Book "Payments and market infrastructures in the digital era"

Money is traditionally defined on the basis of its functions. Yet money is more than just what it does: it is also an institution, built on confidence. It is therefore important to consider the nature of money (Section 1). Money comes in various forms and, over time, has evolved towards dematerialisation (Section 2). Lastly, money creation, which is endogenous, relies on the sharing of roles and functions between a central bank and commercial banks working through a hierarchical structure (Section 3).

Let us begin this chapter by clarifying how the terms “means of payment”, “payment instrument” and “money” are used. The distinction between money itself and the payment instruments used to transfer it is often blurred in practice. This confusion stems from our day‑to‑day use of fiduciary money, i.e. banknotes and coins, which constitute money (a store of value, unit of account and medium of exchange for commercial transactions) as well as payment instruments (used to transfer value). This is not the case for any other payment instrument (card, cheque, credit transfer, direct debit, etc.). We should not allow this characteristic specific to fiduciary money to blur the lines between the two concepts. As regards “means of payment” and “payment instrument”, the difference here relates to the use of terminology: “means of payment” is commonly used as a broad term covering both payment instruments (banknotes and coins, cards, cheques, credit transfers, direct debits and so on) and money (fiduciary money or scriptural money, i.e. bank account balances), without distinguishing between the two. In this chapter, “means of payment” will be used in preference to “payment instrument”, while banknotes and coins will generally be referred to as “fiduciary money”, given their specific nature.

The payment methods in use today are evolving fairly quickly. We are seeing a shift away from physical formats, such as cheques, towards electronic formats like cards and credit transfers, along with the emergence of new payment solutions afforded by the rise of the digital economy. This chapter purports to shed light on these development trends.

This chapter addresses the security challenges posed by means of payment and the mechanisms put in place to defeat fraud in all its increasingly sophisticated forms. The development of electronic means of payment is closely linked to advances in IT and communication technology. Since technological innovations also enable fraudsters to use more sophisticated techniques, the systems security mechanisms associated with means of payment must be upgraded regularly.

Means of payment act as vehicles for trade and, as such, are crucial to the mechanics of our modern economies. To drive this point home, just imagine a world that has no means of payment commonly accepted by all economic agents: in a world like this, any buyer or seller would face substantial costs. By giving all economic agents access to standardised means of payment that are widely accepted and sufficiently secure, we break down these barriers, allowing trade to flow much more freely.

Even though means of payment perform such a vital function, most people know little about the role they play in the economy. This chapter purports to shed light on the relationships between means of payment and the economic sphere. It begins by explaining the links between means of payment and economic activity, focusing on the costs to society of various means of payment. It goes on to address the specifics of the retail payments market, listing the factors that drive demand for means of payment and providing details on how the market is structured. Lastly, it describes the market’s shortcomings, which justify intervention by public authorities to ensure that the sector functions properly.

To be well understood, the place and role of financial market infrastructures must be seen in the broader perspective of the financial ecosystem. Financial market infrastructures, such as payment systems, central counterparties (CCPs) or central securities depositories (CSDs) and securities settlement systems (SSS), play a key role in the exchange of the financial instruments that support the financing of the economy. Specifically, financial market infrastructures process not only payment flows, but also securities flows, in combinations that vary depending on the financial instrument.

After describing elements relating to money and payments in the first four chapters, in this chapter we examine the main concepts relating to financial instruments and the market infrastructures that process them, as an introduction to Chapters 6 to 16, in which we look at how the infrastructures are organised and operate.

In this chapter we provide an overview of the main financial instruments and the market environment in which they are traded, and analyse the various stages of the processing of financial instruments, from issuance to settlement. We also explore the main concepts relating to financial market infrastructures, the actors of the infrastructures and the legal principles underlying the functioning of these entities. The infrastructures in charge of processing financial instruments are discussed in detail in Chapters 11 (CCP), 12 (CSD), 13 (SSS) and 14 (TARGET2 Securities ‑ T2S).

Apayment is a transfer of a monetary asset to discharge a debt. A number of circuits can be used to conduct such transfers, depending on the type of payment concerned. These can be either intra-bank circuits or interbank circuits, with the latter taking different forms: bilateral (correspondent banking), multilateral (use of a payment system) or a combination of the two (correspondent banking +use of a payment system).

A mong the RTGS systems in use across the world’s major monetary areas, the euro area’s TARGET2 system provides a good example of the key features described in the previous chapter.

TARGET2 is the real‑time gross settlement system owned and operated by the Eurosystem. Implemented in 2007‑2008, it is the second generation of TARGET (Trans‑European Automated Real‑time Gross‑settlement Express Transfer system), a system launched in 1999 alongside the single currency and designed to settle large‑value payments in euro using central bank money.

