RTGS part 2

Dave and I thought that there was so much to discuss around RTGS that we decided that we need 2 podcasts. So here is part 2…. 

 We are going to discuss a little of their history and dive into why RTGSs are so critical….

Before the advent of RTGS, many countries used deferred net settlement systems for interbank transactions. In these systems, payments were accumulated over a certain period, and then the net amount was settled at the end of the day or another specified time. While this method was efficient, it carried significant systemic risk. If one bank failed to meet its obligations, it could trigger a chain reaction, potentially destabilizing the entire financial system.

Payments Industry Insights

History of Payments

Payment System Explained

Corporate Payments Strategy

Payment Regulations Impact

ISO20022 Standard

Digital Payments Evolution

CBDC Advancements

Cryptocurrency in Payments

Financial Technology Education

Transcript

SPEAKER_00: 0:00

Welcome back, dear listeners, to Bite Size Payments. Today, we're going to go into part two. Yes, we've never done a part two before, but this is part two of RTGS. RTGS is such an important topic that we really thought we needed to do a little bit more on it. So today, we're going to discuss a little bit of their history and dive into why RTGSs are so important, and of course, who does what. Hang on to your hats. Here we go. So here we go, part two of RTGS, real-time gross settlement. And really, this is such a critical subject for any nation that we thought was really important to go into a little bit more detail. So today we're going to talk a little bit about their history, where they came from, why they are so critical, and give you an idea of some of the scale and the use cases that RTGS is used for. Dave and I really felt we needed to do this bit. So as ever, Dave, pleasure to have you back.

SPEAKER_01: 1:15

Yeah. Hi, Paul. Great to be here again.

SPEAKER_00: 1:19

Okay. So let's delve into the history. Before the advent of RTGS, many countries used deferred net settlement systems for interbank transactions. In these systems, payments were accumulated over a certain period and the net amount was settled generally at the end of the day. While this method was efficient, it carried significant systemic risk if one bank failed to meet its obligations, it could then trigger a chain reaction, potentially destabilizing the entire financial system. So with this as a potential backdrop or issue, if you like, RTGS systems came to the fore. So which one was the first system? Well, some sources say that Fedwire was the first RTGS system, while others say, hey, it was Japs. Fedwire was introduced in the early 1970s. Whilst CHAPS, Clearing House Automated Payment System, was introduced in 1984. However, if you look at the definition of an RTGS system, then CHAPS is technically the first. An RTGS system is a payment system that settles payments in real time on a gross basis and is irrevocable. as we discussed in part one. Real-time means that the payments are settled as soon as they are received. Gross means that each payment is settled individually rather than being netted against other payments. Irrevocable means that the payments are final and cannot be reversed. Fedwire meets all of these criteria, but it was originally developed as a way to transfer funds between the Federal Reserve Banks. It was not until the early 1980s that Fedwire was made available to other financial institutions. CHAPS was the first system to be designed specifically as an RTGS system. So how did that global adoption of RTGSs come about, Dave?

SPEAKER_01: 3:31

Yeah, so throughout the 1990s, the early 2000s, Many countries recognize the benefits of RTGS systems in terms of reducing the systemic risk and enhancing the efficiency of their paint systems. As a result of that, many countries ranging from developed economies, the largest economies in the world, right the way down to smaller developing countries, emerging markets and so forth, began to implement their own RTGS systems. encouraged by a number of organizations, such as the World Bank, the Bank for International Settlements, and so forth. If we go back to what you were talking about earlier, Paul, by the mid-'80s, there were three RTGS systems. You mentioned Chaps and Fedwire. And very shortly after that, the French introduced something called Sagittaire. If we then jump forward to 2005, if there were 90 countries that had implemented RTGS systems, so a huge difference. Wow. Many RTGS systems share the same basic principles of operation, and that degree of commonality leads to a relatively small number of technology providers, the large technology companies that make the technology that run these RTGS networks. So a relatively small number of those companies providing their technology to many countries across So it means that whilst each country's RTGS system obviously supports the central bank in that country and the currency in that country, the way that they tend to operate, the type of transactions that they support, because of that degree of commonality, it means actually they work in quite a similar way. The vast majority of RTGS systems use standards that are defined by SWIFT, the interbank network, and very often they use the SWIFT network as a means of communicating between the central bank and the banks using the RTGS system. As the technology has advanced, RTGS systems have also evolved and also obviously as experience of using RTGS systems has grown, so they've evolved. They became more sophisticated, new features were added. If you look at CHAP, things like queuing mechanisms, for example, offsetting gridlock resolution, allowing banks to do things like better utilize their liquidity.

