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The Chinese payments system

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1 The Chinese payments system
The Chinese financial system, spring 2014 PV Viswanath Lubin school of business P.V. Viswanath

2 Learning objectives An important part of the financial system is to provide an efficient way for people and businesses to make payments to each other when they wish to buy goods and services. Can you pay with cash? Must you pay with cash? Can you pay with a check? If so, how will your payment reach your seller ultimately? Can you pay with a credit card? Do vendors accept credit cards? Do buyers wish to use credit cards? And, once again, how will the payment reach the seller ultimately if the buyer uses a credit card? What happens if there is a transaction on an exchange? How is payment made? Do businessmen require payment in cash? Do they provide trade credit? What about international transactions? Is it possible for somebody in China to pay for international purchases in RMB? Can foreigners use foreign currency in China? How does that work? Are there political, legal and social issues involved in the answers to these questions? If so, what are they? We will discuss some of these issues in these slides. P.V. Viswanath

3 Clearing A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. Settlement in the context of securities trading refers to the delivery of the security to the purchasing party and payment of the agreed upon price to the selling party. Clearing refers to the facilitation of such settlement. The two parties to the transaction or their responsible representatives are usually members of the clearing house that clears their trade. A clearing house stands between the two member firms and its purpose is to reduce the risk of one (or more) of the member firms failing to honor its trade settlement obligations. A clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called “margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the clearing firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing firm's collateral on deposit. Sometimes (but not always) a clearing house will also take the opposite position of each trade, so that the legal counterparty to each trade cleared through the clearing house ill be the clearing house itself. This reduces the need for each party to a securities transaction to evaluate the creditworthiness of the other party to the transaction. P.V. Viswanath

4 Payment system players
Payment service providers are either banking institutions or non-bank financial institutions such as finance companies of enterprise groups, which provide financial management services such as collecting and paying money, accepting bills, discounting etc. for their members. Several other institutions provide clearing and settlement services: There are several clearing houses that provide clearing services for different groups of banks. The Clearing Center for City Commercial Banks (CCCB) mainly engages in clearing services and other business for city commercial banks, urban credit cooperatives and some rural banks. It clears transactions related to bank drafts, online payments, and interbank deposits and withdrawals. The Rural Credit Banks Funds Clearing Center (RCBFCC) provides clearing services for real-time electronic fund transfers, bank drafts, and interbank deposits and withdrawals for China’s rural credit cooperatives, rural commercial banks, rural cooperative banks and other local financial institutions. Local clearing houses are institutions that provide physical negotiable instrument exchanges or clearing services for local banking institutions. There are several clearing houses that help clear financial securities transactions. China Central Depository and Clearing Corporation (CCDC) is responsible for the registration, custody and settlement of most fixed income securities on the inter-bank bond market. Shanghai Clearing House (SHCH) provides RMB and foreign currency clearing services for both spot and derivatives markets. China Securities depository and Clearing Corporation Ltd. (SD&C) is the sole operator of the registration, clearing and settlement system for the stock market. China UnionPay Co. Ltd helps clear bankcard transactions between issuing and acquiring institutions. P.V. Viswanath

5 Cash and other Payment media
Cash is one of the very important transactions media in China. The ratio of currency to GDP is about 11% today. The ratio was about 11% for India in For the UK, it is around 4%. However, the proportion of non-cash transactions is increasing from year to year. In volume, negotiable instruments such as checks, bank drafts and commercial drafts and banker’s promissory notes comprised 3.24% of transactions in 2010, while bankcards represented almost 93% and remittances 3.69%. In volume terms, the proportions were about 31%, 27% and 40%. However, checks are used mainly by governments and enterprises for making payments. Bankcards are the most popular payment instrument for residents; debit cards account for 80% of all cards. At the end of 2010, more than 2.4 billion cards had been issued. Remittances involve credit transfers and are the primary means of inter0city payment. These are processed by local clearing houses or by the RCBFCC or the CCCCB. ATMs and POS terminals are also used; the former are used by commercial banks, while the latter are used by merchants. Source: Payment, Clearing and Settlement Systems in China, 2012 P.V. Viswanath

