Payment systems in Sri Lanka Financial System Stability Financial system stability means a safe and secure financial

system which is able to withstand external and internal shocks. A stable financial system creates a favourable environment for depositors and investors, encourages financial institutions and markets to function effectively and efficiently, and hence, promotes investment and economic growth. Financial system stability requires a stable financial and economic environment within an effective regulatory framework and a safe and robust payment and settlement system. The maintenance of financial system stability entails identifying and addressing potential vulnerabilities and risks to the financial system. creating a trust-worthy and enabling environment favourable to savers and investors helping the transmission of monetary policy, thereby assisting the attainment of price stability encouraging efficient financial intermediation, which eventually promotes investment and growth, and encouraging effective and efficient operation of markets and improving distribution of resources in the economy The Committee on Payment and Settlement Systems (CPSS) periodically publishes - under the aegis of the Bank for International Settlements (BIS) - reference works on payment systems in various countries, widely known as "Red Books". The CPSS has also invited the central banks of a number of countries where important developments in payment systems are under way to prepare - in collaboration with its Secretariat at the BIS - separate volumes on their respective payment systems. The present volume, the first edition of the Red Book for Sri Lanka, is a further step towards increasing our understanding of the way payment systems work in different countries. Properly functioning payment systems enhance the stability of the financial system, reduce transaction costs in the economy, promote the efficient use of financial resources, improve financial market liquidity and facilitate the conduct of monetary policy. In recent years, issues relating to the economic efficiency and financial risks of all types of payment systems have come to the fore. Central banks have a strong interest in promoting safety and improving efficiency in payment systems. They play a key role in domestic payment system development and, in many cases, operate large-value payment systems. Central banks in many countries have been influential in improving public understanding of payment and settlement arrangements in their countries and public awareness of the various policy issues connected with such arrangements. Payment systems include not only retail money transfer systems used by businesses and consumers for commercial purposes but also large-value interbank funds transfer systems that underpin the money and credit markets of market-oriented economies. Systems for the settlement of securities transactions and the related payments are also key elements in financial system infrastructure. Financial System Stability Monitoring and Surveillance Maintaining Stability in Money and Foreign Exchange Markets The Central Bank is responsible for maintaining stability in the money and foreign exchange markets Inter-bank Call Money Market The inter-bank call money market is an overnight market and mainly serves commercial banks in meeting their immediate liquidity needs and reserve deficiencies. Hence, an important task of the call money market is to facilitate liquidity management in the economy. Therefore the orderly and stable functioning of the inter-bank call money market is important to minimise liquidity risk in the banking system as a whole. The stability of the market is supported by the provision of Repurchase (Repo) and Reverse Repurchase facilities by the Central Bank at its policy interest rates. The Central Bank's policy interest rates - the Repo Rate and Reverse Repo Rate form an interest rate corridor for the interbank call money market rates, with the Repo Rate being the lower limit and the Reverse Repo Rate being the upper limit. This reduces potential large fluctuations in the short- term market interest rates. Changes in the Central Bank's policy interest rates have an immediate effect on interest rates in the inter-bank call money market. Changes in the call market rates would lead, within a very short period, to changes in other short-term money market interest rates, such as the yield on Treasury bills, commercial paper and the short-term lending rates of commercial banks. These changes would, with a time lag, affect the medium-term lending rates of banks, the yields on Treasury bonds and the deposit rates offered by banks. The inter-bank call money market is the first step in the transmission of the Central Bank's monetary policy signals to the economy. Hence, the Central Bank closely monitors the inter-bank market and makes a daily assessment of the liquidity in the banking system. Under the current open-market operations system, the Central Bank will conduct either a Repo or Reverse Repo auction for a determined amount, in order to reduce large fluctuations in the inter-bank call money market interest rate. If there is excess liquidity in the market, the Central Bank will conduct a Repo auction to mop-up the surplus money. Likewise, if there is a shortage of liquidity in the market, the Central Bank will conduct a Reverse Repo auction to inject

