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Japan's Payment and Settlement Systems and the Bank of Japan

Speech given by Toshiro Muto, Deputy Governor of the Bank of Japan, at a meeting commemorating the 20th anniversary of the Center for Financial Industry Information Systems in Tokyo on December 3, 2004

March 24, 2005
Bank of Japan

Contents

  1. Introduction
  2. I. Payment and Settlement, and the Bank of Japan
  3. II. Promoting the Safety and Efficiency of Payment and Settlement Systems in Japan
  4. III. Retail Payments
    1. A. Cash
    2. B. Various Non-Cash Payment Instruments
    3. C. Electronic Payment of Treasury Funds
  5. IV. Large-Value Payments
    1. A. Changeover to the New RTGS System
    2. B. Further Improvement in Large-Value Payment Systems
    3. C. Reduction of Settlement Risk in Foreign Exchange Transactions
  6. V. Securities Settlement
    1. A. Delivery versus Payment
    2. B. Straight-Through Processing
    3. C. Dematerialization of Securities
    4. D. Shorter Settlement Cycles
  7. VI. Strengthening Business Continuity Planning
  8. VII. Oversight of Payment and Settlement Systems by the Bank of Japan and Efforts of the Private Sector to Improve Payment and Settlement Systems
  9. VIII. Conclusion

Introduction

It is a great privilege to speak at this meeting commemorating the 20th anniversary of the founding of the Center for Financial Industry Information Systems (FISC).

Since its establishment, FISC has been engaged in research and analysis of important issues concerning the use of information systems by financial institutions and their IT security measures. The center has also been active in putting forward various proposals regarding guidelines for system auditing and security standards for computer systems. FISC's endeavors over the years have contributed greatly to strengthening Japan's financial system in a situation where the financial services sector has become increasingly dependent on IT systems. On behalf of the Bank of Japan, I would like to express our deep respect and gratitude for the hard work done by FISC.

To make the most of this valuable opportunity, I will talk about Japan's payment and settlement systems, the topic most relevant to the activities of FISC.

I. Payment and Settlement, and the Bank of Japan

In a monetary economy, most economic transactions of firms and households entail settlement, that is, transfer of money. Physical delivery of cash is used only in relatively small-value face-to-face transactions. Other transactions are mostly settled by transfer of money deposited at banks, and thus, banks play a vital role in settlement. If the payer and payee hold accounts at different banks, funds also need to be transferred between the two banks. This transfer of funds is normally carried out by debiting and crediting the current account deposits these two banks hold with the central bank. One of the essential functions of the Bank of Japan, as "the bank for banks," is to ensure safe and smooth interbank funds transfers through its settlement services. The Bank undertakes a number of tasks as the country's central bank, but as the name--the Bank of Japan--indicates, its most fundamental business is banking. Monetary policy, which is another important mission of the Bank, is also implemented through its banking operations as it provides funds to the market by conducting various financial transactions based on policy directives.

The Bank of Japan was founded in 1882, and according to the documents recommending its establishment submitted by the then Minister of Finance Masayoshi Matsukata to the Prime Minister (Dajou-Daijin) Sanetomi Sanjo, one of the major aims of establishing the Bank was to develop an efficient correspondent banking network linking the nation's banks and enable funds to be lent and borrowed to even out excesses and shortfalls of funds across the economy. It is evident that creation of a nationwide financial market and an efficient payment system was a major policy objective of the Bank from the time of its foundation. The fundamental function of the central bank has not changed: it is, in modern terms, to provide safe and secure settlement assets, namely banknotes and current account deposits, and based on these to provide safe and efficient settlement services.

II. Promoting the Safety and Efficiency of Payment and Settlement Systems in Japan

Let us look back at the changes in the environment surrounding payment and settlement systems in Japan since the foundation of FISC in 1984. The most notable change in the past 20 years has been an expansion in the settlement volume reflecting the huge leap in financial transactions due to the liberalization and globalization of financial markets.

The first and most important task for operators of payment and settlement systems and other relevant parties was how to cope with an increase in operational costs associated with settlement, which was brought about by the expansion in settlement volume. It had become increasingly difficult to process manually the swelling volume of transactions at low cost and in an efficient manner with the conventional paper-based settlement procedures. "Automation" was in order.

