Getting ready to establish the Sri Lanka Common Payment Switch (SLCPS) - A new dimension in Banking and Payment System

General Background

In a modern economy, the payment system is a major component of the country’s infrastructure system. In deed, no country nowadays can afford to take its payment system for granted. Firms pay wages to their employees and purchase raw materials from their suppliers.  In turn, they receive payments for the sale of their products and services.  Consumers make payment transactions several times in a day.  Needless to say, value is transferred among participants in the economy every minute of the day, and it increases as the economy grows.  The country’s payment system, therefore, must be efficient so that funds can quickly move among market participants for productive use, thereby promoting more activities in the economy.  Thus, while the country continues to spend on roads, bridges, power supply etc., it must not neglect to invest in its payment system to improve the efficiency of economy, in general, and the financial system, in particular.

Advances in information technology and changes in laws, institutions and regulations in some countries have encouraged the emergence of new payment instrument as well as the delivery and processing arrangements for small and large value time-critical payments.  With e-commerce now in the mainstream of economic activities, we can therefore expect more major changes in the payment systems worldwide in the next five years than we have in the last five decades.  Obviously, the Sri Lanka cannot escape from this sea of change.

Through the years, payment systems have considerably changed as forms of payment have evolved from precious metals to currency and cheques and recently to electronic payments.  These changes have been made because of the need to facilitate voluminous transactions occurring in rapidly growing and increasingly more sophisticated economies.   Customers naturally seek the most efficient payment method, while providers of payment services normally select the more profitable among several options in supplying payment system services.

Functions of a Payment System

Any payment transaction has essentially two parts: the flow of information providing payment instructions and the flow of funds.  Both flows may have different timing and direction.  Each payment transaction requires some form of payment instrument to convey the information about the transactions, which may include the face value of the payment the identity of the parties (i.e., the payer and the payee) and their intermediaries, the transaction date and the value or settlement date.  Regardless of the type of payment instrument used to effect payment, the payment system’s functions of clearing and settlement occur.  Clearing is the process of transmitting, reconciling and in some cases confirming payment orders or security transfer instructions prior to settlement, possibly including netting of instructions and the establishment of final positions for settlement.

Settlement is the act of transferring “good and final funds” between two parties.  A payment is settled with finality when the payer can no longer revoke the transfer of funds to the payee and the funds have been delivered unconditionally to the payee.  This is the ultimate objective of a payment system.

In Sri Lankan context as per Payment & Settlement Act No.28 of 2005 “clearing and settlement system” means a system or arrangement for the clearing or settlement of payment obligations in the financial system, in any currency, and in which there is a minimum of three participants, at least one of whom is a financial institution: and includes a system or arrangement for the clearing or settlement in the official currency.

The State of Play

The key objective driving reform in payments clearing and settlement in Sri Lanka is enhancement of the safety and integrity of the system.  It is also important to improve the efficiency with which payments instructions are handled and funds made available, and to introduce greater competitive equity among service providers.

These key objectives would lead to less paper and more electronics as the basis for transactions.

Electronic Fund Transfer (EFT)

Electronic funds transfers are more efficient than paper-based transactions, as well as being more secure, cheaper and faster, and capable of providing finality of payment with greater certainty.  Electronic funds transfers can be integrated directly with the ordering and delivery of goods and services, and can substitute more effectively for currency than can paper.

Electronic funds transfers, while providing the opportunity to reduce risk, also change its location.  Unlike cheques, there is no uncertainty about whether payers have the wherewithal to pay – EFT transactions do not proceed unless the customer’s capacity to pay is established beforehand.  As a consequence, electronic funds transfers shift risk away from ordinary customers (who may not be well placed to assess and manage risk) towards financial institutions (which are more adept at both.)

The use of electronic funds transfer technology can also enhance the competitiveness of the market for financial services.  Effective entry in to the EFT payments system is, in a number of ways, easier than into the cheque system. 

