Central Bank of Kenya

KENYA PAYMENTS SYSTEM (Framework and Strategy)

August 2004

FOREWORD

This document provides insights on Kenya payments system evolution and offers an opportunity for all stakeholders to capitalise on the gains that accrue in terms of reduced costs, risks and increased efficiency. It is through the careful implementation of the strategies outlined in this document, that Kenya payments system will reach international standards and ensure that Kenya maintains a lead role in the region and remains a preferred investment destination for growth and development.

Andrew Mullei Governor Central Bank of Kenya

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STATEMENT

A silent revolution is taking place in the worlds entire payment system. Kenya, along with the other East African countries, has joined the list of countries that have realized the importance of managing an important aspect of national economic life - the payments system. Citizens of East Africa are dealing with a plethora of increasingly complex financial and transactional products and systems. The National Payment System Project, currently a partnership between the Central Bank of Kenya and the Kenya Bankers Association, is seeking to bring together all the systems, mechanisms, institutions, agreements procedures, rules and laws that enable the circulation of money. The scope is not limited to the exchange of value only in cash terms, but encompasses non-cash payments, and, critically, the inherent systemic risks underlying the payment system. The vision and strategy articulated in this document is the first bold step to building the payment system in Kenya, and the region, to world-class standards. The benefits that will accrue include: Reduction of risk arising from payment exposure, for both the public and banks. Safe and efficient means of exchanging value between transacting parties. Promotion of Kenya as an international market and a regional financial centre. To attain this vision a lot of work will be required. In the coming months, the National Payments System will critically examine: Risk-reduction measures that support effective inter-bank exposure management. Legal and regulatory reforms that provide adequate protection for existing and envisaged payment practices. Shared payment systems that avoid duplication. Expanded payment systems that integrate both rural banking schemes and micro-finance arrangements. Integration of networks and activities with other service providers and regulatory bodies. Efficient and effective payment modes. The above list is not exhaustive, but it does provide an important and useful starting point.

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In these endeavours, the National Payments System shall not lose sight of the concerns and interests of the most important stakeholder, the banking public. Recently, the Kenya Bankers Association launched The Banking Code, a set of minimum service standards for personal customers across all banks. The forthcoming challenges include the introduction of credit referencing for consumer credit and direct debit for organizations that receive large volumes of payments.

Terry Davidson Chairman Kenya Bankers Association

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TABLE OF CONTENTS
EXECUTIVE SUMMARY............................................................................ vii 1 INTRODUCTION ........................................................................ 1

1.1. 1.2. 1.3. 1.4. 1.5.

2

Preamble..................................................................................................1 Introduction ..............................................................................................1 Components of a Payment System .........................................................2 Stakeholders in a Payment System .........................................................3 Purpose of this document ........................................................................3
CURRENT NATIONAL PAYMENTS SYSTEM ENVIRONMENT. 5

2.1. 2.2. 2.3. 2.4. 2.5. 2.6. 2.7. 2.8. 2.9.

3

Introduction ..............................................................................................5 General Legal Aspects.............................................................................5 Institutional aspects..................................................................................6 The Role of Central Bank of Kenya .........................................................7 Banking Associations and Groupings ......................................................8 Payment Media: Means of payment used in NPS. ..................................9 Automated Clearing House (ACH).........................................................10 Securities Settlement Systems ..............................................................10 Problems and Weaknesses in the Present Payment System:...............11
STRATEGIC FRAMEWORK...................................................... 13

3.1. 3.2. 3.3. 3.4. 3.5. 3.6.

4

Primary Goal ..........................................................................................13 Objectives ..............................................................................................13 Vision .....................................................................................................13 Critical Success Factors.........................................................................14 Fundamental Principles .........................................................................15 NPS Reform Strategies..........................................................................18
BUSINESS PROCESS MODELLING AND ARCHITECTURE .. 23

4.1. 4.2. 4.3. 4.4. 4.5. 4.6.

5

Introduction ............................................................................................23 Conceptualising the NPS Model ............................................................23 The Payment Process............................................................................24 The Clearing Process.............................................................................25 The Settlement Process.........................................................................25 Risk Monitoring ......................................................................................26
NPS STAKEHOLDERS AND ROLES........................................ 27

5.1. 5.2.
6

Introduction ............................................................................................27 Stakeholders ..........................................................................................27

IMPLEMENTATION STRATEGY............................................... 33

6.1. 6.2. 6.3. 6.4. 6.5. 6.6.

Background ............................................................................................33 Realisation of the vision .........................................................................33 Implementation Approach ......................................................................33 Phasing of the Implementation Process ................................................34 Project Plan............................................................................................34 Implementation Schedule ......................................................................34

COUNTRY PROFILE..................................................... 35 PROVISIONAL IMPLEMENTATION SCHEDULE......... 38 THE BIS CORE PRINCIPLES AND CENTRAL BANK RESPONSIBILITIES ....................................................... 39 APPENDIX IV: GLOSSARY OF NPS TERMS AND ABBREVIATIONS 41

APPENDIX I: APPENDIX II: APPENDIX III :

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EXECUTIVE SUMMARY

INTRODUCTION This Framework and Strategy provides an overview of the Kenyan National Payment System and lays a strategy for the future. A payment system is an essential part of the financial infrastructure in a market economy where the organisation and operation of monetary, banking and payment systems are largely determined by the needs of the market. The document further articulates an overview of the NPS conceptual design. The benchmark is to focus in the present and the future payment systems needs of the economy and the milestones for their accomplishment based on best international standards and practices. Furthermore, the NPS vision aims at reducing the dominance of cash instrument usage and promoting minimal risk and irrevocable non-cash based instruments of exchange. CURRENT NPS OVERVIEW Kenya is rich in number and type of financial institutions, with the Central Bank at its apex, it has a well-developed financial market with over sixty financial intermediaries providing payments services and credit facilities to the public and businesses. In addition, there is a Capital Market Authority, Stock Exchange and a developed Money and Capital market with all the attendant traditional financial instruments available in an international centre. The clearing of payment between banks has been efficiently processed through the Automated Clearing House for clearing of Magnetic Ink Character Recognition (MICR) based technology cheques and Electronic Funds Transfer (EFT) payments. Cash is the most common form of payment media used. However, it has the major disadvantage of being insecure, bulky and costly to produce. The Central Bank of Kenya is encouraging the population to move to non-cash payment instruments such as payment cards and electronic money. The development of financial infrastructure has become a top priority in the economy and the Central Bank is at the forefront to ensure that an efficacious system is developed and maintained to facilitate smooth operations of payment systems and the stability of the financial markets.

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PURPOSE OF DOCUMENT This document provides the basis and strategy for the reform and modernisation of the Kenyas NPS. It is modelled along the vision described herein, of achieving a diversified, resilient, effective and secure payment environment for all sectors of the Kenyan economy. The efforts of the NPS Project team in documenting the Framework and Strategy is motivated by the importance attached to an efficient, secure and robust NPS to the modernisation of the economy and its impact on monetary policy execution and financial stability. PRIMARY GOAL OF THE ENVISAGED NPS The envisaged vision for the NPS is to put in place a developed and modern payment system that is effective, efficient, secure, accessible, reliable, robust, viable and demand-driven. The kind of payment system that facilitates the flow of money within all sectors of the economy in the face of technological advancement is target. This will entail having an open competitive NPS architecture with varied financial instruments, rules and regulations available to all players in the system. The NPS development will be geared towards the exploration of an explicit legal framework to support the payment systems modernisation process by introducing regulations and laws in relation to Electronic Funds Transfer, E-Banking, EMoney Schemes and Products, and Anti-Money Laundering Laws etc, that support NPS practices and agreements, so as to enhance international recognition of Kenya as a viable regional and an international financial centre. A review of the legal and regulatory framework will support the statutory powers of CBK regarding payment systems and adaptation of a legal framework. This will ensure legal enforceability and sole overseeing of payment service agreements and legal certainty in respect of industry practices especially in areas of risk containment within the clearing and settlement circuits. All inter-bank exchange functionalities will be settled at the centralised accounts held at Central Bank where risks related to finality and irrevocability of clearing and settlement arrangements will be contained by way of having mandatory collateralisation practices and a move towards real time settlement using Real Time Gross Settlement (RTGS). NPS PROJECT OBJECTIVES To embrace the virtues of the envisaged NPS, many changes to the existing payment practices will have to be made especially in the areas of systematically important payments system arrangements. It is in this context that the NPS Project is articulating the following objectives: -

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 To promote the efficiency and effectiveness of the payments, clearing and settlement systems. To provide a variety of instruments and mechanisms for an integrated, modern and technologically sound payment system for transfer of funds between transacting parties. To facilitate irrevocability of payment and finality of settlement arrangements. To reduce the length of payment cycles for high value payments to same day settlement by implementing Real Time Gross Settlement (RTGS) system. To enable the management, reduction and containment of systemic and other payment-related risks. To develop and put in place a sound legal framework that will support the reformed payment regime. To promote the emergence of Kenya as a competitive regional and international financial market. To create public awareness on the various available options in the payments industry. The roles and responsibilities of all the stakeholders are also discernibly defined and specified in the document. NPS INSTITUTIONAL FRAMEWORK The National Payment System strategy will involve all the stakeholders whose roles and responsibility will need to be clearly defined. The NPS Council will be the supreme policy organ and will be chaired by the Governor of the Central Bank. The NPS Operations (Steering) Committee will transform itself into a policy body called NPS Steering Committee that will keep consulting other NPS-related service providers, e.g.: Telkom Kenya Ltd., Kenya Power Ltd., Nairobi Stock Exchange, Giro Banks, Postal services and other Information Communication Technology (ICT) regulatory bodies, such as The Communication Commission of Kenya (CCK). This Committee will be mandated to steer the NPS Project as elaborated in this document. FUNDAMENTAL PRINCIPLES The designing and development of the Payment System will need to consider several factors that will act as guiding principles in the development of a National Payments System. The guiding principles will form the basis on which the payment needs of the country will be developed and managed. All banks will thus be required to have settlement facilities at the Central Bank of Kenya and participate in inter-bank clearing. Every bank participating in the NPS will need to take responsibility for the risk it introduces into the payment system. Risk control measures and the legal framework will therefore need to be put in ix

place so as to support NPS practices and agreements. The ultimate responsibility for overseeing the NPS will be vested on the Central Bank of Kenya. Finally, the strategic approach will be followed based on the understanding of the following assumptions and fundamental principles: REFORM AND NPS MODERNISATION STRATEGIES The main strategies for aligning the current and rudimentary payment system with the envisaged NPS includes Systemic Risk Reduction measures; Legal and Regulatory framework adequacy; measures towards interfacing trading practices and financial markets and NPS and payment practices; a structured NPS Governance structure and lastly making Nairobi a regional and international financial centre. IMPLEMENTATION STRATEGY The NPS major objectives in the reform and modernisation as articulated in this strategy document will be undertaken in phases with a migration plan that combines both short and long term upgrading parameters. A phased and evolutionary approach will continue to be followed via short-term strategies/projects and medium/long term strategies/ projects. CONCLUSION The NPS modernisation and Reform process is a daunting task full of challenges. Its evolution will take the concerted effort by all stakeholders for the benefit of all Kenyans. With improvements in the NPS, the volumes of payment transactions executed through the banking system are predicted to increase tremendously after the year 2005. By strengthening the operational capacities of banks, and enabling them to provide a range of new innovative banking products and services to their customers, the future of payment system will meet the demands of a fast growing market-oriented economy and align itself to the internationally accepted best practice. The success of the NPS vision hinges on the expected high level of cooperation from payment service providers, regulatory authorities, the banking industry as a whole and the public at large.

