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.