China CIPS - How is It Likely to Operate?

March 2016: CIPS and SWIFT Sign the MOU

Introduction:

If you read my previous post, then hopefully you’ve accepted the argument that CIPS is designed as a payment utility (analogous to CHIPS) not as a replacement for SWIFT (a global secure messaging utility).

Thus, if CIPS is an alternative to anything, it is an alternative to currently existing cumbersome methods for parties outside of Mainland China to make and receive RMB payments.

By way of fleshing out this analogy, let’s look a bit closer at CHIPS and how it fits into the domestic US payment system.  CHIPS processes US dollar payments –largely those related to cross border transactions.  FEDWIRE and ACH (for smaller payments that are made in very large numbers, e.g., salaries) handle the bulk of domestic (US) oriented dollar payments. 

Similarly CIPS will handle internationally oriented RMB denominated payments, while CNAPS2--the local equivalent of FEDWIRE-- (primarily) will process domestic oriented RMB payments in the PRC.

Key Results of CIPS Likely Method of Operations

There are four key likely effects:  

1. Requirement that CIPS member banks be located in the PRC.  Banks around the world are not going to be connected to CIPS as they currently are to SWIFT.
2. Reliance by foreign banks wishing to use CIPS on Chinese correspondent banks. 
3. Use of SWIFT means that perceived risks associated with the use of SWIFT are not mitigated. 
4. Negative impact on existing RMB clearing banks and centers, with Hong Kong potentially hard hit.

Domestic Membership:  Like CHIPS, CIPS almost certainly will require that its members (the institutions who can directly enter payment orders into the system and who directly receive payments from the system) be in the PRC (not offshore) and have accounts with the (local) central bank (the PBOC) to settle transactions.  Credit concerns over settlement of transactions, including minimizing systemic risks to the national payment system and economy, and operational needs motivate this requirement.

Reliance on Correspondent Banks: Offshore banks that want to send payments via CIPS will have to maintain RMB accounts with Chinese correspondent banks who are direct CIPS members or with other banks who themselves maintain such accounts.  This latter option is more operationally complex and not one that many banks are likely to take -- unless they have credit concerns about maintaining large balances in accounts subject to PRC jurisdiction.   Offshore banks who want to send USD payments through CHIPS or Sterling payments through London-based CHAPS have a similar reliance on correspondents. 

Use of SWIFT by Foreign Banks: What this means then is those offshore banks are very likely going to use SWIFT to send messages to the correspondents (CIPS direct members) and receive information from CIPS members about transactions via SWIFT just as they do with CHIPS USD transactions. 

If as it  seems, foreign banks will send their payment instructions to CIPS members via SWIFT, then if sanctions or other pressure forces SWIFT to deny a Chinese bank access to SWIFT, that bank will no longer be able to receive SWIFT payment messages from foreign banks or send them messages.  

Potential Use of SWIFT by CIPS:  If CIPS direct participants use SWIFT to send payment instructions to CIPS, then a denial of SWIFT services to Chinese banks could “shut down” CIPS. 

Impact on Perceived Risks Associated with SWIFT Usage:  As I hope is evident, to the extent that SWIFT is used with CIPS, concerns about “spying” or sanctions-induced denial of SWIFT access—assuming that these really exist--are not eliminated.

But note, at this point it’s not clear –at least to AA—if CIPS will 

• rely on SWIFT for such “internal” communications or 
• operate a separate secure communication system of its own.   
• Target, the Europe-based payment system that makes euro denominated payments, uses SWIFT for this purpose.  
• CHIPS has a different model.  It relies on its own secure communication system to send payment instructions to CHIPS.   

Of the two options, I expect that China will adopt the CHIPS model, if not immediately, as soon as it can. 

Problems that both Iran and Russia faced no doubt have been noticed by PRC decision makers.   Iran’s SWIFT access was suspended --now restored in the wake of the nuclear agreement.  US sanctions restricted Russian domestic debit and credit card processing almost all of which was offshore and thus outside of Russian authorities’ control until that processing was subsequently brought onshore.  Calls by the then British PM and other EU entities for Russia to “de-SWIFTed”  threatened the potential shutdown of the country’s SWIFT-based domestic payment system with potentially devastating economic effects, causing the Central Bank of Russia to  introduce a replacement non-SWIFT-based payment national payment system.  

But I think that the Chinese need little “education” on this topic. 

Well before Iran’s or Russia’s problems, the PRC required that domestic credit and debit card transactions be processed by a domestic system. Some of this was likely motivated by a desire to promote local business as well as to limit the risks of reliance on foreigners.