6 Payments systems The PBOC is the backbone of the payment system, the banking institutions are the main parts and systems such as the interbank bankcard transaction clearing system, the foreign exchange settlement system and the securities settlement system are important components of the overall payment system. The PBOC has developed several interbank payment systems. The most important are the HVPS and BEPS, which together constitute the China National Advanced Payment System (CNAPS): The High-Value Payment System (HVPS) handles inter-city and local credit transfers above a given value. The main participants in this system are the commercial banks which have RMB reserve account with the PBOC and are directly linked to the HVPS through their internal systems. Commercial banks which have no direct link to the HVPS connect to the system through direct participants that do. Payment instructions are sent in real time and cleared transaction by transaction. The Bulk Electronic Payment System (BEPS) deals with local and non-local paper-based debit payments as well as low-value credit transfers below a given value. The system sends payment instructions in bulk, nets in real time and settles at regular times. (This is in contrast to the transaction-by-transaction clearing for the HVPS; there is a tradeoff of efficiency against credit risk.) Again, the main participants are the commercial banks as well as centralized collection and payment centers. Netting is first done at the level of City Clearing Processing Centers (CCPCs). The National Processing Center (NPC) receives and forwards payment transactions and information, nets payment transactions across CCPCs, and then submits the net amounts to the HVPS for settlement. P.V. Viswanath

7 Payment systems There are four additional systems:
The Internet Banking Payment System (IBPS) handles interbank retail payment transactions via the internet, enabling customers to submit online payments and obtain results in real time. The IBPS has been in operation since August Obviously the existence of an efficient and quick internet banking payment system is crucial to the development of e-commerce. Local clearing systems conduct centralized exchange and netting of local electronic payments and paper-based instruments such as checks, promissory notes and bank drafts. Participants in these systems are mainly banking institutions, accounting and treasury departments of PBOC branches and other institutions approved by the PBOC. Check Image System (CIS) is a system that converts physical checks into images and then transmits the check image and related image to the drawer’s bank. Participants include banking institutions and local clearing houses, which process transactions on behalf of local banks. China Domestic Foreign Currency Payment System (CDFCPS) is a real time gross settlement system (RTGS), i.e. a funds transfer systems where transfer of money or securities takes place from one bank to another on a "real time" and on a gross, i.e. non-netted basis. CDFCPS was developed by the PBOC for the foreign currency payments incurred by domestic purchases of goods and services. Settlement is in one of eight foreign currencies. P.V. Viswanath

8 clearing & Settlement systems for securities
In mainland China there are two Central Securities Depositories (CSD), the China Securities Depository and Clearing Co. (SD&C), which serves the two stock exchanges and also acts as a central counterparty (CCP) for them, and the China Government Securities Depository Trust & Clearing Co. (CDC), which serves the interbank bond market. Bond settlement of the two mainland stock exchanges is also handled by the SD&C. After completion of the stock exchange trades, they are sent from the stock exchange to the respective SD&C branch. While the SD&C is responsible for the settlement with securities companies or direct investors (first tier), securities companies are responsible for the settlement with their clients (second tier). The SD&C acts as a central counterparty (CCP) to the counterparties of a securities transaction. If a trading counterparty defaults on its obligation in securities or cash, the SD&C fulfils the obligation on behalf of the defaulter. There are two levels to each trade: first of all, even though the trade on the stock exchange is between two investors ultimately, each investor trades through a security company. Secondly, even though the trade now is between the two security companies, the transaction is splintered further in that the SD&C takes the opposite position vis-à-vis each security company. In this way, individual investors don’t need to worry about the creditworthiness of the opposite parties to their trades and even the security companies don’t need to worry about the security companies trading with them because each of them really only trades with the SD&C. This is what it means for the SD&C to act as a central counterparty. P.V. Viswanath

9 Settlement procedure Each security company has an account with the SD&C and has been vetted as to its creditworthiness. Each securities company needs to open securities accounts with the SD&C to deposit the securities of its clients or its own securities. To perform settlement, the SD&C maintains – for its deliveries or receipts as a CCP – a Centralized Securities Settlement Account, and each settlement participant must – under its own name and legal person – open a Securities Settlement Account with the SD&C for securities deliveries or receipts between itself and the SD&C. Similarly, each settlement participant must open a dedicated cash account with one of the settlement banks as well as a Fund Settlement Account with the SD&C to deposit its minimum settlement reserve fund and to settle the cash positions between itself and the SD&C. In addition, the SD&C has opened a deposit account with each settlement bank for receiving and transferring the cash positions resulting from securities settlement. For cash settlements in its role as a CCP, the SD&C maintains in addition a Centralized Fund Settlement Account, from or to which the net cash proceeds are booked to or from the Fund Settlement Accounts of the settlement participants. P.V. Viswanath

