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PAYMENT AND SETTLEMENT SYSTEM

This article will cover:

Introduction Objectives of the payment system The Board for Payment and Settlement Systems Payment and Settlement Systems Act 2007 Payment System RBIs role in modernizing payment systems RBIs approach to responsible regulation RBIs role as facilitator of innovation Facts delivered by N. R. Narayana Murthy The Chalanges ahead Conclusion

Introduction The central bank of any country is usually the driving force in the development of national payment systems. The Reserve Bank of India as the central bank of India has been playing this developmental role and has taken several initiatives for Safe, Secure, Sound, Efficient, Accessible and Authorised payment systems in the country. The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a sub-committee of the Central Board of the Reserve Bank of India is the highest policy making body on payment systems in the country. The BPSS is empowered for authorising, prescribing policies and

setting standards for regulating and supervising all the payment and settlement systems in the country. In India, the payment and settlement systems are regulated by the Payment and Settlement Systems Act, 2007 (PSS Act) which was legislated in December 2007. The PSS Act as well as the Payment and Settlement System Regulations, 2008 framed thereunder came into effect from August 12, 2008. Objectives of the payment system As some of you might recollect, a monograph on Payment Systems in India was prepared by the RBI in 1998 to increase the awareness, both within the country and abroad, of the payment systems existing in India. The monograph also detailed the objectives that needed to be achieved. To that end, a Payment System Vision Document for 2001-04 was prepared to draw up the roadmap for consolidation, development and integration of payment systems in the country. Once these objectives were achieved, a Vision Document for 200508 was published in May 2005, articulating the Reserve Banks vision for the coming four years for the payment and settlement area. The mission enshrined in the Vision Document is the establishment of safe, secure, sound and efficient payment and settlement systems for the country, towards which all the upgradation efforts are focused. Whereas safety in payment and settlement systems relates to risk reduction measures, security pertains to confidence in the integrity of the payment systems. All payment systems are envisaged to be on sound footing with adequate legal backing for operational procedures and transparency norms. Efficiency enhancements are envisaged by leveraging the benefits of technology for cost-effective solutions. Thus, as part of its public policy objectives, the Reserve Bank has played a major role in the design, development and functioning of payment and settlement systems, and the multi-dimensional efforts of the RBI over the years have been geared to realise this vision. The Board for Payment and Settlement Systems In order to strengthen the institutional framework for the payment and settlement systems in the country, the Reserve Bank constituted, in 2005, a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) as a Committee of its Central Board. The Board is chaired by the Governor, RBI while all the four Deputy Governors and two external Directors of the Central Board are its members. The role of the BPSS is to lay down policies relating to the regulation and supervision of all types of payment and settlement systems, set standards for existing and future systems, approve criteria for authorisation of payment and settlement systems, and determine criteria for membership to these systems, including continuation, termination and rejection of membership. Thus, the BPSS is the highest policy making body in regard to the payment and settlement systems in the country and

encompasses electronic, non-electronic, domestic and cross-border payment and settlement systems which affect the domestic transactions. In its relatively short span since its inception, the BPSS has provided valuable guidance in shaping the emerging contours of the payment and settlement system in the country and has helped widen the reach of the payment services of the banks to the hinterland areas. Payment and Settlement Systems Act 2007 It is internationally acknowledged that payment and settlement systems should function on a well-founded legal basis. This entails among other things, proper authorisation requirement for setting up and payment systems, legal recognition for netting, settlement finality, providing for regulation and oversight of the payment and settlement systems. Many countries have either provided for these requirements in their central bank statutes or have drafted separate and comprehensive laws for this purpose. In India where the economy is growing at a fast pace increasingly large volumes and values are being handled by payment systems. Non-bank entities who are outside the explicit regulatory purview of the central bank are running/ are likely to run important payment systems. A number of innovative payment instruments/systems have been introduced by unregulated entities. While large payment systems which are unregulated present risks to the stability of the financial systems, unauthorised retail payment systems without proper management and operational structures can undermine public confidence in the efficacy of the payment systems as a whole. The Reserve Bank and the Government felt that there should be an explicit law to regulate the BIS Review 96/2008 5 payment and settlement systems. The Parliament has enacted the Payment and Settlement Systems Act in December 2007. This Act empowers the Reserve Bank to regulate and supervise the payment and settlement systems and provides a legal basis for multilateral netting and settlement finality. The Act empowers the Reserve Bank to lay down the policies for regulation and supervision of the payment and settlement systems, authorise their setting up/continuance, for issuing directions, laying down standards, calling for information/data, initiating prosecution/levying penalties for violation of the provisions of the Act, its regulations and directions etc. The Act will come into operation very shortly. Payment Systems The Reserve Bank has taken many initiatives towards introducing and upgrading safe and efficient modes of payment systems in the country to meet the requirements of the public at large. The dominant features of large geographic spread of the country and the vast network of branches of the Indian banking system require the logistics of collection and delivery of

