Hong Kong - CHATS

by Norman T.L. Chan, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at the AiC Conferences : RTGS '97 Hong Kong)

11 June 1997

1.Ladies and Gentlemen, I am delighted to be invited to participate in this Conference and to speak on Hong Kong's experience in developing RTGS.
2.I remember quite clearly that three years ago, i.e. June 1994, the HKMA, following six-month consultation with the banking industry through the Hong Kong Association of Banks, decided to go ahead with a major reform through which Hong Kong's large value interbank payment system, known as CHATS as most of you may know, would be converted to RTGS. In 1994, the debate was focused on what were the risks in the old system which settled on a net basis the next day and how would a RTGS reduced such risks. Understandably, the knowledge within Hong Kong on RTGS systems was rather limited at that time, but fortunately we were able to tap the expertise on payment systems from the leading central banks, including the Federal Reserve Bank of New York, the Bank of England and the Swiss National Bank. Comparing with three years ago, the general level of understanding in Hong Kong, and for that matter in Asia, on payment system risks and related issues, have been greatly enhanced. Very few people interested in payment system issues would now ask why one should adopt RTGS but how. That is why in my presentation today I would like to share with you our experience in implementing RTGS and the lessons that we learned in the process. I hope this will be of interest to you.

CHATS - before RTGS
3.For those of you who may not be very familiar with Hong Kong's CHATS system, I would like to say a few words to explain its main features. Under the old system, we had a rather complex settlement structure involving several layers. First of all, there were over 170 banks which used 10 banks to settle their interbank payments. These settlement banks then settled with the Hongkong Bank, which served as the Management Bank of Clearing House. Hongkong Bank then settled with the HKMA on a one to one basis. As I mentioned earlier, all the CHATS payments were settled on a net basis the next day across the books of a commercial bank, i.e. the Hongkong Bank. Obviously the old system fell short of the international standards recommended by the G-10 Committee on Payment Systems and the HKMA was able to reach consensus view with the banking sector that we had to bring our payment system into line with the highest international standards.

Core Features of the new RTGS System
4.Following a six-month feasibility study, we decided on the architectural design of our new RTGS system. It has a number of core features :

(a) instead of a multiple tier system, it has a single tiered system, in which all licensed banks open settlement accounts with the HKMA. This means that all interbank payments are now settled across the books of a central bank, which is a more robust arrangement than settlement across the books of commercial banks. Moreover, this will be a simpler design in terms of IT and software;
(b) it adopts a Y-shaped topology whereby payment messages are channeled to the CHATS processor for stripping before the settlement information is passed on to the Settlement Account Processor;
(c) payment message will only be settled when there is sufficient fund in the settlement account. Unlike the Fedwire system, no daylight overdraft will be granted. Payment messages that cannot be settled will be queued in the system until sufficient funds are available. There is therefore no need to re-input the unsettled payment messages, although banks can alter, cancel or resequence their own payment queues;
(d) as the system does not allow daylight overdraft, the HKMA provides intraday liquidity to the banks by conducting intraday repo transactions against Exchange Fund Bills and Notes. To enable intraday repos to be conducted efficiently throughout the day as and when individual banks are short of liquidity, we have developed a seamless interface between CHATS and the debt securities clearing system, known as the CMU; and
(e) recognising the importance of reducing settlement risks in securities transactions and in foreign transactions, the new system has incorporated capability to provide Delivery Versus Payment and Payment Versus Payment facility in due course.

Implementation of RTGS Project
5.As can be seen from this Slide, from the outset we had given ourselves less than two years to develop and test the system. We committed to such a tight and ambitious timetable partly because we were confident on the typical efficiency Hong Kong Style. More importantly, we were anxious to upgrade our system to bring it up to the highest international standards as soon as possible. We are keenly aware of the fact that without a robust payment system Hong Kong would have a tough time to maintain its competitiveness as an international financial centre.
6.Now that we managed to cut over to RTGS successfully in December last year and so far the system has been operating smoothly, I would like to share with you a few lessons that we picked up in implementing a major system project of this scale and complexity on time and within budget:

(a) there must be unwavering commitment up to the very top within the central bank. One should never underestimate the amount of senior management time that needs to be devoted to the project to ensure that it is on track and continues to receive the general support of the banks, which are ultimately the users of the system. We have seen many examples in which progress has been held up due to insufficient consultations between the central banks and the commercial banks. A suitable mechanism must be in place to enable the various parties to communicate and provide policy steer to the project. In Hong Kong's case, we have set up a high power Committee of Payment System, chaired by the Chief Executive of HKMA and represented by the top bankers. The Committee on Payment System has provided very useful policy steer to the design as well as implementation of the RTGS project;
(b) spare no effort in the IT development. Pick a reliable and professional software developer, especially someone with experience or knowledge on the present or new system. In our case, we were lucky to have the Hongkong Bank, which developed and operated the old CHATS system, to write the software for us. Hongkong Bank's contribution to the success of the project has been invaluable; and
(c) again, spare no effort in testing. There are three distinct types of testing: User Acceptance Test (UAT), Integrated Test and Simulated Test. All three are important. In our case, we have identified over 1,000 bugs in the UAT and Integrated Test. One may think that was bad news. However, we considered that was highly successful because we must ensure that we uncover all the bugs before but not after the system goes live. These tests are the only means to find out these bugs. If any of your IT experts were to tell you that testing is a simple or routine matter which need not concern the senior management, then you are receiving bad advice.