SPEAKER_00: 5:56

Yeah. With the globalization of finance, there's been a a huge push to make RTGS systems interoperable and to facilitate faster cross-border payments, such as SWIFT's initiative, GPI, Global Payment Innovation, which was aimed to streamline and speed up international transactions. We've also seen the emergence of regional as opposed to national RTGS systems. For example, the SADAC RTGS system that settles South African RAND payments between banks in a number of Southern African countries. And starting in the early 2000s, we also saw the introduction of CLS, or Continuous Linked Settlement, which is a means of ensuring that financial transactions which have payment obligations that need to be settled in multiple currencies can be executed essentially simultaneously across RTGS systems in different countries. According to the World Bank's 2019 Global Payments System Survey, there are now 98 real-time payments growth settlement systems in operation around the world. And of course, we should remember that the introduction of the euro and subsequently other countries joining the euro means that around 20 RTGS systems were effectively replaced by the pan-European Target and Target 2 systems operated by the European Central Bank. Okay, so let's switch gear a bit and chat about what type of payments are going over the RTGS system.

SPEAKER_01: 7:40

Yeah, so when RTGS systems were first implemented, they were often the only means of executing payments in real time. If we think about the UK, until 2008 and the introduction of the faster payment system, the options for electronic payments were either to use BACs, which uses a three-day cycle, or CHAPs, which allow payments to be executed in close to real time. This meant that if you needed to make an urgent payment, or if you needed to make a very large payment, because BACS imposes a limit of 20 million pounds, CHAPs was, and actually to some extent still is, the only option.

SPEAKER_00: 8:16

So who needs to make these urgent and very large payments and why? Well, urgent payments is possibly the easy one, as everybody at some point needs to make a payment urgently. and doesn't want to wait, well, three days for a backs payment. Whilst we now will take faster payments for granted or immediate payments for granted, possibly we forget that that's only in the last 10 to 15 years that it's been possible to make payments from our bank accounts that are executed in real time. Now, remember in part one, we said that probably everyone at some point will have to make an RTGS payment. Well, An example that we had in mind, of course, was the house purchase, something that's very dear to me at the moment. A great example of urgent and quite possibly large payments, even if for most of us, it isn't big enough to exceed the bank's payment size of 20 million. I can assure you that's the case, Dave. When we are buying a house, we need to transfer a probably quite large deposit. And if there's a mortgage being taken out, the banks providing the mortgage needs to transfer the proceeds of that mortgage. It would be highly unsatisfactory to say the least if we had to wait three days for these payments to be processed through BACs. So CHAP solved that problem.

SPEAKER_01: 9:34

Yeah, exactly. And of course, if we think about the attributes of an RTGS system you talked about a few minutes ago, we can see why they're important in the context of our house purchase. We absolutely want the transaction to be executed and settled in real time. with the guaranteed finality that RTGS provides. The last thing we want is to make that payment and then to be some delay or for us not to be totally sure if the payment has succeeded or for the seller not to be sure if the funds might be recalled or the payment cancelled.

SPEAKER_00: 10:06

Yeah, and of course, an example of a house purchase shows us why the attributes of an RTGS system are important. But really, that's a retail payment initiated by us, the citizen. The only reason that we would use the RTGS systems, well, probably, is because it's been the only option available to us. But it's not really what RTGS systems were intended for. Fundamentally, RTGS systems were intended to handle systemically important payments and to eradicate the settlement risk that we discussed in part one. So, systemically important payments, Dave?

SPEAKER_01: 10:44

Yeah, so essentially what we mean by that is payments that are critical to the safe and secure operation of a country's economy. Very often those will be very, very large payments, as we'll talk about in a minute. But yeah, systemically important that if something went wrong with those payments, it would cause disruption in the economy. It would cause a lack of confidence in the economy. That's what we mean by systemically important payments, and that's what RTGS systems are fundamentally aiming to accommodate. Those could arise for several reasons. We can't go through them all, but let's give a few examples. They could be corporate payments, for example, so one business paying another business for goods or services. They could also be payments relating to wholesale banking and capital markets activity. So if you think about transactions that banks enter into with other banks, and often that's on behalf of corporate or institutional customers of those banks, things like structuring finance, arranging large loans, hedging financial risk using all sorts of different financial products. All of those types of transactions will have payment obligations that arise from them. And often the size of those payments can be really, really large. You know, we joked about 20 million not being enough to make a house, but here we're talking tens, hundreds of millions, even billions of pounds, so truly massive payments. And of course, another really interesting one to understand is RTGS systems also provide the settlement of payments that are executed in many other payment systems. So for example, if we use the UK as an example, any payment that we as consumers make through a system such as Faster Payments will ultimately be settled at the interbank level. And by the interbank level, we mean between the participating banks that were sent and received that payment. So ultimately, the settlement of those Faster Payments transactions will be made through CHAPS.

