- 13

from that of the United States.

(1) The U.K. banking structure is highly concentrated, con-
siderably different from the dispersed nature of the U.S. banking
system.

(2) Sterling is a secondary international currency; it has a
considerably less important international role than the U.S. dollar.

(3) The Bank of England is not an independent provider of
funds transfer services. By contrast, the Federal Reserve operates its
own funds transfer mechanism, the Fedwire -- the preeminent U.S. dollar
funds transfer mechanism.

It has been noted that CHAPS provides the necessary infra-
structure for large-scale clearing in London. Technologically, CHAPS
could be readily adapted to provide clearings in both dollars and
sterling, with settlement of dollar transactions processed in the
United States. However, the concentration of CHAPS settlement respon-
sibilities with only the clearers is inconsistent with the development
of a major dollar clearing mechanism in the United Kingdom / Other
banks, particularly U.S. banks, would have to be involved in the
assumption of risk responsibility for the enlarged credit exposures
generated by large-scale dollar clearings. The diffusion of risk could
be effected through an increase in the number of CHAPS settlers or by
the current CHAPS settlers entering into bilateral reinsurance arrange-

ments.

TI7 The prominence of the concerns about credit risk is indicated in
"Possible Advantages and Disadvantages of Setting up Wholesale Dollar
Clearing Arrangements in London", Working Party on Wholesale Dollar
Clearing (Committee of London Clearing Bankers), March 1980.


-4-

CHAPS appears to have been influenced by the competitive policy regulations
of the United Kingdom. These regulations stress the avoidance of pricing
conventions based on any explicit agreements among competitors. Thus,

the clearers' decision to avoid joint expenditures on a centralized
processing capability, so as to minimize the common cost elements for
their competing payment services, might have been prompted by a strong
group preference to preserve an officially acceptable restricted-member-
ship club. By contrast, the organization of U.S. interbank payments networks
have been strongly influenced by banks' anticipations of strong legal
challengesto agreements which restrict access of competitors to

“essential facilities."

Basics of a CHAPS Payment

CHAPS payment messages enter the CHAPS network only through a
settlement bank's Gateway. As soon as a message is entered and acknow-
ledged the funds transfer is guranteed by the sending settlement bank.
In fact, a settlement bank's guarantee is binding even if a payment is
subsequently found to have been fraudulently initiated -- individual
payments cannot be modified once made.

A CHAPS third-party payment is initiated when a customer (a
bank or a firm) of one of the settlers requests a sterling payment,
either for same-day or later execution. A customer may forward CHAPS
payment instructions to its settlement bank through a direct link or
via the SWIFT network -- the CHAPS message format was designed to con-
form to SWIFT message standards. Thus a CHAPS message may be originated

at any one of more than 900 banking offices in the world that are now


-9-

Under current payments conventions for sterling-denominated
transactions, after the posted daily closing hour of 3 P.M. there are
potentially 50 minutes for the clearers to exchange information so as
to allow each clearer to anticipate its net position at the Town Clear-
ing and to participate in position-squaring money-market trades. It
is widely recognized that if after-hours money-market trading could
indeed be limited to the clearers, the aggregate need for operating
balances at the Bank of England would tend to be reduced. However, in
practice, to accommodate the money-market trading of their most-valued
customers, the clearers contract to receive bankers' payments for
collection until five minutes before the daily close of the Town Clear-
ing.

To process the late-in-the-day transfers of (bank and non-
bank) customers, the clearers find it cost effective to raise their target
end-of-day holdings of deposits at the Bank of England. Furthermore,
their desired holdings are also boosted by the Bank of England's known
reluctance to provide late-in-the-day liquidity adjustment facilities.
The clearers do not assess customers for the costs of late-in-the-day
funds transfers, or receipts, but rather assign such costs to the
generally allocated overhead charges to customers using their payment
clearing services Thus, customers that utilize the late-in-the-day clear-
ing services have not had any incentives to modify their behavior so as
to reduce the costs of settlement to the clearers.

