No. 8910 THE CLEARING HOUSE INTERBANK PAYMENTS SYSTEM: A DESCRIPTION OF ITS OPERATION AND RISK MANAGEMENT by Robert T. Clair* Federal Reserve Bank of Dallas June 1989 Research Paper Federal Reserve Bank of Dallas This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library ([email protected]) t No. 8910 THE CLEARIIIGHOUSE IIITERBAIIK PAYI,IEI{TS SYSTEII: A DTSCRIPTIOXOF ITS OPERATIOI{AND RISKI.IA}IAGEI{II{T by Robert T. Clair* Federal ReserveBank of Dallas Jurn 198!l * Theviews expressed .in this article are solely thoseof the authorand shouldnot be attributed to the FederalReserve Bank of Dallas. or the FederalReserve System. The Clearing HouseInterbank Payments System: Descriptionof Its 0perationsand Risk Manaqement 1. General0vervjew of the System The Clearing HouseInterbank Payment Systenr (CHIPS) is a high-speed message-s\4itchingnetwork owned and operatedby the Newyork Clearing House Assoc'iation(NYCHA) to clear jnternationaldollar payments.Based 'in Newyork Cit.y, CHIPSwas developed in the late 1960sas an e'lectronic replacementfor a paper-basedpayment system, the PaperExchange Payment System (PEPS), PEPSprovided an effective clearjng arrangementbut the paper-based strtrcturewas unable to handlethe rapidly growingvolume of paynentsthat neededto be cleared. Thegrowth in paymentvolume was partial'iy the resu'lt of the growthof the Eurodollarmarket.l Thechange in foreign exchangerate r For a discussionof the causesfor the surge in the Eurodollar market,see Sarkjs J. Khoury,Dynamics of I nternati ona'lBank ing, Praeger1980,p.24-6. regine from fjxed to floating rates jn lg73 also ljkely jncreasedthe volumeof internationa.l paymentsthat neededto be cleared. In responseto the growingvolurne of internationdl paymentsthe NYCHA developedthe ClearingHouse Interbank Payments System (CHIPS). The crucial Jifference betweenCHIPS and PEPS, its paper-basedpredecessor, is that CHIPS is an electronic-basedpayment system cdpable of handljng higher volumesof payments.CHIPS began operations with only 9 NYCHAparticipants and processed 800,000transactions with a total valueof $1 trillion in 1921,its first full year of operations. ln 1974,it expandedits operationto 56 participants by taking in all the formerparticipants of PEPS.Partjcipation continued to rise during the late 1970s,stabilizing at about140 in the mjd-1980s.2In l9BB, CHIPSprocessed 34 million transactionsworth $165 trilljon, (SeeAppendix A for annuaivol unes. ) tsecauseCHIPS originated from a paper-basedsystem, it initially retained someof the characteristics of that system,such as next-daysettlement. But as demondof participantsand the ava.ilability of technologyhave changed over the years, CHIPShas also changed.In 1981,it adoptedsame-day settlement. In 1984,it beganincorporating risk-management measures that are monitoredin real time, somethingonly possibleon an electronjc network. Il. Legal Frameworkfor the System TwelveNew York money-centerbanks make up the membership.ofthe NYCHA, eachof which is representedon the ClearingHouse Committee that establishes z In 1980, a morator.iumon newparticipants was.imposed. The reasonfor the moratoriumwas the needto expandcomputer capac'ityand to resolve somelegal issues before newpart ici pants could be added. That noratoriumwas lifted in 1983. 3 the ru1esfor the operationof CHIPS.(See Appendix B for a list of members.) TheCiearing House Committee chooses an executivevice presidentwho enforces the rules andoversees all operationsof the clearing house. Thebasic frameworkfor the operationsof CHIPSis presentedin the Constitutionof the NewYork Clearinq House Association and in the RulesGoverning the Clearing HouseInterbank Payment System as adoptedby I{YCHA.I'ionnember of NYCHAmust agreeto abideby CHIPSrules beforebeing allowed to partjcipate in the system, Anyfinancial institution can applyto participate in CHIPSif it meets severalmlninum requ i renents. l) Participantsmust be either a commercialbanking institution, an Edge Act corporation,or a bankingaffiliate of a commercialbanking 'jnstitution locatedin NewYork City. In addition, the parent companyof an EdgeAct corporation or an lnvestmentCompany as defined by NewYork State BankingLab, may become a substitute participant therebyproviding the greaterfinancial strengthof the parent in placeof its eligible subsidiary. 2) Pdrticipantsmust be subjectto regulationby the NewYork Srdte BankingDepartnent or a federal bankregulator. 3) Participantsnust also agreeto transmjttheir messagesto CHIPS througha primary connectionlocated in NewYork City or a backup connectionlocated in the greater NewYork metropolitanarea. 4) In addition, there mustbe locatedin NewYork City an officer of the participant institution whois authorizedto makebindjng commitnentsto CHIPSwhi.le CHIPS is operating. 