Key Features of the Payment Systems - Essay Example

Payment systems involve the contribution from cash-dominated systems, to non-cash payment instruments. The key feature of payment system is the way payments are effected. In a currency-based payment system, payments are concluded by the transfer of currency notes from payer to payee; settlement takes place simultaneously with the transaction because currency represents final payment 1 so no clearing function is needed. The involvement of at least one-third party makes the payment system more complicated. For example processing of cheques, involves some means of clearing; settlement takes place through correspondent balances in accounts held at the central bank. (Fry, 1999) The same is true for all noncash payment instruments. An important factor that influences the choice of payment system lies in the value of the transaction. The most efficient and fair payment system in terms of the risk tradeoff for transactions of $100 may not be the same as it is for transactions of $1,000,000. So alternative payment systems often distinguishes between a large-value transfer system (LVTS) and a small-value transfer system (SVTS).2 The following stages are involved in Payment System development: 1. Cash 2. Cash plus noncash instruments but with no formal clearing arrangements. 3. Non automated, unprotected DNS system. 4. Automated, unprotected DNS system with or without an RTGS system operating alongside it. 5. Fully automated and protected RTGS or DNS systems. Stage 1: The initial stage in which the primitive cash economy encountered in rural areas of some developing countries where there were no banks at that time. Stage 2: Transitional economies started their payment system development from stage 2, a cash circuit for consumers and a paper-based noncash circuit for enterprises in which all transactions were gross but with long lags between payment instruction and receipt of payment. Stage 3: The prototype DNS system of stage 3 was a simple clearinghouse in London where banks exchanged cheques at the end of each business day. In this system, there were no credit limits between banks, in part because banks did not provide unconditional funds against deposited cheques. Such deposits became unconditional only after clearing and the confirmation that sufficient funds were available in the payer's account. In the case of credit transfers, however, the credit risk is more likely to fall on the receiving bank. With a credit transfer, customers and their receiving banks know that the payer had sufficient funds when making the transfer. So the receiving bank makes funds available to its clients and bears the risk that the payer's bank may fail in the interval between sending the credit transfer information and settling that payment in the end-of-day netting. Stage 4: Most industrial countries had reached stage 4, predominantly with DNS systems, by the 1970s or 1980s. In such unprotected DNS systems, commercial banks provided free, unlimited, uncollateralised intraday credit. 3 As risks in both net and gross systems were recognized, central banks required collateral or charged for intraday credit. With limited intraday liquidity, both DNS and RTGS systems have adopted prioritization arrangements, while some DNS systems have increased the frequency of batch settlements during the day. Stage 5: Automation increased speed and reduced costs, both followed by the dramatic increases in transaction values in both domestic and international financial liberalization that took place during these two decades. The traditional DNS systems of stages 3 and 4 involved unlimited implicit credit granted to the paying bank by the receiving bank from the time a payment instruction was received until the time of final settlement after clearing. Risks In Payment Systems Legal risks are one aspect of the need for certainty about how the system operates. Participants need to know what happens in different circumstances. If a participant defaults, for example, what will be the impact on other participants Operational risk is the risk of system malfunction because of information technology or mechanical failure, which may include problems in the wider infrastructure, such as an unreliable electricity supply or failures in the national communications infrastructure. Security risks arise from fraud or other abuse of the systems. Payment systems must be designed in a way that ensures that users or operators cannot interfere with the integrity of the data being transmitted or the instruments being exchanged. Economic risks come in many different forms but can be divided broadly into credit and liquidity risks. Credit risks generally arise as a consequence of the failure of a participant. One form of credit risk is market risk, also known as replacement cost risk, which is larger the greater the gap between a contractual agreement to make a payment and the settlement of that obligation.4 Liquidity risks arise not only as a consequence of insolvency but also as a result of any failed delivery. These may be caused by technical problems either with the party due to pay or with the system. Liquidity risks occur when a participant does not receive an expected payment but has obligations to make payments to other counter parties, which may be difficult to fulfill. (Fry, 1999) Central Banks Role in Payment Systems The role of Payment Systems in the financial and banking system, raise two questions. The first is to examine the reasons why central banks are interested in payment systems. The second is to provide an overview of the role of central banks in the payment system. As an illustration, the Bank of England's mission statement specifically recognizes the promotion of efficient payment arrangements as an important element of the Bank's core purposes. Gerry Corrigan, former President of the Federal Reserve Bank of New York, also recognized this important role when referring to the "trilogy" of central banking functions and responsibilities: monetary policy, banking supervision and payment systems. 5 Andrew Crockett (1998, p. 4) realizes that "payment systems were not only a technical matter but also went to the very heart of central bank policy concerns." Jacques' Theory of "Fair Payment System" In his book "Equitable Payment", Jacque proposed a universal theory of "fair payment for work." 6 Two concepts constitute the backbone of the theory. One is the felt-fair payment for work representing the wage perceived by the employees participating in the research to be fair for the work. (Dornstein, 1991) The second concept is the level of work performed by the participants measured in terms of time span of discretion. The time span of discretion as defined By Jacques is "the maximum period of time during which the use of discretion is authorized and expected, without review of that discretion by a superior" (Jaques, 1970: 21). According to Jacques a "totally unexpected" finding was a "regular connexion' between time span of discretion of the employees and the sum of money, which they claimed would constitute fair payment for their work. 7 Jacques calls the pattern of differential payment so derived the equitable work payment scale. Jacques, suggests the existence of an "unrecognized system of norms of fair payment for any given level of work, unconscious knowledge of these norms being shared among the population engaged in employment work" (1970: 146 ). The fair-payment scale is described as having the following features, among others: 1. Payment refers to total emoluments (i.e., wage or salary plus any other fringe benefits such as use of car, assistance with purchase of home, etc.) 2. During the years of data collection, the standards of what constitutes equitable payment moved upward, conforming closely percentage-wise, to the wage index. Jacques argues "equity is concerned with the relative treatment, within any given economy, of individuals compared with one another, rather than with any absolute standard of living" (1970: 148). 3. The norms of equity are independent of the amount of income tax paid by individuals. 4. The norms of equity for all hourly- and non hourly-rated workers are the same regardless of the length of their normal working week. Jacques suggests the shared norms of what constitutes fair pay for any given level of work, strongly influence a person's feeling about his actual pay: "A person's attitude toward the wage or salary packet paid for his work appears to be fundamentally influenced by the extent to which that bracket is consistent with what would be equitable for the range of level of work in his job, or deviates from equity either upwards or downwards" (1970: 153). Bibliography Donna Fossum, David Frelinger, Gerald Frost, Irving Lachow, Scott Pace, Monica Pinto and Donald K. Wassem (1995) The Global Positioning System: Assessing National Policies. Rand. Place of Publication: Santa Monica, CA. J. Lawrence Broz (1997) The International Origins of the Federal Reserve System. Cornell University Press. Place of Publication: Ithaca, NY. Mark J. Flannery and George G. Kaufman (1996) Financial Crises, Payment System Problems and Discount Window Lending. Journal of Money, Credit & Banking. Volume: 28. Issue: 4. Ohio State University Press; COPYRIGHT 2002 Maxwell J. Fry, Isaack Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard, Francisco Solis, John Trundle (1999). Payment Systems in Global Perspective. Routledge. Place of Publication: London. Miriam Dornstein, (1991). Conceptions of Fair Pay: Theoretical Perspectives and Empirical Research. Praeger Publishers. Place of Publication: New York. Read More