 from B and 100 from C = 150 (horizontal) • Net: net claim (creditor) for 75 (150 receives - 75 sends) • Bilateral Positions with A • B: net debtor for 25 (sent 50 - received 25) • D: no position (no sends or receives)

  22. CHIPS DNS Transactions among Four Participants in a Funds Transfer Clearinghouse p. 403

  23. What happens if D fails? Delete and Unwind A B C D Net Pre-Failure 75 25 50 -150 0 Post-Failure 75 -50 -25 xx 0 • Is A Unaffected? • What can A do if B & C do not come up w/ A’s 75? • What will the Fed do?

  24. CHIPS “delete and unwind”

  25. CHIPS: pre-01 risk reduction • Bilateral Credit Limits: Set by each participant on each other participant (net of receives - sends) • Example: X sets 1000 limit on Y, so that receives from Y MINUS sends to Y cannot exceed 1000 • Net debit caps: 4% of the sum of all bilateral credit limits extended to a participant • Too high to make a difference • Collateralized Additional Settlement Obligations (ASO)—loss sharing (post 1991) (used T-bills)

  26. The new and improved CHIPS • Pre-funded balances based on past activity, can be increased during day (average $2.8 billion per day, 2005) • Balances cannot go below zero or over two times initial balance (ceiling limits ability of any bank to dominate traffic) • Payments settled during day by bilateral or multilateral netting against balances by a balance release algorithm designed to get the most settlement out of the available balances • End of day net settlement: unsettled messages returned to sender

  27. Remaining issues for CHIPS • Suppose Bank F, a CHIPS participant, fails at the end of the day. • Suppose Bank A has sent $7 billion to Bank F (the failed bank) during the day and received $6 billion (the difference funded by A’s pre-funded balance) • If netting respected by F’s bankruptcy trustee, no claims either way. • If netting not respected by F’s bankruptcy trustee, A would claim $6B in B’s bankruptcy • Note: not out $7 billion, because debited customers for those transfers • U.S. banks still have a significant risk that netting would not be respected by a foreign bank’s bankruptcy trustee

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