10 Settlement procedure Clearing phase: At the end of the trading day T, the SD&C calculates the net amounts of cash and securities receivable and payable by each settlement participant according to the multilateral netting principle, and informs them accordingly before midnight (24:00) on T. Netting refers to the fact that instead of requiring each pair of parties to each transaction to exchange cash and securities, the SD&C nets across trades and computes the net amount due to or from each party. Thus, if a party needs to pay 1000元 on one trade and is due to receive 2000元 on another trade, it will only receive the net amount of 1000元. Settlement phase: At the end of day T (18:00), the SD&C completes in its role as a CCP the settlement of securities delivery obligations between itself and the settlement participants by directly debiting or crediting their Securities Settlement Accounts, with the securities being transferred on a final and irrevocable basis. For A shares and bonds, the net fund movement occurs one day after the final movement of securities: On T+1, each settlement participant with a payment obligation transfers the funds from its dedicated cash account to the deposit account of the SD&C with that settlement bank. At 16:00 on T+1, the SD&C completes the fund settlement by directly debiting or crediting the Fund Settlement Accounts of the settlement participants. For B shares, cash is paid on a net basis on T+3. The SD&C explained this longer settlement cycle by the different time zones involved for B share investors (e.g. Europe and the US). P.V. Viswanath

11 Early History of credit cards
The Bank of China offered the first credit cards in China in 1979, acting as an agent for non- Chinese banks such as the Chase Manhattan Bank. The Bank of China issued the first domestic credit card named the Great Wall Card in June In 1987, the BofC joined the international credit card associations of Visa and MasterCard and issued the first internationally accepted Great Wall MasterCard in 1989. The large debt levels plus the lack of nationwide processing and settlement networks or credit bureaus constrained the features of these early credit cards. Most of these cards did not provide interest free periods or revolving credit. They typically required a security deposit or payment guarantee before issuing a credit card. Foreign banks could enter China since the later 1970s; however, they operated under severe restrictions. When China joined the WTO in 2001, they had to agree to remove restrictions on foreign bank operations by 2007. Originally foreign banks could not offer RMB denominated services, but this restriction was lifted in December 2006; still limits on bank location and the services remained. Issuing plastic payment cards and credit cards gave foreign banks a way to evade branch banking restrictions. Sharpe, Deanna; Yao; Liao, Correlates of Credit Card Adoption in Urban China, J Family & Econ Issues (2012) 33: P.V. Viswanath

12 Credit card use in china
In a 2008 survey of national households, Sharpe, Yao and Liao found that wealthier families tended to use credit cards more. Also, younger individuals are more open to using credit cards for payments. However, many did not know about critical credit card features, 10% did not know of credit card risks or of interest increases after a late payment. 20% did not know about the consequences of default or of the penalty for a cash advance. Many customers being new to credit cards, have not managed to use them responsibly. In July 2009, the CBRC demanded that banks not offer gifts to new credit card holders, set sales quotas or issue cards to persons under 18. Still, credit card use in China is growing fast and there is a lot of competition amongst credit card issuers in China, who are using creative marketing techniques. Citic Bank uses the Ms. Magic credit card which offers free beauty treatments and health insurance. Huaxia Bank's Pretty Lady card, co-issued with Deutsche Bank, provides fitness club memberships and triple points for cosmetic purchases. Citigroup, in 2012, became the first U.S. bank allowed to issue its own solo logo cards in China. Interest rates fixed by the government at 18 percent annually, so banks compete by offering merchant discounts and gifts, including Coach wallets, Hugo Boss quilts, and free Starbucks upgrades to a larger coffee. In 2012, 46 million credit cards were issued in China, increasing the total in circulation to 331 million at the end of 2012, compared to 536 million cards in the U.S. Fees paid by retailers to banks whenever a customer uses a credit card range from zero for schools and public hospitals to 1.25 percent of the purchase price for entertainment and catering. In the U.S., retailers are charged about 2 percent. About 3 percent to 8 percent of cardholders in China roll over their debts, generating interest charges, compared with about 40 percent in the U.S. It costs 200 yuan to 300 yuan to issue one credit card (Richard Huang, a Beijing- based partner at Boston Consulting Group). P.V. Viswanath

