"6135 Viewpoint The World Bank April 1996 Note No.76 The Net, Cybermoney, and Credit Risks New technology-and payment system risks Cathy E. The application of new technology to the busi- automated payment processing and communi- Mineban ness of payments is giving rise to new payment cations systems such as Fedwire and CHIPS ex- alternatives. Smart cards, electronic checks, and perienced huge growth in the number of on-line various forms of electronic money, combined participants and in the volume and value of with the emergence of extensive, broadly ac- transactions. Throughout this period, it seemed cessible communications facilities such as the that "bigger" and "faster" meant "better." And in Internet, are rapidly expanding the choices for many ways, this was true. But the ability to de- low-value, or "retail," payments. liver payment instructions and securities trans- actions outpaced the ability to achieve final It is tempting to treat the proliferation of tech- settlement. The delivery of payment instructions nology and service providers in the retail arena was essentially real-time for on-line institutions, with an attitude quite unlike that with which but final settlement-the actual posting of en- we in the financial community have addressed tries to participants' settlement accounts-was wholesale payment systems over the past two typically an end-of-day (or next-day) process- decades. After all, the values involved are rela- ing activity. Even in systems that settle with each tively small, the potential for efficiency is large, transaction-real-time gross settlement systems and to the casual observer the risks seem low. -payment transfers were completed without But the experience with wholesale systems regard to balances on hand. As a result, the intra- shows that the application of technology to the day credit incurred by payment system partici- business of payments can be a double-edged pants grew at a staggering rate. sword, bringing efficiency and higher service levels but also increasing risk. Developers have Similar applications of technology in the securi- tended to rush new technology to the market ties and foreign exchange markets increased in an attempt to "be there first" to attract new both the volume and the velocity of turnover in business. And users have been quick to adopt these markets. The time lag between the initia- new technology for fear of losing competitive tion of securities and foreign exchange trans- advantage. The speed at which this has oc- actions and their ultimate settlement often curred has often precluded analysis of its po- exceeded the time lags in settling pure payment tential effects, intended or unintended. This transactions. As a result, the temporal risk in- Note reviews some of the experience the fi- curred by market participants was also greater. nancial community has had in trying to tame the technology genie in wholesale systems, As the 1970s gave way to the 1980s, countries highlighting lessons to guide participants as around the world began to take note of the they capitalize on changing technology. growing risk inherent in their payment systems. Various isolated payment system problems dur- Changing technology ing the 1970s, and the resulting losses, served to focus minds. By the mid-1980s, technology In the 1970s and early 1980s, technology was was being applied to improve risk control in applied to payment and clearing systems with a domestic payment systems. Sophisticated soft- vengeance. In the United States, for example, ware systems were developed to measure risk L'3a Financial Sector Development Department . Vice Presidency for Finance and Private Sector Development MN The Net, Cybermoney, and Credit Risks as a first step toward controlling it. With some Other systems take this concept a little further, prompting from regulatory authorities, risk allowing the card holder to transfer value to management software began to be integrated other cards or to a system operated by the seller with and operated as part of the payment sys- to receive those payments. This can come close tem applications. Real-time balance monitor- to being a new form of currency: the potential ing, net debit caps, and bilateral limits are all exists for the value on the card to remain in examples of automated risk management con- circulation, transferring from card to card, and trols made possible by creative application of one endpoint to another, without necessarily technology in wholesale payment systems. But being converted to a more traditional form of regaining some control over technology in the money. wholesale systems had taken nearly twenty years. We may be poised to repeat this process More traditional banking services are also be- in retail payments. ing offered electronically. "Virtual banks" are being formed that use the Internet in place of Debit cards, smart cards, and "virtual banks" traditional brick-and-mortar infrastructure, ac- cessing services provided by banks and other Now we are seeing a migration of sophisticated financial and nonfinancial institutions. An inter- technology to the retail payment sector, and esting, and perhaps troubling, aspect of this the possibility of the integration of the retail development is the emergence of nonbanks as and wholesale payment systems in ways never major providers of banking and payment ser- before possible. Automated clearinghouses are vices. In the United States, such major software moving