money into the market. The magnitude of the Central Bank intervention depends on the overall liquidity excess or shortfall. Treasury Bill Market The Treasury bill market is another segment of the Money Market. Treasury Bills are highly liquid money market instruments that provide financial institutions with an alternate source of liquidity and investment. Furthermore, interest rate movements in the Treasury bill market provide a benchmark for the short-term credit market. Hence, changes in the volumes and rates in the Treasury bill market affect the cost, profitability and liquidity of financial institutions. Secondary market transactions in Treasury bills amounted to Rs. 1542 billion for outright transactions and Rs. 15,681 billion for repurchase transactions at the end of October 2010. Treasury bills are also the main securities are used as collateral by the Central Bank in the conduct of its open market operations. Foreign Exchange Market One of the main purposes of the foreign exchange market is to obtain foreign currency funds for the purchase of imports of goods and services and to service loan repayments. The foreign exchange market consists of the spot market and the forward market. The spot market is the market for purchase/sale and delivery of foreign currency on the same day or within two business days, while the forward market is for the purchase / sale of foreign currency at a price specified now, with delivery and settlement at some future date (usually in 30, 90 or 180 days). The foreign exchange market in Sri Lanka consists of two tiers, the client or retail market and the inter-bank or wholesale market. The transactions in the inter-bank market partly result from transactions that banks have had with their customers in the retail market. The inter-bank market is mainly organized among Authorized Dealers in foreign exchange, which comprise all commercial banks and plays an important role in the Sri Lankan financial system by redistributing liquidity within the banking system. The main risks to the financial system from the foreign exchange market arise from the impact of excessive volatility in the exchange rate on the net open positions in foreign exchange of commercial banks. This risk could arise either from ineffective internal controls or due to excessive volatility brought about by macro-economic conditions, both domestic and external. There is also a possibility of a potential contagion effect as problems in one commercial bank could spread to others. Overseeing the Payment and Settlement System Payment and settlement systems (PSS) enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions. In a systemically important PSS, a significant proportion of transactions in terms of value consist of transactions conducted in financial markets. Although disruptions to operations of such systemically important PSS are rare, the potential consequences of such a disruption are substantial and widespread and could lead to a systemic disruption and financial shock even beyond the system and its participants, which could adversely affect the stability of the financial sector. Therefore, the safety and efficiency of the PSS, particularly systemically important ones, is critical for the effective functioning and stability of the financial system. Legal Framework The Payment and Settlement Systems Act No.28 of 2005 (PSSA) provides for the regulation, supervision and monitoring of payments, clearing and settlement systems, the regulation of providers of money services and the electronic presentation of cheques. The Central Bank performs three key roles in the PSS namely, 01. Overseeing the payment, clearing and settlement system. 02. Operating systemically important payment and settlement systems 03. Formulating a national payments policy and developing the payment systems LankaSettle - Real Time Gross Settlement(RTGS) System and LankaSecure The Central Bank operates LankaSettle, the systemically important high value payment and securities settlement system. The LankaSettle system has two components i.e. the RTGS system (which processes large value and time critical payments) and the LankaSecure system (Scripless Securities Settlement System). The integration of the RTGS System and LankaSecure System provides the most secured securities settlement mechanism based on Delivery versus Payment for scripless securities transactions. Participants of the LankaSettle System, as at end Dec 2010, are the Central Bank, 22 Licensed Commercial Banks , 6 Non-Bank Primary Dealers , the Employees' Provident Fund and the Central Depository System of the Colombo Stock Exchange. The RTGS System is operated by the Payments and Settlements Department of the Central Bank. Real Time Gross Settlement System The RTGS System is a computer based fund settlement system which processes and settles each payment instruction individually and irrevocably on real time basis using funds in the participants' RTGS Settlement Accounts in the RTGS System. The value of transactions settled in the RTGS System accounts for about 89 per cent of the non-cash