Electronic payments can be cleared immediately against both the paying customer’s balances and the receiving institution’s exposure limits against the paying institution.  This means that prudentially sound financial institutions (including relatively small non-bank players) that meet the required technical standards can be accommodated more readily.  Conversely, the cheque payments system is less amendable to accommodating new entrants on the same terms as the well established players, because the attendant risks on institutions cannot be managed as effectively in advance, and the systems for physically processing paper are more cumbersome and expensive.

Cheque Truncation & Imaging System (CITS)

The inherent advantages of electronic systems, however, do not mean that cheuqes will disappear overnight.  Cheques have some obvious attractions in a community so accustomed to their use.  With appropriate reforms to processing (e.g. truncation, imaging) cheques are likely to remain for a good while yet.  Currently, around 200,000 cheques are cleared through on each business day.  Number of cheques cleared in 2007/08 through CITS amounts to 45.85million. On the value of cheques cleared through CITS amounts to Rs.4,389billion compared to Rs.3,980billion during the previous year.  This is an increase of 10.27%.  Nonetheless, it is clear that the reform and development of the Sri Lanka payments clearing system will cause more value to shift out of paper onto electronic systems.  In the longer term, it is likely that there will also be a substantial, (though not total), shift of ordinary, low-value cheque payments to EFT mechanism.

The cheque Truncation is an image-based cheque clearing system, which replaces the physical cheque flow with electronic information throughout the entire clearing cycle.  Truncation is to eliminate the movement of paper in order to eliminate the bottlenecks and delays associated with the movement of paper.  This include the expeditious handling of returned items, exchange of data images with remote locations and reduce security risk as a result of reduced handling of the physical cheques.  Cheque truncation spans a wide spectrum that is truncation at the paying bank, truncation at the collecting bank, truncation at the bank branch or at the collecting bank branch.

Cheque imaging – is the process involved in the capture, storage, display and printing of digital images of a cheque.  Image processing spans a sequence of three steps.  The input step (image capture and digitalizing) converts the differences in colouring and shading captured by a scanning machine into binary values that a computer can process.  The processing step can include image enhancement and data compression.  The output step consists of the display or printing of the processed image.  Cheque Imaging technology also eliminates bottlenecks and delays associated with handling of paper and thereby increase the efficiency, reduce the operational cost, expedite the time taken to complete clearing process and improve customer service.

Sri Lanka Interbank Payment System (SLIPS)

There are two main systems visible in the Interbank Electronic Funds Transfers.

• The first type is the direct On-line Interbank funds transfer System. The best example on this in Sri Lanka is the Real Time Gross Settlement System. (RTGS)
• The second type is the Off- Line Inter bank Funds Transfer System where the data is transferred as Debit and Credit using a magnetic diskette or through the File Transfer Protocol (FTP). 

FTP is an acronym for File Transfer Protocol. As the name suggests, FTP is used to transfer files between computers on a network. FTP sites are typically used for uploading and downloading files to a central server computer, for the sake of file distribution.

In Asian region Singapore Clearing House implemented an off-line interbank Funds Transfer System in 1984, which they named as interbank “GIRO”. In 1993, The Central Bank of Sri Lanka (CBSL) too implemented an off-line interbank payment system in association with the Sri Lanka Bank’s Association. This system was called the Sri Lanka Interbank Payment System (SLIPS).

SLIPS is an offline interbank payment system catering mainly for low-value payments, which allows a customer of a participating bank to transfer funds through direct debits or credits, to or from the accounts of customers of any other participating bank.  All commercial banks and the CBSL are direct participants of the SLIPS. Other financial institutions, corporate bodies and individuals can participate in the SLIPS only through their correspondent banks.

LankaClear (LCPL) receives several thousand (sometimes hundreds of thousands) debit/credit transaction requests (outward SLIPS items) per day from client banks. These transaction requests represent fund transfers authorized by the payer and the payee, which simplifies some of the issues that usually complicates fund transfers.