Impact on Clearing Banks and Centers –Particularly Hong Kong: Finally, another often overlooked result of CIPS is the impact on offshore clearing banks. Under the current “clearing bank” arrangement designated banks outside the Mainland handle offshore and cross-border RMB transfers.  Hong Kong is particularly vulnerable as it handles roughly 70% of all offshore RMB transactions.  (Page 7)

Once CIPS is successful, Hong Kong banks (particularly Bank of China Hong Kong) are likely to experience a dramatic fall in transaction volume and fees. Customer RMB deposits are also likely to decline as deposits are shifted to CIPS member correspondent banks on the Mainland. 

Factors that could mitigate that fall are

1. the utility of offshore accounts for “workarounders’” and “investors’” currency exfiltration and infiltration transactions with the mainland, a lot of HK – Mainland trade is actually composed of regulatory avoidance transactions dressed up as trade, 
2. more “legitimate” regulatory planning reasons for maintaining offshore RMB deposits similar to those for offshore US dollar deposits, and 
3. a possible depositor preference for banks and jurisdictions perceived to be more creditworthy and offering more legal protection to depositors than those on the Mainland.

CIPS (China International Payment System) Hysteria Largely Dispelled?

AA Reporting from His Secure Location: Sometimes You Need More Than Just the Hat

When the PRC announced its intent to create CIPS--the China International Payment System, now renamed the Cross- Border Interbank Payment System--some trumpeted it as a replacement for SWIFT and another, perhaps, the fatal step in global de-dollarization, heralding the end of the primacy of the US dollar.  Here’s one particular brilliant “insight” cast in terms of “white and black hats” and “blessings”. 

Most of this commentary was ideologically-driven:  a preconceived notion in desperate search for  validation. When your ideology gives all the answers, analysis is not only very easy but very facile. You just fit the facts or what might pass as “facts” around the preordained answer.

My favorite exemplar of this way of “thinking” is the assertion that the ruble is fully supported by gold and thus in some way superior to the US’s “fiat” money.  That’s “supported” like Golden Belt Sukuk was “asset backed” –“way back” it turned out.  No doubt AA is missing the opportunity of a lifetime by not converting his deposits to rubles and depositing them in a Russian bank. What could possibly go wrong?  But then I resisted buying Golden Belt Sukuk so I have a track record for missing out.  

Some of it was based on the latent hysteria that often informs discussions of politics and economics, particularly when certain actors are involved.  Here there was a veritable trifecta:  possibly including China, Russia, and Iran – an “axis of evil” for some.  But as the video above shows for others an “axis of virtue”.  Count your blessings!   And note the white cowboy hat on the wall in the video!

At the time there were more balanced analyses like this one from the FT which cast CIPS  as an attempt to simplify the process of making cross-border RMB payments to promote internationalization of the RMB and perhaps lessen exposure to alleged spying and the threat of denial of SWIFT services.  As it turns out these latter goals appear not to have been met as will be outlined in a following post.  CIPS may well facilitate greater “regulatory supervision” (but not “spying” for sure) of offshore RMB-denominated transactions by PRC authorities.

SWIFT’s 25 March 2016 press release by and large put an end to nonsense about CIPS as a global replacement for SWIFT or should have. 

“The MOU sets out plans for a strategic collaboration to develop China’s Cross-border Interbank Payment System (CIPS) using SWIFT as the secure, efficient and reliable channel to connect CIPS with SWIFT’s global user community.”

But there are still holdouts.

Ideology is a powerful thing in the face of mere facts. Here’s one from Jim Willie over at the aptly named website “Before It’s News” carrying a dateline four days after SWIFT’s press release.  I guess the site name means the articles are written before looking at the news.

What’s clear or should be now is that CIPS is not a replacement for SWIFT.  It’s analogous to CHIPS – a New York-based bank-owned utility that makes the bulk of cross-border payments in the US dollar. That is, CIPS is a payment utility like CHIPS or CHAPS, not a secure messaging system like SWIFT. 

Why create CIPS? 

The PRC is looking to promote the internationalization of the RMB.  CIPS is designed to streamline the currently cumbersome process of making cross border RMB payments.  It is also a way to bring this payment “traffic” within the PRC.  As a result of bringing that traffic onshore, PRC authorities will have more visibility into offshore RMB payments than they previously had.  

But could we have figured out that CIPS was highly unlikely to replace SWIFT when CIPS was first mooted?  Yes!

Because there’s a lot of apparent confusion about precisely what SWIFT does, let’s start with some basic facts as they’re part of the foundation of the argument to follow.