payments in Sri Lanka. The RTGS System settles large value and time critical rupee payments. The majority of RTGS transactions are relating to: transactions in the inter-bank call money market, Government securities markets, Open Market Operations, the rupee leg of transactions in the foreign exchange market, urgent payments of customers and net obligations under the systems operated by LankaClear (Pvt) Ltd. LankaSecure - Scripless Securities Settlement System (SSSS) and Scripless Securities Depository System (SSDS) The LankaSecure System comprises of the Scripless Securities Settlement System (SSSS) and Scripless Securities Depository System (SSDS). LankaSecure facilitates the issue of Government securities and Central Bank securities in electronic or scripless form and settlement of trades of such scripless securities on a Delivery versus Payment (DvP) basis. Accordingly, transactions are settled in the system if the participant who sells securities has sufficient eligible securities in his Securities Account in LankaSecure and the buying participant has sufficient funds in his Settlement Account in the RTGS System to pay for the transaction. All securities transactions settled in the system are irrevocable. The SSDS is the title registry as well as the custodian for Government securities. The ownership of securities is recorded to the beneficiary level in the SSDS. The holders of scripless securities in the SSDS can obtain up to date details of their investments at any point of time through LankaSecureNet, an internet based facility. Sri Lanka Interbank Payment System Sri Lanka Interbank Payment System (SLIPS) was introduced in 1993 by the Central Bank, as an off-line retail fund transfer system. With the establishment of LCPL, operations of SLIPS were handed over to LCPL in 2002. SLIPS handles pre-authorised small value bulk payments (direct credit and debit transfers). In 2010, SLIPS was upgraded to an on-line interbank payment system to facilitate settlement of transactions on T+0 basis. Transactions are cleared electronically on a multilateral net settlement basis and interbank net balances arising from SLIPS transactions are settled in the RTGS at 8.30 a.m. and 3.00 p.m on each business day. During the year 2010, the daily average value of transactions cleared through SLIPS was 1.4 billion. Rupee Draft Clearing System and US Dollar Cheque Clearing System LCPL also operates a Rupee Draft Clearing System and US Dollar Cheque Clearing System. In the Rupee Draft Clearing System, cheques and drafts of foreign banks drawn on their 'nostro' accounts with Commercial Banks in Sri Lanka and in favour of customers of Commercial Banks in Sri Lanka are cleared manually by LCPL. The net clearing balances of this system are settled at the RTGS at 2.15 p.m. on each business day. The daily average value of cheques cleared by this system was Rs. 3 million in 2010. The US Dollar Cheque Clearing System was launched in 2002 and is a semi-computerised clearing system for cheques and drafts in US Dollars issued by Commercial Banks in Sri Lanka and payable to Sri Lankan individuals and institutions, and issued by banks and exchange houses abroad and drawn on Commercial Banks in Sri Lanka. This system reduced the time lag for clearing and settlement of US Dollar cheques and drafts from 3 weeks to about 4 days. The system also reduced the clearing charges by banks significantly, as previously cheques and drafts had to be dispatched to correspondent banks abroad for realisation, whereas now they are exchanged over the counter locally. The settlement of interbank clearing balances of the US Dollar Cheque Clearing System takes place through the accounts of participants maintained in a private Commercial Bank. A daily average of 236 cheques worth of US $ 871,197 was cleared in the system during 2010. Equities Trading System and Debt Securities Trading System The Colombo Stock Exchange operates two on-line systems: i.e. the Automated Trading System (ATS) for real time trading of equity (shares) and the Debt Securities Trading System (DEX) for trading of beneficial interest of Government securities and corporate debt securities. Stockbrokers licensed by the Securities and Exchange Commission of Sri Lanka (SEC) perform as direct participants in the ATS and DEX. At the end of Dec 2010 there were 24direct participants, 15 member firms and 09 trading members permitted to trade in the DEX System. Surveillance of Financial Conglomerates The existence of large financial conglomerates, especially those that have banks as part of the conglomerate, is another area that has attracted increased supervisory concern in recent times. The regulation and supervision of such financial conglomerates is becoming increasingly more important and complex, due to the potential systemic risk that could arise from the interrelated nature of their activities. Large numbers of cross shareholdings, common