The planned schedule for the daily operations of CHAPS calls

for one hour between the close of normal activity at 3 P.M. and the


-6-

that CHAPS payments not be processed if they are covered only by same-day
CHAPS receipts. These restrictions will be imposed to generate float
revenue and to limit the number of customers' accounts requiring
expenditures on real-time monitoring and control. High-volume customers
will be more likely to pay explicit fees for CHAPS payment services rather
than compensating their settlers through float.

The absence of a centralized processing facility for CHAPS is
reflected in its settlement process. Because there is no centralized
calculation of CHAPS net settlement positions, each pair of CHAPS settle-
ment banks must agree on the net result of a day's bilateral payments
transactions. Settlement information is transmitted at the end of each
business day by each settler (via its Gateway) to an automated settle-
ment ledger at Bank of England. After a day's settlement information
has been verified, the Bank of England makes the indicated transfers
among the operating reserve accounts maintained with it by the settlers.
If such a transfer by the Bank among its accounts generates an overdraft
in the account of one of the settlers then the Bank might provide cover
at a penalty interest rate.

The primary motivation for setting up CHAPS has been the banks'
anticipation of large savings in labor costs from the replacement of the
current procedures for executing paper-based funds transfers of large
same-day sterling payments with an automated funds transfer mechanism.
The adoption of an automated payments mechanism was also favored by some
banks because of the opportunities such a system would create for the

refinement of credit control procedures.


connected to the SWIFT network.

The rules of the CHAPS network do not require that a settling
bank follow any particular procedure before determining whether a
customer's payment instruction will be executed, including whether they
will honor the payment requests of their sponsored CHAPS participants.
Settling banks will likely monitor and control the accounts of parti-
cipants relative to established bilateral credit limits, although the
access provided to some participants (those most creditworthy) may be
only monitored and not controlled. In any case, the balancing of credit
and operational considerations of conditions for access to the CHAPS
network are the responsibility of each settler .o/

CHAPS settlers, when they receive a payment for a customer,
have the responsibility of advising the customer of the receipt of the
payment. However, the within-day availability of funds received is
regarded as an area to be negotiated between a settler and each of its

customers. It is likely that the service contracts for customers

expected to make only a limited number of smaller payments will specify

‘6/7 CHIPS (CTearinghouse Interbank Payments System) is the major
computerized international payments network which served as the inspira-
tion for the development of CHAPS. CHIPS, with 100 (mostly non-U.S.
chartered) bank participants, is operated by the 12 member New York
Clearing House Association. About 20 CHIPS participants settle for
themselves, with half of these settling for one, or more, of the other
CHIPS participants. Sponsoring CHIPS participants make a once a day
decision whether to honor the settlement obligations of their sponsored
banks, they (unlike their CHAPS counterparts) are not permitted to con-
trol the intraday access to the network of their respective sponsored
participants.

The fact that all CHIPS payments are not authorized, when made, by
the "most creditworthy" participants in the network has prompted proposals
that a CHAPS-type procedure be adopted for CHIPS to reduce the risk of a
settlement failure. Legal concerns about the need to assure equitable
access among competitors has apparently inhibited the member banks of the
New York Clearing House Associations from adopting these proposals.


-8-

their customers' credit exposures. The availability of more timely
information on customers' credit exposures should prove valuable since
it will facilitate adoption of less costly within-U.S.-business day
processing of dollar payment orders by U.K. banks (to be executed by
U.S. banking correspondents) on behalf of customers.