SWIFT not hold any accounts, nor does it execute any payments.  It transmits payment instructions to financial institutions that then “make” payments either (a) through utilities (like CHIPS or CHAPS) or national payment systems (like FEDWIRE, CNAPS2—China’s domestic RMB payment system) or  (b) on their own books (book transfer) when they hold the account of the intermediary or final beneficiary. 

That is, assume Bank A receives a SWIFT message from Bank B ordering Bank A to debit Bank B’s account and pay Bank C for account of Person or Company K. 

1. If Bank A holds the account of Bank C, it will make payment on its own books (an internal payment or book transfer) unless Bank B instructs it otherwise. As the name implies, the payment is made within Bank A.  Bank A’s assets and liabilities don’t decline when the transfer is made.  All that happens is that the amount of the payment is moved from Bank B’s to Bank C’s account –an internal shift within liabilities.   
2. If Bank A doesn’t hold Bank C’s account, it will pay the correspondent Bank that holds Bank C’s account either through the utility or national payment system (in banker speak a “wire transfer”).  In this case Bank A’s assets and liabilities will decline by the amount of the payment and Bank C’s correspondent bank’s assets and liabilities will go up by the amount of the payment.  Here there’s an actual movement of funds out of Bank A to Bank C’s correspondent.

While SWIFT is probably the most convenient and most used method to send and receive payment instructions, it is not the only way.  If SWIFT denies a financial institution access to its system, that financial institution can use a variety of other methods (proprietary PC based systems that mimic SWIFT, or other methods like telex, facsimile, email, letters) to send payment instructions to its correspondent.  These will often be more cumbersome and costly and less secure, but if the correspondent is willing to accept them, the payment can be made.

What’s involved in creating a global replacement for SWIFT?  

First a side digression to place this question in context. Creating a bi-lateral alternative or regional alternative would be much easier.  Most internationally active banks offer their customers PC-based systems for transmitting payment orders and receiving account information though such services are limited to two-way communication between the specific customer and a single bank.  Banks in Russia and China offer these services and could easily set up a communications system. If there was a preference to avoid the internet, a cable could be laid.  But that would not be a global replacement.

Putting aside the not inconsiderable cost of creating a new SWIFT, one would have to build a system offering similar services at the same or lower costs, persuade existing SWIFT clients that there was a good reason to shift from SWIFT, and at least for now convince them to shift a large portion of their transactions to the RMB.  That of course would require that the banks’ customers shifted their transactions to the RMB away from the dollar or other currencies.  All this seems to AA to be well beyond a hard slog.

SWIFT works.  That’s why it is the global communication utility. It is as embedded in the payments world as Microsoft software is in the PC world, though I’d argue that SWIFT has the better product. 

Here’s the hill to climb.

1. More than 11,000 financial institutions in more than 200 countries use SWIFT. 
2. SWIFT supports more than 150 payment and settlement systems around the globe.  
3. In 2015 SWIFT handled over 6.1 billion messages related to payments (in a wide variety of currencies not just one), securities transactions, treasury operations (FX dealing, interbank deposits, swaps, loan syndications, gold trading), trade finance (letters of credit, collections).   With this sort of volume fixed cost per transaction is low.  Variable cost is very low.  How does an upstart match this advantage? 
4. SWIFT offers a robust range of products beyond “mere” payments, including financial messaging, bulk file transfers, secure internet browsing/web access for SWIFT members’ clients, a comprehensive suite of compliance and analytical tools --anti-money laundering, sanctions enforcement, etc. 
5. And does so with 99.999% reliability year after year after year.  Its credibility as a reliable partner is proven.

Beyond these obstacles there is another very serious impediment to getting banks to embrace CIPS as an alternative to SWIFT: currency.

CIPS is likely to be limited to a single currency—the RMB.   Today only about 40 percent or so of SWIFT payments are in dollars (Page 5).  What do foreign banks do with the other 60% of their payments?  Run two communication systems?  SWIFT for everything but RMB? And CIPS for RMB?  That’s operationally cumbersome and thus expensive in an environment when cost minimization is key.

On top of that the RMB is less attractive than the dollar and likely to remain so for a long time because of concerns about transparency, business ethics and fair dealing, legal redress, market size (availability of sufficient investable RMB denominated assets), and their liquidity and credit quality to name just a few of the challenges the PRC faces in making the RMB a true alternative to the US dollar. 

Don’t mistake this comment as a Pollyannaish view that the dollar’s place in the world economy is unassailable.  It isn’t.   Sadly, our “own goals” are likely to be the main factor in the dollar’s fate.  Richard Dunne step aside for the real pros!  Any alternative currency will also have to offer the same or greater benefits than the dollar.

Next post will discuss some of the issues arising from how CIPS is likely to operate.