13 How Credit Cards work Merchant Processor: Performs credit check on merchant, sells or leases a terminal, establishes a connection between merchant and the Credit Card processor Credit Card Association: Establishes rules and guidelines for card issuance and acceptance, markets brand name and various products. North American Credit Card Association is one such association. Visa, MasterCard, Discover, China UnionPay and American Express are also credit card associations that set transaction terms for merchants, card-issuing banks, and acquiring banks. Acquiring Bank: A bank or financial institution that processes credit or debt card payments on behalf of a merchant. Card Issuer: Establishes criteria to approve or deny applicants and sets credit limits, interests rates, and fees. Ultimate risk taker. These are the actual issuers, e.g. Discover, Capital One, Barclays, Chase and many other banks issue credit cards. Credit Card Processor: Receives and processes credit card applications, maintains cardholder data. Visa, MasterCard, Discover and American Express process payments. Discover and American Express issue credit cards as well. Credit Card Transaction example of a $100 purchase by consumer using Visa or MasterCard: $2 discount fee charged to merchant by acquirer/processor, which includes: $1.50 interchange fee paid to card issuer $0.10 assessment fee paid to card association (Visa/MasterCard) $0.40 merchant processor fee $98 credited to merchant for the transaction P.V. Viswanath

14 Credit Card Transaction Process
Automated Clearing House From: Ramon P DeGennaro. “Merchant Acquirers and Payment Card Processors: A Look inside the Black Box,” Economic Review - Federal Reserve Bank of Atlanta. Atlanta: First Quarter Vol. 91, Iss. 1; pp P.V. Viswanath

15 Union Pay The Chinese Government created China UnionPay Co. as a bankcard association in 2002 to form a strong electronic payments infrastructure. In this capacity, UnionPay operates an inter-bank transaction settlement system. The government requires that all automated teller machines and Chinese merchants use UnionPay's electronic payments network to process payments in the local currency. The rule extends to Visa, MasterCard, and American Express, which typically give UnionPay a cut of each transaction. This provides UnionPay with a strong advantage over competing bankcard associations such as Visa and MasterCard. UnionPay also had 2.9 billion cards in circulation in 2011 – equal to 45 percent of the world's total. Accepted in 135 countries, its share of global credit- and debit-card transaction volume for the first half of 2012 rose to 23.8 percent, propelling it to No. 2 behind Visa International, according to the Nilson Report, an industry newsletter. In 2013, UnionPay became largest: when comparing debit card purchase volume, UnionPay’s share increased by 7.38% to percent. Visa’s share fell 6.05% to percent, and MasterCard’s share declined by 1.33% to percent.  This made UnionPay the largest general purpose debit card band based on the purchase volume. P.V. Viswanath

16 Bank cards The main driver of revenue growth has been debit cards: UnionPay had $2.1 trillion in debit-card transactions and credit-card volume of $660 billion last year, according to Nilson Report. In addition, UnionPay has a card processing subsidiary, China UnionPay Data. Another subsidiary, China UnionPay merchant acts as a sales organization for credit card issuers, acquiring merchants for its members. Before UnionPay’s centralized payments network, each bank had to form its own merchant relationships for card acceptance. China's receivables from credit cards could rise 40 percent annually to reach 2.5 trillion yuan ($397 billion) by 2015, according to a 2011 report from Boston Consulting Group; this implies a 2011 number of about $105bn. This compares to a Federal Reserve’s Consumer Credit report that consumers carried a total of about $800bn. in outstanding balances on their revolving accounts as of the end of 2011. P.V. Viswanath

17 E-commerce E-commerce is becoming more and more popular in China. McKinsey Global Institute predicts that China’s total e-commerce market could be worth $650 billion by (Bloomberg BusinessWeek, Feb. 18, 2014, “The Secret of Taobao’s Success.”) In 2005, a new law came into effect stipulating that that “digital documents shall have same effect with those in paper form, so that traditional civil law could also apply to digital documents.” Procedures for accepting electronic signatures are also laid out under the law, which helps e-commerce tremendously. Taobao is the most successful e-tailer. Taobao was established by Alibaba in May 2003 and took off because in its early years, it charge no transaction or listing fees. According to Prof. Barney Tan, this is because “Taobao has catered to Chinese preferences for doing business—for example, it’s enabled buyers and sellers to negotiate and bargain on prices.” Given common (often warranted) fears about being cheated online, Taobao has also “incorporated an optional escrow service to allow shoppers to pay for goods only after they’ve received and inspected them.” Its Alipay system, which somewhat resembles PayPal, can debit a Chinese bank account, so no financial card is required for online shopping sprees. (Bloomberg Business Week and Lixia and Xun, Proceedings of the 2009 Int’l Symposium on Web Information Systems and Applications, 2009, pp ) P.V. Viswanath

