ISSUE IX : Technology and electronic payment system in India

INTRODUCTION

The Indian banking system has come a long way from archetypal commerce establishment to a highly proactive and dynamic entity. This transformation is the consequence of liberalization and economic reforms that allowed banks to explore new business opportunities rather than generating revenues from conventional streams (i.e. borrowing and lending). It has finally worked up to the competitive dynamics of the new Indian market and is addressing the relevant issues to take on the multifarious challenges of globalization.

The internet has emerged as the latest challenging frontier of marketing with the conventional physical world tenets being just as applicable like in any other marketing medium. Indian banks are employing IT solutions to be perceived “futuristic” and proactive players capable of meeting the diverse requirements of the large customer’s base. When electronic mode of transaction is increasingly becoming the preferred route among customers, it has become essential to identify the existing regulations for the payment systems in India. The present bulletin tries to sum up the existing rules and regulations related to electronic payment system in the banking sector of India.

1 Authority of Reserve Bank of India (“RBI”)

To ensure smooth, safe and efficient operations of payment and settlement systems, RBI is empowered to frame regulations and rules for systems operated by it under sections 58(2)(p) and 58(2)(pp) of the RBI Act, 1934 which enable it to undertake the following:

“(p) the regulation of clearing-houses for the banks(including post office savings banks).

(pp) the regulation of fund transfer through electronic means between the banks or between the banks and other financial institutions referred to in clause (c) of section 45-I, including the laying down of the conditions subject to which banks and other financial institutions shall participate in such fund transfers, the manner of such fund transfers and the rights and obligations of the participants in such fund transfers.”

Accordingly, RBI formulated Uniform Regulations and Rules for Bankers’ Clearing Houses (“URRBCH”) in 1986. URRBCH guidelines have been adopted by all the clearing houses1 in India to harmonize the framework governing the conduct of the clearing houses, which had become necessary in the backdrop of increasing computerization in the banking industry and the consequential changes in the functioning of the clearing houses. Individual clearing houses are free to frame their own rules, though they should essentially be consistent with the broad framework provided by in the URRBCH guidelines.

RBI has also prepared the Minimum Standards of Operational Efficiency for Magnetic Ink Character Recognition (“MICR”) cheque processing centres. These standards relate to encoding of instruments, time schedule, maintenance of machines, operational procedures, monitoring of reject rates, speed and accuracy of on-line reject repair, checking of settlement reports for supervisory signals, return clearing discipline to be adhered to, enabling banks to download reports/data on-line, reconciliation, customer service, and business continuity plan. Similar standards have been introduced for non-MICR (but computerized) clearing centres and banks operating such centres will have to submit self-assessment reports on half-yearly basis.

2 The Acts supervising the payment system

The enactment of the Payment and Settlement Systems Act, 2007 (“the Act”) empowers RBI to regulate and supervise the payment2 and settlement3 systems in the country, give authority to permit the setting  up/continuance  of  such  systems  and  to  call  for  information/data  and  issue  directions  from/to payment system providers. The Act defines a payment system and gives legal recognition to multilateral netting4 and settlement finality. In absence of the Act, the inter-bank netting was governed by the provisions of the Indian Contract Act, 1872. RBI is now in the process of finalizing a regulation in consultation with the Government of India (“GOI”).

Further, the Negotiable Instruments Act, 1881 (“NI Act”) continues to be the predominant legal base for all non-cash, cheque-based (instrument-based) payment systems in India. It has been amended several times to enable space for the new instruments of business transactions. The latest amendments5 in respect of the definition of “cheque” by inclusion of the “electronic image of a truncated cheque”6 and a “cheque in the electronic form”7 have opened up avenues for introducing new methods of processing paper- based payment instruments. Simultaneous amendment8 to the Information Technology Act, 2000 (“IT Act”), making it applicable to NI Act has accorded legal status to the usage of electronic payment systems in

Indian banking. However, the electronic payment systems in India work on the basis of a series of bi-lateral agreements made specifically for each one of them which are of contractual nature between the participant and the manager of the systems.