The central banks participating in TARGET2 are, in principle, those of the countries that adopted the euro as their currency. However, the central banks of other European Union Member States can also participate so that users of their national RTGS systems can settle euro transactions in TARGET2 (these central banks are then said to be “connected”).

At the end of 2017, alongside the European Central Bank (ECB), 24 national central banks (NCBs) were participants in TARGET2: the 19 NCBs of the euro area, plus 5 “connected” NCBs.

As referred to in Chapter 6 (Payment circuits and systems), all the G20 member countries currently have RTGS systems, except for Canada.1 In addition, in the United States and the euro area, a key feature in the landscape of large value payment systems (LVPS) is “cohabitation” between an RTGS system operated by the central bank and a deferred net settlement (DNS) system operated by a private entity, as is the case with CHIPS2 in the United States and the EURO13 system in Europe.

This chapter focuses on these two systems, together with Canada’s LVTS.4 5 Although these are all DNS rather than RTGS systems, they handle large amounts and are therefore deemed to be systemically important for the smooth functioning of the financial system. In view of this, each of the three systems has put specific solutions in place to facilitate settlement in near real‑time and reduce credit risk exposure, without overly inflating the liquidity needs inherent in RTGS systems. As a result, these systems can now be qualified as “hybrid” systems (see Chapter 6).

This chapter deals with settlement on a “payment versus payment” (PvP) basis, focusing particularly on the CLS (Continuous Linked Settlement) system, which is used to settle foreign exchange transactions on a PvP basis, currently in 18 eligible currencies. After addressing the need to manage settlement risk in foreign exchange transactions (section 1), we go on to present the CLS system (sections 2 to 4). What makes a PvP system like CLS different is that it offsets positions in different currencies against each other and completes the final stage of foreign exchange transactions.

Retail payment systems play a key role in the economic sphere, handling payment transactions for retail customers and corporates. They typically process large volumes of low‑value payments. The landscape in which these systems operate in Europe has evolved significantly over the last decade with the introduction of the European format (SEPA) for credit transfers and direct debits, but it remains relatively fragmented. New developments are now underway with the arrival of instant payments. The first section of this chapter presents the challenges, background and functioning of retail payment systems, together with their development, both to the present day and underway. The second section focuses on the payment system landscape in Europe, the third on financial risks in retail payment systems and the fourth on the oversight framework established by the Eurosystem for retail payment systems.

Central counterparties (CCP) have become a cornerstone of the financial market infrastructure landscape, mainly since the development of the derivatives market on the one hand and the 2008 financial crisis on the other. A central counterparty plays a very important role by interposing itself between the counterparties to a transaction.

Conceptually, the notion of a central counterparty must be clearly distinguished from that of a clearing house, whose main function is to calculate a net balance from a set of individual (or “gross”) transactions. The existence of these clearing houses, which originally were limited to clearing payment flows, goes back more than two centuries.

However, these infrastructures have evolved and nowadays, in the field of financial instruments, the vast majority of clearing houses also fulfil the role of central counterparty, and vice versa. The current practice is therefore to use either term to designate an infrastructure that offers both services. In this chapter, the term “CCP” refers to a clearing house that acts as a central counterparty.

CCPs play a very specific role in the processing chain of securities and other financial instruments (including derivatives): they replace the seller and the buyer and are thus a counterparty to each of them. They are therefore at the heart of the transaction processing system for financial instruments. During the financial crisis of 2008, CCPs demonstrated strong resilience and effectively implemented their default management mechanisms, thus preventing contagion to the other financial players.

The increased role that regulators have assigned to CCPs since the crisis, especially with respect to derivatives, has been accompanied by transparency requirements and the establishment of an even more stringent international risk management framework, which has been transposed at European Union level into Regulation (EU) No 648/2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, called “EMIR” for “European Market Infrastructure Regulation”.

The standards and the regulatory framework for CCPs are still evolving. The EMIR framework was amended twice in 2019, first with regard to the requirements applicable to CCPs (EMIR “Refit”) and second with regard to the supervisory architecture for EU and third-county CCPs (EMIR 2), which was complemented by the drafting of the “Level 2” texts published in September 2020. Furthermore, the forthcoming European Regulation on CCP recovery and resolution,4 aiming at ensuring the continuity of the CCPs’ critical services after exhaustion of pre-funded resources , was agreed upon by the EU co-legislators in July 2020, and should be published in the EU official Journal by end-2020.

