Designated Payment & Settlement Systems in the European Union

An essential requirement of the Bank for International Settlements "Core Principles for Systematically Important Payment Systems" is to ensure that payments and settlements that pass through critical systems have the full protection of the law. Essentially this means that payments and settlements in a Real Time Gross Settlement system have to be final and irrevocable at the moment they are processed through the payment or settlement system itself, in other words in 'real time". To ensure this means that the payment or settlement also has to be protected from the effects of any "zero hour" based insolvency laws.

In most jurisdictions insolvency laws take effect from the start of the day (i.e. midnight) of the day on which insolvency or incapacity is declared – hence the "zero hour".  This clearly presents a challenge to the concept of finality and irrevocability in real time.

A solution is to legally "override" the "zero hour" concept for certain payments and settlement systems. A way to do this is to "designate" certain payments and settlement systems as being exempt form the "zero hour" insolvency rule. The insolvency laws for such designated systems usually only take effect from the day following the date of insolvency.    

The European Union (EU) makes extensive use of the Designation approach to ensure the stability and the protection of payment, settlement and securities settlement systems. The legal basis for this designation approach is Directive 98/26/EC of the European Parliament and of the Council dated 19 May 1998 on settlement finality in payment and securities settlement systems.

In terms of the directive Designation is required where;

• The reduction of systemic risk requires the finality of settlement and the enforceability of collateral security (Paragraph 9).
• Payment orders and their netting need to be legally enforceable (Paragraph 11).
• It is necessary to ensure that payment orders cannot be revoked after a moment defined by the rules of the system (Paragraph 14).
• Insolvency proceedings should not have a retroactive effect on the rights and obligations of participants in a system (Paragraph 16).
• Collateral security needs to be insulated from the effects of the insolvency law applicable to the insolvent participant (Paragraph 18).

This is fully in keeping with the key reasons from other non-EU countries for designation – namely that:

• Payment finality must be protected against retroactive insolvency laws
• Payment netting (both bi- and multilateral) must be legally recognized and must be protected against retroactive insolvency laws
• Collateral pledged to support payments and securities settlement arrangements must be realizable and not have a prior lien on them in terms of current insolvency laws.

The Directive (in terms of Article 2 A) allows EU member states to designate as a system, any formal arrangement (minimum of 3 participants) whose business consists of the execution of transfer (payment) orders or may also include any system such a formal arrangement between only two participants, when that member state considers that such a designation is warranted on grounds of systemic risk. In other words the appropriate authorities within each country may decide on which systems need designation.

Generally the need to protect the system against the problems already set out are the main criteria for designation and not any notion of a total value of transactions passing through the system. This is mirrored by the published reason for the recent designation of the BACS Electronic Funds Transfer system in the United Kingdom which to ensure that the default arrangement (i.e. the loss sharing arrangement) can be enforced (Payment System Oversight Report. Bank of England: 2005).

The Directive has bearing on both members of the EU and EU accession countries.

Currently 107 separate systems had been designated, of which 49 are payment systems and 58 are securities settlement systems. Included in this list are 22 retail payment systems in 15 countries covering cheque and electronic funds transfer systems.

While both RTGS systems and Securities Settlement Systems are both regarded as Systematically Important Payment Systems (SIPS) in the BIS’s “Core Principles”, designation has also been extended to many retail systems - both cheque and electronic funds transfer (electronic debit/credit systems) on the grounds of ensuring finality of settlement (legality of netting and protection from regular insolvency laws).