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1 1.1.

INTRODUCTION

PREAMBLE Efficient payment systems are vital for the proper functioning of financial markets. A well-functioning payment system is essential for both an efficient financial sector development and increasing confidence in the banking sector. The Central Bank has the overall responsibility of achieving financial stability in the financial sector. In this regard, the Central Bank has to ensure that banks and other stakeholders operate in a stable and efficient financial market and that the payment, clearing and settlement system functions smoothly. A well functioning payment system will facilitate the effective execution of monetary policy, bank supervision, currency issuance and distribution functions, financial stability and confidence.

1.2.

INTRODUCTION

1.2.1. Definition: A Payment System can be defined as a system that facilitates the process of making payments. It consists of a set of payment instruments, banking procedures and inter-bank funds transfer that enable the circulation of money in an economy. A National Payments System (NPS) comprise of the Central Bank, the Government, Commercial Banks, and Financial Institutions, Payments System Providers, Laws, Rules and Regulations governing the payment system, technology and physical infrastructure and users. 1.2.2. Terminology: The term NPS is used to describe all payment mechanisms and encompasses the underlying role players (stakeholders) systems, agreements, associates, technology and legislation. It encompasses all payments-related activities, processes, mechanisms, institutions and users. The term NPS thus refers to payment systems in the widest context and is not restricted to NPS mechanisms only as the term NPS mechanism is strictly used to refer to the physical infrastructure, for example, payment processing utilities, networks, computer systems etc.

1.3.

COMPONENTS OF A PAYMENT SYSTEM The components of a payments system include:

1.3.1 Banks and Financial Institutions: banks, post office savings banks, building societies, mortgage finance companies, forex bureaus and cooperative societies (SACCOS). 1.3.2 Providers of access to payment related services: e.g. Information Technology Solution Providers, SWIFT, etc. 1.3.3 Customers: individuals, governments, etc. companies, organisations, institutions,

1.3.4 Legal and statutory framework: appropriate legislative provisions governing the system. 1.3.5 Rules, Regulations and Agreements: govern the rights, duties and obligations of the participants in the system. 1.3.6 Payment and Settlement Transactions: represent the various activities undertaken that will require the exchange of values between the transacting parties. 1.3.7 Payment and Settlement Systems: represent the various processes and channels undertaken to realise the exchange of values between the transacting parties. 1.3.8 Payment Instruments and Streams: consist of cash, cheques, debit and credit cards, ATM cards, postal and money orders, Electronic Funds Transfers, Electronic Funds Transfer Point of Sale (EFTPOS), smart cards and vouchers. 1.3.9 Clearing instruments: cheques, Electronic Funds Transfer (EFTs) and both direct credits and debits. 1.3.10 Infrastructure: These are systems processes and procedures. They support the functioning of the payment systems and consist of telecommunication, power and transport systems.

1.4.

STAKEHOLDERS IN A PAYMENT SYSTEM This includes everyone that has an interest in the payment system. This interest can be through ownership, use or service provision to any component(s) of the system. The stakeholders include: Central Banks Banking Industry Infrastructure Providers e.g. Automated Clearing House, Telkom International Card Operators e.g. VISA, transaction switches. Service Providers and End-Users/Customers (Individuals and companies). Regulatory Bodies and Government. International Monetary bodies such as Bank for International Settlements (BIS), International Monetary Fund (IMF), etc.

1.5.

PURPOSE OF THIS DOCUMENT

This document is the result of a joint effort of the Central Bank of Kenya and the Kenya Bankers Association. It reviews the current status of the NPS, the reform agenda undertaken since the mid 1990s when the automation of the cheque clearing system started; the limitations and obstacles to the modernisation process, the pronounced NPS goal, vision and the strategic approach to its realisation.

2 CURRENT NATIONAL PAYMENT SYSTEM ENVIRONMENT

2.1

INTRODUCTION The Central Bank of Kenya is aware of the numerous benefits that can accrue from an efficient payment system, especially in its role in the effective implementation of the monetary policy operations, and ensuring financial stability. It is jointly collaborating with Kenya Bankers Association in coordinating the modernisation and the reform programme of the payment systems in Kenya. Other stakeholders will be incorporated at various stages of implementation of this strategy.

2.2

GENERAL LEGAL ASPECTS Banking business and the conditions in which banks operate in Kenya are governed by the Banking Act and Central Bank of Kenya (CBK) Act. Other legislations include Bills of Exchange Act, Companies Act (Insolvency Law included therein), Building Societies Act and Cheques Act, among others. Laws relating to the use of cheques are derived from the English law mainly the Cheques Act of 1957 and the Bills of Exchange Act 1882. In Kenya, there is no law that explicitly and exclusively deals with payment systems. However, in its current form, The Central Bank of Kenya (CBK) Act, as amended in 1996, gives the Bank powers to oversee and regulate the payments systems. Section 4A (d) of the Central Bank of Kenya Act provides that the Bank shall promote the smooth operations of payments, clearing and settlement systems. Section 4A (f) further stipulates that the Bank has the sole right to issue currency notes and coins. The new statutes recognise these two tasks as part of the fundamental responsibilities of the Central Bank. To promote public confidence in the banking system, a legal mechanism for liquidating the assets and paying off the liabilities of the failed banks and financial institutions has been bestowed upon the Deposit Protection Fund Board within the Banking Act. There is also an Act of Parliament governing the Central Depository System for trading in equities debt instruments on the Nairobi Stock Exchange.

The CBK is already exploring the need for an explicit legal framework to support the modernisation process of payments systems. This includes introducing regulations and laws in relation to Electronic Funds Transfer, E-Banking, E-Money Schemes and Products, Money Laundering Law etc. 2.3 INSTITUTIONAL ASPECTS

2.3.1 Financial intermediaries that provide payment services Major institutions which provide payment services in Kenya are Commercial Banks, Non-Bank Financial Institutions, Post Office Savings Bank, Specialised Financial Institutions, Building Societies and Mortgage Finance Companies, Forex Bureaus. 2.3.2 Credit Institutions Kenya is rich in variety and number of financial institutions, and has a good depth of financial assets compared to most Sub-Sahara African countries. With the Central Bank regulating and supervising the banking system and managing monetary policy operation, at the apex, the industry is a pyramid of financial activity comprising 48 commercial banks, 13 nonbank financial institutions and 2 mortgage finance companies. There is also a large number of non-bank financial institutions segment comprising 4 Building Societies, 37 insurance companies, 20 micro-finance institutions, 57 hire-purchase companies, and some 2,670 Savings and Credit Co-operatives Societies. 2.3.3 Specialised Financial Institutions There are about 10 or so specialised organisations set up by the Government to assist the specific sectors of the economy; these include the Agricultural Finance Corporation, Agricultural Development Corporation, Industrial and Commercial Development Corporation, Kenya Industrial Estates, and the Industrial Development Bank among others. 2.3.4 Other Institutions Currently there about 1300 registered administrators of pension schemes in Kenya with an estimated portfolio of Kshs 140 billion, which is 27% of GDP. Kshs 59 billion is held by the National Social Security Fund (NSSF), which is a mandatory pension scheme. There are about 1100 other private registered pension and provident fund providers countrywide. The Retirement Benefits Authority Act, 1997 governs operations within the sector.

2.3.5 The Post Office The Post Office has three main instruments: The Ordinary Money Orders that can be drawn for any sum up to a prescribed maximum per order and which identify the recipient and are en-cashable only at specified Post Offices. The Telegraphic Money Order which guarantees customers same day value. The Postal Order is a bearer instrument which can be encashed at any Post Office. The main advantage of the Post Office is accessibility by virtue of having a large network reaching almost every township in the country. 2.4 THE ROLE OF CENTRAL BANK OF KENYA The Central Bank of Kenya Act empowers it to "promote smooth operation of Payments, Clearing and Settlement Systems". The CBK participates in the payment system in the following ways: 2.4.1 As a user of payments system: The Central Bank has its own transactions to carry out requiring the movement of funds. 2.4.2 As a member of payments system: It is both a member and supervisor of the Clearing House. 2.4.3 As a provider of payments system: The Central Bank of Kenya provides clearing and settlement services on a net-multilateral arrangement at the Nairobi Clearing House. This is done on behalf of Kenya Bankers Association (KBA). 2.4.4 As a guardian of public interest: Acting as a systems regulator, arbitrating in the event of complaints and handling compensation procedures. 2.4.5 As a facilitator of daily settlement: This involves facilitating commercial banks obligations arising from their payment system activities by using their centralised settlement and clearing accounts domiciled at Central Bank. 2.4.6 As an Overseer of Payment Systems: The Central Bank has formal authority relating to the supervision of payment system. This is in keeping

with Central Bank Responsibility No. 3 of the BIS Core Principles for Systemically Important Payment Systems. The oversight approach has been facilitated through a combination of cooperation and consultation with the banking industry. The reform and modernization process has been facilitated by the National Payment System Operations Committee, a joint committee of the Central Bank and the Kenya Bankers Association. The NPS Division forms the secretariat. 2.4.7 On a regional front, there is an East African Payment System Harmonisation Committee comprising of the respective technical teams drawn from the three NPS units of the three Central Banks. 2.5 BANKING ASSOCIATIONS AND GROUPINGS The following groups, committees and associations are involved in National Payment Systems. 2.5.1 Kenya Bankers Association: An association of banks that safeguards and raises matters of common interest with regulators and government. It works through various sub-committees. 2.5.2 The Clearing House: Owned by Kenya Bankers Association, its membership is limited to licensed banks including CBK who meet KBA prescribed terms and conditions. It is managed by CBK on behalf of KBA. Its main role is to facilitate settlement of clearing instruments such as, cheques, EFTs, Direct debits and credits. 2.5.3 National Payments Systems Operations Committee: This is the steering and decision making body on National Payment Systems in Kenya with membership from KBA and CBK officials. 2.5.4 NPS Technical Committee: This comprises experts drawn from KBA Member banks and CBK. It is responsible for the overall strategy formulation and framework design pertaining to payment systems in Kenya. 2.5.5 Kenya Swift User Group: This is a committee of SWIFT users in Kenya.

2.6

PAYMENT MEDIA: MEANS OF PAYMENT USED IN NPS.