Central securities depositories (CSDs)1 are essential infrastructures for the proper functioning and security of financial instrument markets. They play a key role in maintaining the integrity of securities issues by ensuring that securities are not created or deleted accidentally or fraudulently. The provision of securities accounts at the highest level of the holding chain (i.e. for the benefit of financial intermediaries themselves) and the reconciliation, at least daily, of these securities accounts with issue securities accounts2 allow them to discharge this responsibility. In jurisdictions where this “notarial” service is provided by registrars, the  CSD reconciles its own data (on ownership) with those of the registrar (on issues).

While the Principles for Financial Market Infrastructures (PFMI, see Chapter 18) consider that CSDs do not necessarily operate a securities settlement system, the European regulation transposing the PFMI establishes a very close link between CSDs and securities settlement systems. As a result, since the entry into force of the European CSDR3 (see Section 2 of this chapter), an entity must operate a securities settlement system to qualify as a CSD (and also provide at least one of the other two core services defined by CSDR: notary services and/or central securities accounts maintenance services at the top tier level). In addition, CSDR considers that CSDs are the only entities authorised to operate a securities settlement system.4 It should be noted here that TARGET2 Securities (T2S), which will be described in Chapter 14, is not considered as a CSD, nor indeed as a securities settlement system but as a technical platform for settlement and delivery developed and operated by the Eurosystem.

The CSDs are also active participants in the integration of financial markets, in particular by establishing links between CSDs: these links are one of the ways for participants in a given market to be able to access securities issued in other jurisdictions. The establishment of a link from a CSD (called the “investor CSD”) to another CSD (the “issuer  CSD”) means that the investor CSD becomes a participant of the issuer CSD, i.e. in practice opens a securities account in its name with the issuer CSD (which is in fact nearly always established in another country, as there are very few countries nowadays with more than one CSD). The investor CSD thus enables its participants to access securities other than those for which it itself performs the notary function.

Th e d e m a t e r i a l i s a t i o n a n d immobilisation of securities, as well as the increase in the volume of securities trades, both domestically and internationally, have made it necessary to set up securities settlement systems (SSS) which are managed by central securities depositories (CSDs, see Chapter 12). The operation of a securities settlement system is one of the three “core services” provided by a CSD (within the meaning of the European CSDR: see Chapter 12), and must be provided for an entity to qualify as a CSD – as well as at least one of the other two core services (notary and central securities accounts maintenance services). SSSs allow all securities admitted to a CSD to be processed, usually shares as well as bonds, or even fund units in certain CSDs.

SSSs come into the picture after the trade and, if necessary, the clearing to allow the execution of securities contracts agreed between the parties, which results in delivery to the buyer of the securities underlying the transaction, in exchange for payment by the latter of the price agreed with the seller. The security of this operation requires that the organisation and rules of the SSS provide the guarantee that during execution of the transaction, delivery of the securities will occur if, and only if, the corresponding payment has been made, and reciprocally. The operational implementation of this principle of conditionality, called delivery versus payment (DvP), is one of the important tasks of SSSs.

SSSs can also provide for the delivery of securities without payment; this is called a free of payment (FoP) transaction. These free of payment transactions are used in the context of securities lending transactions (which can also be done in DvP) or collateral mobilisation to guarantee market transactions or credit from central banks.

As their name suggests, SSSs are “systems” and have no legal personality, unlike the CSDs that operate them. They allow the securities to be transferred and the corresponding cash payment to be settled in accordance with a set of contractually and legally enforceable rules. They thus manage the securities transaction flows, which are recorded in the securities accounts opened in the books of the CSDs.

The settlement systems operated by the CSDs were designed to ensure the operational and legal reliability of these securities transfers, which trigger the change of ownership for the benefit of the buyers. In addition, these systems use standardised messaging and processes, which allows all stakeholders to use a “common language” (international communication standards also facilitate access to the various European CSDs and are therefore now required by the European CSDR – see Chapter 12).

Due to the nature of their operations aimed at ensuring the smooth completion of trades in financial markets or enabling the posting of collateral (including in the context of monetary policy operations), SSSs are viewed as systemically important infrastructures.

In Europe, and in particular in the euro area, securities settlement systems, which had already been greatly improved during the 1990s and 2000s first to meet the international recommendations in this area and then gradually fine-tuned to improve the efficiency of settlement and the management of participants’ liquidity, are undergoing major further developments, with the entry into force of CSDR and, for most of them, the migration to T2S. This technical securities settlement platform, developed and operated by the Eurosystem, is described later (see Chapter 14).