The IT Act provides legal recognition for transactions carried out by means of electronic data interchange and other means of electronic communication, commonly known as “electronic commerce”, which involve the use of alternatives to paper-based methods of communication and storage of information.

3 Initiatives for Banking Infrastructural needs

Empowered by the RBI Act and the Act, RBI has taken several initiatives for ensuring development of technical and institutional infrastructure to meet the electronic payment system and banking needs of the country. Measures most prominent and relevant to the present discussion are provided below-

3.1 RBI introduced the Electronic Clearing Service (“ECS”) system in 1995

ECS is a mode of electronic funds transfer from one bank account to another bank account using the services of a clearing house. This is normally for bulk transfers from one account to many accounts or vice-versa. ECS is the equivalent of the automated clearing house (ACH) system in certain other countries.

ECS has two variants – ECS Credit clearing and ECS Debit clearing. While the Credit clearing operates on the principle of “single debit-multiple credits” and is used for making payment of salary, pension, dividend and interest, etc., the Debit clearing functions on the principle of “single credit-multiple debits” and is used for collecting payments by utility service providers like electricity, telephone bills as well by banks for receiving principal/interest repayments for housing and personal loans from the borrowers.

The National ECS is a product being developed by the RBI to enable centralized processing of the ECS transactions, in contrast to the existing ECS system that has de-centralised operations at 70 locations. The system would facilitate end-to-end seamless posting of the NECS transactions in a straight-through- processing (STP) environment.

3.2 RBI introduced the Electronic Funds Transfer (“EFT”) system in 1995

EFT is a retail funds transfer system enabling customers to transfer funds from one account to another and from one region to another, without any physical movement of instruments. The banks are now permitted to offer internet banking facilities based on the Board-approved internet banking policy and no longer require prior RBI approval. The product portfolio to be offered through internet banking is also no longer confined to only the local currency products but even foreign exchange services. Operations on the Vostro accounts9 of the overseas banks and exchange houses, maintained with the banks in India, are also permitted through the internet-based operations.

3.3 RBI introduced the National Electronic Funds Transfer (“NEFT”) system in November 2005

NEFT is a more secure, nation-wide retail electronic payment system to facilitate funds transfer by the bank customers, between the networked bank branches in the country. With the introduction of NEFT, the EFT introduced in 1995 for retail funds transfer, is now available only for Government payments. This system facilitates electronic retail transfers between bank branches using Structured Financial Messaging Solution (SFMS) and secured by Public Key Infrastructure (“PKI”) technology.10

A variant of the EFT, called the Special Electronic Funds Transfer (“SEFT”) System is also operated by the RBI to provide nation-wide coverage for EFT. Eventually EFT will be subsumed in the NEFT system and all electronic retail payments will be routed via either the NEFT or the ECS system.

3.4 RBI introduced the Real Time Gross Settlement (“RTGS”) system in March 2004

RTGS is a large value funds transfer system whereby financial intermediaries can settle interbank transfers for their own account as well as for their customers. The system effects final settlement of interbank funds transfers on a continuous, transaction-by-transaction basis throughout the processing day. As a step towards risk mitigation in the large value payment systems, the RTGS was operationalised by the RBI in March 2004, which enables settlement of transactions in real time, on a gross basis.11 RTGS is fully secured electronic funds transfer system where banks and customers can receive payments on real time basis. The RTGS System is operated by the RBI. A minimum threshold of INR 0.1 million has been prescribed for customer transactions to ensure that RTGS system is used only for large value transactions and retail transactions take an alternate channel of electronic funds transfer. The entire inter-bank clearing system and a few time critical retail payments have shifted to this secure electronic system platform.

