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    BANK OF FINLANDDISCUSSION PAPERS

    17/2000

    Financial Markets Department29.11.2000

    Re-engineering Payment Systemsfor the E-world

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    BANK OF FINLAND DISCUSSION PAPERS

    Financial Markets Department29.11.2000

    Re-engineering PaymentSystems for the E-world

    The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland.

    Harry Leinonen, Financial Markets Department, Bank of Finland, P.O. Box 160, 00101Helsinki, Finland. Email: Harry.Leinonen@bof.fi , Tel. +358 9 1832112

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    ISBN 9516866832ISSN 07853572

    (print)

    ISBN 9516866840ISSN 14566184

    (online)

    Suomen Pankin monistuskeskusHelsinki 2000

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    Re-engineering Payment Systems for the E-world

    Bank of Finland Discussion Papers 17/2000

    Harry LeinonenFinancial Markets Department

    Abstract

    Payment systems are undergoing rapid changes stimulated largely bytechnological progress. Distributed network technology, real-time processing andcustomers willingness to use electronic banking interfaces will further reshapepayment systems during the coming years. Internet and e-commerce will have a

    major impact on payment systems.This paper presents the current developmental trends. It analyses the need todevelop payment standards and the content of payment instructions in order tofully automate the payment process. Since interbank settlements comprise an es-sential part of payments, they should be made an integral part of the payment pro-cess within the Internet environment. With cross-border payments increasing inimportance, any new developments should take an international perspective.

    Payment system development requires cooperation between the banks andother participants involved. In order to build the necessary consensus, bankingindustry organizations as well as central banks and other regulators will need towork together to re-engineer the present payment systems, making full use of the

    possibilities created by modern technology.

    Key words: payment systems, settlement systems, RTGS, payment systemintegration

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    Maksujrjestelmrakenteiden uusiminen kokonaanelektronista ymprist varten

    Suomen Pankin keskustelualoitteita 17/2000

    Harry LeinonenRahoitusmarkkinaosasto

    Tiivistelm

    Maksujrjestelmt ovat suurien, pasiassa teknisest kehityksest johtuvienmuutosten edess. Hajautetun tietoliikenteen tekniikka, tapahtumien reaali-aikainen ksittely ja asiakkaiden valmiudet kytt elektronisia pankkiyhteyksiuudistavat maksujrjestelmi seuraavien vuosien aikana. Internetill ja elektroni-sella kaupankynnill on huomattava vaikutus maksujrjestelmien kehittymiseen.

    Tss tutkimuksessa esitetn keskeiset kehityssuunnat. Maksuliikestandar-dien ja maksutoimeksiantojen sislln kehittmistarpeita tarkastellaan maksu-prosessin automatisoinnin nkkulmasta. Pankkienvliset katteensiirrot ovat oleel-linen osa maksamista. Niit tulisi kehitt niin, ett ne muodostavat integroidunosan maksuprosessia Internet-ympristss. Kansainvlinen maksaminen lisntyy,

    ja uusissa kehittmisaloitteissa tulisi ottaa huomioon kansainvlinen ulottuvuus.Maksujrjestelmien kehittminen vaatii yhteistyt pankkien ja muiden osa-

    puolten vlill. Riittvn yksimielisyyden aikaansaaminen edellytt, ett pankki-sektori, keskuspankit ja muut stelijt keskittyvt yhdess jrjestelmien uudis-tamiseen kytten modernin tekniikan antamia mahdollisuuksia.

    Asiasanat: maksujrjestelmt, katteensiirtojrjestelmt, RTGS,maksujrjestelmien integrointi

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    Contents

    Abstract 4

    Tiivistelm 5

    PART I: BACKGROUND FOR PAYMENT SYSTEM DEVELOPMENT 71 Introduction 72 Developments in payment transfers 8

    PART II: IMPROVING PAYMENT EFFICIENCY BY SYSTEMINTEGRATION ( 113 The challenge for integration 114 The payment circle 12

    4.1 Payers perspective 134.2 Perspective of the payers bank 144.3 Perspective of the beneficiarys bank 144.4 Beneficiarys perspective 15

    5 Prerequisities for complete STP in the transfer circle 156 The power of common standards 177 The Finnish case 188 The way forward 19

