Alan L Tyree

Regulating the payment system - Part 1

Alan L Tyree*

1  Introduction

In time when "deregulation" seems to be the order of the day, it may seem strange to find that payment systems are coming under increasing regulation. There are three major reasons for the increased regulation:

This is the first of a series of four articles which examine the various aspects of regulation of payment systems. This one considers the nature of payment systems and a brief review of the reasons for regulation. The following three articles examines each of the above in more detail.

2  Payment systems

According to the Payment System (Regulation) Act 1998, a “payment system” is a funds transfer system that facilitates the circulation of money, and includes any instruments and procedures that relate to the system.1

This definition is very broad. It would appear to include ATMs and other “money access” schemes as well as traditional payment systems such as cheques, direct credits and direct debits. As will be seen, the broadness of the definition is unlikely to cause problems because of the discretion given to the regulatory authority.

The broadness of the definition also obscures the reality of existing payment systems. The essential features of a commercially successful standard payment system include:

Computer technology is being used to implement payment mechanisms that do not follow this traditional pattern. So-called “smart cards” are an example of a “purchased payment facility”.4 According to the Payment Systems (Regulation) Act 1998 a purchased payment facility is a facility (other than cash) in relation to which the following conditions are satisfied:

3  Stability risks

Settlement risk occurs whenever settlement is deferred, that is, when settlement occurs after the receiving institution has accounted to its customer. The recipient institution is then exposed to the risk that the paying institution may default on its settlement obligation. Because of the large sums involved, the failure of one institution to settle might cause others to fail. In an extreme case, the entire financial system might be brought down . This is known as “systemic risk”.6

Settlement risk has always been present in the Australian payments system, but because entry to the system was restricted to only the largest financial players, the risk was often overlooked or considered to be insignificant.7 Recent changes, both organisational and technological, have opened the possibility for smaller institutions to become participants in the payments system. In particular,

Managing settlement risk proceeds along two main avenues. Since the risk only arises when settlement is deferred, the obvious solution is to require settlement to be made simultaneously with payment. This is known as settlement in "real time", and the settlement system is known as a Real Time Gross Settlement System. From the end of June, 90% of bank to bank payments are settled in real time, thus removing very significant settlement risks from the payment system.9

Real Time settlement is only practical for relatively large payments. Where the system involves large numbers of small payments, settlement risk must be managed by a system of multilateral net deferred settlement. Until recently, the legal basis of netting agreements was uncertain. This uncertainty has now been addressed by the legislation introduced following the Wallis inquiry.10

4  Controlling access

As noted above, a major reason for increased regulation is the historical attitude of participants in the payment system. Participants have always sought to exclude new entries to the system. Banks successfully excluded building societies and credit unions from the cheque system for many years. The early years of the Australian Payments Systems Council were spent in active and often acrimonious debate over access to the electronic payments system.

Participants in the payments system always justified the exclusion of others on the grounds of financial stability. While it is true that such stability it needed, it is also patently clear that the self-interest of participants in the payment system makes them an poor choice for determining entry. The Wallis Committee clearly recognised the anti-competitive consequences of such a scheme, and the Payment System (Regulation) Act 1998 provides a mechanism to regulate access.

5  Consumer protection

There are two aspects to the consumer protection problem. The first is to protect consumers from harsh and unconscionable terms in the Terms and Conditions of Use imposed on the customer who wishes to use a payment system. The second is to protect consumers from the consequences of financial institution insolvency.

5.1  Terms and conditions

Australian banks followed UK practice in not issuing written terms and conditions for the operation of cheque accounts. The result is that cheque accounts and the operation of the cheque system is largely governed by implied contract. Another way of expressing this is that the terms and conditions of use of cheque accounts were set out by common law judges over a period of many years. The resulting allocation of risks strikes a balance between the participating parties.

With the introduction of Electronic Funds Transfer Systems in the 1980s, the institutions introduced written Terms and Conditions. It was quickly apparent to everyone that permitting the unilateral imposition of Terms and Conditions led to injustice. Conclusive evidence terms were common, and it seemed that the customer was to bear all of the risk without any of the control. The only obligation of the financial institution was to take the money.

Efforts of the Australian Payments System Council and Treasury led eventually to an Electronic Funds Transfer Code of Conduct that provides a workable and generally fair allocation of risks and responsibilities.

The EFT Code of Conduct applies only to transactions that are initiated by means of a card and a personal identification number (PIN). Many of the new payment systems do not fit into this category. For example, the telephone payment system, BPay, does not require the use of a card. Smart card systems do not require the use of a PIN.

The result is an unfortunate disparity of rights which depend upon the form of the payment system being used rather than its function. The Review of the EFT Code of Conduct has recommended that urgent consideration be given to the consumer problems arising from telephone and computer banking.11

5.2  Institutional insolvency

Most consumers are ill-equipped to evaluate the risks of insolvency of a financial institution. This was part of the rationale of the old s 16 of the Banking Act 1959 which provided that depositors were to have priority over certain assets of an insolvent bank.12

Giving priority to deposits is the only direct consumer protection for depositors. Although the idea of depositor insurance has been mooted from time to time, it seems unlikely that it will be adopted in the Australian context.

The problem is a serious political one. As the Wallis committee report acknowledged, there is a widespread belief the the Reserve Bank guarantees bank deposits. No matter how many times this is exposed as an erroneous belief, it seems to persist. The result is that the government is under immense political pressure to come to the aid of ailing financial institutions.

The next article in the series will examine in detail the steps taken to reduce settlement and systemic risks in the payment system.


*
Consultant, Mallesons Stephen Jaques, Sydney; formerly Landerer Professor of Information Technology and Law, University of Sydney.
1
Section 7, Payment System (Regulation) Act 1998
2
The instruction may come from the payer or from the payee. In the first case, the payment will normally be called a credit transaction. Where the instruction is initiated by the payee, it will normally be called a debit transaction.
3
The financial instution of the payee may, of course, be the same as that of the payer.
4
Tyree, Alan L, "Smart cards," Journal of Banking and Finance Law and Practice, 6, pp. 297 - 299 (1995).
5
The Act also gives the Reserve Bank the power to declare a facility to be excluded from the definition under certain circumstances.
6
For a fuller discussion of the settlement risk problem, see Tyree, Alan L, “Legal Aspects of Electronic Clearing and Settlement”, Proceedings of the 13th Annual Conference of the Banking Law Association, May 1996, Surfers Paradise, Queensland.
7
Wrongly, as events during the 1980s showed.
8
See Tyree, Alan L, Digital Cash, Butterworths, 1997; Tyree, Alan L, “Virtual Cash - Payments on the Internet” 7 Journal of Banking and Finance Law and Practice pp. 35-38 (1996).
9
See the Report of the Australian Payments Systems Council 1997-98.
10
Payment Systems and Netting Act 1998; Payment System (Regulation) Act 1998.
11
Electronic Funds Transfer, Report by the Treasury and Australian Competition and Consumer Commission on the operation of the EFT code of conduct, March 1998.
12
See now, s13A(3).