SPEAKER_00: 12:47

So pretty much every transaction ultimately gets resolved through an RTGS system. Is that right, Dave?

SPEAKER_01: 12:53

Exactly, yes. And that's why the total value of the payments that are handled by an RTGS system such as CHAPS is so large. We can look at some of the numbers. So for example, Faster Payments in the UK in 2022, which is the last year they published the full figures for, that handled about 4 billion payments for a total of about£3 trillion. So if you do the maths, the average payment size is about£800. If you look at chaps for the same period, it was only 50 million payments. So a fraction of the payments compared to faster payments. But the total value of those payments was 98 trillion pounds. Absolutely staggering. That means that the average value of each of those chaps payments was 1.8 million pounds. But it actually gets even more interesting because fortunately they split out the transactions between for the statistics between those kind of retail payments, such as the house purchases that you explained, Paul, from the larger kind of wholesale transactions that I was just talking about. So if we do that, the average size of each payment by CHAPS, if we filter out the kind of real retail payments, the average size of each payment handled by CHAPS goes up to nearly£6 million. And then put some of these values into context, the total GDP of the British economy is about£2.5 trillion. Chaps is handling 40 times the entire value of the UK GDP every year in payments. It's absolutely staggering. Wow.

SPEAKER_00: 14:27

Wow. So, you know, RTGS systems like Chaps are so critical in many ways. They run the country's payment systems. If payments of literally millions of pounds cannot be processed safely And quickly, the risk to the stability of the economy is massive, isn't it?

SPEAKER_01: 14:52

Absolutely, yes. And, you know, anytime there is a failure of these systems, I mean, unfortunately, I think with CHAPS, that's probably only happened twice in about nearly 40 years of operation. But any time there's a failure of those systems, it causes a lot of concern. And, you know, that gets escalated and you'll see politicians start to make comments about it. It gets in the news, on the TV and all that kind of stuff. So, yes, absolutely. The risk of stability of the economy if these systems do not work as they're supposed to is massive. And another point that occurred to me that we've still not really touched on, but it's key to actually how these RTGS systems and the settlement of payments in them takes place, is that actually these systems settle in what we term central bank money, which is distinct to something called commercial bank money. So two types of money in the economy, central bank money and commercial bank money, which I think is something else we should delve into at some point.

SPEAKER_00: 15:59

I think that's right. While we've talked a little bit about faster payments and we talked about that in a previous podcast, we do see a lot of the smaller values that currently are in the RTGS systems probably moving across to there. But as Dave, you make the point, some of these transactions are eye-wateringly large. And then to get into this piece about central bank money as opposed to commercial bank money, it also scratches an itch of a different level of conversation, which is we've talked mostly about RTGS systems and we talked about the UK systems, but effectively they're very similar around the world. But actually, how do they join up? How does that work with the World Bank? And how does that work with the Bank of International Settlement? I kind of feel there's a third leg of this to go through, to go through that, perhaps spend a little bit more time on central bank money as opposed to commercial bank money. What do you think, Dave?

SPEAKER_01: 17:05

I think, yeah, I think a part three would be great. We can talk about some of the topics you talked about, so how do countries settle the balance of payments that exist between them when money gets moved between banks in different countries. We can talk about some of the related topics, as we just said, about central bank money and commercial bank money, things like fractional reserve banking, which is very much related to that. And then I thought, again, just to dangle something for people to be excited to hear about, is we can talk about a bank in the 1970s, a German bank, and why the collapse of that bank was really the catalyst for many of the developments that we've been talking about.

SPEAKER_00: 17:52

You know, Dave, I think there's definitely a need for a part three. But for now, let's sum this up and say, really, the need for RTGS systems is much more on the corporate side than we talk about and the way that banks talk to themselves. But the truth of the matter is, effectively, they run the system. payment systems behind the payment systems in every country. And without them, there'd be an awful lot more risk. So for now, Dave, as ever, thank you so very much. I look forward to part three to go through some of these other pieces. And hopefully that'll wrap up RTGS for us.

SPEAKER_01: 18:36

Thanks, mate. Great to talk to you again.

SPEAKER_00: 18:44

Talk to you soon. Well, there you go. RTGS. They really are focused at trying to allow big flows of money to be processed, whether that's from corporates or that's interbank, or in fact, it's the settlement of many of the other payment rails as well. They create stability by making sure that every transaction is settled and cleared and is irrevocable. The money they move around is eye-wateringly large. So we will come back and talk about commercial bank money and central bank money. We'll also talk about how these things work at a different stage, at a world stage, and talk about the World Bank and the Bank of International Settlement. Cheers. And if I could ask a favour, please recommend the podcast to a friend. Thanks so much. Take care.