paper instruments. These aspects of the banking structure in the country have always been kept in mind while developing the payment systems.

Paper-based Payments Use of paper-based instruments (like cheques, drafts, and the like) accounts for nearly 60% of the volume of total non-cash transactions in the country. In value terms, the share is presently around 11%. This share has been steadily decreasing over a period of time and electronic mode gained popularity due to the concerted efforts of Reserve Bank of India to popularize the electronic payment products in preference to cash and cheques. Electronic Payments The initiatives taken by RBI in the mid-eighties and early-nineties focused on technology-based solutions for the improvement of the payment and settlement system infrastructure, coupled with the introduction of new payment products by taking advantage of the technological advancements in banks. The continued increase in the volume of cheques added pressure on the existing set-up, thus necessitating a cost-effective alternative system. Electronic Clearing Service (ECS) Credit The Bank introduced the ECS (Credit) scheme during the 1990s to handle bulk and repetitive payment requirements (like salary, interest, dividend payments) of corporates and other institutions. ECS (Credit) facilitates customer accounts to be credited on the specified value date and is presently available at all major cities in the country. National Electronic Funds Transfer (NEFT) System In November 2005, a more secure system was introduced for facilitating one-to-one funds transfer requirements of individuals / corporates. Available across a longer time window, the NEFT system provides for batch settlements at hourly intervals, thus enabling near real-time transfer of funds. Certain other unique features viz. accepting cash for originating transactions, initiating transfer requests without any minimum or maximum amount limitations, facilitating one-way transfers to Nepal, receiving confirmation of the date / time of credit to the account of the beneficiaries, etc., are available in the system.

Real Time Gross Settlement (RTGS) System RTGS is a funds transfer systems where transfer of money takes place from one bank to another on a "real time" and on "gross" basis. Settlement in "real time" means payment transaction is not subjected to any waiting period. "Gross settlement" means the transaction is settled on one to one basis without bunching or netting with any other transaction. Once processed, payments are final and irrevocable. This was introduced in in 2004 and settles all inter-bank payments and customer transactions above ` 2 lakh. Mobile Banking System Mobile phones as a medium for providing banking services have been attaining increased importance. Reserve Bank brought out a set of operating guidelines on mobile banking for banks in October 2008, according to which only banks which are licensed and supervised in India and have a physical presence in India are permitted to offier mobile banking after obtaining necessary permission from Reserve Bank. The guidelines focus on systems for security and inter-bank transfer arrangements through Reserve Bank's authorized systems. On the technology front the objective is to enable the development of inter-operable standards so as to facilitate funds transfer from one account to any other account in the same or any other bank on a real time basis irrespective of the mobile network a customer has subscribed to. National Payments Corporation of India The Reserve Bank encouraged the setting up of National Payments Corporation of India (NPCI) to act as an umbrella organisation for operating various Retail Payment Systems (RPS) in India. NPCI became functional in early 2009. NPCI has taken over National Financial Switch (NFS) from Institute for Development and Research in Banking Technology (IDRBT). NPCI is expected to bring greater efficiency by way of uniformity and standardization in retail payments and expanding and extending the reach of both existing and innovative payment products for greater customer convenience.

Oversight of Payment and Settlement Systems Oversight of the payment and settlement systems is a central bank function whereby the objectives of safety and efficiency are promoted by monitoring existing and planned systems, assessing them against these objectives and, where necessary, inducing change. By overseeing payment and settlement systems, central banks help to maintain systemic stability and reduce systemic risk, and to maintain public confidence in payment and settlement systems.