It is anticipated that the introduction of the CHAPS tech-
niques for sterling payments will lower the cost of funds transfers in
dollars that are covered by sterling credits. Thus, the introduction
of CHAPS may make it worthwhile for some firms to purchase dollar pay-
ment services from their traditional suppliers of sterling payment
services. That is, the savings produced by cancellation of specific
arrangements for dollar payments (such as fees or compensating balances
for credit lines) may be greater for some agents than the additional
costs of having orders for dollar payments transmitted over the inter-
connections between the sterling and dollar payments mechanism.2/

Money Market Operations of the Bank of England

It is anticipated that the introduction of the CHAPS network
will significantly affect the demand of the U.K. Clearing Banks for non-
interest bearing demand deposits at the Bank of England. The clearers
hold demand balances at the Bank of England to cover their liquidity
needs generated by their preeminent roles in the sterling payments
mechanism. A target level for such balances is set in negotiations
between each of the clearers and the Bank of England.

8/ It should be noted that the choice of one payments vehicle or another
is independent of any agents' underlying exchange rate exposures.


International Finance Disucssion Papers
Number 217
February 1983

AN APPRAISAL OF THE CHAPS PAYMENTS MECHANISM

by

Allen B. Frankel

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished
material) should be cleared with the author or authors.


-lNe-

related to the costs of its money-market operations -- and the Bank does
indicate its expectations concerning their average holdings to each bank.
Although the clearers are free to vary their day-to-day holdings, each
is regarded to be under an obligation to hold, over time, not less than
the agreed target for its reserve holdings 10/

As noted above, the CHAPS-related reorganization of the
sterling payments mechanism should reduce the target amount of reserves
that the clearers will voluntarily hold. Alternatively stated, the
reorganization will reduce the amount of settlement services required
by the clearers from the Bank of England -- a reflection of the greater
productivity of reserve holdings with CHAPS computerized payments
techniques, as compared with the paper-based techniques now employed.
However, it is possible that the Bank of England might attempt to
capture some of these potential savings through a redesign of its
settlemant service meant to boost precautionary reserve holdings of the
clearers. Nonetheless, the switch in clearings technology may be
reflected in a change in the sensitivity of short-term sterling interest
rates to daily changes in the ex post available supply of end-of-day
balances provided by the money-market operations of the Bank of England.
In particular, there would be a greater sensitivity of short-term interest
rates if CHAPS augments the productivity of reserve holding more for
high, as compared with low, reserve intensive payments clearing
techniques. That is, money-market interest rates will be more sensitive
—To7__W separate cash ratio (1/2 percent of eligible liabilities) scheme
requires all participants in the U.K. monetary sector to hold non-operational,
non-interest-bearing, fixed-term deposits with the Bank of England. The

stated purpose of the cash-ratio requirement is to provide income to cover
the general operations of the Bank.


-10-

completion of settlement. It will be less troublesome, compared with
current paper-based payments arrangements, for the clearers to jointly
police a collectively agreed time period for their exclusive use. Joint
policing by the clearers of the buffer is facilitated by the online
character of CHAPS operations, which require that two clearers, rather
than one, must agree to process an after-hours transfer for a customer,
including late-in-the-day money-market trading. Thus, the introduction
of CHAPS payments technology should improve each clearer's ability to
control its end-of-day cash position. In turn, the enhanced within day
abilities of the clearers to predict daily cash flows should work to
lower their desired end-of-day cash holdings at the Bank of England.

The daily operations of the Bank of England in sterling money-
markets are designed to influence very short-term sterling interest
rates.2/ The fulcrum of these operations is the banking system's need
to acquire intraday balances at the Bank of England so that it can effect

, the required monetary transfers (taxes and the proceeds of debt sales)
from the public to the U.K. Government through the agency of the Bank of
England. In such an interest-rate targeting regime, the end-of-day
reserve holdings of the clearers could not be independently targeted if
the interest rate objective is fixed rather than viewed as a range of
acceptable outcomes. In fact, the Bank of England has a notional target
for the aggregate of the clearers' end-of-day operating balances --
~Q/ For a discussion of the current money-market techniques of the Bank
of England see "The Role of the Bank of England in the Money Market"
(Bank of England Quarterly Review, March 1982, pp. 86-94) and John M.