T2S, the technical settlement platform developed and operated by the Eurosystem, is an essential contribution to the integration process of European financial markets. This initiative of the Eurosystem, launched in 2008 and gradually rolled out between June 2015 and September 2017, has already made it possible to harmonize many settlement characteristics (within the euro area and in the non-euro markets that have decided to join T2S) and provides a solution to the disadvantages of the fragmentation of European markets with respect to the settlement of securities. It has developed alongside European regulatory initiatives (such as the European CSDR) and political initiatives (the Capital Markets Union – CMU project launched by the European Commission in 2015), the latter having benefited from the role of T2S as a catalyst for the harmonisation of financial markets in Europe.

By the end of 2018, 23 European CSDs had migrated to T2S, including some CSDs established outside the euro area. This high level of participation demonstrates the expected benefits of T2S in terms of settlement efficiency and harmonisation. As mentioned in Chapters 12 and 13, T2S is not, within the meaning of CSDR, viewed as a securities settlement system – where the latter is defined as the settlement function of a CSD – but as a technical platform to which CSDs that have decided to participate in T2S outsource their settlement operations.

In 2001, at the instigation of the ECB, the CESR and the European Commission, a group of financial sector experts was set up to study the European securities settlement market, which appeared to be highly fragmented. This group published two reports, in November 2001 and then in April 2003, commonly referred to as the “Giovannini Reports” (named after the group’s president, Alberto Giovannini). These reports highlighted various obstacles (or “barriers”) to a smooth flow of securities between European countries, attributable in particular to tax rules, legal aspects, management procedures for corporate actions, technical or organisational aspects, etc. (see table in Section 7 of this chapter).

These “barriers” were compounded by the high number of infrastructures. Organised by domestic market and fragmented, the European settlement landscape in general, and in the euro area in particular, lacked harmonisation, which entailed significant costs for all non-domestic market participants, even European ones, whether they were financial service providers or investors. Despite the existence of a single currency, these costs were such that they hindered the development of cross-border securities circulation within the European Union and especially in the euro area. This is the problem that T2S has solved.

Collateral consists of any guarantee used in the financial sector, i.e. mainly securities and cash, but also precious metals such as gold, or other types of goods. In this chapter, we will discuss collateral in the form of securities, which is the one with the strongest links to the functioning of financial market infrastructures.

The link between collateral and financial market infrastructures is twofold: on the one hand, certain market infrastructures such as central counterparties or payment systems may require participants to post collateral for their proper functioning and security; on the other hand, central securities depositories play an essential role in the collateral posting process. In other words, market infrastructures are both users of collateral and intermediaries or service providers in its circulation.

However, the need for collateral is significant, especially since the 2008 financial crisis, due to new market practices and regulatory reforms to strengthen the security of the financial system.

Due to their role in the use of collateral, financial market infrastructures are crucial in the face of these needs: to improve the management of their clients' collateral, they are required not only to develop services for optimising this management but also to facilitate the circulation of assets, in particular by increasing interoperability between the various collateral management platforms.

According to the definition in the CPSS-IOSCO report entitled Principles for Financial Market Infrastructures, or PFMI,1 a trade repository is “an entity that maintains a centralised electronic record (database) of transaction data”. In this respect, trade repositories constitute a new, very specific type of financial market infrastructure in that they do not process transactions themselves, like central counterparties (CCP) or securities settlement systems (SSS) systems, but manage and store data relating to financial transactions. While they predated the 2008 financial crisis, they have since grown in importance, especially as a means of increasing the transparency of over-the-counter (OTC) derivatives markets.

As described in Chapter 5, financial market infrastructures play a key role in the financial ecosystem and the financing of the real economy. Their effectiveness was demonstrated in particular during the 2008 crisis, when central counterparties (CCPs) contributed significantly to limiting contagion. Regulators have entrusted them with an increasingly wide remit, particularly with regard to implementing the obligation to centrally clear standardised derivatives. This development, combined with a natural concentration (which is due to these entities’ high entry and structural costs), has resulted in a concentration of risks within these infrastructures.

This chapter focuses on identifying and illustrating the risks borne by financial market infrastructures, as set out in the CPMI IOSCO ’Principles for Financial Market Infrastructures’, and also on these infrastructures’ risk management role. It looks in detail at the concept of interdependency and the various forms that this can take, as well as systemic risk. Finally, it addresses the very specific risks associated with offshore infrastructures, in particular those that process one or more currencies other than that of their operating region’s central bank of issue.