5) Final1y, potential participantsmust provide CHIPS with current financial statementsfor themselvesand any parent companies. The annualfinancial reviewprocess is not specified, but CHIPSseeks to maintainfinancial'ly strongparticipants to mininizeany risks to the associat.ion. Therules governingthe operationof CHIPSare establishedby the Clearing HouseCommittee and any changesin these rules mustbe approvedby a majority 0f the membersof the association. Theserules are administratedby the executivevice presidentof the cleaninghouse. Theexecutive vice president can enforce these rules throughhis/her powerto suspendor term.inatea participant fromCHIPS. The decisions of the executivevice presidentcan only be appedledto the ClearingHouse Committee. All participantsare governedby the sanerules. Thereis no distinctjon nadebetween foreign and domesticbanks. Furthennore,there is no explicit distjnction madebetween members of the NYCHAand other.participants. However, the i2 NYCHAmembers wrjte the rules that governall participants. l4hile the nonmernberparticipants can provideinput to importantcledring housedecisions, ultimately the decisionwilI be madeby the twelvemembers. III. Structure, operationsand Administration 0n a normalbusiness day, CHIPSoperates from 7:00 a.n. to 4:30 p.m. with settlementusually completedbefore 6:00 p.m. CHIPScloses for bank holidiiys as set by the State of NewYork and observedby the Federal Reserve Bdnkof NewYork (FRB-NY)over whosebooks CHIPS settles, If CHIPSis closed for a holrdaynot celebratedin Europe,CHIPS operates for extendedhours on the next busjnessday, beginningat 5:00 a.m. andending at 5:00 p.m. The extendedhours accommodatethe addjtional volumegenerated by fore.ignbanks on 5 the day that CHIPSwas closed. The hoursof operation mayalso be extendedor changedby the executivevice presidentas needed. Paymentmessages sent over CHIPSare credit transactions,i.e. the message directs CHIPSto debit the sender'saccount and credit the receiver's account. All messagesare initiated by the institution sendingfunds. Thepayment messageincludes at least the identity of the sender,the identity of the sendinginstitution, the amountof fundsto be transferred,the identity of the receiving institutjon andfinally the receiver's beneficiaryaccount identity.3 Moreinformation can be includedif desired, whichmay be importantto the senoerto expla.injn detail the purposeof the paymentto the receiver.4 A paymentmessage can be either sent or stored on CHIPS. A messagecan be stored on the CHIPScomputers for release later the sameddy, A stored message can be deletedby the sendingparticipant, Alternatively, a paymentmessage can be sent inmediately. In either case, oncea paymentis sent it is 'irrevocable andrepresents an unconditiondlobligation of the sending institutjon. Theob.l igation is bindingregardless of enor, settlement fdilure, on evenbankruptcy of either the senderor the sendinginstitution.5 CIIIPStrti.l izes a two-tier settlementDrocedure. In order to understand " often participantssend or recejvemessages for their owndccounts. In these casesthe senderand the sendjnginstitution are one in the sameas are the receiver andthe receivinqinst'itution. 4 Conmercia.ipayments ro. it',ip*.nt, receivedare often adjustedfor damagedgoods or other returns. Oetails explaining what invoices are coveredby a particular paymentcan be useful in completingthe transactjon. E 'left ' tlhena paymentis sent in error, it is to the two part.icipants to reach a negotiatedsettlement to resolve the error. The negotiation is outside the CHIPSsystem. Thereare acceptedconventions as to the appropriatecharges paid for errors usually in the form of foregoneinterest. o the operation of the settlement it is importantto knowthe four basic entities involvedin clearing andsettling a paymentthrough CHIpS: participants, sett'ling participants, CHIPSas the processingentitJ andthe FederalReserve Bankof NewYork (FRB-NY)across whose books settlenent is accomp.lished in a special settlementaccount. Theparticipants are thosefinancial institutions that dre perrnittedto sendand receive paymentmessages over the comnunication networkestablished by CHIPS.CHIpS itself is only a high-speedmessage switching systen and a set of accounts. An importantsubset of the parLicipantsare the sett'ling participants. Thesesettling participantsare the only par!icipantsdble to nakeor receivetransfers over Fedwireinto or oul of the special CHIPSaccount at the FRB-NY.6They act as correspondent banksrcr the other part.icipantsand makesettlement transfers that settle thejr ownaccounts and the accountsof other participants that settle through them. Eachsettling participant either makesa sjngla,.transferjnto or receivesa single transfer