directors and inter company transactions are areas that are of key interest in this regard, as it could result in conflicts of interests and abuse of power, which would not augur well for the stability of the financial system. Since there are multiple regulators in the financial system, the supervision of conglomerates often falls under the purview of several regulators, requiring close co-operation and supervision. CENTRAL BANK OF SRI LANKA IMPLEMENTS REAL TIME GROSS SETTLEMENT SYSTEM (RTGS) AND THE AUTOMATED GENERAL LEDGER SYSTEM The Central Bank of Sri Lanka (CBSL) takes another important step forward today (8th September 2003) with the implementation of the Real Time Gross Settlement System (RTGS) together with the Automated General Ledger system of the Bank. These systems will bring about a major change in the national payment system of the country. The RTGS system will facilitate large value fund transfers and settlements on an electronic basis in real time rather than settling at the end of the day. It will expedite fund transfers among banks, primary dealers, financial institutions, investors, customers, the government and the public. This system will also bring about financial discipline in the banking sector since banks will have to maintain adequate cash and reserves in their accounts to meet their payment obligations, as the system will instantaneously update their bank accounts for each transaction. This will improve the liquidity management of banks as treasurers and fund managers will have to provide more accurate estimates of their payment obligations. CBSL also intends to implement the Scripless Securities Settlement System (SSSS) in the last quarter of 2003. Until such time, the new system will enable the operation of the real time settlements of large payments combined with semi-automated settlement of government securities with scrips. The proposed SSSS, which deals with securities settlements, would facilitate the transfer of securities from one investor to another, together with a simultaneous transfer and settlement of funds through the RTGS. Sri Lankas RTGS/SSSS schemes are known as LankaSettle. What are Scripless Government Securities? Government securities such as Treasury Bills and Treasury Bonds have hitherto been issued in the form of paper certificates. They are called scrip securities. The scripless government securities are the securities issued in data entry form without a paper certificate. Initially, Treasury Bills and Treasury Bonds are issued in scripless form. To enable primary issues and recording of secondary market transactions of scripless securities, a computer based central depository and a settlement system have been installed. The transactions will be settled through an electronic settlement arrangement known as the Scripless Securities Settlement System (SSSS). The SSSS and the Central Depository System (CDS) are named as LankaSecure. Reasons for Moving from Scrip to Scripless Securities There are a number of benefits associated with scripless securities as listed below. The scripless securities will improve efficiency in the government debt securities market. Since LankaSecure operates electronically on-line, trading will be convenient to all market participants i.e., primary dealers, banks and investors. The settlement of all securities transactions will be recorded in the computer system of CDS, instantaneously. Given the electronic infrastructure, the volume of transactions in government securities is expected to increase by manifold. In the scrip based system, securities are transferred by endorsement and delivery. With the introduction of the SSSS, the need for physical delivery and verification of certificates will not arise. Therefore, the introduction of the SSSS will reduce human intervention and the need for physical verification of securities thus resulting in the enhancement of efficiency. The scripless securities will eliminate the risks associated with paper based securities. Risks involved in physical movement of scrips will be reduced to zero in CDS which will maintain all records electronically. LankaSecure is the registry as well as the custodian for government securities. The payments on settlement of scripless securities transactions are based on a Real Time Gross Settlement System (RTGS) where funds are transferred

instantaneously. In the past, with the scrip environment, this process involved a time lag as the securities had to be submitted physically and payment was made by cheques. Introduction of electronic infrastructure will assist in popularising government securities among the investors. The government securities ownership will be broad based and the depth of the market will increase. Increased efficiency in trading and settlement will enhance the liquidity of government securities. The spreads between buying and selling prices of government securities will reduce and this would assist in minimizing the cost of borrowing to the government as bond prices are likely to go up. Scripless Securities Settlement System (SSSS) In the SSSS, settlement of securities will take place instantaneously as and when transactions take place. Whenever, a transaction takes place, securities will be transferred from one account to another in the form of an electronic data entry. In an outright buying or selling transaction for instance, there will be a buyer who will receive securities and his account will be credited with securities and there will be a seller whose securities account will be debited. The corresponding funds transfer will take place through the RTGS where licensed commercial banks and primary dealers are participants. The corresponding accounting entries will be made to the settlement account of relevant primary dealers or the licensed commercial banks. The settlement of securities through the SSSS and funds through the RTGS will be confirmed electronically to the participants involved.