To address the great expansion in settlement volume, the systems' operators have striven to reduce operational costs by improving efficiency through the introduction of online systems, made possible by the progress in IT. For example, the Bank of Japan Financial Network System, the BOJ-NET, an online system linking the Bank and financial institutions, started operation in 1988. It may be hard to imagine today, but before it started operation, payment instructions for settlement using current account deposits at the Bank were submitted by delivering checks by hand. In those days, it was a familiar sight in the area around the Bank building to see clerks on bicycles carrying such checks. Settlement through online systems has since been realized for wholesale transactions of securities, such as Japanese government securities (JGSs), stocks, corporate bonds, and CP. More recently, online services using the Internet have become widely available for retail transactions by individuals, such as credit transfers and stock trading. The use of online trading and settlement systems has brought about efficiency gains in the overall economy as it greatly reduces costs, making it possible to reallocate the resources saved to other productive areas.

The second task for payment system operators and others concerned was to manage and reduce settlement risk, which rises with an increase in the volume of transactions settled. To give you an idea of the size of transactions settled daily through major payment systems in Japan, here are some figures: the BOJ-NET Funds Transfer System settles transactions to a total value of approximately 78 trillion yen; the Foreign Exchange Yen Clearing System (FXYCS), a clearing system for the settlement of the yen leg of foreign exchange and offshore transactions, settles some 19 trillion yen; and the Zengin Data Telecommunication System (Zengin System), a clearing system for credit transfers and remittances, some 9 trillion yen. If, for some reason, one of the participants in these systems should fail to settle, this could have a domino effect on other participants. Reduction of such risk, referred to as systemic risk, is obviously of utmost importance.

I cannot deny that the importance of managing settlement risk was not given due attention in the past: there was a long-held belief that no Japanese bank would ever fail. However, since the mid-1990s, the heightened concerns about financial system stability after a series of failures of financial institutions has greatly raised awareness regarding the need for sound management and further reduction of settlement risk. Owing to steady and continuous efforts of operators and other parties concerned in the years since then, the safety of Japan's payment and settlement systems has greatly improved.

Next, I would like to explain in some more detail the initiatives taken by payment system operators and others to date to improve the safety and efficiency of Japan's payment and settlement systems and also discuss the tasks that lie ahead of us. Payment and settlement systems are often broadly classified by the type of transactions they handle, namely retail payments, large-value payments, and securities settlement. There is no clear demarcation line between the first two groups. In general, however, large-value payments are those involving large amounts of money per transaction, usually settlement of money market or foreign exchange transactions between financial institutions. Retail payments, on the other hand, are a huge volume of small-value transactions, such as payments for purchases of goods and salary payments. Securities settlement is delivery of a security from a seller to a buyer, but it also involves a corresponding transfer of funds. Furthermore, there are processes prior to settlement, such as trade confirmation and matching, and corresponding cash leg processes, which are all closely related to delivery of securities. I would like to proceed to discuss developments in different types of payment and settlement systems in Japan based on this classification.

III. Retail Payments

A. Cash

First, I would like to discuss retail payments. There is no doubt that cash, comprising banknotes and coins, is the most popular retail payment instrument for face-to-face payments in Japan. It is impossible to measure the exact amount of payments made in cash, but the ratio of cash in circulation to nominal GDP, which is helpful as a broad indication of the level of its use in the economy, is particularly high in Japan compared to other major countries, as is evident from Chart 1. The long-term trend of the ratio of banknotes in circulation to nominal GDP in Japan from 1900 onward in Chart 2 also suggests that cash has been popular in Japan for a long time. Looking at recent developments, the ratio has been at a much higher level and has almost doubled in just ten years. This is due mainly to an increase in cash held at home instead of as bank deposits, against the background of low interest rates and increasing concerns about financial system stability from the late 1990s. The ratio is likely to return to the long-term trend at some point in the future, but even without the recent rise off the trend, it is clear that banknotes have been heavily used in Japan for a long time. This may seem strange, because the advent of a society where non-cash payment is dominant and cash payment is obsolete had long been prophesied. The wide use of cash in Japan is often explained as a cultural preference. However, I think there are more practical reasons. Cash payment is used widely because of its convenience and safety, and we should not forget that this has been achieved thanks to the efforts of a broad range of parties. For example, the number of cash dispensers (CDs) and automated teller machines (ATMs) in Japan is very large compared with other countries. With this highly developed nationwide network, cash can be obtained very readily in Japan. Another important point is that people feel safe carrying cash around in Japan, where crime rates have long been comparatively low.