3.5 Board for Regulation and Supervision of Payment and Settlement Systems (“BPSS”)

In order to strengthen the institutional framework for the payment and settlement systems in the country, the RBI constituted BPSS in 2005 as a committee of its Central Board.12 The role of BPSS is to prescribe policies relating to the regulation and supervision of all types of payment and settlement systems, set standards for existing and future systems, approve criteria for authorisation of payment and settlement systems, determine criteria for membership to these systems, including continuation, termination and rejection of membership. The role of BPSS encompasses electronic, non-electronic, domestic and cross- border payment and settlement systems which affect the domestic transactions.

3.6 Clearing Corporation of India Limited (“CCIL”)

CCIL manages the Government securities clearing system (the G-sec clearing) and the foreign exchange clearing system (the forex clearing), which are large value payment systems13 functioning in the country. These mostly relate to interbank/inter-financial institutional transactions.

The primary objective in setting up CCIL has been to provide a safe institutional structure for the clearing and settlement of trades in the G-sec, forex, money and debt markets, to significantly improve efficiency in the transaction settlement process, and insulate the financial system from shocks emanating from the counterparty risks and market deficiencies of various types that currently plague the Indian financial markets. Operations at the CCIL currently encompass settlement of trades in G-sec, treasury bills and repos concluded and/or reported on NDS. CCIL extended the facility of guaranteed settlement of trade to its members with effect from April 10, 2002.

CCIL has been incorporated as a public limited company under the Companies Act, 1956. CCIL has been set up as a central counter party which operates guaranteed net settlement systems (using the principle of novation) with collateralized borrowing and lending obligation. All these are best practices in the form of the core principles for Systemically Important Payment Systems (“SIPS”)14 and, therefore, the RBI has, in line with the international best practices in this regard, moved them. The Inter-bank Clearings at places other than Mumbai and the High Value Clearings have been shifted to either secure and guaranteed systems or the RTGS System.

3.7 RBI introduced the Cheque Truncation System (“CTS”) in February 2008

The latest electronic payment product introduced by the RBI is the CTS, which was launched, on a pilot basis, in the New Delhi on February 1, 2008, with the participation of 10 banks. The main advantage of CTS is that it obviates the physical presentation of the cheque to the clearing house; instead, the electronic image of the cheque would be sent to the clearing house. The CTS would enable the realization of cheques on the same day, and provide a more cost-effective mode of settlement than manual and MICR clearing.

3.8 National Payments Corporation of India (“NPCI”)

The Indian Banks Association set up a working group which examined this issue and suggested the modalities for setting up NPCI. NPCI shall be an entity registered under the Companies Act, 1956 and will be owned by banks and financial institutions. NPCI will be a section 25 company, which will not distribute its profits as dividend, but will plough it back for the improvement and expanding the reach of the retail payment systems. The ownership of the company will be suitably diverse with no bank or group of banks having shareholding exceeding 10% of the total shareholding. The Act has laid down that such not less than

51% of the equity of NPCI will be held by public sector banks. The work relating to the setting up of NPCI is in progress.

In order to mandate the migration from paper based payment systems to electronic systems, the processing charges for ECS / EFT / NEFT were waived up to March 31, 2008. RBI, in its role as promoter and facilitator of electronic funds transfer waived the charges for another year i.e., up to March 31, 2009. RBI has made all payment transactions of INR 1 crore and above in the money, G-sec and forex markets and the regulated entities (banks, PDs and NBFCs) mandatorily to be routed through the electronic payment mechanism effective from April 1, 2008.

CONCLUSION

The electronic payment system in India is burgeoning to match the international banking standards and cope up with the ever-growing challenges posed by the electronic systems. The endeavor of this article is to encapsulate the existing regulations in the electronic payment system and identify the course traversed by the banking system in India. Pursuant to the recently passed Act and powers conferred to RBI through it, dynamic changes leading to additional regulations are expected for simplification of the vast regulatory system efficiently.