Banks' Support and Readiness
7.It is crucial to bring the banks on board. There are a number of angles to this point. First, they should be supportive of the policy to move to RTGS. Second, they need to be operational ready to function in a RTGS environment. The treasury and settlement managers must be made to realise that life under RTGS is very different from the good old days when they needed only to worry about the end of day position. The system will not be ready until and unless the banks are also ready, both in terms of front office and back office. The only means to gauge whether they are ready would be the simulation test, in which all the banks were required to participate as if it was a live situation.
8.In principle, the longer time that one could have in conducting the simulation test the better. However, one should bear in mind that, to ensure that the test is effective, most if not all of the active users of the payment system should participate in the test to try to simulate a live situation. In Hong Kong's case, it would not have been possible to conduct the test during banking hours and all the tests had to be held after office hours and during weekends and holidays. This would mean that the bank treasurers and settlement officers had to stay until very late hours and sacrifice a number of weekends in the interest of the project. It would therefore not be difficult to understand that there was a limit to how long one could prolong the simulation test without overstretching the banks' patience and willingness to cooperate with the central bank in the implementation of RTGS. In Hong Kong's case we had to cut short the simulation test from three weeks to two weeks, due to delays in completing the earlier phases of the testing. This put everybody under considerable pressure, as there was very little time to identify the errors and rectify all the bugs during the simulation test. In the end, we had to conduct two extra test sessions at the very last moment in order to satisfy ourselves beyond doubt that the fixes we just produced were effective and free of further problems. It was only when we were satisfied that the system was robust and resilient that we eventually declared to cut over to RTGS as planned.

Intraday Liquidity
9.To ensure that the banking industry are on board and supportive of the RTGS project, it is of course necessary to consult the banking industry during all stages of the project. However, this is not enough. I have seen many examples in which the move to RTGS has been frustrated or delayed due to banks' reservations on how intraday liquidity is to be made available and who is to bear the costs of such liquidity. Under a net settlement system, intraday liquidity is free of charge but this is no longer the case under a RTGS environment because payment instructions will be held in queue until and unless sufficient funds are available in a bank's settlement account. It is easy to understand that banks do not wish to keep large credit balances in their settlement accounts because such balances either do not earn interests or, if they do as in the case of Hong Kong, earn well below the interbank lending rates. So the challenge to central banks and policy makers is how to devise a mechanism which is capable of providing intraday liquidity as and when needed but which would not result in a significant increase in costs to the banks. The way in which Hong Kong tackled this important issue is to offer a facility through which banks can obtain intraday liquidity by repoing with the HKMA their holdings of Exchange Fund Bills and Notes. The total amount of Bills and Notes held by the banking sector was $55 bn, which was equivalent to 20% of the average daily turnover of the interbank CHATS system. Judging from the experience overseas, such as Switzerland and the UK, we believed that the banks' holdings of Bills and Notes should be adequate to meet the daily payment flows on a day-by-day basis. However, towards the end of November when we were about to introduce RTGS, the demand for Bills and Notes rose very sharply because, while the major participants had for a long time been sitting on sizable holdings of Bills and Notes, many less active CHATS participants suddenly went to the market and purchase large amounts of Bills and Notes before the cut over to RTGS. The amounts of Bills and Notes that they bought varied, but in general it related to what these banks perceived to be their requirements to ensure smooth payment flows under RTGS. To address this sudden and sharp increase in demand for Bills and Notes, the HKMA decided as a matter of urgency to increase the supply of Bills and Notes, principally by issuing special Bills with only 28 days maturity. The additional amount then became available was $24 bn, or 44% increase as compared to pre RTGS bank holdings of Bills and Notes. Up to the present moment, we still make available the 28-day Bills, although we will keep the situation under review.
10.Prevention of gridlock is another important issue faced by any payment system. A gridlock is a situation in which a number of banks are unable to settle with each other because they are all awaiting incoming funds from each other. In Hong Kong's case, while we take comfort in knowing that the banks as a whole possess adequate holdings of Bills and Notes, there have been concerns that some banks may, for whatever reasons, be sitting on their liquidity and become unwilling to settle early in the day. In an extreme scenario, this may lead to a gridlock situation in which many banks become unable to settle as they are awaiting incoming funds. To prevent this situation from arising, we have decided to introduce what we call the CHATS throughput guideline. The guideline requires all banks to settle not less than 35% of their CHATS throughput by 12:00 noon and 65% by 2:30 pm each day. This guideline will ensure that banks will not be hoarding their liquidity for whatever reasons. With a few initial teething problems, the guideline has worked well and the banks are complying with it in the interest of the general smooth functioning of the RTGS system.

http://www.hkma.gov.hk/eng/key-information/speech-speakers/ntlchan/speech_110697b.shtml