2.6.1 Cash Payments: the most common form of payment because it is readily accepted. 2.6.1 Non Cash Payments: 2.6.2.1 Cheques Cheques are the major non-cash payment instruments in Kenya accounting for over 90% of all non-cash payment. The bulk of cheques issued in Kenya bear the MICR code line. These cheques are cleared in T+3 days in most parts of the country and (T+1) day for high value (i.e. Shs.10m and above). Cheques from remote centres are cleared on (T+10). 2.6.2.2 Payment Cards

These have taken a significant leap within Kenyas non cash payment instruments segment. They include different cards: credit, debit and prepaid, with credit cards being the most common. 2.6.2.3 2.6.2.4 Electronic Funds Transfers through the Clearing House Electronic Funds Transfer: Credit

EFTs is used for transferring value through the Clearing House among banks and on behalf of their customers. On conclusion of days settlement value is given on a same day basis. Finality and irrevocability is guaranteed. 2.6.2.5 Electronic Funds Transfer: Direct Debits

These are pre-authorised by the paying customer who gives permission for his bank to debit his account upon receipt of instructions initiated by the receiving customer e.g. insurance or mortgage companies. 2.6.2.6 EFTs through SWIFT Majority of the banks are members of the Society for Worldwide Interbank Financial Telecommunications (SWIFT). It is a requirement by CBK that

any interbank transfer must be through SWIFT. The banks are connected to SWIFT either directly or through a bureau. 2.7 AUTOMATED CLEARING HOUSE (ACH) The clearing and settlement arrangement is divided into two sessions and there are no limits to the value of credit or debit items that pass through the Clearing House. 2.7.1 Cheque Clearing Process: Presently, all commercial banks have settlement accounts at the Central Bank and credit extended to them for settlement purposes has to be covered by collateral. There are no intraday arrangements or intraday controls on net debit balances. In the Clearing House, banks are exposed to clearing and settlement risk and the unwinding of all instruments of a defaulting bank is the ultimate solution in the event of failure to settle. However, the Central Bank in conjunction with the industry is planning to come up with management and containment of these risks. 2.7.2 Credit and Liquidity risks The cheque clearing system is exposed to both credit and liquidity risk. A Failure to Settle Mechanism to mitigate these risks is currently lacking. The situation is aggravated by the lack of an automatic settlement overdraft facility from the Central Bank. In terms of liquidity risk the participating banks are exposed due to lack of mechanism to facilitate final settlement by member banks. 2.8 SECURITIES SETTLEMENT SYSTEMS Major categories of financial instruments commonly traded in Kenya include, Equity Securities, Corporate Debt Securities, Treasury Bonds and Bills. 2.8.1 Government Securities Government Securities include Treasury Bills that are short term (1-12 months) and Treasury Bonds, which are medium Term (1-10 years). Investors are required to open a Central Depository System (CDS) Account with the CBK. The CDS is a paperless book entry account used as evidence of investment instead of paper certificates. On redemption,

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the CDS account holder, is paid by an electronic credit (EFT/SWIFT) to his/her commercial bank account. 2.8.2 Equity Securities: Capital Markets Authority (CMA) and Nairobi Stock Exchange (NSE) Capital Markets Authority (CMA) is the regulator of capital markets in Kenya. CDS accounts are opened for listed companies in the Nairobi Stock Exchange. Trading is currently manual and there are plans to automate it. 2.8.3 REAL TIME GROSS SETTLEMENT SYSTEM (RTGS) The conceptual design for RTGS is being finalized for implementation in 2005. 2.9 PROBLEMS AND WEAKNESSES IN THE PRESENT PAYMENT SYSTEM:

2.9.1 Risks Associated with Payment Systems Risk in payment systems refers to the possibility/threat/danger of payments being incomplete. The impact can be measured in terms of damaging value or level of confidence in payment systems. Basic sources of risks include: Failure of one of the parties to perform, time lag between trade and settlement, lack of co-ordination between delivery and payment; linked transactions triggering a chain reaction and risky settlement medium. To ensure smooth and reliable modernization of the Payment Systems, it is important to understand the inherent spectrum of risks given the increasing number of payments streams in this market. It is important to identify, measure, contain and manage these risks. It is worthwhile to note that the major payment system risks are: Credit, Custodian, Foreign Exchange, Settlement, Legal, Liquidity, Operational, Systemic and reputation risk. 2.9.2 The culture of a cash society: Cash is risky and expensive and the publics propensity to hold cash has not diminished. This is evidenced by a high percentage of cash holdings as a proportion of the money supply. People distrust cheque payments due to lack of legal meaningful penalties against cheques not honoured due to lack of funds. 2.9.3 Use of cheques by Financial Institutions to effect high-value payments: Cheques are the second most popular payment instrument in Kenya but with the advent of EFTs, now in place, and the proposed 11

introduction of RTGS System, it is expected that the use of cheques to effect high value payment will diminish. 2.9.4 Service providers of electronic payment media: Existence of credit/debit card service providers yet no mechanism for sharing elaborate information exchange infrastructure. 2.9.5 Inadequate regulatory framework to support modern payment systems: Enactment of draft bills to support modern payment systems is yet to be done. 2.9.6 Limited knowledge and expertise in National Payment Systems, within the Financial Sector. 2.9.7 Inadequate and unreliable Infrastructure programmes. 2.9.8 Lack of a co-ordinated public awareness among the payment system stakeholders.

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STRATEGIC FRAMEWORK

3.1

PRIMARY GOAL The primary goal of the NPS is: To facilitate the efficient and effective flow of value within the economy. This goal gives due cognisance to the fact that NPS has today become a core component of not only a broader financial system but also the economy at large. It is also presently viewed as the infrastructure that provides the economy with highways for processing the payments resulting from various economic activities within the Kenyan economy.

3.2

OBJECTIVES The objectives of the NPS are: To provide effective mechanisms for the exchange of value between transacting parties. To ensure finality and irrevocability of both payment and settlement. To facilitate the management, reduction and containment of systemic and other payment-related risks.

3.3

VISION It is envisaged that by the end of year 2008, Kenya will have put in place a modern payment system that is effective, efficient and secure. It will be characterised by the following features: Risks related to Payment Systems will be well understood and managed by all stakeholders. The Payment System shall be self-regulated. Settlement of all domestic inter-bank exchanges on the value date of the settlement instruction.

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 Open for all parties, both domestic and foreign who wish to provide payment services. Easily accessible to both urban and rural consumers to effect both domestic and international transactions. Efficiency and lack of duplications as shared payment infrastructure will be encouraged. Basic NPS features well understood by all including the rural populace. The Payment System will support electronic trading in both the securities and foreign exchange markets. The Payment System will be compliant with international standards, practices and compatible with other international payment systems. 3.4 CRITICAL SUCCESS FACTORS The success of the NPS Vision will be measured against the achievement of the following: 3.4.1 NPS Awareness: All the stakeholders know the NPS basic objectives and features. 3.4.2 NPS Risk Management: All participants have a clear understanding of the risks they run in the NPS and their liability. All payment streams contain appropriate risk-control and containment measures. 3.4.3. NPS Management: Clearly defined structures, roles, responsibilities and relationships among the established bodies and stakeholders. 3.4.4. Irrevocability of Settled Transactions: All interbank settlement instructions processed through the Central Bank System are final and irrevocable. 3.4.5. All Eligible: The system is open to all eligible participants subject to laid down criteria. 3.4.6. NPS Accessibility: Payment services are accessible to all irrespective of whether they are in the metropolis, remote rural areas, banked or unbanked.

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3.4.7. Facilitation of Monetary-policy Execution: The NPS mechanism enhances the ability of the Central Bank to execute monetary policy. The NPS provides banks with the necessary information to manage their demand for Central Bank money and to react immediately to new market conditions or to unexpected shortages or surpluses. 3.4.8. Sound and Supportive Legal Frameworks: Appropriate legislative and regulatory framework recognising agreements between parties are in place and respected by all and are enforceable. There is a mechanism for speeding up dispute resolutions of any kind in the system. 3.4.9. Confidentiality and Security: The NPS mechanism ensures privacy of all transactions. Confidentiality required in a competitive environment cannot be compromised in any way by the mechanisms transmitting information on payments through the NPS. 3.4.10. Robustness: The NPS is reliable and provides adequate protection to the financial system in crisis situations. 3.4.11. NPS Integration and International Compatibility: The NPS complies with international standards and practices that facilitate international transfers and ensures compatibility with payment systems and instruments developed internationally. 3.4.12. National Standards: The NPS standards exist on a national level and/or within a holistic context to enable: The smooth introduction and operation of payment instruments and the functioning of the system overall; and The effective technological integration of systems. 3.4.13. Fraudulent Incidences: Effective fraud-prevention and detection measures are in place. Fraud occurrences in all payment streams are effectively minimised. 3.4.14. Variety of Payment Instruments: A sufficient variety of instruments are available to enable the selection of the most appropriate instrument for a particular situation, from a convenience, cost and risk perspective. 3.5 FUNDAMENTAL PRINCIPLES Fundamental principles guide the development, deployment and management of the NPS. Once agreed on, they should be non-negotiable and form the basis on which future disputes will be resolved.

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Fundamental principles are also aimed at dispelling any ambiguities about the roles, responsibilities, ownership and participation of different stakeholders in the NPS. The principles dispel any confusion about different payment system processes and should be fair to existing and future NPS stakeholders. The following are the principles guiding the development, deployment and management of the NPS: 3.5.1 Clearing and settlement of payments is the exclusive domain of banks: The banks are the gateway to the payments clearing and interbank settlement facilities. Only banks and recognised institutions can act as principals in Central Bank settlement. 3.5.2 The provision of NPS services is not exclusive to commercial banks The provision of NPS services will not be limited to only banks. The provision of payment services by non-bank institutions and other service providers shall be recognized in the NPS and be subject to elaborate code of conduct and best practices. 3.5.3 The Evolution of the NPS Infrastructure is a Co-operative Responsibility The payment service infrastructure is critical to the smooth operations of the economy. The Central Bank, Commercial Banks and the Payment Service Providers will co-operate in the design, implementation and management of infrastructure components. The infrastructure that will facilitate NPS will be accessible to all eligible participants. 3.5.4 Payment Related Risks and Exposure are visible Since NPS does not control risks, all payment-related risks should be identified and assessed so as to provide information to participants to manage their exposures. 3.5.5 NPS Participants are liable to the risks introduced into the NPS NPS participants are responsible for managing the risks that they introduce into the system. Participants in either bilateral or multilateral netting arrangements carry the risk of potential default of one or more of the participants concerned and will be involved in designing the suitable risk reduction measures.

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3.5.6 A balance is maintained between risk reduction and cost: A justification will be required in terms of the cost of risk reduction measures vis--vis the potential system risks being addressed. 3.5.7 Central Banks response to problems in the NPS will be in the interest of the system not individual participants. The Central Bank will act to provide liquidity to a participant experiencing a temporary liquidity problem subject to its meeting borrowing terms and conditions. The Central Banks response in a systemic crisis is geared towards meeting national interest, for the sake of the stability of the financial system as a whole. 3.5.8 All banks are eligible to have a settlement account at the Central Bank The Central Bank is the settlement agent to the banks and each bank will be responsible for its own inter-bank indebtness and can settle over its own account and hence all banks settlement accounts must be domiciled in the Central Bank. 3.5.9 All banks are entitled to clear payments under their own name In order to ensure that all exposures are visible, a bank, providing payment services to its customers will preferably participate in the interbank clearing process under its own name. 3.5.10 Settlement is subject to the availability of funds All inter-bank settlements require pre-funding. Any arrangements to obtain accommodation from the Central Bank to pre-fund the settlement account shall apply equally to all banking institutions. 3.5.11 The payer has responsibility to initiate the transfer of funds to an account For a credit push instruction the responsibility lies with the payer to initiate payment by issuing a payment instruction to his bank. The bank then issues a payment instruction to the payees bank in favour of the payee. 3.5.12 Finality of payment follows settlement finality Settlement of inter-bank indebtness is achieved once entries have been passed over the settlement accounts of the banks held at the Central Bank or cash has been exchanged. Irrevocable finality of payment follows settlement finality and is achieved only in Central Bank money.