to more daily cycles and ultimately to providers as Intuit, Microsoft, and Netscape are processing batches on a flow or "on-demand" battling for a share of the potentially lucrative basis, creating a real technological alternative market of on-line banking services. Some banks for the smaller, less time-sensitive payments are forming alliances with these new players; now made on Fedwire. The retail payment sec- others are developing their own proprietary tor has gone beyond bank-owned networks systems. Who will emerge as the dominant into much wider areas accessible to consum- player (or players) and what the principal net- ers initiating payments. These new electronic work will be remain to be seen. access options are generally of two types: those that use a debit card and those that depend on The Internet as a payment network "smart" card technology to store value. The Internet is free; no one owns it; no one In the United States the use of debit cards has oversees, controls, or secures it. These very grown considerably through traditional net- aspects that make the Internet so flexible and works developed by VISA and Mastercard as foster its incredible growth also make it less well as through proprietary bank systems such than ideal for payments. For every "expert" who as NYCE and MAC. But these cards have the claims that achieving adequate security on the potential for even broader use, independent Internet is simply a matter of applying the right of these systems and networks, when combined technological solution, there is one who de- with use of the Internet for electronic authori- nies that the Net will ever be secure enough zation. Similarly, smart card technology is be- for payments. ing used to store electronic "notes," authorized by the card holder's bank, that can be used to It is too early to know who is right. But the transfer value between banks, consumers, and volume of transactions is growing fast-from merchants. These electronic notes flow over US$20 million in 1994 to an estimated US$200 the Internet and provide authorization for the million in 1995. Business-to-business payments withdrawal of funds from a bank account for are beginning to cross the Internet. On-line electronic payment to another party. banking and brokerage services are being es- tablished. Payment values, volumes, and cross- The end first border activity are growing rapidly-so much so that Internet-based transactions could soon First, neither technology nor payment systems account for a significant share of payment sys- are ends in themselves. Payment systems are tem activity. Moreover, with the proliferation important, if not vital, to economic growth, but of competing electronic systems, whether it is that growth itself that is our end. It would Internet-based or not, the landscape is begin- be both fruitless and counterproductive to be- ning to be reminiscent of the U.S. payment situ- lieve that we can or should hinder the infusion ation in the mid-1800s, when commercial banks of new technologies into the payment system. issued their own currencies and an integrated In the United States, for example, where 60 nationwide payment system was still only a billion paper checks are still processed and col- dream. lected every year, a shift to electronics could reduce the cost of payment operations and sig- Risks? nificantly increase returns to banks, bank cus- tomers, and society. But if we learned nothing Do these developments pose new elements of else during the 1980s, we learned that the im- risk that we do not yet fully understand? possible can, and sometimes does, happen. * Is the proliferation of payment and payment Computers fail just as payment overdrafts are information systems working to increase mounting, liquidity problems can complicate rather than decrease the time between the creditworthiness, markets can drop precipi- exchange of payment transactions and their tously, interest rates don't move in the same ultimate finality? direction indefinitely-and on and on. Systemic * Will the ease of access and the low cost of fragility can damage economic growth just as these new systems attract payments of in- surely, and perhaps more violently, than the creasing size in ways that enhance short-term failure to introduce new technologies. There- efficiency but increase long-term risk? fore, payment systems must be developed to * Does the disintermediation of payments away withstand turmoil. from the banking system make payment sys- tems more or less accident-prone? Credit and payments together * Are the new links among systems-national and international-more or less likely to in- Second, it is impossible to separate credit and duce a chain reaction if one system encoun- payment systems. While time intervals are short, ters a major mechanical or credit disruption? there is probably more credit extended through * Are the risks of unauthorized entry and large- payment systems than through any other single scale fraud greater? And even if security is source. That is why depository institutions, with adequate, who will guarantee that techno- their inherent expertise in assessing credit risk, logical failure will not impede access to elec- have specialized in payment operations, and tronic cash? why central banks take payment systems so * And finally, at the extreme, is there a danger seriously. It is true that information services that these trends can produce distortions in can make the transfer