A major payment system reform

The benefit enjoyed by the customers through faster means of funds transfer for efficient treasury
management will be evident when the system is fully operational, says M. R. Ramesh.
THE INTRODUCTION of Real Time Gross Settlement (RTGS) system is a major initiative taken by the
Reserve Bank of India in the area of payment system reforms. In fact, in a majority of countries, migration
to an RTGS environment is considered a core objective of payment reforms especially where it involves
accessing cross border settlements. All major financial centres now operate RTGS systems and India will be
joining the big league. Moving over to RTGS is indicative of robustness of the country's payment system.
No settlement risk
The RTGS system is a large value funds transfer arrangement. It effects final settlement of inter-bank funds
transfers continuously throughout the business day on a transaction by transaction basis. Inter bank funds
transfers are considered final, in the sense that they are irrevocable and unconditional, only when the
transfer of balances takes place on the books of the central bank ( that is, in central bank money). This is
precisely what is achieved through RTGS payments. In short, RTGS completely eliminates settlement risk
(counter party credit risk) by ensuring payment v/s payment or delivery v/s payment on a gross individual
transaction by transaction basis.

Types of transaction
* Inter-Institutional
* Customer payments
* Delivery v Payments
* Multilateral net settlements

Drawback of alternative system

An alternative followed in many places for managing large value payments was the multilateral Deferred Net
Settlement (DNS) system. In a DNS system, the participant banks' individual payment messages are netted
and the net amount is settled at a specified time, typically at the end of the day. There are two major
drawbacks in such a system :
(1) The settlement risk is carried by the counter parties till the end of the day
until the settlement is complete.
(2) There is a systemic risk in the sense that if a party defaults, the transactions
are to be unwound , that is, all transactions involving the defaulting party
have to be taken out and the netting carried out giving fresh obligations to the participating entities.
This may lead to a domino/knock on effect resulting in fresh problems. However, the DNS system provides
substantial benefits to the participants by way of reduced liquidity need consequent to multilateral netting
and day end or one-go settlement.

One of the ways devised to get over such systemic risk was to make the DNS system more secure. This was
achieved by following strict risk management procedures such as ensuring that no disruption is caused even
if the institution with the largest net obligation fails, by having some committed liquidity arrangements,
participating members following risk management measures with bilateral limits, fixing net debit caps on
participants, and asking participants to post collaterals. In some cases, the clearing house that does the
netting extends its guarantee to the participants by acting as the central counter party (CCP) with well
defined risk management procedures to ensure that it is fully covered for the risk it undertakes. In fact, the
Committee on Payment and Settlement Systems (CPSS) of IOSCO - Bank for International Settlements
(BIS) has framed guidelines for comprehensive standards for risk management for CCPs.
The settlement process undertaken by the Clearing Corporation of India (CCIL) for the security of foreign
exchange transactions is a secured DNS fully in conformity with international standards, with the CCIL acting
as the CCP guaranteeing the settlement. In many countries, the secured net settlement systems and RTGS
are run concurrently.
Critical liquidity management
As indicated earlier, RTGS is meant for large value payments and since the transactions are settled on a
gross basis liquidity management becomes critical. The participants may need large intra-day liquidity and
possible sources for such liquidity are the reserve balances maintained with the central bank, inflow from
other participants by borrowing in the call money market or otherwise and finally credit extended by the
central bank, and all these come at a cost. The actual operation of the RTGS system may vary from country
to country depending on the policy stance taken by the central bank of the country. The RBI has already
framed guidelines for operationalising the RTGS system, in terms of which the following types of transaction
are to be handled by the system :
(a) Inter-Institutional,
(b) Customer payments,
(c) Delivery v/s Payments
(example, security settlements),
(d) Multilateral net settlements.
The membership will be of four different categories depending on the type of transactions the entities are
allowed to handle.
The Category A members will be scheduled commercial banks which will handle both (a) and (b) type
transactions, Category B will be essentially primary dealers who will not be allowed to handle type (b)
transactions.
Category C will be entities that have a current account with the RBI and participate in the money market
and these will participate through a sponsor bank
( Category A member). Category D will be the clearing and settlement entities handling type (d)
transactions.
The privileges available to the members vary. For example, only Category A and B will be allowed intra-day
liquidity by the RBI which will be collateralised, while a Category C member can have credit lines with the
sponsor bank for its liquidity needs.

The net settlements (such as CCIL) may also go through RTGS and instead of one end-of-day settlement
there can be settlements in batches bringing down the settlement time.
A dedicated settlement account is to be opened by members of Category A and B with the RBI for putting
through RTGS transactions.
These members can use their reserve cash balances for intra-day liquidity needs by transferring them to the
settlement account.
At the end of the day, the balance in the settlement account will be swept back to the current account
holding the reserve balance. The handling of transaction initiated by the paying member will be on a first - in
- first - out basis (FIFO).
The member can also assign priority to its messages and change the priority before it is acted upon. A
standing committee with market participants as members has been formed by the RBI for management of
the RTGS system. Trial run has already commenced with participation by four banks.
All eligible entities are expected to join the system in the next three months to make the system fully
operational.
The benefit enjoyed by the customers through faster means of funds transfer for efficient treasury
management will be evident when this happens