Atkin "U.K. Monetary Control: The Need for Further Changes", (The Banker,
November 1982, pp. 25-29). a



-7-

Operating and Credit Links with Dollar Payments Arrangements

Large-value sterling payments are now made by checks drawn on
the London Clearers. These payments are "batch" processed by the payors'
clearing banks only after they are received at the Town Clearing late in
the afternoon. Problem checks received at the Town Clearing can be
returned to the payees' banks on the same business day. Consequently,

a payor's clearing bank normally will not make credit decisions until

late in a day. By contrast, a CHAPS settler's acceptance of the credit
risk associated with a particular CHAPS transfer accompanies the transfer.
That is, a CHAPS payment is the electronic equivalent of the certification
of a check by a CHAPS settler -- at a considerably lower cost than for
the current cost of having a paper check certified.

End-of-day processing of sterling payments transactions through
the Town Clearing encourages U.K. banking offices seeking to control
customer credit exposures to schedule the execution of each day's dollar
payments for late in the day. The execution of a dollar payment involves
the transmission of a payment message to a U.S. banking correspondent;
these messages are irrevocable commitments of the sending U.K. bank.

Thus, the bunching of dollar payments processing produces higher operating
costs and more credit exposure control than a more even processing of dollar
transactions throughout the day .2/

When the CHAPS payments network is operational, U.K. banking

offices will, if they choose, have access to intraday information on

77 Higher operating costs for peak-load processing of payments reflect
the lumpy technical and contractual characteristics of the capital and
jabor inputs purchased by banks.


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-4-

The state of the art of international financial communication
favors the merging of clearing and settlement functions for wholesale
transactions in any currency. It is of considerable value to banks to
integrate the information generated by their cash management and pay-
ment services for corporate customers and bank correspondents with that
from their own daily money-market activities. The cost of transmitting
data is now low enough to justify central processing. Thus, there is
now no economic rationale for the creation of a separate dollar clearing
mechanism in London.

However, a restrictive policy of U.S. authorities toward net
settlement mechanisms in the United States could stimulate interest in dollar
clearings through CHAPS and other offshore arrangements. In particular,
banks might use CHAPS (or other non-U.S. network) for dollar clearings
in response to “arbitrary" restrictions that U.S. bank regulatory

: agencies might apply to intra-day extensions of credit in domestic U.S.

12/

payments mechanisms .—

12/ For discussions of possible restrictions that could be imposed by
U.S. authorities see Warren Coats and Allen Frankel, "The Effects of
Prohibiting Reserve Account Overdrafts", Research Papers in Banking and
Financial Economics, Federal Reserve Board, September 1980; and Allen
Frankel and Jeffrey Marquardt, "Payments Systems: Theory and Policy",
International Finance Discussion Paper, Federal Reserve Board, 1983.



-2-

clearing arrangement will be perpetuated in CHAPS.

The core group in the CHAPS mechanism will consist of the 13
CHAPS settlement banks.2/ Each of the CHAPS settlers will have access to
a CHAPS Gateway .2/ The Gateways are interface devices that will be linked
together via the British Telecom's Packet Switching Service (a common
carrier's data transmission service) and will also be connected to each
settling bank's own mainframe computer system. Each bank's own computer
systems will be able to support computer-to-computer connections to CHAPS
for sponsored CHAPS bank participants and corporate customers 4/ Alter-

natively, sponsored banks will be ablé to connect to CHAPS through the

SWIFT network -- see Figure 15/

CHAPS, by design, is a very limited joint undertaking of the
U.K. Clearing Banks. The joint work on CHAPS by the clearers has been
limited to the development of standard interfaces, with known rules and
procedures for the exchange of payment messages. The clearers' decision
to create a dispersed,rather than a centralized, processing capacity for

27 The CHAPS settling banks are: The Bank of England, Bank of Scotland,
Barclays Bank, Central Trustee Savings Bank, Clydesdale Bank, Co-operative
Bank, Coutts and Co., Lloyds Bank, Midland Bank, National Girobank,
National Westminister Bank, The Royal Bank of Scotland and Williams and
Glyn's Bank.