of value more efficient. measures of the money supply, complicat- It is also true that central banks that are active ing the conduct of monetary policy? as payment system service providers, such as the Federal Reserve System, may not have taken Five lessons the information component of payments as se- riously as they should have. However, it is a Although the answers to these questions are worry that providers of information technol- not yet clear, our work with wholesale systems ogy offering systems to support retail payments gives us some leads. There are five critical transfer are attempting to remove credit ex- lessons. pertise from the heart of the system. When the The Net, Cybermoney, and Credit Risks impossible happens, and liquidity is needed be valuable payment service providers. But in to make some new, all-pervasive, payment sys- the new retail systems, the use of technology tem function, the further banks and central could take netting to new heights, with trans- banks are from the action, the more difficult actions passed between the ultimate settling the solution will be. banks only on a net, net, net basis. Adding to this mix the technical ability to make payments Legal and regulatory framework of increasingly large value raises the question of whether some of the surprises we found in Third, effective payment systems, whether large-value payment systems will come back wholesale or retail, must have certain crucial to haunt us in the new retail systems. characteristics-accuracy, security, reliability, timeliness, and certainty of value. The means This brings us to the issue of system oversight. of achieving these characteristics may vary with In many clearinghouses, the members are the the system, but they must be present. Their most severe regulators of one another, because presence is determined by the integration of they realize that their ability to be funded at the the system's technology, its structure and par- end of a clearing cycle depends on the strength ticipants, and a legal and regulatory framework of the weakest participant in the clearing. The that clearly defines the roles, rights, obligations, new, broad, retail electronic networks do not and liabilities of those who use the system. invite the same kind of participant control-the Thus, it is not technology alone, or even pri- addition of participants seems more a matter of marily technology, that creates a payment sys- marketing than of system control. Banks and tem. Technology interacts with participants' other payment system providers must ask them- needs and responsibilities and with laws and selves whether they know in detail what would T he Note series is an open foram intended to regulations to define a payment system. happen if a participant fails to make payment, encourage dissemina- or computers malfunction, or a power outage tion of and debate on Finality and system oversight stops normal operations. And as these systems ideas, innovations, and best practices for become more pervasive, enlightened oversight expanding the private Fourth, we've also learned that payment sys- by central banks will be necessary to ensure sector. The views tems function best when they have both trans- that payment system rules, controls, and par- poblished are those of the authors and should parency and effective internal oversight. In the ticipation all help to enhance financial stability. not be attributed to the wholesale payments world, much attention has World Bank or any of its been focused on making the ultimate transfer Strategic integration affiliated organizations. Nor do any of the con- of value as transparent in timing as possible. clusions represent This has been done by emphasizing finality- Finally, in the move to more electronic retail official policy of the that is, the irrevocable availability of funds at a and wholesale systems, it would be a shame if World Bank or of its Executive Directors predictable time. Increasingly, central banks and no consideration is given to how payments ini- or the countries they other payment system participants have seen tiated in one system can be transferred and represent. the advantage of systems that grant finality trans- settled in another. One of the reasons the Fed- Comments are welcome. fer by transfer-real-time gross settlement sys- eral Reserve System came into being was to Please call the FPD tems-and, in securities transfer and foreign create a nationally integrated payment transfer Note line to leave a exchange, of systems that achieve simultaneity process. Now that the United States is just be- or contact Suzanne in the delivery of the security and the cash or in ginning to make great inroads in decreasing Smith, editor, Room the two legs of the foreign exchange settlement. the volume of paper-based payments, it must G8105, The World Bank, not lose the fabric of a nationwide retail pay- 1818 H Street, NW, Washington, D.C. 20433, But wholesale systems did not all start out like ment system in the process. To prevent this, or Internet address this. Many began as the new retail systems the central bank must continue to play a large ssmith7@worldbank.org. have-as net settlement systems-largely be- role in strategic payment system development. @Printed on recycled cause the netting process is so efficient. Large- paper. value net settlement systems have been Cathy E. Mineban, President, Federal Reserve strengthened over the years and continue to Bank of Boston