After my last post (“Using Distributed Ledgers as a Payment System” – August 3rd), one of the replies I received highlighted the differentiation between payments made in Central Bank Money and those in Commercial Bank Money. In my response to that point, I highlighted that Payments between Direct Participants in a given Payment System will always settle in Central Bank Money (on either a netted or direct basis). Payments between Indirect Participants may or may not involve Central Bank money depending upon whether they involve the same Sponsoring Direct Participant. If they do not, then they are likely to then involve the use of a core Payment System with the transaction “backed” by Central Bank money.
I went on to state that this highlighted the differentiation between the payment instruction, the form of underlying settlement and the finality protection this afforded. Having reflected further since that post, I think these are key distinctions that many customers of Payment Institutions are not aware of and felt that it would be helpful to make this the subject of a specific post in its own right and what that might mean for future payment types.
In a Payment Chain, an end-customer (the payment originator) will submit an instruction via their Financial Institution to pay away from their account the sum of X for the benefit of someone else (either a corporate or individual). The latter is known as the end beneficiary and the payment instruction could entail just one intermediary bank (if the originator and end beneficiary both bank at the same institution) or up to several if either the originator’s bank or the end beneficiary’s bank are not Direct Participants in the Payment System through which the payment is settled. Transactions that settle across the books of a single financial institution are considered “internalised” and merely reflect a book transfer. Most other transactions will “settle” across a payment system unless the institutions on either side of the transaction choose, for whatever reason, to settle outside of the payment system.
What parties on either side of a payment transaction want above all else is certainty around the payment successfully taking place. In particular, that the payment will not be revoked. Whilst this is an obvious concern for the end beneficiary, at a systemic and commercial level, the risks go deeper than the simple question of whether the Payee has sufficient liquid funds for the payment to be successful and centre on whether multiple payments can be revoked owing to the Financial Institutions handling the payments becoming insolvent.
At this point, it is worth differentiating between the protection available to depositors for funds held in a failing Financial Institution (whether that be the UK’s implementation (via the FSCS) of the €100,000 EU Deposit Guarantee Scheme Directive or the intervention of the Central Bank to Resolve a failing Institution by bringing it under protection as a “bridge bank”) and the means of protecting payments made on the day of insolvency in case they are reversed.
For the main UK Payment and Settlement systems, the means of protecting payments “in transit” is provided via their designation under the Settlement Finality Regulations. Specifically, payment and settlement systems that are designated may apply for protection against the operation of insolvency law for instructions entered into their system. This is achieved via the application of the relevant Settlement Finality law operable in that country. For countries within the EU it would be the local law passed under the “umbrella” of the EU Settlement Finality Directive (in the UK it is the Financial Markets and Insolvency (Settlement Finality) Regulations 1999 http://www.legislation.gov.uk/uksi/1999/2979/pdfs/uksi_19992979_en.pdf). By virtue of the application of the regulations, payments then effectively become final and irrevocable at the point in the system’s processes where settlement is deemed to have taken effect.
The list of those systems in the UK that have been designated under the Settlement Finality regulations is set out on the Bank of England’s website (http://www.bankofengland.co.uk/financialstability/Pages/fmis/supervised_sys/systems.aspx). In order to become designated, the Payment or Settlement system must apply for designation and meet the criteria set out in the Settlement Finality Regulations. Once designated, there are then obligations placed upon the System that must continue to be maintained (in particular, the ongoing provision of information to the Designating authority). The Settlement Finality Regulations are continually being amended and updated (the latest taking place in March 2015 (http://www.legislation.gov.uk/uksi/2015/347/pdfs/uksi_20150347_en.pdf) which all participating systems must continue to remain cognisant of.
Whilst the above may seem somewhat heavy for a post, it is essential to understand the importance of this in terms of how payments transacted through the designated Payment Systems become final and irrevocable which, in turn, is what generates the fundamental trust present within the UK Payment Infrastructure.
This also highlights a key foundation requirement that must underpin payment innovation; evolution should not result in a reduction in the protection that is currently available.
Payment Services that UK Financial Institutions provide in their role as Payment Service Providers (PSPs) are, themselves, underpinned by the requirements present in the Payment Services Regulations (which, in turn, follow on from the EU Payment Services Directive). They will leverage the underlying functionality that their own internal systems and the relevant backing Payment System can provide. For example, innovative consumer-facing payment products such as the various forms of mobile payments provide a convenient means of accessing funds held at an institution and paying someone else. However, they all rely upon the core foundation stones that have already been laid.
The next few years are likely to be the most exciting and innovative that the Payment Industry have ever seen. This post hopefully highlights some of the quietly understated mechanisms that exist behind the scenes and the need to ensure that these protections remain available.