3/ The CHAPS Gateways are computers which are specially suited to
operate in a dispersed processing network. Particular attention has been
paid in the technical design of CHAPS to assure the ongoing operation of
the network after a failure of any one of its components.

4/ CHAPS participants will include some of the U.K. banking offices of other
than the CHAPS settlers. A CHAPS participant will have the privilege
of being able to designate its settlement bank to the operating manager
of the CHAPS network. Without this privilege, a bank would have to
inform, and update, all potential payors to it of its choice of settle-
ment bank.

5/ SWIFT is the acronym for the Society for Worldwide Interbank
Financial Telecommunication, a co-operative company created under Belgian
law. It is wholly owned by member banks. SWIFT provides an inter-
national transaction processing network to which only banks (or bank-
owned organizations) may connect.


February 1983

An Appraisal of the CHAPS Payments Mechanism
by Allen B. Frankel*

Introduction

The purpose of this paper is to highlight some of the possible
consequences for payment practices and money markets in the United
Kingdom of the introduction, later in 1983, of CHAPS. CHAPS, an
acronym for Clearing House Automated Payment System,is 2 real-time
interbank sterling payments mechanism developed by the U.K. Clearing
Banks. It is anticipated that CHAPS will replace the paper-based end-
of-day Town Clearing as the core clearing mechanism for sterling~-
denominated transactions ./

All interbank clearing arrangements in the United Kingdom are
operated by the U.K. (London and Scottish) Clearing Banks. Each
clearer maintains an account with the Bank of Engtand and this account
is used to make and receive settlement payments to and from other
clearers. The U.K. Clearing Banks are not the only providers of ster1-
ing-based payment services. Other financial institutions, including
the U.K. branches of non-U.K. multinational banks, offer sterling pay-
ment services. For such institutions, however, participation in the
clearing arrangement must be through a sponsoring Clearing Bank. This
"two tiered" structure in which the Clearing Banks operate the interbank
—¥7 International Finance Division, Federal Reserve Board. This paper
represents the views of the author and should not be interpreted as
reflecting the views of the Board of Governors of the Federal Reserve
System or other members of its staff. The paper benefited from comments

on an earlier draft by Peter Clark, Robert Gemmill, Jeffrey Marquardt,

and Howard Sherman.

1/ The Town Clearing refers to the daily exchange of large value checks
drawn against the Bank of England and the City of London offices of the
London Clearing Banks. Checks exchanged in the Town Clearing are for

same-day value.


-12-

to changes in the supply of reserves if the introduction of CHAPS reduces
the interest-rate sensivity of the clearers' holdings of operating
balances.

Observations

CHAPS is a prototype for other national wholesale payments
mechanisms. Participants in CHAPS will be able to employ standardized
SWIFT techniques for funds transfers within CHAPS. CHAPS highlights the
considerable flexibility that SWIFT has introduced into payments arrange-
ments. Links among potential participants in a net settlement payments
network can be readily established. Furthermore, links between bank
participants and specialized facilities, such as automated ledgers to
monitor network credit of individual participants, can also be readily
established. The design of the CHAPS mechanism thus embodies a solution
to the problem of non-indigenous bank participation in a national payments
mechanism.

The CHAPS solution involves the assignment of risk management
responsibilities for sterling payments arrangements to the U.K. Clearers
as a group and individually. U.K. authorities have not indicated any
interest in supervising the terms on which the U.K. Clearers will admit
other participants to the CHAPS network, a policy based on the view that
CHAPS network relationships ought to be described and maintained by the
banks "responsible" for the day-to-day operation of U.K. payments arrange-
ments.

Alternative to Domestic Dollar Arrangements

The design and organization of the CHAPS mechanism is con-

formable with the U.K. environment, an environment quite different