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3.5.13 Surveillance is necessary to ensure safety and soundness of the NPS oversight framework The Central Bank through its oversight responsibility will focus on the overall soundness and effectiveness of the NPS. All risk reduction measures applied in the interbank payment clearing and settlement will be agreed with the Central Bank as an overseer of NPS before being introduced. All payment related interbank exposures will be available to the Central Bank in its overseer capacity. 3.6 NPS REFORM STRATEGIES The following are the main strategies for aligning the current payment system with the envisaged NPS visions. 3.6.1 Systemic Risk Reduction Strategy 1: Introduction of an on-line Settlement System to enable banks to effect Interbank funds transfer electronically on a real time basis A major shortcoming in the current Kenyan payment system is the lack of a real time interbank exchange. In the envisaged Framework and Strategy the proposed settlement system will provide facilities for banks to settle their obligations on a real time basis, or in a delayed settlement arrangement, providing guaranteed settlement. This then calls for the Introduction of Real Time Gross Settlement System (RTGS) for high value and time critical payments. Strategy 2: Implementation of risk-reduction measures in bilateral and multi-lateral netting schemes The main advantage of netting inter-bank settlement obligation is that it limits the actual values that are exchanged between two banks (bilateral) schemes and multiple banks (multilateral). BIS-CPSS core principles for systemically important Payment Systems in particular Core Principle 5 (CP-V) will be adhered to as risk-reduction measures in all netting schemes. The cheque clearing system is on a multi-lateral netting basis in line with the Lamfalussy Standards on Netting.

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Cheque Truncation In order to reduce clearing days from T+ 3 to at most T+ 2, it is planned to introduce cheque truncation in the country. A prerequisite for this is the enactment of an enabling legal framework. Strategy 3: Introduction of same day settlement Currently, all our settlement streams are not on a same day basis. Hence all the settlement protocols will have to be adapted to achieve true same day settlement for and across all payment streams. Strategy 4: Collateral Requirements and Related Management Processes Availability of liquidity for settlement purposes will require a dynamic collateral management system especially intra-day liquidity management techniques. Currently there is a functional Central Depository Systems (CDS) for Government debt instruments and line arrangement for Lender of last resort facility by the Central Bank. In view of the measures taken to reduce payment-system-related risks, the prudential requirements (that is, capital and reserves, cash reserves, liquid assets) also need to be reassessed, to ascertain whether such cash reserves or liquid assets could be considered, in part as collateral for settlement purposes. Strategy 5: Payment System Oversight For continuous surveillance and assessment of the payment system efficiency and effectiveness, a comprehensive checklist to be used in payment system oversight, shall be developed. Specific legislation on NPS and amendments to the Central Bank of Kenya Act will be enacted to give CBK formal statutory authority relating to the oversight of payment systems. This will involve public policy activities principally intended to promote the safety and efficiency of payment systems and in particular to reduce systemic risk embedded in the systemically important payment systems. The Systemically Important Payment Systems (S.I.P.S.) will be designated and continuously reviewed and evaluated to ensure their design and operations meet and continue to meet, at the very minimum, international best practices, standards and protocols.

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3.6.2 Legal and Regulatory Framework Adequate laws and regulations must be put in place to regulate and support payment systems. Currently, the laws are inadequate and in some cases non-existent. Hence there will be comprehensive review of existing laws relating to the payment systems and amendments formulated, where necessary. Strategy 6: Review the statutory powers of the Central Bank regarding payments systems Shortcomings in the current statutory powers of the Central Bank, in its role in the NPS, will be identified and amended in the Central Bank of Kenya Act. Strategy 7: Adaptation of the Legal Framework to ensure legal enforceability of payment service agreements and legal certainty in respect of industry practices The relevant Acts of Parliament will be identified for possible amendments. In the absence of this a new legal framework, in the form of a specific Payment System Act will have to be introduced. This will ensure that payment practices are legally sound, taking into account regional and international practices and payment requirements. The legal foundation pertaining to finality of payment needs to be affirmed. This includes legal clarity on the role of a statutory manager, receiver and the legal powers of any subsequently appointed liquidator in the event of insolvency of a system participant. 3.6.3 Interface Between the Trading System and the NPS and payment Practices Strategy 8: Review of Financial Market Practices from an NPS Perspective NPS will influence and encourage the financial markets practitioners to embrace modern payments system developments in the market domain to contain systemic risks caused by contagion, as risks arising from market practices can be introduced in the NPS. Hence the NPS should create an environment that will be acceptable for both the market players and the NPS participants.

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Strategy 9: Encouragement of Electronic Trading and Payment Mechanisms in the Trading Systems The Trading System developers will be encouraged to introduce deliveryversus-payment (DvP) and payment versus payment (PvP) principles accompanying payment, clearing and settlement with supporting mechanisms e.g. EDI (Electronic Data Interchange), E-Commerce and the regime of information flow accompanying an electronic payment. Strategy 10: Introduction of mechanism to relay information associated with a payment to the beneficiary NPS will facilitate the flow of information accompanying an electronic payment where applicable. A mechanism to support business applications of EDI, especially in electronic commerce will also be accommodated in the design of NPS. Strategy 11: Review of cross Border/Foreign Currency Market Practices from an NPS perspective Cross border and foreign currency market practices will be reviewed with a view to incorporating them into the NPS. 3.6.4 Payment practices Strategy 12: Introduction of a regulatory framework for a payment service provider Legally enforceable rules and regulations as well as a code of conduct applicable to all participants will be formulated published, implemented and enforced in order to ensure sound payment services. Strategy 13: Creation of public awareness The Kenyan public will have to be made aware of the features and risks involved in accepting and using payment instruments. The awareness campaigns will take many forms, e.g. organising payments system sensitisation seminars and workshops, placing advertisements in the mass media, as well as working closely with the banks and utility companies in Kenya to promote the understanding of available payment instruments.

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3.6.5 Management of the NPS Strategy 14: Establishment of a Kenya NPS forum The Central Bank will establish a forum in which stakeholders will be represented. Strategy 15: Establishment of NPS standards A function will be established to oversee the development of national standards and to ensure that Kenyan standards are in harmony with international standards, where applicable.

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BUSINESS PROCESS MODELLING AND ARCHITECTURE

4.1

INTRODUCTION In order to achieve the stated vision and objectives of the NPS Project, the business requirements and processes at a conceptual level will have to be defined and guiding principles built into the proposed systems so as to ensure that the resulting systems are consistent with the NPS vision, objectives and expectations of the NPS Project. In this chapter a description of business processes at a conceptual level is made with the aim of defining a high level design, which embodies the fundamental principles and issues detailed in Chapter Three entitled Strategic Framework. The emphasis is therefore on a design framework, within which every component can be identified, viewed within the context and appropriately addressed. This design or model will serve as a common basis for further analysis and numerous independent projects.

4.2

CONCEPTUALISING THE NPS MODEL Conceptualising and determining the nature and scope of the NPS model for Kenya to adopt, will be a Herculean task as there are various factors to be considered ranging from costs to the present and projected state of the countrys needs. The different phases of the envisaged business processes encompassing both the market and payment systems are to be studied in detail. The Business processes are as follows: Payment Clearing Settlement Risk Monitoring

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4.3

THE PAYMENT PROCESS

Below is the Payment Process in a diagram showing its linkage with the financial markets and the real sector activities. THE PAYMENT PROCESS

REAL ECONOMY AND FINANCIAL MARKETS Purchase and sale of goods and services

BANKING SYSTEM Provision of payment services

INTERBANK FUNDTRANSFER SYSTEMS Clearing and settlement processes

Deal Agreement

Payment Instruction

Payment Initiation

Clearing

Settlement

Payment Finality

Payment Confirmation

Payment process includes: Deal agreement, resulting in a payment instruction. Payment initiation: through credit transfer or debit collection channel. Clearing: through the clearing house to generate a settlement instruction Settlement: Interbank settlement once forwarded to Central Bank is irrevocable Payment finality: This follows settlement payment finality Deal completion, resulting from a payment confirmation Synchronisation of delivery and payment

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Deal Confirmation

4.4

THE CLEARING PROCESS The nature of the clearing process will be determined by the nature of the settlement required, e.g.: Payment of a low-risk and/or a low-value nature will be cleared in bulk through the Clearing House on a multi-lateral basis. Payment instructions requiring immediate payment finality will be cleared bilaterally as individual payment instructions.

4.5

THE SETTLEMENT PROCESS Final settlement in Central Bank money will be achieved only through entries across the accounts of the banks held at the Central Bank. The settlement system will provide a range of alternative settlement options, including: Immediate settlement, that is, settled in real time, on a gross basisprinciple through a Real Time Gross Settlement (RTGS) system; and Delayed settlement, that is, for settlement instructions due but placed on hold and accumulated for queuing settlement. These settlement instructions will be processed conditionally, that is, settlement at, inter alia, a specific time and when funds are available. The Clearing House resultant multilateral net values will be settled as a batch through the RTGS system. The settlement system encompasses the following: A settlement instruction. A settlement instruction registration process. A real-time line, a number of netting bands, and a process to manage them. Real time line will provide for immediate final settlement. A settlement instruction will be processed only if funds are available in the particular account. In this line there will be no build-up of unprocessed settlement instructions. The netting bands will provide for delayed settlement, that is, settlement instructions that are already due for settlement, but are delayed and accumulated in a net to achieve off-setting with other settlement instructions to minimise liquidity requirements. A scheduled list. Collateral and a dynamic collateral-management process. A set of settlement accounts and an account management process.

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 A settlement process to effect final settlement, both in trading and at the end of the day, and; Various confirmations. 4.6 RISK MONITORING Deal agreements initiated in the trading system are a source of payment risk. Risks build up in the trading system and can spill over to payment system. Monitoring should start as early as possible in the trading cycle. Risk monitoring of the NPS should therefore harmonise with risk monitoring of the broader financial system. Risk monitoring for the NPS focuses primarily on the payment risks and exposures of banks. The NPS should therefore provide integrated information, to compile a holistic payment-risk profile of a bank. Every bank should be able to access all information pertaining to it, to build a dynamic risk profile comprising, inter alia, the following: The bilateral and multilateral exposure limits for delayed settlement. The settlement instructions in the real-time line and scheduled list in the settlement system. The balance on its settlement account. The status regarding the utilisation of securities it has provided as collateral, and; The status of all other relevant accounts. As the overseer of the NPS, the Central Bank will have access to the same information mentioned, above in the paragraph on Risk Monitoring, for every bank. This information will be utilised to provide a risk profile to the NPS in total. To support the Central Banks oversight role, the Central Bank will have access to the RTGS centralised accounting system and monitor the positions of all participants on a real-time basis.

