G Padmanabhan: International Seminar on Principles of Financial Market
Infrastructures and Innovations in Retail Payments
Valedictory address by Mr G Padmanabhan, Executive Director of the Reserve Bank of
India, at the International Seminar on Principles of Financial Market Infrastructures and
Innovations in Retail Payment organised by the Reserve Bank of India, New Delhi,
15 February 2013.
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Assistance provided by Shri Saswat Mahapatra and Smt Radha Somakumar is gratefully acknowledged.
Distinguished speakers, participants, other guests, ladies and gentlemen. It is a pleasure to
be amidst you and speak to you all as we conclude this International Seminar on "Principles
of Financial Market Infrastructures and Innovations in Retail Payments" organized by the
Reserve Bank.
The theme of the seminar, which was chosen after considerable deliberations, is quite apt,
given the markets around us. As you know, the term FMI refers to systemically important
payment systems, CSDs, SSSs, CCPs, and TRs which facilitate the clearing, settlement, and
recording of monetary and other financial transactions, such as, payments, securities, and
derivatives contracts (including derivatives contracts for commodities).
The role and importance of FMIs in the global financial system came to fore during the crisis
which has been succinctly captured in the IMF report "Central Banking Lessons from the
Crisis" (May 27, 2010). The report mentions "The crisis would have been much more severe
had central banks not taken efforts to introduce robust payment and settlement systems,
including for foreign exchange, over the two decades ahead of the crisis. The systemic
impact of failure of a financial institution depends critically on the robustness of the
infrastructure underpinning those markets in which it is active".
The FMIs which act as plumbers in the financial system helped in maintaining the market
confidence during the crisis for two reasons. First, FMIs like the CCPs shift the counterparty
risk from participants to themselves thereby ensuring trust in an environment where
participants distrust each other and thus provide the market confidence to carry on
transacting. Second, their ability to settle when transactions are due for settlement on
account of their risk management practices helps in retaining the sanity in the market.
Many studies had been undertaken analyzing the role of FMIs during the crisis. The common
findings of such studies are that FMIs were successful in ensuring reliability and mitigating
risks despite unprecedented volatility and shaken market confidence. FMIs like CLS, RTGS
systems and CCPs helped in containing the materialization of systemic risk by maintaining
confidence in the interbank trading and settlement of foreign exchange, money markets, etc.
FMIs were successful in handling the defaults in a non-disruptive manner.
Lessons learned from earlier crisis, such as, Herstatt failure in 1974, US equity clearing
house difficulties faced in 1987, Hong Kong Future Exchange in 1987, etc. helped the
regulators in addressing the risks in payment, clearing and settlements systems.
Implementation of RTGS systems, adoption of PvP and DvP modes of payments, sound
legal framework for settlement finality, setting up of new market infrastructures and robust
clearing and settlement infrastructure are the initiatives that helped in curbing recurrence of
these risks. Establishment of global standards, such as, RCCP, RSSSs, SIPS, etc. helped in
effective governance, oversight and supervision of systemically important financial market
infrastructures.
However, the crisis also gave few important lessons to the regulators. Readiness for the
worst case scenario does not guarantee protection against future scenario as the future crisis
could be much bigger than what has been experienced. There is a need to capture newer
risks emerging from links, tiering and indirect participation which were hitherto not captured
fully in the existing standards. The recent global crisis revealed that liquidity lines assumed to
be secured are not so secured in a stressed scenario. Another important lesson that can be
drawn from the recent crisis, especially in a globally interconnected financial market on
account of links and interdependencies, is the need for communication and co-ordination
among regulators. Finally, there is a need to reduce regulatory and policy arbitrage within
and among the jurisdictions.
The response of the policy makers to the crisis has been multi-prong and multi-dimensional
to ensure that a crisis on this scale may never happen again. The regulatory reforms
undertaken under the aegis of G-20, Financial Stability Board and other international
standard setting bodies focus on strengthening the micro-prudential and market-conduct
regulations supplemented by effective macro-prudential frameworks.
The CPSS-IOSCO Principles for Financial Market Infrastructure which replace the earlier
standards are part of the global initiatives to reform the financial markets. The principles
amplify the critical role the FMIs play in maintaining and promoting financial stability and
economic growth and also prescribe standards for strengthening the FMIs to make them
robust and resilient to handle future crisis. The standards when fully implemented would
ensure that FMIs perform the role they have been designed for viz. shock absorber and
plumber of financial systems rather than being the major channel for transmission of financial
shocks in form of liquidity dislocations and credit losses.