RBI Role in Modernizing payment systems Introduction of MICR technology in the mid 80s Many of you would have seen the magnetic inks bar codes printed on the bottom of your bank's cheque leaves. These bar codes are known as MICR code, an abbreviation for 'Magnetic Ink Character Recognition'. In the early 1980s the Reserve Bank of India introduced many new modes for safe and effective payments across the country. One such important mode introduced was the unique system of MICR based cheque clearing system. Apart from being a security bar code to protect your transaction, the MICR code is also an indispensable part for online money transfers. Every bank branch is given a unique MICR code and this helps the RBI to identify the bank branch and speed up the clearing process. Introduction of Speed Clearing for outstation cheques in 2008 Speed Clearing refers to collection of outstation cheques (a cheque drawn on non-local bank branch) through the local clearing. It facilitates collection of cheques drawn on outstation core-banking-enabled branches of banks, if they have a networked branch locally. The collection of outstation cheques, till now, required movement of cheques from the Presentation centre (city where the cheque is presented) to Drawee centre (city where the

cheque is payable) which increases the realisation time for cheques. Speed Clearing aims to reduce the time taken for realisation of outstation cheques. Banks have networked their branches by implementing Core Banking Solutions (CBS). In CBS environment, cheques can be paid at any location obviating the need for their physical movement to the Drawee branch. The concept of Speed Clearing combines the advantages of MICR clearing with that of CBS. Cheques drawn on outstation CBS branches of a Drawee bank can be processed in the Local Clearing under the Speed Clearing arrangement if the Drawee bank has a branch presence at the local centre. Banks including public sector, private sector, cooperative and foreign banks, which are members of BBCH and have implemented CBS, can now locally pay outstation cheques of branches covered under CBS without having to physically send the cheque to the branch of the drawee for clearing. Customers would in such cases get credit on T+1 basis ('T' being cheque presentation day at the clearing house) provided the other conditions for passing the cheques are met. In other words, outstation cheques drawn on branches covered under the CBS will effectively be treated as local cheques for clearing purposes saving time and cost of collection, thus benefiting the customers. RTGS was introduced in 2004 as a large value payment system

RTGS is a funds transfer systems where transfer of money takes place from one bank to another on a "real time" and on "gross" basis. Settlement in "real time" means payment transaction is not subjected to any waiting period. "Gross settlement" means the transaction is settled on one to one basis without bunching or netting with any other transaction. Once processed, payments are final and irrevocable. This was introduced in in 2004 and settles all inter-bank payments and customer transactions above ` 2 lakh.

RBIs approach to responsible regulation Non-banks allowed to enter the retail payment space

Recognising that non-banks can provide innovative payment products and foster competitiveness in the market, the Reserve Bank authorised non-banks to enter the retail payment space. At the same time, we took care to ensure that the non-banks which come in adhere to KYC/AML guidelines and follow the prescribed guidelines for customer protection and customer service. For example, even as non-banks specialise in payment services and products, the settlement domain remains with the banks, and the outstanding balances are required to be kept in an escrow (trust) account so as to insure against bankruptcy. Now, non-bank also allowed to set up "White Label ATMs" Promoting Safety and Security of Payment Instruments The security of online card transactions has been strengthened with the implementation of additional factor of authentication. With effect from July, 2011, an online alert for all card transactions has become mandatory. Similarly, to protect card present transactions, we issued directions to banks and other stakeholders to initiate measures to strengthen the security and fraud risk management practices, merchant sourcing, and to issue EMV (EuropayMasterCard-VISA) chip card and PIN to customers who have evidenced at least one purchase using their debit/credit card in a foreign location. Customer Centric Regulation By far the largest number of complaints we receive in the Central Office of the Reserve Bank as well as at our ombudsman offices across the country are about failed ATM transactions. RBI has mandated that in case of a dispute, the disputed amount should be credited to the customers account within seven days, failing which the customers bank is liable to pay compensation to her at the rate of `100 per day from the date of the complaint, provided the complaint is filed within 30 days from the date of the failed transaction. RBIs role as facilitator of innovation Introduction of New Payment Products

he last few years have witnessed a remarkable growth in new payment products and access channels viz. debit cards and credit cards issued by banks, and prepaid cards that can be issued by both banks and non-banks. The safety and efficiency of the access channels viz. ATMs, PoS, E-commerce and M-commerce have been instrumental in the popularization of these alternate payment products. In October 2008, the Reserve Bank put out operating guidelines on mobile banking for banks. Only banks which are licensed and supervised in India and have a physical presence in India, are permitted to offer mobile banking, after obtaining the necessary permission from the Reserve Bank. The guidelines focus on systems for security and inter-bank transfer arrangements through Reserve Bank's authorized systems. On the technology front, the objective is to promote inter-operable standards so as to facilitate fund transfers from one account to another in the same bank or in another bank on a real time basis irrespective of the mobile network of the customer.