    PART III: DEVELOPMENT OF SETTLEMENT ALTERNATIVES FORPAYMENT TRANSACTIONS 219 Challenges for settlement systems 2110 European consolidation developments 2211 Network topologies and hierarchies 2312 Alternative settlement schemes 25

    12.1 Batch-based settlement schemes 2512.2 Real-time based schemes 2712.3 Real-time settlement of batched payments 2912.4 Assessing the different schemes and anticipating developments 29

    13 Diverging paths for settlement systems 31

    PART IV: THE PROCESS OF CHANGE 3214 Striving for the new payment system process for the e-world 32Lhteet 33Appendix 1. The need and alternatives for an international bank account

    number space/standard 34Appendix 2. Distributed network based central bank money for interbank

    settlement in the e-world 39

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    7

    PART I:BACKGROUND FOR PAYMENT SYSTEMDEVELOPMENT

    1 Introduction

    Todays payment systems have emerged over time by building on paper-basedprocesses. Automation has occurred in phases where various parts of the processhave been electronified independently, without redesign of the whole process.Now we are in a situation where major benefits can be realized only by re-engineering the entire payment process in order to utilize the new efficient fea-tures provided by modern technology.

    The major user trends and technology changes that would seem to requirethis re-engineering are

    the distributed network solutions (ie the Internet and TCP/IP 1) and the newinteractive real-time communication mode based on direct one-to-one con-tacts

    customers readiness and interest in using electronic interfaces and integrat-ing their internal systems with bank systems for transaction processing

    security infrastructure using modern encryption techniques and secured chipbased processors

    decreasing costs of real-time processing and telecommunications increase in global cross-border communications, which requires efficient

    cross-border operability.

    The changes have to be implemented in the two different phases of payment proc-essing

    the flow of payment information from paying customer to receiving cus-tomer and

    the interbank settlement transfer.

    The aim should be to design a completely electronic process straight through thesystem (=STP), where each phase is automatically linked to the next one. Theonly intervention needed is to control the correctness of payments against relatingagreements and deals. Even this process could be to a large extent automated.This calls for bank-to bank, bank-to-customer as well as customer-to-customerintegration of payment processing systems. In the e-world, the ultimate result is atransfer that occurs in real time from end-to-end for all participants. This is al-ready the case in some limited Internet payment environments (eg Internet pay-ments provided by the major Finnish banks).

    Interbank settlement systems today consist of large varieties of solutions.Common to all these systems are the heavy costs involved in matching or keeping

    1 Transmission Control Protocol/Internet Protocol (TCP/IP) is the basic communication languageor protocol of the Internet.

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    8

    the payment information transactions synchronized with interbank settlements.Central banks RTGS systems and some private continuous net-settlement systemshave solved the synchronization problem by settling all transactions at a centralintermediary point before transferring the payment onwards to the receiving bank.However, in order to support the distributed network process in the e-world, adistributed interbank e-settlement process is needed.

    This paper deals mainly with credit transfers, which will probably be themain and basic mode of payment in the e-world. Checks and direct debits can andwill generally be separated out of credit risk concerns into a payment requesttransaction with the credit transfer being made after successful debiting of thepayers account.

    Many of the examples cited here are from European and Finnish paymentsystems, and the paper generally takes a European perspective on payment sys-tems. However, most of the conclusions are general and could be implementedalso in other geographic regions. In general, the focus of payment system devel-opment should be on designing a general and global payment system infrastruc-ture. The e-world will have no geographic borders.

    This paper is organized as follows. The first part contains introductory andbackground information. The second part presents ways to improve payment sys-tem efficiency by system integration. In the third part different settlement alterna-tives are presented and their efficiencies are assessed. The forth part concludes bypresenting some views on the process for change. There are two enclosures ana-lyzing in detail the two main items requiring redesign, ie the payment rout-ing/account numbering convention and the e-settlement process.

    2 Developments in payment transfers

    The following important technical changes will bring a need for restructuring thecurrent payment processing schemes and will result in increased efficiency

    open network structure in interbank connections interactive real-time processing electronic customer payment input need for end-to-end control in order to enhance service le