Given this background, we thought PFMI would be an apt theme for the conference. I am
certain the esteemed speakers who have been closely associated with the framing of new
standards would have demystified the principles and explained the nuances and subtleties of
the principles. You would have noticed that the new standards seek to introduce more
demanding requirements. The new standards have raised the bar in form of financial
resources and risk management frameworks. The significant being the need for Cover 2
requirements both for liquidity and credit risks for systemically important CCPs which are
operating in multiple jurisdictions/currencies and which deal in asset classes with "jump to
default" risk profile in recognition of the increased risk posed by such CCPs. The standards
also bring forth other important requirements, such as, need for addressing the business risk,
need for a recovery and resolution plan, fair and open access, portability and segregation
which are all critical.
The new standards when compared to old standards provide additional guidance both to the
regulators and the FMIs. The standards provide building blocks for risk models, be it for
margin calculation, collateral requirements, back-testing and stress testing methodology
requirements or liquidity and financial resource planning. It must be recognized that the FMIs
differ significantly in terms of their organization, functionality and design. Thus, principles
have been framed with a functional focus so that they provide flexibility while applying them
to the FMIs in respective jurisdictions.
The intended benefits of the standards could be achieved through effective implementation.
The challenge lies in measuring the effectiveness. The Assessment Methodology provides
guidance to the regulators for determining the scope of assessment, gathering facts,
developing conclusions and assigning a rating of observance for each principle. The
Assessment Methodology helps in promoting objectivity and comparability across the
assessments of observance across FMIs and across jurisdictions. I hope the sessions on the
Assessment Methodology would have equipped the participants in undertaking effective
assessment of principles in your jurisdictions.
Another aspect you might have observed would be that unlike the previous standards, the
new standards have more enforceability as they are binding on the members of the
CPSS-IOSCO on account of their commitment to financial sector reforms. Further,
compliance to these standards also provides economic incentive in terms of capital benefits
to banks for their exposure to qualified CCPs.
No doubt the implementation of these principles is going to pose challenges both to the
authorities and FMIs. I am sure the panel discussion would have provided insights on how to
meet the implementation challenges. Meeting the liquidity requirements under Principle 7 is
going to pose challenges for countries where markets are dominated by a few large players
with limited liquidity support from private sources. In such a scenario, liquidity support from
central banks assumes significance but it has its own challenges. First, central banks should
have mandates for providing liquidity support. Second, even if there are no technical
obstacles, the challenge would be in addressing the moral hazards.
Similarly, some of the principles would require changes in the legal and regulatory
framework. Many jurisdictions are likely to face limitations while complying with requirements
under segregation, portability, recovery and resolution, etc. In some of the jurisdictions, the
Trade Repository (TR) may be a new concept. Without proper legal framework for the
regulation and oversight of TRs including the need for addressing the confidentiality issue, it
would be a challenge for the regulator to mandate reporting of trades to TRs.
The FMIs would also find it challenging in meeting the new standards involving credit risk,
liquidity risk or financial resources. FMIs need to build skills and have adequate resources in
terms of technology, manpower to develop risk models, historical data bases, scenarios
analysis, etc. The regulators also need to build skills for evaluation and validation of risk
management framework put in place by the FMIs.
To summarise, the deliberations, the central bank and the market regulators have challenges
ahead of them with respect to performing the responsibilities envisaged under the
CPSS-IOSCO principles of FMI. The regulators will be required to set out responsibilities,
objectives and criteria for determining who the standards apply to and the necessity to clarify
roles in case of multiple authorities. A combination of enforcement tools consisting of formal
legal instruments (guidelines, regulations, instructions, sanctions, etc.), informal tools (moral
suasion), cooperation with other authorities, voluntary agreements, etc. have to be worked
out. Further, these regulatory and oversight policies have to be transparent, consist and
effective.
Let me now turn to the other major theme of the seminar - Innovations in Retail Payment
Systems.
Retail payment systems
Although the growing importance of FMIs is acknowledged, the retail payments have their
own share of recognition. The innovations that have taken place in retail payments have
been country specific, within the respective regulatory framework catering to the needs of the
customers. The impact of innovation in retail payments is directly felt by the end-users and
reshapes the payment process. Allowing retail payment operations in the country within the
broad vision of inclusiveness and moving to less-cash society and ensuring its compliance to
the regulatory stipulations keeps the regulators on their toes. But the uniqueness lies in the
fact that in most of the countries, the innovations in retail payments are regulator driven.