For example, a commercial firm might pay employee salaries using SLIPS. The list of receiving accounts, which are the employee current or savings accounts, are credited from the employer’s payroll account (one to many Transactions). Similarly, a public utility might have authorizations from their clients to recover utility bill payments (many to one Transaction). In this case the possibility of insufficient funds exists, and it might result in the client’s bank sending a return on the following day to the transaction originated bank. (Returns are also possible for technical reasons, of course, such as incorrect account numbers.)

Payments of public sector salaries have commenced paying government salaries using non-cash instruments through the SLIPS system.  However, from the point of view of increase in the using of this non-cash payment instrument, there are certain constrains involved in the current SILPS system mainly on the capacity upgrade aspect to cater to the volume needs of the government and payment security to comply with international best practices.

Types of Risk in a Payment System

A country’s payment system no matter how advance and sophisticated is usually exposed to settlement risk the risk that settlement will not take place as expected.  This risk comprises two types of financial risks – liquidity and credit risks Liquidity risk arises from the possibility that the payer or the payer’s financial institution may fail to meet its payment obligation on the due date because of insufficient liquid funds.  Although the payee will eventually receive in full the principal amount of the payment from the payer in some future date, he will, however, likely forego interest income or incur interest costs if he borrows money to make some payment transactions while waiting for the receipt of his payment.  Credit risk, on the other hand, arises from the possibility that the payer fails to meet his payment obligation on a due date because of insolvency.  In this case, the likelihood of settling the payer’s obligation with the payee in the future is virtually nil, and the payee may lose all or part of the principal amount of the payment. 

Liquidity or credit risk may lead to systemic risk, which is the possibility that the failure of one participant to meet payment obligations on a due date will cause other participants in the payment system to fail to meet their payment obligations when due.  This large-scale liquidity or solvency problem can undermine a country’s payment system, which, in turn, can adversely affect the whole economy.  It is, therefore, understandable that monetary authorities are very much concerned about systematic risk facing their country’s payment system.

As per Payment & Settlement Systems Act (PSSA), has defined risk to the financial system as follows:

“risk to the financial system of Sri Lanka” means the risk that the inability of a participants to meet its obligations in a clearing and settlement system as they become due, or a disruption to a clearing and settlement system, that could through the transmittal of financial problems into the system, cause-

1. other participants in the clearing and settlement system to be unable to meet their obligations as they become due:
2. financial institutions in other parts of the financial system of Sri Lanka to be unable to meet their obligations as they become due, or
3. the clearing and settlement system’s clearing house or the clearing and settlement system within the financial system of Sri Lanka to be unable to meet its obligations as they become due.

A payment system may also be exposed to operational, security and legal risk, which may give rise to liquidity or credit risk, and potentially to systematic risk.  Operational risk arises from human error, equipment malfunctions, natural disaster, or system design flows, which can cause error in payment or disruption in the payment system.  An example is the failure of a telecommunications system, causing terminals to be offline for a few minutes.  Security risk refers to risk of fraud, which can leave a party subject to financial loss, or the risk to privacy when a third party illegally gains access to confidential payment information that can be used to exploit the financial position of another party.  An example is forging a signature on a payment instruction such as a cheque.  Legal risk arises from the absence or lack of clarity in the legal framework that causes some uncertainty about, and misinterpretations of, the legal enforceability of parties’ rights and obligations.  The inefficiency of the judicial system of the country also can make the litigation cost very prohibitive.  However, with the enactment of Payment & Settlements Act No.28 of 2005, Devices Frauds Act No.30 of 2006, Electronic Transactions Act No.19 of 2006, Financial Transactions Reporting Act No.6 of 2006 and Computer Crime Act No.24 of 2007, some of the legal risks have been mitigated to some extent in Sri Lanka leaving room for further development in this sphere.

