Payments in India: the Journey so Far and the Road Ahead

With developments in payment infrastructures around the world working towards the goal of lower risk and more effective payments, it is only natural for corporates and treasury professionals in India to have similar expectations. Governments and regulators too are focused on providing a stable and efficient payment system – realising that they form the backbone of any economy. India, however, places some unique demands on its payment systems.

This paper looks at what payment systems and options are currently available for both corporates and institutions in India, discussing the key features of these systems.

We will also look at how much progress India has made on its journey towards the panacea of country wide implementation of a truly world-class payment system and assess future initiatives underway to address the issues/gaps.

Being of the belief that looking at the history, paves the way for better understanding of the present, let us begin at the beginning.

The Evolution of the Indian Payment System:

Indian payment systems have a really long history, the study of which can be an exercise in itself. For our purposes, looking at the progress of the payment systems in three phases, will help us put current initiatives into perspective.

Ancient payment systems (historical to mid 1900s):

India’s long history of payment instruments and mechanisms, started from coins (either punch marked or cast in silver & copper) to pay orders (called Barattes) that are akin to current day drafts or cheques. The most important class of credit instruments that evolved in India were local language bills of exchange (called Hundis) that are still in vogue.

This phase culminated in the enactment of the Negotiable Instruments Act in 1881 (NI Act), which formalised the usage and characteristics of instruments like the cheque, bill of exchange and promissory note. The NI Act provided and still provides the legal framework for non-cash paper payment instruments in India.

Modern payment systems (mid 1900s to 1997):

After the enactment of NI Act, and the steady growth in volumes of cheques, the establishment of clearing associations was the next logical step. This phase was characterised by the set-up of clearing associations in the presidency towns, each of them run differently and finally taken over by Reserve Bank of India. Computerisation of clearing operations was a key step towards modernisation of the payment systems. The introduction of magnetic image character recognition (MICR) based mechanised cheque processing technology in Mumbai (1986), Chennai, New Delhi (in 1987) and Calcutta (1989) was a significant milestone.

To reduce the pressures on the cheque clearing and settlement process, and to improve customer service (especially for high volume, low value clearing,) the central bank introduced an electronic clearing service (ECS) credit scheme. An ECS debit scheme was also brought to market to facilitate payment of charges to utility services. ECS is the ACH system in India, with electronic funds transfer (EFT) being the system for single/individual payments.

Payment systems alignment to global standards (1997 to date):

This phase has focused on further strengthening and modernising the payment systems. One key driver was the formation of a payment systems group (within the central bank) specifically tasked to conceptualize, design and implement an integrated payment system across India.

Some of the key achievements in this phase include:

• Increasing use of MICR in clearing centres (leading to 39 centres having MICR clearing)
• Introducing CFMS (centralised funds management system,) centralising ECS and rolling out special EFT (SEFT), to increase scope and coverage of EFT.
• A significant milestone in this phase has been the roll out of real time gross settlement (RTGS) in March 2004. Standard Chartered was one of the first four banks that piloted this roll out in India.

So Where Are We Now?

This evolution has left India with myriad payment systems. Considering the features of these payment systems along the below two axis helps us understand their roles better.

From a corporate perspective, the situation has materially improved over past few years. ECS and EFT/SEFT meet disbursement and collections requirements (i.e. a low cost electronic payment system to handle low value payments with predictability.) RTGS provides a payment platform (with no systemic risk) for high value payments and growing geographic coverage. The current coverage of RTGS is 275 banks, whose branches cover almost 500 centres. Having said that, for greater coverage, especially for payments made to a member bank of clearing house at over 1050 centres, cheques would still be the preferred payment method.

The following table maps out the key characteristics of payment systems available to corporates.

Description:

• Characteristics: of the payment system (esp., of interest being when the beneficiary gets value.)
• Amount restrictions: are there any amount restrictions in using the system?
• Locations coverage: i.e., the locations covered in terms of number of cities/centers.
• Bank Participants: i.e., how many banks can participate (with related comments.)

Are Paper-based Instruments still King?

Even with various electronic channels to choose from, cheques (MICR, non MICR, high value and inter-bank cheques) still form the lion’s share of payments in India, accounting for over 1,000 million payments a year. Even after including card transactions, cheque volumes form 80 per cent of total payment volumes.

India Payment volume trend

* 2004-05 numbers are forecast numbers based on actuals during 2004

The volume trend clearly shows that cheques are still the primary payment mechanism in India. This behaviour is due to obvious advantages of geographic coverage, convenience and strong history of usage.

The advantages of electronic payments i.e., an efficient, safe and secure method of making payments vs. the disadvantages of cheques (inefficient, fraud prone debit mechanism with timing uncertainty) are slowly being appreciated and adopted by the industry. It is worth realising that for cheques, banks/participants are responsible for routing the cheques to the appropriate clearing centre via their own branch or correspondent banks’ branch, further increasing the risk in inter-city clearing.

Has India completed the journey towards world-class payment systems?