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NPS STAKEHOLDERS AND ROLES

5.1

INTRODUCTION The NPS modernisation and reforms, once accomplished will have implications for a wide range of stakeholders requiring a redefinition of roles, responsibilities and management structures. In this chapter, the stakeholders in the NPS are identified, designated functionalities and roles articulated accordingly.

5.2

STAKEHOLDERS Stakeholders are those that have an interest in the NPS. The definition includes those that need to be informed and consulted and those that own, provide, manage or use components of the system, or take ultimate responsibility thereof. Central Bank of Kenya The Banking Industry Payment-system infrastructure providers Payment-service providers End-users Regulatory bodies Government Regional monetary authorities and regional arrangements International monetary authorities International financial community

5.2.1 Roles and Responsibilities of the Stakeholders To manage and operate the NPS, it is necessary to define the role and specific responsibilities of all the key NPS players clearly. It will also be necessary to identify and, if necessary, create structures to provide for the requirements of the NPS. 5.2.2 Role of the CBK in the NPS The CBK fulfils a number of roles that, to a greater or lesser extent, are related to the above-mentioned function, including:

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a.) b.) c.) d.) e.)

Monetary policy-maker Banker of banks and government Settlement institution Issuer of currency legal tender Overseer of the NPS.

Within the context of NPS, Central Bank is responsible for the following among other roles: (a) Ensuring that the interests of all stakeholders are served by the NPS. (b) Guiding the evolution of the NPS, focusing primarily on the overall soundness and effectiveness of the NPS. (c) Ensuring that a sound legal framework exists. (d) The clearing and settlement services on a net-multilateral arrangement at the Nairobi Clearing House. (e) Overseeing the application of NPS risk-management measures. (f) Ensuring the smooth functioning and conclusion of the settlement process. (g) Ensuring that infrastructure relating to settlement process is in place. 5.2.3 Role of Commercial Banks in the NPS For the purposes of the NPS, a commercial bank is understood to be an institution registered as a bank or as a branch of a foreign institution under the Banking Act. Banks are the gateway to the NPS clearing and settlement facilities and only commercial banks are eligible to: (a) Have a settlement account at Central Bank (b) Participate in interbank clearing and settlement: and (c) Act as both principal and/or intermediary in payment transactions. (d) Deal in the forex market. A commercial bank can fulfil one or more of the following roles: (a) As a settlement bank, settling its own interbank payment obligations and effecting real-time payments. (b) As a clearing bank, clearing payment instruments by joining the Payment Clearing House (PCH). (c) As an end-user, issuing payment instructions on its own behalf and as the beneficiary of payments made by other banks.

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Within the context of the NPS, commercial banks are responsible for the following: (a) Managing the risks that they introduce into the NPS and ensuring that their institutions have a clear understanding of these risks and their liability in terms thereof (b) Ensuring that they have sufficient liquidity for their interbank settlement (c) Ensuring that their interbank payment obligations can be settled in Central Bank money, either across their settlement account held at Central Bank of Kenya or in cash. (d) Ensuring that the payment-processing cycle is completed in accordance with customers requirements and the risks associated with the payment instruction in terms of interbank agreements and procedures (e) Making their customers aware of the features of, and the risks involved in, accepting and using payment instruments and educating them in the alternatives available. 5.2.4 Role of a Payment Clearing House (PCH) in the NPS A PCH is defined as any central location or processing mechanism whose role is to facilitate exchange of payment instructions or other financial obligations. It may also be a physical entity such as the Nairobi automated cheque-clearing house, a manual clearing process in remote centres or an electronic switch. These processes will be subject to similar controls, rules and regulations. 5.2.5 Role of the Proposed Kenyan National Payment System Council A national body to be called National Payment System Council will be constituted. The Council will be the supreme policy body to direct and oversee the development of a sound, stable, market-oriented NPS. Its role will be to determine the national payment systems policy while ensuring that the interest of all participants and key stakeholders are served by the NPS. The body will also debate issues relating to payment systems practices and developments. The Governor of the Central Bank will chair the Council. Its composition will include KBA, Telkom, financial market regulators and other major service providers.

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5.2.6 Role of NPS Steering Committee The present NPS Operations Committee will be transformed into NPS Steering Committee whose responsibility will be to develop the overall strategy and framework for NPS modernisation and reform process, define ownership and operational responsibilities. The Committee will have powers to co-opt other sub-committees and form relevant and specific Task Forces for various NPS projects. The Committee will also act as the Secretariat for the NPS Council and will be manned by technocrats drawn from major designated stakeholders, e.g., other financial market regulators. 5.2.7 Role of NPS Division The NPS Division within the Central Bank will act as the Secretariat to the NPS Steering Committee and will be chief co-ordinator of the NPS Project on a day-to-day basis. The Division will comprise of a multi-disciplinary team of professionals and will be responsible for the Central Banks oversight role as articulated in the CBK Act, Section 4A, (D). The Division will also be responsible for carrying out research and development of payment products and services. The Division will endeavour to: Facilitate the development of payment systems in Kenya so as to provide for the needs of the economy. Provide for a secure and efficient payment, clearing and settlement system. Monitor and identify risks that could undermine the soundness of the payment system. Reduce and contain systemic risks inherent in the payment system. Involve and disseminate information to stakeholders in NPS developments affecting payment system education/public awareness. Ensure that the domestic payment system keeps abreast with international developments and best practices. Facilitate the development of regional strategies for payment systems. Develop and continuously review the necessary legal and regulatory framework to regulate and support payment systems. Research and continuously review payment systems and practices with the aim of introducing and implementing strategies to enhance existing payment systems

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5.2.8 Role of a Securities Depository in the NPS A securities depository, although not part of the payment clearing and settlement domain of the NPS, fulfils the role of custodian for immobilised/dematerialised securities. In efforts to synchronise delivery with payment, it will be the responsibility of the depository to: a) b) c) reserve the securities on request of a securities clearing house prior to confirming a payment instruction; change the ownership of securities once confirmation of payment has been received; and, Enable the pledging of immobilised and/or dematerialised securities.

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IMPLEMENTATION STRATEGY

6.1

BACKGROUND The opening up of the economy has resulted in notable developments in the number of participants and the range of payment instruments. The level of competition has increased significantly and the payment systems currently include the use of ATMs, debit and credit cards, execution of payments through EFTs at the Point of Sale (EFT-POS) and Web-based Internet banking practices. Furthermore, developments are anticipated to continue in these areas, and not least in terms of the operational structure and automation of the clearing and settlement systems. It should also be noted that the CBK has a direct interest in ensuring that the development of the payment system proceeds in a co-ordinated manner and that potential credit and settlement risks are sufficiently controlled. On the part of the banks, the evolution of the payment system in a coordinated manner will entail greater co-operation and this will enhance operational efficiency and cost savings as unnecessary duplications are avoided and economies of scale realized.

6.2

REALISATION OF THE VISION In an endeavour to resolve the current shortcomings and envisage the ideal NPS for Kenya, the vision of the NPS architecture was set for 2008. The vision defines the end state, which is the situation that should prevail in 2008. This does not imply, however that all the NPS project proposals will be implemented by 2008. It should be noted that our vision date is linked to the East African Communitys NPS reform agenda as a result of the regions harmonization efforts being carried by the East African Payments Harmonization Committee (EAPSHC) as mandated by the Monetary Affairs Committee (MAC) of the 3 Central Bank Governors.

6.3

IMPLEMENTATION APPROACH The Kenyan NPS reform process follows the strategic approach. This is firstly because there are certain issues that need immediate attention due to their impact on payment systems efficiency and effectiveness and

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secondly because this is the globally accepted best practice for NPS reform process and is also internationally recommended by BIS Committee on Payment and Settlement Systems (CPSS). The NPS implementation began with the modernization of the payment and settlement arrangement initiated with the Automation of The Nairobi Clearing House. 6.4 PHASING OF THE IMPLEMENTATION PROCESS The strategic approach adopted by the NPS Operation Committee calls for a systematic implementation of the development program in a phased and evolutionary manner. 6.5 PROJECT PLAN Development and Implementation of the NPS will be based on consultation with and consensus amongst the relevant stakeholders. This will be a co-operative endeavor, characterized by joint ventures with various stakeholders, requiring multi-disciplined and skilled people from many different business areas and organizations. Effective co-ordination of inter-organizational system developments will be a critical success factor in the development of the NPS Project. To this end, structures will have to be created to ensure that all parties, not banks only, are kept fully informed of and involved in the development and implementation plan. The Central Bank, as a neutral agent and the overseer of the NPS, will co-ordinate the implementation process. 6.6 IMPLEMENTATION SCHEDULE In an effort to establish a sound and robust NPS by 2008, the provisional implementation plan is articulated in Appendix II. The sole responsibility of managing the Implementation Plan during the interim period lies with the operations NPS Committee presently chaired by the Deputy Governor with the various sub-committees and Task Forces as and when constituted.

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APPENDIX I Country Profile

APPENDIX I: COUNTRY PROFILE 1.0 Geography: Kenya, bisected by the Equator line and strategically located in the eastern coast of the African continent, has an area covering 569,259 square kilometres - about the same size as France and roughly twice the size of the United Kingdom. The dominant physical feature is the Great Rift Valley, which bisects the country from north to south. The country shares common borders with Somalia, Ethiopia, Sudan, Uganda and Tanzania. 2.0 Climate: With the Equator running through the middle and the countrys altitude ranging from the sea level to 5,199 meters, Kenya enjoys a varied climate ranging from tropical to temperate and has two rainy seasons first being the long rains in April May and then the short rains in OctoberNovember. Population: Kenyas population is approximately 30 million, which is both multi-racial and multi-ethnic, with a rich diversity of cultural roots. Nairobi, the capital of Kenya, has an approximate population of 3 million. Other cities are Mombasa and Kisumu, the former being Kenyas main port on the Indian Ocean, and the latter a major port on Lake Victoria. Other mainland urban centres are Nakuru, Eldoret and Thika. Language: Kiswahili is Kenyas national language and English is the official language. Various local languages and dialects are also spoken. Political Situation: Kenya has been a republic in the Commonwealth since independence in 1963. Executive authority is vested in the President with two five-year term limits, who is directly elected. The legislative authority is vested in the National Assembly. Presidential, Parliamentary and Civic elections are held every 5 years. Mayoral elections are held by elected civic leaders once every two years. International Relations: Kenya is a member of the East African Community, Common Market of Eastern and Southern Africa (COMESA),

3.0

4.0 5.0

6.0

35

the Commonwealth, the United Nations, the African Union (AU), and an associate of the EEC as a signatory to the Lome Convention. 7.0 The Economy: Kenya runs a mixed economy and has the potential to be dominant in the region and an engine for regional growth. Agriculture, the main sector of the economy, being the largest source of employment and foreign exchange earnings, contributes a quarter of total GDP, while manufacturing, the second most important sector and the strongest in East Africa, contributes about 13%. The other important sector is the trade, restaurants and hotels contributing about 12%, with tourism being second in foreign exchange earnings after agriculture. 8.0 Infrastructure: Kenya has a well-developed infrastructure in the subregion, with an extensive road network, three international airports, a national carrier Kenya Airways, the port of Mombasa, which is an excellent natural harbour that is the gateway to the sub-region and a railway line connecting Mombasa and Kampala via Nairobi. The Government is implementing a number of measures with the assistance of development partners, among them the World Bank, to rehabilitate the infrastructure. Two major players in power and telecommunications sectors are undergoing restructuring, while plans are underway to streamline operations in the port of Mombasa to allow private sector participation in the provision of services. 9.0 The General Business Climate: Kenya has enjoyed a stable government since independence, forty years ago. Kenya has made a strong political commitment to promoting private-sector investment, both local and foreign to sustain economic growth. Over the past eight years the Government has introduced liberal market-oriented policies and reforms to improve the investment environment. Exchange controls have been removed, prices de-controlled, import licensing abolished, interest rate regimes decontrolled and divestiture from non-strategic public sector bodies, privatisation and parastatal reform programmes instituted.