Financial market infrastructures play a pivotal role in serving financial markets, supplying them with liquidity and ensuring payments and the settlement and delivery of financial instruments. In doing so they contribute directly to maintaining confidence in currencies and financial markets and, more generally, to financial stability. They also enable the smooth implementation of monetary policy by making it possible to raise and deliver securities as collateral against the delivery of cash. These infrastructures showed strong resilience in the 2008 crisis; the G20 assigned additional responsibility to some of them in 2009 (notably central counterparties and trade repositories) with a view to improving financial stability and transparency, which has led to enhanced oversight.

Operationally speaking, it is also in central banks’ direct interest that infrastructures – primarily payment systems – function smoothly, as most central banks operate a national payment system themselves, while others are direct participants in such systems. Moreover, central banks themselves use financial market infrastructures for the operational implementation of monetary policy and delivery of collateral (see Chapter 12, Section 1.5; Chapter 13, Section 4.3 and Chapter 15, Section 5); this increases their interest in infrastructures’ efficient functioning, as they cannot provide liquidity if the securities accepted as collateral are not delivered, for example.

As part of their mission of conducting monetary policy and ensuring financial stability, the challenge for central banks, as ’lenders of last resort’, is to prevent generating moral hazard – which for market players consists in relying on central bank intervention in the event of failure of an infrastructure or a major participant.

Central banks therefore naturally started paying attention, in the early 1990s, to the systemic risks that their national payment systems could pose. It is in this context that the term ’oversight’ – which at the time had no legal or regulatory basis – first appeared. As a knock on effect, central banks’ oversight scope was subsequently extended to securities settlement systems (SSS). To the extent that SSSs were required to perform settlements in the central bank’s books (known as “settlement in central bank money”) in order to ensure settlements’ security, these systems could indeed jeopardise the proper functioning of national payment systems. Lastly, while offering greater financial security, central counterparties (CCP) have also led to risk concentration (see Chapter 11), as participant’s default as well as a failure of the CCP itself can generate systemic risk. In this context, and in the interests of financial stability, the G10’s central banks in particular began to work alongside financial market authorities – which were traditionally responsible for the regulation and supervision of central securities depositories and CCPs – to help oversee such entities. As a result, the financial market infrastructure ecosystem monitored by central banks has gradually expanded, and now covers not just payment systems but the entire financial instruments processing chain.

The importance of financial market infrastructures for the authorities, particularly central banks, is highlighted in the CPSS’ May 2005 report Central bank oversight of payment and settlement systems. 

The purpose of central bank oversight of financial market infrastructures is to ensure the effectiveness and security of existing systems (as well as the ones being developed), assess these systems against applicable standards and principles and encourage relevant adjustments where necessary

I n the economic sense, “infrastructures” generally refers to institutions used to exchange goods, information or rights between agents. As the previous chapters have shown, financial market infrastructures (hereinafter FMI) specifically serving the functioning of financial markets are the subject of particular attention by legislators and regulators because they generally have characteristics that influence how smoothly those markets function. FMIs’ economic characteristics make them an archetype for market failure situations, in which market price formation mechanisms alone are unable to fully capture the costs and benefits of the activities under consideration and to lead to an optimal allocation of resources.

Economic analysis of FMIs’ functioning can largely be done using the tools developed in the field of network economics (particularly communication). According to Nicholas Economides, networks can be formally defined as a set of “links” connecting “nodes”, whose different components function in a complementary manner. This definition can be applied to FMIs, all of which are designed to establish links between participants (nodes), via their connection to the same technical system, and thereby provide the desired service. A payment system, for example, connects participants, and the complementarity between the different components comes from the fact that participants need to be connected to the system for the payment service to be provided. Generally speaking, networks can be understood through two different prisms: a technical prism, where they consist in an interconnection of components that ‘cooperate’ in order to transport flows such as assets or information, and an economic prism, where essentially they act as a physical medium for economic intermediation (transactional view).

This chapter describes the impact of FMIs’ economic characteristics (I) on market organisation and dynamics (II) and investigates pricing‑related issues (III).

Technical innovation is salient to market infrastructures and most non‑cash payment instruments (the direct result of technological innovation), enabling them to meet market requirements in terms of transaction reliability, execution speed and service diversification.

The  1960s to  1980s saw exponential advances in information technology and are a prime example of financial technological innovation, specifically in the field of market infrastructures. Until then, financial market infrastructures’ (FMIs) role had been to physically centralise transaction‑related documents in order, as far as possible, to clear the transactions in question (by calculating net balances from their gross amounts) and then exchange the physical documents needed to complete them. Securities were thus physically transferred, in paper form, from seller to buyer as proof of ownership. Computing power and the concomitant development of information technologies then made it possible to replace the physical holding of securities in the form of paper certificates by computer records. This paperless technology enabled market infrastructures to evolve towards the modus operandi with which we are familiar today.