Mobile Financial Services The Interbank Mobile Payment Service (IMPS) launched by the NPCI in November 2010 is expected to give a further boost to the growth of mobile payments. The IMPS is a unique 24x7 inter-bank electronic funds transfer system which provides instantaneous credit to the beneficiaries which, I am told, is the first of its kind in the world. Currently, the IMPS is at a nascent stage with limited volume of transactions and settlement values, but several enhancements currently under way, are expected to increase the volume and value substantially.

Focus on Central Clearing

India has preferred a central clearing arrangement for large value interbank transactions wherever feasible. The Reserve Banks tryst with central clearing started with the setting up of the Clearing Corporation of India Limited (CCIL) in 2001. CCIL offers central counterparty clearing and settlement arrangements for transactions in government securities, forex segment and CBLO. Settlement through the CCP arrangement has reduced the associated risk, cost and time in the completion of the settlement. Quite early on, the CCP arrangement instituted netting in forex transactions. This proved to be particularly valuable in the depth of the crisis when, even as liquidity lines had virtually dried up, banks in India did not face any liquidity and funding shortages.

Facts delivered by N. R. Narayana Murthy Payment Systems Efficient and effective payment and settlement systems are critical for the financial performance of the institutions and are strategic to the stability of the financial systems. According to a study by Boston Consulting Group (BCG), payments business in banks represent more than 40% of their total revenues and 33% of their profits. Payments offer banks significant opportunities to increase transaction volumes and fee income. Payment Systems in India India has several payment systems, ranging from paper-based systems to the most sophisticated electronic fund transfer systems that offer real-time settlement. These payment systems are managed by multiple entities and are regulated by the Reserve Bank of India (RBI). RBIs thrust on technology in payment systems have resulted in visible improvements in the settlement processes, where over 70% of the transactions are handled electronically. Real Time Gross Settlement (RTGS), accounted for 23% of the total settlements, is emerging as the largest among the payment systems. Retail Payment Systems (RPS) include cheque clearing systems,

electronic clearing systems and the card-based systems. Cheque clearing accounts for over 95% of the retail payment, and more than 70% of cheque clearing is based on Magnetic Ink Character Recognition (MICR) technology. Increased acceptance of electronic payment systems resulted in the growth of retail electronic clearings by 168% .

Board for Regulation Settlement Systems

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BPSS was constituted in March 2005, to prescribe policies relating to the regulation and supervision of all types of payment and settlement systems, set standards for the existing and future systems. To assist BPSS, RBI constituted a Department of Payment and Settlement Services (DPSS). BPSS had made several important decisions, for example, finalizing the payment and settlement systems bill, which provides a legal basis for the payment and settlement systems. Recommendations of BPSS Following BPSS recommendation that the RTGS system in India is benchmarked with the best in the world, a study was conducted on several RTGS systems across multiple parameters. Retail payments are used by the masses and should provide secure, safe and faster mean of remittance to their customers. These systems should ensure proper customer redressal arrangements.

Imperative for India Proliferation of modern payment systems have far reaching economic and social implications for India where significant population have so far been excluded from the benefits of the financial systems. Payment systems help in the financial inclusion and improve the quality of their lives. Implementing such systems increase transparency, lower transaction costs, improve operational efficiency of trade and commerce and provide support to the globalization of the economy. Payment Systems Benefits for India