10.0 Trade and Investment: A number of incentives to promote foreign investment are being implemented. The introduction of tax holidays under the Export Processing Zones and elimination of restrictions on the repatriation of profits was aimed at promoting foreign investment. The

36

capital account was freed to allow investment in the Nairobi Stock Exchange, which however is limited to 40% of the value of floated shares. Traditionally, larger share of foreign capital inflows originate from the European Union countries, however South Africa and some Asian economies are gaining importance. Some of the foreign direct investments are in form of invested profits by multinational companies. As far as trade is concerned, Kenyas major trading partners are African countries, which account for 47% of its exports and 9% of imports, followed by European Union countries which account for 30% of exports and 33% of imports. Other trading partners are the Far East and Middle East Countries, which account for 13% of exports and 23% of imports. 11.0 Kenyas Other Potentials: Since independence, Kenya has enjoyed political stability that has enabled it to emerge as one of the strongest economies in the region. The varied agro-ecological zones and the unique tourist attraction sites also provide a great potential for the economy.

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APPENDIX II: PROVISIONAL IMPLEMENTATION SCHEDULE

Year 2001/ 2002 2002/ 2003 (i) (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) 2003/ 2004 (i) (ii) (iii) (iv) 2004/ 2005 2006/ 2007 (i) (ii) (i) (ii) (iii)

Activity and Description

Responsibility CBK

Develop and Document NPS Vision and Strategy Develop Guidelines on Credit Reference Bureaus Implementation of an Operational Credit Reference Bureaus House Exchange of information/returns electronically Kenswitch Settlement Mechanism Encourage use of EFTs for transfers of Funds Promote SWIFT for Domestic Payments Promote SWIFT for Regional Payments Encourage Connection of Non-swift Banks to SWIFT Work out Modalities for introduce direct debit instrument Finalise RTGS Concept and Design Memorandum for discussion and way forward Transform the NPS operations committee into NPS steering committee Implement Local Foreign Currency Clearing Arrangements Implement Central Depository System (CDS) for Nairobi Stock Exchange Realisation of high value interbank exchange (RTGS) Institute the NPS Council Establish a link between ACH and other cross border small value payments. Linkage of the 3 E. African RTGS Systems Implement Cheque Truncation/Imaging CBK KBA/CBK CBK CBK CBK KBA/CBK KBA/CBK/NSE CBK/KBA CBK/KBA CBK CBK KBA CBK CBK/KBA CBK/KBA Promote Sharing of ATMs Kenswitch Project and implement KBA KBA KBA

Implementation Electronic Exchange of data with the Clearing KBA/KBA

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APPENDIX III : THE BIS CORE PRINCIPLES AND CENTRAL BANK RESPONSIBILITIES

Public Policy Objectives: Safety and Efficiency in Systematically Important Payment Systems Core Principles for Systemically Important Payment Systems I. II. The system should have a well-founded legal basis under all relevant jurisdictions. The systems rules and procedures should enable participants to have a clear understanding of the systems impact on each of the financial risks they incur. The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. A system in which multilateral netting takes place should, as a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. Assets used for settlement should preferably be a claim on the Central Bank; where other assets are used, they should carry little or no credit risk and little or no liquidity risk. The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. The system should provide a means of making payments, which is practical for its users and efficient for the economy.

III.

IV* V*

VI.

VII.

VIII.

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IX. X.

The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. The systems governance arrangements should be effective, accountable and transparent. * Systems should seek to exceed the minima included in these two Core Principles.

Responsibilities of the Central Bank in applying the Core Principles A. The Central Bank should define clearly its payment system objectives and should disclose publicly its role and major policies with respect to Systemically Important Payment Systems. The Central Bank should ensure that the systems it operates comply with the Core Principles. The Central Bank should oversee compliance with the Core Principles by systems it does not operate and it should have the ability to carry out this oversight. The Central Bank, in promoting payment systems safety and efficiency through the Core Principles, should cooperate with other Central Banks and with any other relevant domestic or foreign authorities.

B. C.

D.

BIS Committee on Payment and Settlement Systems Core Principles January 2001

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APPENDIX IV: GLOSSARY OF NPS TERMS AND ABBREVIATIONS

Accommodation Refers to any extension of credit, or any purchase of assets by the Central Bank in the performance of its various Central Bank functions. In its narrowest term refers to Central Banks refinancing at the discount window. Auditable Payment Schemes Are payment schemes that facilitate payment, exchange of instructions and exchange of value through the existing banking and NPS infrastructure, and for which e-money product transaction data are maintained as value is expended and can be traced throughout the processing cycle to its finality. (See Nonauditable payment schemes. Automated Clearing House (ACH): see Clearing House Automated Teller Machines (ATM) Electro-mechanical device that permits authorised users, typically using machinereadable plastic cards, to withdraw cash from their accounts and/or access other services, such as balance enquiries, transfer of funds or acceptance of deposits. ATMs may be operated either on-line with real-time access to an authorisation database or off-line. See also cash dispensers. Appointed Member A member of an Electronic Clearing House (ECH) who has been appointed as an agent of a non participating member of the ECH. Bank Draft Is the term that generally refers to a draft drawn by a bank on itself. The payer purchases the draft from his bank and sends to the payee, who presents it to his bank for payment. The payees bank presents it to the payers bank for reimbursement.

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Batch Is the transmission or processing of a group of payment orders and/or securities transfer instructions as a set at discrete time intervals. Bilateral Clearing Arrangement Is an agreement between two banks to clear instructions between them. Bilateral Netting Is an arrangement between two parties to net their bilateral obligations. The obligations covered by the arrangement may arise from financial contracts, transfers or both. Bilateral Net Settlement System Is a settlement system in which participants bilateral net settlement positions are settled between every bilateral combination of participants. Bill of Exchange Is a written order from one party (the drawer) to another (the drawee) to pay a specified sum on demand or on a specified date to the drawer or to a third party specified by the drawer. Widely used to finance trade and, when discounted with a financial institution, to obtain credit. Book-entry System Is an accounting system that permits the transfer of claims (e.g. securities) without the physical movement of paper documents or certificates. Bulk Transfer System Is an inter-bank funds system which handles large volume of payments or relatively low value in such forms as cheques, credit transfers, direct debits, ATM transactions and EFTs at the point of sale. See also retail transfer system.

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Caps For risk management purposes, the quantitative limits placed on the positions (debit or credit positions, which may be either net or gross) that participants in a funds or securities transfer system can incur during a business day. Caps may be set by participants on credit extended bilaterally to other participants in a system, e.g. bilateral credit limits, or by the system operator or by the body governing the transfer system on the aggregate net debit a participant may incur on the system, e.g. sender net debit limits. Sender net debit limits may be either collateralised or uncollateralised. Card See cash card, chip card, credit card, debit card, debit card, delayed debit card, prepaid card, retailers card, travel and entertainment card. Pre-paid card (or payment card) is a card loaded with a given value paid for in advance. (See smart card). Cash Card Is a card for use only in ATMs or cash dispensers (often, other cards also have a cash function that permits the holder to withdraw cash). Cash Dispenser Is an electro-mechanical device that permits consumers, typically using machinereadable plastic cards, to withdraw banknotes (currency) and, in some cases, coins. See also Automated Teller Machine (ATM). Cheque Is a written order from one party (the drawer) to another (the drawee, normally a bank) requiring the drawee to pay a specified sum on demand to the drawer or to a third party specified by the drawer. Central Bank Credit (liquidity) Facility A standard credit facility that can be drawn upon by certain designated account holders (e.g. banks), at the Central Bank. In some cases, the facility can be used automatically at the initiative of the account holder, while in other cases the Central Bank may retain some degree of discretion. The loans typically take the form either of advances or overdrafts on an account holders current account which may be secured by a pledge of securities (also known as Lombard loans or of traditional rediscounting of bills).

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Central Securities Depository (CSD) System Is a securities trading system for holding securities in a book entry form and enables securities transactions to be processed and transferred in a dematerialised and immobilized manner. The system may incorporate safekeeping comparison, clearing and settlement functions. Central Bank Money Consists of notes and coins in circulation outside the Central Bank, and all deposits with the Central Bank by other banks. (Sometimes known as MO or the banking system cash base). Clearing Is the process of transmitting, reconciling and confirming payment orders or security transfer instructions prior to settlement. Clearing may include netting of instructions and the establishment of final positions for settlement. Clearing Bank A Clearing Bank is a bank represented at the Clearing House. Clearing House Is a central location or central processing mechanism through which financial institutions agree to exchange payment instructions or other financial obligations. The institutions settle for items exchanged at a designated time based on rules and procedures of the Clearing House. Automated Clearing House (ACH): is an electronic clearing system in which payment orders (cheques) are exchanged among clearing house participants, primarily via magnetic media or communication networks, and handled by a data-processing centre. Clearing Centre The operational centre of a Clearing Bank or group of banks which prepares and accepts transactions from the Clearing House. A Clearing Centre will have as many settlements as the number of banks it is acting for i.e. sponsored banks.

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Local Clearing Is the clearing of instruments originating from and destined to banks or their branches located within the municipality of the same clearing centre. Clearing Days This refers to the days during which the process of transmitting, reconciling and in some cases confirming payment in order of security transfer instructions prior to settlement possibly including netting of instructual establishment of final position for settlement. The clearing days are counted from the day of lodging the cheque at the bank which is referred as T and this is added to the number of days that the cheque would be processed in the clearing house i.e. T+ No. of days. Clearing System Is a set of procedures whereby financial institutions present and exchange data and/or documents relating to funds or securities transfers to other financial institutions at a single location (Clearing House). The procedures often also include a mechanism for the calculation of participants bilateral and/or multilateral net positions with a view to facilitating the settlement of their obligations on a net or gross basis. Clearing Cycle The timetable for processing Inter-bank payments. References to days in the Clearing Cycle DO NOT take account of delays, however caused. Chip Card Also known as an IC (integrated circuit) card or smart card; is a card containing one or more computer chips or integrated circuits for identification, data storage or special-purpose processing used to validate personal identification numbers (PINs), authorise purchases, verify account balances and store personal records. In some cases, the memory in the card is updated every time the card is used, e.g. an account balance is updated. Code Line This refers to the MICR code-line at the bottom of the cheques and as specified in the Cheque/Voucher Design document. The code-line is the single most important feature towards the automation of the clearing process.