While the Report of the Working Group on Innovations in Retail Payments (BIS, May 2012)
formed under the CPSS identifies five product categories: (i) innovation in the use of card
payments; (ii) internet payments; (iii) mobile payments; (iv) electronic bill presentment and
payments and (v) improvements in infrastructure and security, it is increasingly evident that
innovations are taking place with new technology by intertwining products and processes.
The emergence of the NFC technology is an example where the card payment product is
intertwined with the mobile technology. The mobile POS is also another example. Hence, to
my mind, the need of the hour is to think of linkages and integration of technologies.
Thinking beyond domestic coverage and integrating retail payments worldwide
As you know, one of the trends highlighted in the Report of the Working Group on
Innovations in Retail Payments, is the fact that most of the innovations are developed for the
domestic market and only a few have international reach, although similar products and
categories have emerged worldwide. The challenge of stretching a retail payment product or
process beyond domestic boundaries brings about the need for international standards and
principles. The success of the card payment networks like MasterCard and Visa is a classic
example of the above. The PCI-DSS1 standards for the card industry and the PA-DSS
standards for the payment application software developer are some such internationally
accepted standards. Owing to the network effects inherent in the retail payment market,
common standards may help to achieve the necessary critical mass and can create a stable
ground for new players coming into the market. Economies of scale and scope, pricing and
cost reduction are advantages of the same.
Thinking of interoperability while innovating a retail payment system
While innovation has brought about many products and processes, the challenge is in
gearing up to allow interoperability between two retail payment operators. Have the risk
factors, costing, pricing, customer convenience and ease been thought of? Integrating two
competitive offerings and giving the best product with portability to a customer would lead to
a demand driven initiative for the retail payment system providers. For interoperability to
happen, standardization is a pre-requisite. Convergence of any payment instrument into the
mainstream acceptance infrastructure is the need of the hour. In India, the prepaid payment
instrument (PPI), popularly known as "e-money", is also issued by non-banks and accepted
on their own infrastructure. If these instruments have to be accepted on the existing POS
infrastructure, it presupposes adherence to internationally accepted standards of form factor
and connectivity. Is the industry geared up for this? Significant changes will, therefore, be
required in the technology and business model of non-bank PPI issuers.
Thinking of financial inclusion while innovating a retail payment system
We are all aware that financial inclusion has served as an important driving force for
innovations in many countries either under a government mandate or because of the new
business opportunities opened up by an untapped market. But how many companies are
betting on innovation beyond the Return on Investment (ROI) concept, given the fact that the
bottom of the pyramid is very sensitive to costs? Moving away from the single economic ROI
to an integrated economic, social and environmental approach would bring in the desired
results of financial inclusiveness.
Non-banks in retail payments - need for a status
The role of non-banks in retail payments has increased significantly, owing in part to the
growing use of innovative technology that allows non-banks to compete in areas not yet
dominated by banks. The Working Group on Non-banks in Retail Payments firmed under the
aegis of CPSS is also attempting to understand the challenges and the advantages of
non-banks in the payments space. The increased role of non-bank entities in payment
system is linked to their potential to change the payment system landscape as they can
leverage on their product offerings with latest technological features to cater to wide segment
of the market.
Regulators' effectiveness as catalysts, overseers and/or operators of payment systems
As regulators, you will agree that the most defining moment is to be effective as a catalyst
without compromising on the regulatory concerns. It is like a parent having to know when to
be a friend of the child and when to be a parent. Monitoring and assessment of innovative
retail payments by central banks calls for engaging appropriate skill-sets regularly updating
with technological developments and having a machinery to gauge the need and efficacy of
such a retail payment system for the country. The impact of innovations on cash and
monetary policy may be required to be analyzed in the long run once the volumes pick up.
Retail payment systems - KYC constraint
Although we always propagate that availability and accessibility of a payment
product/process is the key factor to be considered for financial inclusion the fact remains that
these customers have to pass the test of proving identity. Innovating a retail payment system
keeping the biometric identity in mind is the need of the hour. But that calls for nationwide
initiative. In India, however, integrating the Aadhaar (biometric) with payment systems has
started happening with the regulator supporting its acceptance as a valid KYC proof.
Concluding thoughts
I hope all of you have had two days of fruitful discussions and debate. I also hope you had a
pleasant stay in India. I know the best is yet to come when you will be taken to the country's
historically most important infrastructure, the Taj Mahal, tomorrow. Wish you have a great
time exploring India and that you will all return academically and culturally richer back to your
respective countries. Wish you all the best.