Payment systems improve financial transparency, by bringing cash into the banking system, which would otherwise have been kept out of the system. Banks can then effectively deploy additional cash flow, thus stimulating business growth and consumption. This is especially significant in the Indian context, where, as per estimates, more than 90% of the consumer spending is handled by cash basis money which never enters the payment systems. In fact, according to a study by the McKinsey, India ranks No.4 in the world, in terms of currency in circulation. Indias currency in circulation is 11.8% of GDP. This could be attributed to the fact that more than half of Indias economic output is produced by small-scale agriculture and some 44 million household businesses. Mckinsey estimates that improving the payment systems in India, by fully moving to electronic systems, could result in an annual savings of close to $6.3 billion. Retail Payment Systems India, has made visible progress in the high value payment systems, However, retail payment systems in India need to be improved. Existing retail payment systems should move to more advanced, efficient and reliable systems comparable to global standards. In order to widen the reach of these systems, participating institutions should develop appropriate applications and user friendly websites with simple interfaces and local content. Among the retail payment systems, electronic clearing accounted for less than 1.5% of total value of transactions. The efficiency of Retail Payment Systems could be improved by increasing the usage of electronic payment systems and rolling out the cheque truncation system. The challenges ahead We have no doubt covered considerable ground in modernising our payment and settlement system. The banking system too has made considerable investment in the related infrastructure to upgrade the payment system. However, there are several challenges that need to be effectively addressed if the full benefits of the achievements so far are to be reaped. One of the main challenges in the payment system area is to promote large-scale use of the electronic modes of payment across the country and requires addressing the constraints that impede the adoption of this mechanism. To my mind, the primary reason for slow pace of adoption of the electronic modes of

funds transfer, particularly in the retail segment, is the lack of education particularly on the part of the bank staff at the branch level that have interface with the public. A survey conducted by one of the Regional Offices of the RBI in the recent past revealed that in the limited sample covered, there were several bank branches in the State which were not even aware of the National Electronic Fund Transfer system. The banks, therefore, need to make concerted efforts to increase the degree of awareness at the level of the branch staff so that the electronic fund transfer services percolate down to the level of the public in a significant manner. The other side of the coin is the lack of customer education and awareness about the features and benefits of the EFT, which precludes wider adoption of this product and leads to carrying on with the traditional modes of payment. I would, therefore, like to urge upon the banks to launch a systematic educational campaign for their clients to educate them of the suite of electronic products offered by them. This would not only reduce the avoidable paper work in the operation of the banks but would also improve the quality of customer service and eventually, business volume. In so far as the RBI is concerned, with a view to promoting the electronic payment culture and to make it more user-friendly, the RBI has intervened and mandated reasonability in pricing of transactions effected through ATMs and compulsory use of electronic mode for transactions above a specified threshold. The service charge levied on banks by the RBI for ECS, EFT / NEFT and RTGS transactions, so that this benefit of reduced costs is passed on to customers, and the right incentive framework is created for the use of electronic retail payment products. Although the share of electronic payment products is improving in the overall retail segment, the share of public sector banks in this area is very low even as the number of branches offering the electronic payment facility is increasing. It is, therefore, necessary to make these products available across all bank branches. There is also a need to focus on expanding the geographical reach of the electronic payment services so as to include the segments of the population not yet touched by it. It is difficult to achieve financial inclusion without encompassing rural-India in the payment system out-reach and the banks that do so first, will reap the rewards of the first-mover advantage in terms of higher market share, with the concomitant increase in business and revenues. And as we all know, the electronic payment medium is not only speedier and more efficient, but is also more environment friendly as it reduces the reliance on paper required for effecting payments. It is our vision that electronic products reach a level of 50% by volume and 95% by value of the aggregate payment system transactions in the country, by the end of March 2013. Then, there are also some nagging efficiency issues in the payment system. Whilst the current clearing cycle of T+1 basis for the cheques payable locally, compares favourably with the best in the world, it is necessary to look into the entire cheque collection cycle from the time a customer deposits a cheque at a branch till the point of realisation of credit in his account. There is perhaps scope for continuous improvement in overall

collection cycle. Going by the number of complaints received, it appears that customer-service in this area is not very customer-centric. Conclusion The payment and settlement system constitutes the backbone of the financial sector and enables conclusion and settlement of financial contracts. The country has made phenomenal progress in enhancing the reach and improving the efficiency of the national payment system in which the RBI and the banking system have been equal partners. Creating a world-class payment system in the country is a long, arduous but an exciting journey in which we have to constantly keep striving to better our past achievements.