India has come a long way towards a world-class payment infrastructure, but the journey is certainly not completed. The question is, how far is there left to go? Consider the following:

• The availability of technology and a robust communications network.
  With INFINET (INdian FInancial NETwork) becoming the secure communication backbone, RTGS being rolled out, the centralisation of ECS and the introduction of SEFT, this goal is closer to being realized.
• A Risk management framework.
  The Committee on Payment and Settlement Systems of G-10 countries (set up under the auspices of BIS) formalised the “Core Principles of Systemically Important Payment Systems (SIPS)” during 2001. India, having identified SIPS (which include RTGS, inter-bank and high value clearing) has focused on making them compliant with the Core Principles of SIPS. There are gaps though, namely high-value and inter-bank clearing – these are still some way off from these standards.
  The existence of multiple payment and clearing systems is not only leads to confusion in the market place, but also forces participants to maintain and manage multiple liquidity pools, thereby increasing the overall liquidity risk of participants in the system.
• A well-founded legal framework
  Although much has been done in this area by the regulators, I believe there is still some distance to be covered. Some of the issues are:
• The Negotiable Instruments Act (1881) continues to be the predominant legal base for all paper-based instruments. Currently, there is no such similar legal framework for Electronic payments (ECS, EFT and RTGS.) They work on the basis of agreements that are tailor-made for them and are contractual in nature between the participant and the manager of the systems. The various participants/banks have also been relying on the amendments carried out to the Indian Evidence Act, and the Information Technology Act, to offer electronic payments initiation to their customers.
• No legal structure exists currently to cover ‘netting’ and ‘finality of settlement’, key requirements for Deferred Net Settlement systems like ECS, EFT etc.
• There is merit in the argument that the lack of legal framework has been one of the reasons for the weak adoption of the electronic payment systems by the Small & Medium Enterprise segment of industry.
• A ‘last mile’ issue exists, especially in the low value electronic payment systems. There is no legal pressure on the beneficiary bank to credit the beneficiary promptly (a result of the lack of legal framework for Electronic payments.)

What can be expected in the near future? Are there any initiatives to address above issues?

The central bank (RBI), having successfully brought focus to the Payment systems during the Post Modern phase, has rightly decided to repeat the feat.

RBI formed a ‘Committee on Payment Systems’ that looked into key gaps in the current systems (both technical, regulatory and legal.) The agenda of the central bank during the next few years draws from the recommendations of the committee.

Some of the key initiatives being undertaken, which should be of interest to corporates are *:

• A ‘Board for Payment & Settlement Systems” cleared by the Government, to be formulated during March 2005, will regulate and provide oversight on payment and settlement systems.
• The ‘Payment and Settlement Systems Bill’ has been propounded with the view to receive legal definition of ‘netting’ and ‘finality of settlement’ and to create a regulatory framework for payment and settlement systems (especially electronic payment systems.) A need for a law similar to UNCITRAL (United Nations Commission on International Trade Law,) to cover electronically initiated credit transfers has also been recognised. These legal measures should also help address the ‘last mile’ issue and increase the popularity of electronic payments (by putting such payments on a surer legal footing.)
• Further automation of cheque clearing, through implementation of Image Based Cheque Truncation model in India (with long term goal of a National Truncation System) is being planned for in Q3, 2005, for piloting in the National Capital Region (i.e., a 100 km region around Delhi) aiming to provide T+0 clearing. This will help reduce the risk of fraud in paper-based systems.
• Introduction of NEFT (National Electronic Funds Transfer) in Q2, 2005 – the end state for EFT/SEFT. Batch payments will continue to be pushed through ECS-Debit and ECS-Credit. Reduction in number of systems available (RBI’s design being that EFT/SEFT be merged into NEFT) will reduce the need for multiple liquidity pools.
• Increase in membership of banks in RTGS, gradually increasing the coverage (though, in my opinion, the current coverage is good enough for the target payment traffic.)
• Risk mitigation has justifiably caught the special attention of the regulators, and certain steps are being planned:
• Address systemic risk by migrating ‘inter-bank clearing volumes’ in all places to RTGS (Mumbai has already been done) and securing ‘high value clearing systems’ through the introduction of guarantee funds.
• Address liquidity risks by implementing National Settlement System across all clearing systems (allowing participants to benefit from lower liquidity requirements by removing the need to maintain multiple pools of liquidity.)
• Address operational risks by enhancing security of message to PKI based systems, and providing high availability of systems (improving Disaster Recovery / Business Continuity Planning at RBI with both on-site and off-site backups).

In Summary

Indian payment systems have come a long way. They can now support over a billion payments pa., and have done a commendable job of meeting the goals of increased efficiency and robustness while expanding geographic coverage.

There is still work to be done before Payment Systems in India can truly mature. India must get the last lap in this journey right, if it wants to transform the image of India to the new Asian tiger, namely all centres to be electronically linked for all payments (including paper based cheques via cheque truncation.)

* a note of thanks to Mr. R. Gandhi, Chief General Manager-in-Charge, Dept. of IT, Reserve Bank of India for sharing insights on the future initiatives in the payments infrastructure space in India.