18 A different Chinese model: online malls
In developed nations, the retail industry began with the rise of regionally dominant players. This field then consolidated into a smaller number of national leaders. Eventually, online players challenged them, and the industry became multichannel. Some brick-and-mortar players (Tesco and Wal-Mart Stores, for instance) have embraced a multichannel strategy, while others (such as Borders in the United States and Jessops and Woolworths in the United Kingdom) have been driven from the market. In China, there are no traditional retailing giants. Building stores across China’s considerable geography, with its many smaller cities, takes both time and high levels of investment. As a result, China’s largest brick-and-mortar retailers have captured a smaller share of the country’s overall retail market: the top five retailers by category hold less than 20 percent of the market—much lower than US levels of 24 to 60 percent in comparable categories. China’s online ecosystem of marketplaces and agile support services has grown rapidly precisely because it can exploit the inefficiencies and higher costs of China’s existing retail market. The major online companies Alibaba (which owns marketplaces such as Taobao) and (focusing on sales of electronics) have established a prominent national role, ranking among China’s top ten retailers. Apparel, recreation and education, and household products are the three largest online retail segments in China. As competition among e-tailers has lowered prices, it has also both increased the size of the consumer market and created efficiencies in the important adjacent markets that support e-commerce—logistics, supply chains, IT services, and digital marketing. However, there is a growing talent shortage in e-tailing resulting from heady growth. It is still an open question as to whether individual e-tailers will overtake online malls. P.V. Viswanath China’s e-tail revolution, Mckinsey Global Institute Report, March 2013, Dobbs et al.

19 Mobile payments According to John Heggestuen on Business Insider (Feb. 14, 2014), the PBOC is establishing a new national mobile payments platform. This will provide provides a single mobile payments infrastructure for all financial institutions and mobile operators. The new system was developed for NFC-based smartphone payments, which require users to move their mobile phones in close proximity to a scanner in order to make a payment. However, NFC-based proximity payments accounted for just 0.8% of payments made with mobile devices in China in 2013, according to iResearch. On the other hand, “According to Datamonitor's 2012 Financial Services Consumer Insight Survey, a staggering 81.7% of Chinese consumers are interested in gaining the ability to pay for things in shops using their mobile phones. This compares to only 49.0% of UK consumers, and a low of 36.2% among Dutch consumers.” Furthermore, right now, the relatively high cost of smartphones puts them out of the reach of many Chinese citizens. This means that mobile payments are unlikely to be widely used. Finally, the Chinese government on March 24th 2014 announced limits on the amount Chinese can spend using smartphone payment services. This will affect the business plans of Alibaba Group and Tencent Holdings, who have been rushing to release products helping smartphone users shop with their phones. This may be related to the fact that “over the past year, Alibaba and Tencent have attracted tens of billions of dollars by marketing online investment products that feature higher returns than those on savings accounts offered by state banks. The success has sent ripples through China's state-dominated and heavily regulated financial industry, as many younger Chinese have transferred their savings from the banks into the online products.” (WSJ, March 24th 2014). China Construction Bank (among other major banks) imposed a limit of 5000 元 (and 50K/month) on transfers to Alibaba‘s Yu’E Bao fund, and 10K元 (50K/month) for Tencent's online product. Furthermore, the PBOC has suggested that online investment products could be forced to hold reserves on funds they attract—much like banks on their deposits. P.V. Viswanath

20 Themes A dependable payments system is the backbone of a financial system. China has realized the importance of a payments system and has worked hard to improve payments systems for transactions. In keeping with the growing importance of securities markets, China has also developed a dependable clearing system for the stock market and for the bond market. Cash is very important as a medium of payment in China; however, non-cash payments are slowly increasing in importance. Online transactions are booming and mobile payments systems are increasing in importance. P.V. Viswanath

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