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May 23, 1 980
In the C IPS
The global market for dollars has created the
need for an efficient mechanism to transfer
dollar funds among banks throughout the
world. The banking system now transfers
about $ '130 billion every ciay, with New York
City banks handling nearly 90 percent of all
such transactions. These interbank payments
employ a little-known electronicfundstransfer (EFT)system called CHIPS: the Clearing House Interbank Payments System. The
history and operation of CHIPS illustrate the
prospects and challenges that lie ahead for
financial institutions and their regulators as
EFT systems evolve further.
Clearing house functions
The evolution of funds-transfer mechanisms
like CHIPS can be traced to the changing
nature and volume of payments activity. Simple transactions -such as the transfer of
funds between two local parties who use the
same bank-do not require elaborate mechanisms for effecting payment. Party A simply
writes a check on its account at the bank, and
when party B presents the check for payment
at the same bank, the account of A is debited
and the account of B is credited.
If the parties have different banks, however,
the transaction involves an interbank exchange of funds. This requires communication between the parties' banks to provide the
accounting information needed to record the
transaction (part of the process called "clearing") and to provide some means of fin Jlizing
(or "settling") the obligations of one bank to
the other. As an economy grows and the
number of banks increases, this type of transaction increases in frequency.
In the early days of banking, clearing and
settling involved direct exchanges of objects
between banks. Messengers carried checks
back and forth between individual banks,
and those banks settled the obi igations
created by such drafts by the physical movement of gold or bank-note assets.As the
number of banks grew, the amount of interbank communication rose sharply, and
"clearing houses" came into heing to
simplify the process. By rroviding all hanks
with central meeting places, clearing houses
streJmlined the check clearing and settlement processes considerably.
As the volume of transactions grew further,
the clearing-house functions of check clearing and settlement frequently became lagged
processes: banks would post each day's transactions to their own books at an agreed-upon
time, but would delay settlement by a day
because of the difficu Ity of immediately satisfying the net settlement obligations to all
other banks. (Unti I each transaction is settled,
the proceeds cannot be used in any domestic
transactions outside the clearing house,
although they can be used internally.) Moreover, over time, the settlement of transactions
through the exchange of gold and bank notes
gave way to the exchange of other forms of
"good funds," mainly Federal Reserve andcorrespondent balances.
Evolution of CHIPS
CHIPS is owned and operated by one such
clearing house-the New York Clearing
House Association (NYCHA). N YCH A has
been in existence since 1853 to service interbank transactions for New York banks. As a
focal point for many domestic and international transactions, the New York banks have
always generated a substantial volume of
interbank transactions. Prior to 1 971 , the
clearing house handled these transactions in
the traditional manner-exchanging paper
checks at the clearing house and effecting
settlement the next day by a transfer of
reserve balances.
But in view of New York's prominence as an
international-banking center, and in view of
the growing activity in Eurodollarand foreignexchange markets in the late sixties, the New
York banks eventually found themselves with
Operation of CH I PS
an expanded volume of international dollar
transfers. The old paper process of clearing
and settling dollar payments presented an
increasing number of problems. First, the old
system created severe "back room" problems for banks, because of the sheer volume
of paper that had to be handled to initiate a
transfer of funds for their customers. Payment
instructions had to be typed, official checks
had to be written, and messengers had to be
dispatched to the clearing house. The process
was cumbersome and costly.
Modern technology has made possible the
rapid growth of CHI PS' payments activity.
The CHIPS computer operates on a "store
and release" basis. A bank making a payment
on behalf of one of its customers simply
provides the CHIPS computer with payment
instructions, including assigned accountidentification numbers. The computer stores
this information until an authorized person at
the bank approves the release of the message
to the receiving bank. This relieves the
account officer of some of the decisionmaking pressures involved in payment
authorizations for transactions that have not
yet been covered.
Second, the manual payments system apparently created problems of risk management.
For example, a customer often asks a bank to
initiate a payment on his behalf before the
customer has "covered" the transfer with
good funds in his account. As long as cover is
received before the check is dispatched to the
clearing house, the bank's exposure is minimized; however, the bank may decide to take
the risk that the cover will be received by the
settlement time (the next day), which means
initiating the transfer without cover and carrying the customer overnight. Permitting an
overn ight overd raft of a customer's accou nt is
a potentially important credit decision which
becomes difficult to make amid the paperwork and time pressures involved in manual
clearing-house procedures.
The CHIPS computer also performs the basic
accounting functions required for clearing
and settlement. At the end of each day, CH IPS
nets out the debits and credits to members'
accounts that occurred during the day, and
composes the settlement obligations for each
bank. Actual settlement occurs the next day
at 1 0:00 a.m. If the bank is an associate
member of CHIPS, it typically settles through
a correspondent account-at one of 14
"settling" member banks which acts as its
sponsor. (These 14 banks are the 12 large
members of N YCH A plus two Edge corporations of non-New York banks.) The "settling"
members exchange reserve balances at the
Federal Reserve Bank of New York to achieve
settlement. (Recent rule changes open the
door for all CHIPS members to settle directly
at the Fed if they have an account there.)
In response to these problems, N YCH A
initiated CHIPS in 1971, utilizing a small
computer and 42 terminals located in the
clearing-house banks. Through a system of
account-identification numbers, CHIPS permitted complete payment instructions to be
exchanged electronically between the two
banks involved in any transfer, and in the
process eliminated the former paper media.