 Common Payment Switch (CPS)

High liquidity, secure transactions and instant payment realization in the payment and settlement system is essential in order to fast track economic development and to induce high economic activity. In order for Sri Lanka (SL) achieve its goal of being a regional financial hub the above needs to be realized. Therefore the National Payment Council (NPC) together with Central Bank of Sri Lanka (CBSL) and LankaClear (LCPL) will be launching a Common Payment Switch (CPS) to enable Online, Real-time, Secure and Reliable fund transfers for low value interbank payments. This national system will have multiple multilateral Net Settlements during a day. The Net Settlement will be via the Banks’ Current Accounts maintained at CBSL.

(Note: No full disclosure due to IT security reasons)

Legend:

The above diagram depicts the high level operation of the CPS System. A Bank Customer instructs his bank (Bank-A) to transfer funds to the account of a customer in Bank-B. Then Bank-A will generate a transaction that will be sent to LCPL via the CPS network (VPN). LCPL will record this transaction and route it via the “Main Router” at LCPL to the relevant bank (Bank-B). This will enable instant payment realization to the beneficiary. Each business day will have multiple Net Settlements which will be carried out through the existing CBSL RTGS system based on the consolidated multilateral Net Settlement Report provided by LCPL.

Benefits to Banks

The CPS system will greatly help banks in 3 major areas: 1. Higher operational efficiencies, 2. Greater revenue generating capabilities and cost savings and 3. Hi-Tec capabilities.
In terms of higher operational efficiencies, banks will benefit tremendously by lowering its operational overheads by almost eliminating the manual work and errors induced due to most processes being manual in the current operations. CPS will help banks to create new products and thus significantly increase the “Top Line”, as well as the margins. With the CPS system, banks can easily take advantage of creating an efficient salary payments system that has a potential market of 4.5 million transactions a month. Also, not forgetting 3rd party payments, bill payments, direct debits, card based POS payments, local credit cards, inward remittances, statutory payments, etc. Thus the products banks can create around these features offered in the CPS are numerous, resulting in high revenue. Also, banks will save on cost associated with counter-times (i.e. a physical visit of a customer) and also by repurposing employee involved in manual work towards other income generating activities. Since CPS is an online real-time system, banks will have 24x7 access to standard or customized reports, transactions status liquidity positions, etc. Also, it will integrate seamlessly to the existing banking systems, while making each transaction more secure and reliable. Essentially banks will get a future proofed online, real-time payment system for a very low Total Cost of Ownership (TCO).

Benefits to Bank Customers

Some of the main advantages that bank customers will benefit from will be: faster realization of interbank payments via secure transactions that has multiple access points (i.e. ATMs, Internet banking, Mobile banking, etc.) and 24x7 access to banking services. SL already has a very technically savvy community as evident from the mobile and sms penetration in all demographics and regions. With the introduction of this online, real-time payment system where the payment is realized instantaneously there will be an explosion of usage given its ease of use and the high security of each transaction.

Benefits to Sri Lanka

Some of the main benefits this nationwide system will bring into the SL economy will be: Higher liquidity in the payment and settlement system of SL, and will induce rapid economic activity and growth. This will assist SL in realizing its goal of being a regional economic hub.  The CPS framework will create the infrastructure required for a payment super highway in SL to enable future development in the banking sector, such as eCheques, integration of payment modes such as mobile cash, card integrated POS systems, ATMs, etc. This will result in creating an explosion in the payments and settlements industry in Sri Lanka, which will place us as a global leader, if not at least a regional leader.

Road Map

The CBSL established a National Payment Council (NPC) which is the highest decision making body with regard to payment & settlement systems.  As per the road map of the NPC, the Common Payment Switch initiative has already begun and the pilot run will commence in February 2009. We expect to see all banks be fully integrated to the CPS during the year 2009 and thus ushering a new area in the payment and settlement sphere, not only in Sri Lanka, but the region.

A Sarath de Silva
Chairman
The writer / former General Manager of Bank of Ceylon, presently the Chairman of Lankaputhra Development Bank also a Member of the National Payment Council and a Board Member of Strategic Enterprise Management Agency (SEMA).