Risks Associated with Payment Systems and Risk Mitigation Measures

Risks in payment systems

In any payment transaction, there will be a time lag between the time payment instructions are issued and final settlement of these claims (either on gross or net basis). This time lag exposes the entire system to various risks which are given below:

  1. Credit Risk: the risk that a party within the system will be unable fully to meet its financial obligations within the system either when due or at any time in the future
  2. Liquidity Risk: the risk that a party within the system will have insufficient funds to meet financial obligations within the system as and when expected although it may be able to do so at sometime in the future
  3. Legal Risk: the risk that a poor legal framework or legal uncertainties will cause or exacerbate credit or liquidity risks
  4. Operational Risk: the risk that operational factors such as technical malfunctions or operational mistakes will cause or exacerbate credit or liquidity risks
  5. Systemic Risk: the risk that the inability of one of the participants to meet its obligations, or a disruption in the system itself, could result in the inability of other system participants or of financial institutions in other parts of the financial system to meet their obligations as they become due. Such a failure could cause widespread liquidity or credit problems and, as a result, could threaten the stability of the system or of financial markets.

Risk mitigation measures

As stated earlier, most of the risks in payment systems arise during and due to the extent of time lag between finalisation of the transactions and their ultimate settlement with finality. Besides this, risks in payment systems could also arise due to inadequate safeguards in the security and procedures of operations as well as insufficient legal backing to the payment and settlement systems.

Since the process of netting reduces the ultimate payment obligations, the element of liquidity risk as well as liquidity requirements by the participants is reduced in netting systems but not completely eliminated. Reduced obligations also lead to reduced credit exposures. But the greatest risk involved in netting systems can arise out of the legal validity of the netting calculations itself. In the absence of legal framework which recognizes netting as a valid means of settling payment obligations, in the event of one bank defaulting, the net amount of the defaulting bank / member, represent real or legal obligations / claims of the remaining banks. In such a case, the liquidation process may challenge the netting procedure claiming that the underlying gross payment flows are the real obligations and not the netted amounts, thereby necessitating other participants to fulfill their obligations with the defaulting member first and then seek compensation, if any. In this process, the element of credit risk increases. It can also have a snow-balling effect in the sense that, ‘unwinding’ or ‘unpicking’ of netting calculations can lead to default by other banks which otherwise were in a position to fulfill their obligations (especially if they were net recipients in the settlement and were expecting large flow of funds from the defaulting banker in the first place) thereby leading to systemic risk.

Besides addressing this risk through legal framework, payment systems in different countries adopt different practices to mitigate the above risks. Some of these practices include:

  • Application of strict membership criteria for the system and restricting those members / class of members who may pose significant risks to the systems.
  • Application of caps or limits on intra-day exposures to the system by the participants along the lines of counterparty exposure limits which members themselves adhere to in the markets.
  • Limits set up by the system so that no single party breaches such limits.
  • Delaying the availability of funds to the final customer till settlement is reached with finality.
  • Liquidity sharing or loss sharing arrangements in the system with appropriate contributions from the members.

However, one common way of addressing most of these risks, especially in case of large-value netting systems, is through the way of gross settlement of payment obligations. Gross settlement systems, however, expect constant availability of liquidity with the participants to enable them to put through transactions which can be settled in real time with finality, leading to building up of liquidity pressures on the system. In order to reduce such liquidity burden, many gross settlement systems also provide liquidity avenues in the form of central bank support of intra-day funds, queuing mechanisms for payments, gridlock resolutions etc.