The system grew rapidly, especially after
1974, when CHIPS installed more computer
capacity and extended associate membership to the agencies and branches of foreign
banks and New York Edge Act corporations.
Today CHIPS has over 90 members, and has
experienced peak volumes of nearly $200
billion, compared to about $4 billion daily in
its first year of operation.
Paymentssystemsand risk
Credit risk arises in all payments mechanisms
because banks often implicitly extend credit
in order to facilitate transactions for their
customers. In the context of CHIPS, for
example, a bank may initiate a payment on
behalf of a customer anticipating receipt of
"cover" (from the customer) by the settlement hour. If the bank fails to receive the
cover, however; it must incur the expense of
disentangling itself from the transaction. The
failure to receive cover may occur for a
number of reasons, including the financial
2
collapse of a customer or a bank in the transactions link. A serious problem of this sort
arose in 1974, with the sudden demise of the
Herstatt Bank of Germany.
of the payments marketplace. Because EFT
systems generally cIsplay considerable
i
economies to scale, single suppliers can often
serve entire markets economically. (CHIPS,
for example, handles virtually all of the New
York banks' interbank transfers of dollars.)
Banking institutions-and their regulatorsare concerned that such technological imperatives may lead to anti competitive behavior
on the part of providers of EFTservices.
This type of risk is not peculiar to CHIPS.
However, other potential problems may
occur under CHIPS settlement procedures.
That process, for example, involves a
/Jnetting" of the settlement obligations of a
CHIPS participant within its account at a settlement bank. Despite obvious accounting
advantages, this procedure makes the settlement accounts of the various participants
highly interdependent. If one participant is
unable to obtain funds for settlement by the
settlement hou r, th is can affect the net obi igations of many other participants and cause a
chain of settlement problems, with the settling members probably bearing the ultimate
credit risk. CHIPS employs a number of proceduresJo control such problems, including
a set of rules for /Junwinding" transactions if a
participant is unable to obtain funds for settlement, but potential difficulty may remain.
Another consideration involves the risks to
the "safety' of the banking system posed by
the existence of private settlement mechanisms. Under CHIPS, for example, N YCH A
members perform settlement services for
smaller CHIPS participants through debiting
and crediting of correspondent balances,
rather than through transactions with Federal
Reserve banks.
This is an attractive feature for those users
who do not have Federal Reserve bank
accounts. In addition, this feature reduces the
amount of Federal Reserve processing
required. Some observers of the EFT industry
fear, however, that such private settlement
devices make the health of the payments
mechanism overly dependent upon the
health of the settling institutions.
The convention of next-day settlement may
also contribute to credit risk within the
system. Most other domestic and European
payments systems use a same-day settlement
convention: transfers are made in immediately available /Jgood funds." Thus the risk
associated with uncovered transfers does not
extend overnight. It is debatable, however,
that the resultant reduction in settlement lag
wou Id reduce overall risk. But clearly,
moving to same-day settlement imposes
additional operating costs on participants
because banks have less time to make adjustments to errors in their CHIPS transactions
and their settlement positions. N YCH A is currently studyi ng these and other factors
involved in a conversion of CHIPS to sameday settlement.
Despite these challenges, CHIPS illustrates
EFT'sgreat potential for improving the efficiency of financial markets, by expanding the
range of services available to financial institutions, their customers, and the general
public. As a result, CHI PS-like systems are
likely to evolve to perform payments functions in other markets.
Randall Pozdena
Other EfT issues
N YCH A's experience with CH IPSserves to
illustrate otherfactors that arise in EFT
operation. One such consideration is the
competitiveness (or lack of competitiveness)
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BANKING DATA-TWELftH fEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected
Assets Liabilities
and
Large
Commercial
Banles
Loans (gross, adjusted) and investments* .
Loans (gross, adjusted) - total#
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U.s. Treasury securities*
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savings deposits - total
Time deposits - total#
Individuals, part. & corp.
(Large negotiable CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess Reserves(+ )/Deficiency ( - )
Borrowings
Net free reserves (+ )/Net horrowed( -)
Amount
Outstanding
5/7/80
Change from
year ago
Dollar
Percent'
Change
from
4/30/80
137,699
116,041
33,390
46;132
24,133
1,139
6,357
15,301
42,904
30,456
26,066
64,943
55,919
23,369
+ 11,483
+ 12,860
+ 2,510
+ 8,979
+ 2,353
695
649
359
+ 53
- 181
+ 16
34
12
-1 ,01 7
- 629
+ 162
+ 426
+ 309
+ 144
-
-
+
+
+
-
+
+
+
Weekended
Weekended
5/7/80
4/30/80
295
34
261
331
88
243
522
1,463
86
2,105
129
3,640
14,892
15,201
6,212
+ 9.1
+ 12.5
+ 8.1
+ 24.2
+ 10.8
-
+
+
+
+
+
+
31.4
18.7
0.6
5.2
0.4
12.3
29.8
37.3
36.2
Comparahle
year-ago period
17
90
73
* Excludes trading account securities.
# Includes items not shown separately.
Editorialcomments
maybeaddressed theeditor(William Burke)or to the author.... Free
to
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of
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Reserve
publications beobtained callingor writing the PublicInformation
can
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Reserve
Bankof SanFrancisco, Box7702,SanFrancisco
P.O.
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