1 Association of banks organized to exchange checks, drafts, or other payments types, including electronic transfers. A clearing house maintains a daily log of transactions it accepts on behalf of members. At the close of business the clearing house arranges the settlement of obligations and transfer of funds from members who owe money to members who have money due. In its capacity as a central facility, the clearing house acts as buyer to all sellers and seller to all buyers.

2 Per section 2(i) of the Act, “payment system” means a system that enables payment to be effected between a payer and a beneficiary, involving clearing, payment or settlement service or all of them, but does not include a stock exchange. Also, for the purposes of this clause, payment system includes the system enabling credit card, debit card and smart card operations, money transfer operations or similar operations.

3 Per section 2(n) of the Act, “settlement” means settlement of payment instructions and includes the settlement of securities, foreign exchange or derivatives or other transactions which involve payment obligations.

4 Per section 2(e)of the Act, “netting” means the determination by the system provider of the amount of money or securities, due or payable or deliverable, as a result of setting off or adjusting, the payment obligations or delivery obligations among the system participants, including the claims and obligations arising out of the termination by the system provider, on the insolvency or dissolution or winding up of any system participant or such other circumstances as the system provider may specify in its rules or regulations or bye-laws (by whatever name called), of the transactions admitted for settlement at a future date so that only a net claim be demanded or a net obligation be owned.

5 The NI (Amendment and Miscellaneous Provisions) Act, 2002. The amendment to the definition of cheque came into effect from February 6, 2003.

6 Per section 6 Explanation I (b) of the NI Act, “a truncated cheque” means a cheque which is truncated during the course of clearing cycle, either by the clearing house or by the bank whether paying or receiving payment, immediately on generation of an electronic image for transmission, substituting the further physical movement of the cheque in writing.

7 Per section 6 Explanation I (a) of the NI Act, “a cheque in the electronic form” means a cheque which contains the exact mirror image of a paper cheque, and is generated, written and signed in a secure system ensuring the minimum safety standards with the use of digital signature (with or without biometrics signature) and asymmetric crypto system.

8 Amendment in section 1(4)(a) of the IT Act w.e.f. February 6, 2003. The section is extracted as: “Nothing in this Act shall apply to-(a) a negotiable instrument (other than cheque) as defined in section 13 of the NI Act.”

9 A demand account maintained for a bank by a correspondent bank in a foreign country. The nostro account of one bank is the vostro account of the other bank.

10 PKI is the combination of software, encryption technologies, and services that enables enterprises to protect the security of their communications and business transactions on networks. PKI integrates digital certificates, public-key cryptography, and certificate authorities into a total, enterprise-wide network security architecture. A typical enterprise’s PKI encompasses the issuance of digital certificates to individual users and servers; end-user enrollment software; integration with certificate directories; tools for managing, renewing, and revoking certificates; and related services and support.

11 Per section 2(d) of the Act, “gross settlement system” means a payment system in which each settlement of funds or securities occurs on the basis of separate or individual instructions.

12 The affairs of RBI are governed by a central board of directors. The board is appointed by the GOI in keeping with the RBI Act. The committee is chaired by the Governor, RBI. The four deputy Governors of RBI and two external Directors of the central board are its members.

13 The other large value payment systems are the inter-bank cheques clearing systems (the Inter-bank Clearing), the high value cheques clearing system (the High Value Clearing- non-electronic system used to clear high value customer cheques), and the RTGS System.

14 The core principles of SIPS was published in 2001 by Committee on Payment and Settlement Systems are intended for use as universal guidelines to encourage the design and operation of safer and more efficient systematically important payment systems worldwide. CPSS jointly with the International Organization of Securities Commissions (“IOSCO”) studied the practices being followed in different countries with respect to trading, clearing and settlement activities of securities transactions. Based on it, CPSS and IOSCO jointly published the “Recommendations for Securities Settlement Systems” in November 2001 and the “Recommendations for Central Counter Parties” in November 2004.

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