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Code-line Clearing Is the automation of cheque clearing by adopting electronic exchange of MICR (see magnetic ink character recognition) code-lines in computer files on diskette or on-line. The MICR code-line at the bottom of the cheque form comprises the details of the branch and account number, where the cheque has been drawn, the cheque number and the amount of the cheque. Collateral Is the security provided to the Central Bank in conjunction with an agreement to borrow funds to relieve a shortage of liquidity. Collateral Depository Is a register of all securities lodged with the Central Bank for securing settlement. Dynamic Collateralisation is a system in which automatic lending to a net deficit clearing participant is fully covered automatically by collaterals drawn from a reserve of liquid collaterals usually securities. Corrupt Data File Electronic file that contains data which is either wholly or partly unreadable, or incomplete or contains meaningless characters that cannot be processed including odd cents. Collecting Bank or Branch The bank or branch first receiving payment instructions from a customer. Collecting Clearing Centre The Clearing Centre receiving payment instructions from collecting branches and banks. Correspondent banking Is an arrangement under which one bank (correspondent) holds deposits owned by other banks (respondents) and provides payment and other services to those respondent banks. Such arrangements may also be known as agency relationships in some domestic contexts. In international banking, balances held

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for a foreign respondent bank may be used to settle foreign exchange transactions. Reciprocal correspondent banking relationships may involve the use of so-called nostro and vostro account to settle foreign transactions. Counterparty The opposite party to a financial transaction. Credit Card Is a card indicating that the holder has been granted a line of credit. It enables him to make purchases and/or draw cash up to a pre-arranged ceiling; the credit granted can be settled in full by the end of a specified period or can be settled in part, with the balance taken as extended credit. Interest is charged on the amount of any extended credit and the holder is sometimes charged an annual fee. Credit Push Instruction This implies the paying bank initiates the settlement transaction on its behalf or on behalf of its customer and assumes responsibility for obtaining finality of settlement. If the payers funds do not suffice, the payment does not go further than the paying bank. This method of payment provides a pre-fated or preauthorised payment transaction. Credit Risk/Exposure Is a risk that a counterpart will not settle an obligation for full value either when due or at any time thereafter. It includes principal risk, or cost risk. The counterpart may be insolvent. Credit Transfer Is a payment order or possibly a sequence of payment orders made for the purpose of placing funds at the disposal of the beneficiary. Both the payment instructions and the funds described therein move from the bank of the payer/originator to the bank of the beneficiary, possible via several other banks as intermediaries and/or more than one credit transfer system. Credit Transfer System (Giro System) Is a system through which payment instructions and the funds described therein may be transmitted for the purpose of effecting credit based payments.

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Cross Border Transaction Is a transaction in which at least one of the counter parties is located outside the home country. Cross Currency Settlement Risk Also known as Harsttat Risk is the risk that a transaction with a correspondent bank may not materialize due to instantaneous of transactions caused by time zones differences and currency differences. Customer Network Is where buyers and sellers interact for the purpose of buying goods and services. This is known as a Customer Payment Service Provider (CPSP). Daylight Credit (or daylight overdraft, daylight exposure, intra-day credit) Credit extended for a period of less than one business day. Debit caps: see caps Debit Card Card enabling the holder to have his purchases directly charged to funds on his account at a deposit-taking institution (may sometimes be combined with another function, e.g. that of a cash card or cheque guarantee card). Debit Transfer System (or debit collection system) Is a funds transfer system in which debit collection orders made or authorised by the payer move from the bank of the payee to the bank of the payer and result in a charge (debit) to the account of the payer; for example, cheque-based systems are typical debit transfer systems. Deferred Net Settlement (DNS) Systems Are settlement systems in which payment instructions are batched and off-setting positions calculated between participating banks before settlement is undertaken.

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Final settlement occurs at one or more discrete, pre-specified settlement times during the processing day. If such settlement takes place only once, normally at the end of the processing day, the system is called End-of-Day settlement system. Delivery Versus Payment (DVP) Is a mechanism in an exchange-for-value settlement system that ensures that the final transfer of one asset occurs if and only if the final transfer of the other asset occurs. DVP is mainly used in reference to securities trading where the transfer of securities ownership is tied to the transfer of respective funds. Debit Pull instrument Is like a cheque or credit card whose processing involves presenting the cheque or the details of the credit card to the collecting bank. Clearing is usually done in bulk at the clearing house. Payment is only final if the buyer has sufficient funds to cover payment and the cheque is not fraudulent. This means a debit-pull instrument is only fated at the end of the process. The sellers bank collects the money on his/her behalf, and the transaction date is determined by the seller, but the payment finality is still determined by the buyer, e.g. debit order. Discrepancy File The file returned to the Collecting Centre identifying the cheques identified in the Electronic Journal but not received. Dematerialisation Is the elimination of physical certificates or documents of title which represent ownership of securities so that securities exist only as accounting records. Direct Debit A pre-authorised debit on the payers bank account initiated by the payee. Disintermediation Occurs when one party borrows from another instead of from a bank. Disintermediation is also said to occur when two or more parties discharge their financial obligations to each other wholly or partially being made for only the net amount owing. Barter can be regarded as disintermediation.

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Drawee or (Payee) bank/branch The bank or branch of the bank of the customer whose cheque or instruction is being processed. In the case of Electronic Funds Transfers to credit an account at another bank, the Drawee Bank/Branch is the bank branch to be credited. Drawee Clearing Centre The Clearing Centre processing a cheque or instruction on behalf of the Drawee Bank/Branch. Drawers Bank A bank or branch of the person who issues the cheque to pay the amount mentioned herein (also referred as the paying bank or branch). Electronic Clearing House (ECH): See Clearing House Electronic Data Interchange (EDI) Is the electronic exchange between commercial entities, in a standard format, of data relating to a number of message categories, such as orders, invoices, customs documents, remittance advices and payments. EDI messages are sent through public data transmission networks or banking system channels. Any movement of funds initiated by EDI is reflected in payment instructions flowing through the banking system. EDIFACT a United Nations body, has established standards for electronic data interchange. Electronic money Refers to electronically stored monetary value on a device that functions as a prepaid bearer instrument, which can be widely used for making payments to parties other than the issuer, with or without involving bank accounts in the transactions. Electronic commerce Interactions relating to the purchase of goods or services, conducted over public networks that requires the use of intelligent networked devices. Electronic Funds Transfer File A file containing details of customer credits and/or debits destined for banks and branches not served by the collecting Clearing Centre.

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Electronic Journal A file containing details of the cheques and vouchers passed to the Clearing House by the collecting Clearing Centre. Endorsement Endorsement means the printing or writing of information on the rear of the cheque or voucher for various reasons, by the holder or issuer e.g. the cheque or voucher in the course of transferring or processing the cheque or voucher. Final settlement Refers settlement, which is irrevocable and unconditional. Final Transfer Is an irrevocable and unconditional transfer that effects a discharge of the obligation to make the transfer. The terms Delivery and Payment are each defined to include a final transfer. Finality of Payment Takes place when a customer has been given advice of payment finality after settlement has taken place. Final payment is irreversible, irrevocable and unconditional payment. Float The aggregate value of a payment instruments submitted for clearing and settlement through a payment system but not cleared. The float magnitude is a factor of volume of transaction per period (usually a day) value per transaction and the payment cycle or payment lag. Giro System See credit transfer system. Gridlock A situation that can arise in a funds or securities transfer system in which failure of some transfer instructions to be executed (because the necessary funds or

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securities balances are unavailable) prevents a substantial number of other institutions from other participants from being executed. Gross Settlement System Is a transfer system in which the settlement of funds or securities transfers occurs individually on an order-by-order basis according to the rules and procedures of the system, i.e. without netting debits against credits. See Real Time Gross Settlement. High Value Items High value items means instruments that are equivalent to or above a defined amount. Home Banking Banking services a retail customer of a financial institution can access using a telephone, television set, terminal or personal computer as a telecommunication link to the institutions computer centre. IC Card: see Chip Card. Immobilisation Placement of certified securities and financial instruments in a central securities depository to facilitate book-entry transfers. Image Processing Computer based technology that allows end users to electronically capture, store, process and retrieve images that may include numeric data, text, handwriting, graphics, documents and photographs it heavily uses optical scanning and optical desk technologies Interbank Funds Transfer System (IFTS) Is a funds transfer system in which most (or all) direct participants are financial institutions, mainly banks. Irrevocable and Unconditional Transfer Transfer that irrevocable by the person transferring and is unconditional.

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Large-value Funds Transfer System Inter-bank Funds Transfer System through which large-value and high-priority (Critical Credit) funds transfers are made between participants in the system for their own account or on behalf of their customers provided that the sending bank has sufficient covering balances or credit. As a rule no minimum value is set for the payments they carry, the average size of payments through such systems is relatively large. Large-value funds transfer systems are sometimes called wholesale funds transfer systems. Time Critical or Time Sensitive Payments are funds, which need immediate settlement. (See Time Critical and Time Sensitive). Legal Risk The risk that a loss in a payment transaction may be incurred because of inadequate non-coverage of a certain element in a payment process or arrangement. It also includes differences in two legal systems covering the same payment arrangement in the case of payment counterparts operating in different countries. Lender of Last Resort Where a deposit taking institution experiencing a need for cash balances that cannot readily be satisfied in any other way, are allowed to obtain cash balances from the Central Bank. Liquidity Risk The risk that a counterpart will not settle an obligation for full value when due, but may be able to settle the required obligations at some other time. Risks include replacement cost risk and adjustment cost risk. The counterpart in this case is still solvent. Loss Sharing Arrangement Payment System Risks mitigating measures agreed upon by members of a Clearing House or a transfer system, which involve a bailout mechanism, or allocation of any loss arising when one or more participants fail to fulfil their obligation. They include Defaulter Pays Mechanisms which involve the use of the defaulters collateral to settle the deficit position, and the Survivors Pay Arrangement, which means the surviving members assume the loss based on agreed formula.

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Market Risk Is the risk that a loss in a payment transaction may occur because of fluctuations in interest rates and foreign exchange rates. Market risks are linked to securities trading and trading in futures. Magnetic Ink Character Recognition (MICR) Is a technique, using special MICR machine-readable characters, by which documents (i.e. cheques, credit transfers, direct debits) are read by machines for electronic processing. See optical character recognition (OCR). Member Means a licensed bank which participates in a Clearing House. Missing (Electronic Journal) Record An entry in the Electronic Journal for which a corresponding cheque has not been identified. Money Order Is an instrument used to remit money to the named payee, often used by persons who do not have a chequing account relationship with a financial institution, to pay bills or to transfer money to another person or to a company. There are three parties to a money order: the remitter (payer), the payee and the drawee. Drawees are usually financial institutions or post offices. Payees can either cash their money orders or present them to their bank for collection. Multilateral Clearing Is an arrangement between more than two parties to clear instructions between themselves. Multilateral Netting An arrangement among three or more parties to net their obligations. The obligations covered by the arrangement may arise from, financial contracts, payment transfers or both. The multilateral netting of payment obligations normally takes place in context of a multilateral net settlements system. See bilateral netting, multilateral net clearing, and multilateral net settlement system.

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National Payment System (NPS) Is defined as a defined group of institutions using a set of instruments and agreed procedures used to effect payments transactions in the process of ensuring the circulation of money within a specified geographical area; usually a country. NPS Stakeholders Comprise of the Central Bank, the government, commercial banks, financial institutions, payment system providers, laws, rules and regulations governing the payment system, technological and physical infrastructure and users. Net Credit or Debit Position A participants net credit or net debit position in a netting system is the sum of the value of all the transfers it has received up to a particular point in time less the value of all transfers it has sent. If the difference is positive, the participant is in a net credit position; if the difference is negative, the participant is in a net debit position. The net credit or net debit position at settlement time is called the net settlement position. These net positions may be calculated on bilateral or multilateral basis. Net Settlement The settlement of a number of obligations or transfers between or among counterparties on a net basis. See netting. Net Settlement system A system to effect net settlement. Netting Is a process in which gross, or trade by trade obligations between two or more participants are settled by a single transfer of the net amount of funds. See also bilateral and multilateral netting, position netting. Non-auditable Products Are those in respect of which no record of payment transactions is maintained (i.e. as value is expended).

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Off-line The term may refer to the transmission of transfer instructions by users, through such means as voice, written or tele-faxed instructions that must subsequently be input into a transfer processing system. The term may also refer to the storage of data by the transfer processing system on media such as magnetic tape or disk such that the user may not have direct and immediate access to the data. On-line In the context of payment and settlement systems, the term may refer to the transmission of transfer instructions by users, through such electronic means as computer-to-computer interfaces or electronic terminals, that are entered into a transfer processing system by automated means. The term may also refer to the storage of data by the transfer processing system on a computer database such that the user has direct access to the data (frequently real-time) through input/output devices such as terminals. Operational Risk Is a risk that settlement finality may not be achieved due to mal-functioning of a system, mishandling, manipulations etc. Operational risks include systems risks, security risks, technology risk and intellectual risk. Optical Character Recognition (OCR) The machine identification of printed characters through the use devices sensitive to light. Overnight Money A loan with a maturity of one business day. Paperless Credit Transfers Credit transfers that do not involve the exchange of paper documents between banks. Other credit transfers are called paper-based. Participant/ Member A party who participates in a transfer system. This generic term refers to an institution which is identified by a transfer system (e.g. by a bank identification number) and is allowed to send payment orders directly to the system or which is

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directly bound by the rules governing the transfer system. participant/member, indirect participant/member. Paying Bank/Branch See Drawers bank branch. Payment

See direct

The payers transfer of a monetary claim on a party acceptable to the payee. Typically, claims taken the form of banknotes or deposits balances held at a financial institution or at a central bank. Payment Instrument Is a device or system or physical unit used to initiate instructions for the transfer of value from a payer to a payee in settlement of an obligation. The more common forms of payment instruments are cash, non-cash debit payments, cheques, bankers drafts, bankers payments cards, Mail Transfers and Telegraphic Transfers. Payment Lag Is the time-lag between the initiation of the payment order and its final settlement. Payment Instruction (Payment Order) An order or message requesting the transfer of funds, in the form of a monetary claim on a party, to the order of the payee. The order may relate either to a credit transfer or to a debit transfer. Payment Network Is where actual payment takes place. Customer Payment Service Providers (CPSPs) enter payment networks when they receive or make payment on behalf of the customers. Payment System A payment system consists of a set of instruments, banking procedures and typically, interbank funds transfer systems that ensure the circulation of money. Payment system covers the whole process of initiating a payment transaction, processing the transaction throughout to its settlement finality known as payment system cycle/chain.

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Payment Versus Payment (PVP) This is a mechanism that ensures that the final transfer of one value is conditional to the final transfer of the correspondent value. PVP is used in foreign exchange or cross currency transactions. Payment System Consists of a set of instruments, banking procedures and typically interbank funds transfer systems that ensure the circulation of money. PIN (Personal Identification Number) A numeric code that the cardholder may need to quote for verification of identity. in electronic transactions. It is seen as the equivalent of a signature. Point of Sale (POS) This term refers to the use of payment cards at a retail location (point of sale). The payment information is captured either by paper vouchers or by electronic terminals, which, in some cases, are designed also to transmit the information. Where this is so, the arrangement may be referred to as Electronic Funds Transfer at the Point of Sale (EFTPOS). Principal Risk The credit risk that a party will lose the full value involved in a transaction. In the settlement process, this term is typically associated with exchange for value transactions when there is a lag between the final settlement of the various legs of a transaction (i.e. the absence of delivery versus payment). Processing Endorsements The printing of the Clearing Centre system generated variable information on the rear of a voucher. Provision Transfer A conditional transfer in which one or more parties retain the right by law or agreement to rescind the transfer.

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Queuing A risk management arrangement whereby transfer orders are held pending by the originator/deliverer or by the system until sufficient cover is available in the originators/deliverers clearing account or under the limits set against the payer; in some cases, cover may include unused credit lines or available collateral. See also caps. Real-time Gross Settlement (RTGS) Is a gross settlement system in which processing and settlement take place in real time (continuously). Real Time Settlement Systems are systems where final settlement occurs on a continuously on real time transaction-by-transaction basis during the processing day. Real-time Processing or Settlement The transmission, processing or settlement of a funds or securities transfers instruction on an individual basis at the time it is initiated. Reason for Return Code A code to indicate the reason for returning a payment as Unpaid or Unapplied. Receiver Finality Analytical rather than operational or legal term used to describe the point at which an unconditional obligation arises on the part of the receiving participant in a transfer system to make final funds available to its beneficiary customer on the value date. See Final Settlement. Real Time Line Where a settlement instruction settled immediately is sent by debiting the paying bank and crediting the beneficiarys bank by the value of the settlement instruction. Replacement Cost Risk (or Market Risk, Price Risk) The risk that a counterparty to an outstanding transaction for completion at a future date will fail to perform on the settlement date. This failure may leave the solvent party with an unhedged or open market position or deny the solvent party unrealized gains on the position. The resulting exposure is the cost of replacing, at current market prices, the original transaction. See also credit risk.

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Retailers Card A card issued by non-banking institutions, to be used in specified stores. The holder of the card has usually been granted a line of credit. Retail Transfer System Inter bank funds transfer system which handles a large volume of payments of relatively low value in such forms as cheques, credit transfers, direct debits, ATM transactions and EFT at the point of sale. Sender Finality Is an analytical rather than operational or legal term used to describe the point at which an unconditional obligation arises on the part of the initiating participant in a funds transfer system to make final payment to the receiving participant on the value date. See final settlement. It indicates that once a payment instruction by the sender is sent, it cannot be altered or reversed by the sender. Settlement Is an act that discharges obligations in respect of funds or securities transfers between two or more parties. Inter-bank settlement is accomplished by posting entries across the accounts of the banks held at the central bank resulting in finality and irrevocability. Settlement Agent An institution that manages the settlement process, e.g. the determination of settlement positions, monitoring the exchange of payments and so on for the transfer systems or other arrangements that require settlement. See Final Settlement, Settlement, Settlement Institution(s), Multilateral Net Settlement System. Settlement Certificates Means a certificate issued by the Clearing House to indicate the settlement position (balance) of each bank at a particular clearing session. Settlement File A file of totals (volume and value) being passed from a collecting bank.

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Settlement Position File A file of totals (volume and value) received by a bank form collecting banks. Settlement Finality Settlement that is irrevocable and unconditional. In this regard receiver finality refers to a point at which an unconditional obligation arises on the part of the receiving participant. Settlement Network Is the network that link banks and the settlement agent when inter-bank settlement takes place. The central bank is the settlement agent to the banks just as a bank is a payment agent to CPSPs and customers. Clearing houses do not settle on their behalf. They provide service to allow banks to clear, net and settle their inter-bank obligations. Settlement Risk General term used to designate the risk that settlement in a transfer system will not take place as expected. This risk may comprise both credit and liquidity risk. Settlement System Is a system in which settlement takes place. Settlement systems are basically of two types, namely designated-time (deferred) net settlement, and real-time (or continuous) gross settlement. The distinction lies basically on the methods in which settlement takes place and the timing/frequency of settlement. Settlement Lag The time lag between the initiation of a payment instruction and its discharge by the final exchange of a financial asset for payment. It is sometimes referred to as a payment lag. Situational Risk Also known as circumstantial risk is the risk that settlement may not be achieved due to factors outside payment and settlement systems such as natural disasters, political uprising war etc. Situational risk includes country risks.

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Smart Card (having an embedded computer chip) Has the capability of performing stored value applications, in addition to other functions such as debit and credit payment capabilities. Sponsored Bank This is a bank whose clearances are forwarded to the Clearing House on its behalf by a clearing bank. Receipt of inward clearing is also through the sponsoring clearing bank. However, the settlement figures with Settlement Agent will be for the individual sponsored bank to facilitate liquidity position management by Settlement Agent. The sponsoring bank will take no responsibility for the settlement position of the sponsored bank. Standing Order An instruction from a customer to his bank to make a regular payment of a fixed amount to a named creditor. SWIFT (Society for World-wide Interbank Financial Telecommunication) A cooperative organization that operates a network for the exchange of payment and other financial messages between financial institutions throughout the world. The organization is owned by banks. Systemic Risk The risk that the failure of one participant in a transfer system or in financial markets to meet its required obligation will cause other participants or financial institutions to be unable to meet their obligations. Time Critical Payments Are payments whose settlement at due date trigger other financial transactions. Non-settlement of Time Critical Payments leads to a non-fulfillment of the secondary transactions. Time Sensitive Payments Are payments whose non-settlement at the due date draws immediate legal and other implications including penalties and other obligations.

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Trading System Is where a deal is entered between the buyer and seller of goods and services, or trading of securities. Transaction Code These are codes that indicate the nature of a transaction. These are also helpful in obtaining specific statistics for any code. Transfer Operationally, the sending (or movement) of funds or securities or of a right relating to funds or securities from one party to another party by (1) conveyance of physical instruments/money; (2) accounting entries on the books of a financial intermediary; or (3) accounting entries processed through a funds and/or securities transfer system. The act of transfer affects the legal rights of the transfer or transferee and possibly third parties in relation to the money balance, security or other financial instrument being transferred. Transfer System Is a generic term covering interbank funds transfer systems and exchange-forvalue systems. Unwinding (or Settlement Unwind) A procedure followed in certain clearing and settlement systems in which transfers of securities or funds are settled on a net basis, at the end of the processing cycle, with all transfers provisional until all participants have discharged their settlement obligations. If a participant fails to settle, some or all of the provisional transfers involving that participant are deleted from the system and the settlement obligations from the remaining transfers are then recalculated. Such a procedure has the effect of transferring liquidity pressures and possibly losses from the failure to settle to other participants, and may, in the extreme, result in significant and unpredictable systemic risks. Truncation A procedure in which the physical movement of paper based payment instruments is curtailed or eliminated, and is replaced in whole or in part by their electronic data contents for processing and transmission.

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Value Date Means the date when the cheque proceeds are credited on the payees account. Voucher Type Code These are codes that indicate the nature of a transaction. These are also helpful in obtaining specific statistics for any code. Wholesale Funds Transfer System See large-value funds transfer system. Wrongly delivered cheque. A cheque delivered accidentally to the wrong Clearing Centre.
The glossary gives an explanation of terms used in the payments context on the basis of best consensus between the central banks involved (G-10 and EC). It does not attempt to provide precise legal definitions. It is recognized that it may not always be possible to find an exact equivanlent for each term in other languages.

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