B. Various Non-Cash Payment Instruments

Turning to payment instruments other than cash, various methods are used for retail payments, such as credit transfers, credit cards, and checks. Interesting differences can be observed among countries with regard to the use of these instruments. For example, credit transfers and direct debits are frequently used in Japan, while in the United States the use of checks remains most prevalent followed by credit cards. In Europe, in addition to credit transfers and direct debits, use of debit cards is relatively common. These national differences have to a large extent resulted from the diversity in the historical development of the banking systems. For example, a decentralized banking structure is often cited as one of the factors behind the fact that credit transfers are less used than checks in the United States.

Japan, on the other hand, has not had to bear the huge cost of handling checks, since individuals rarely use them. In 1973, the Zengin System, an online network system for credit transfers and other retail payments, was introduced, connecting almost all bank premises in Japan and replacing the previous paper-based processing. Since then, the Zengin System has served as the major Japanese retail payment system. It can effect a vast volume of credit transfers anywhere in the country on the same day in a very efficient manner, which is outstanding performance even for a major industrial country. Consumers in Japan may not be aware of the efficiency with which the system supports their everyday life, but I believe we should all be proud of it.

Retail payment services are a field where private-sector initiatives to advance innovation play an important role. Indeed, with continued technical innovation, the variety of payment instruments available to consumers has expanded and the quality of payment services has improved. Electronic access channels for banking services have also diversified, with new channels such as the Internet and mobile phones. In addition to payments by credit card and debit card, payments by prepaid cards using the contactless chip technology, which allows information stored in the card to be read without physical contact between the card and card reader, have attracted more customers recently, and the range of services offered through these interfaces has expanded.

C. Electronic Payment of Treasury Funds

I would like to touch briefly on recent developments in retail payment of treasury funds. Payment of taxes and receipt of social security benefits are typical retail payment transactions, and efficiency in the processing of these transactions is also making steady progress thanks to the efforts of all concerned. In addition to government disbursements of treasury funds which were already effected electronically, electronic payment of government taxes and fees through Internet banking services and through ATMs provided by financial institutions was introduced in January 2004. This has enabled taxpayers to make treasury funds payments from virtually anywhere in the country and at any time of day and night. This has not only made payment more convenient for taxpayers, but also streamlined administrative work for the institutions involved. The Bank has endeavored to promote progress in electronic payment of treasury funds through many initiatives in line with the government's "e-Government projects" and in cooperation with the private sector.

IV. Large-Value Payments

Next, I would like to discuss the second category of payment and settlement systems, those for settling large-value payments. It is important to note that systemic risk, which I mentioned earlier, is potentially larger for these systems than for retail payment systems, since the average value per transaction is greater.

A. Changeover to the New RTGS System

In order to prevent systemic risk from materializing, unceasing efforts have been made by operators and other relevant parties to improve the safety of Japan's payment and settlement systems. A system that achieves a high standard of safety tends to be expensive to use, and no matter how safe it is, it will be useless if market participants avoid using it due to the high cost. Improvement of the efficiency and convenience of payment and settlement systems is therefore also essential. The need to improve these systems concerns not only those in the private sector, but also the system operated by the Bank. The most important measure taken in this regard by the Bank was the changeover to the new RTGS system by the BOJ-NET--the central bank's online network system for the settlement of funds and JGSs--in January 2001, making RTGS, which I will discuss next, the only settlement mode.

RTGS, as you know, stands for real-time gross settlement. Simply put, it is a settlement method in which payment instructions sent by private-sector financial institutions for funds transfer through current accounts at the central bank are processed immediately and individually upon receipt. In the past, the use of designated-time net settlement mode was dominant. Payment instructions were accumulated until certain designated settlement times, and net amounts of payments and receipts (net settlement positions) were calculated and settled. Compared to this mode, RTGS considerably reduces systemic risk that can materialize when even one financial institution is unable to settle its net settlement position.

When it started operation, the BOJ-NET provided both RTGS and designated-time net settlement modes. In practice, however, the use of RTGS mode was very limited; most participating financial institutions chose the designated-time net settlement mode because RTGS is less efficient in terms of liquidity. Nevertheless, the Bank considered it necessary to make RTGS the only settlement mode for the BOJ-NET in order to reduce settlement risk. In cooperation with relevant parties, the Bank started planning and preparing for the changeover to the new RTGS system, allocating a vast amount of manpower and capital. The Bank changed over to the new RTGS system in January 2001, generally abolishing the designated-time net settlement mode for both funds and JGSs settled through the BOJ-NET. Significant progress has been made in terms of the safety of Japan's large-value payment system as a result of the changeover.

At the same time, it posed a new challenge to participating financial institutions. In the designated-time net settlement mode, financial institutions only needed to have funds equivalent to their net debit positions at each designated settlement time. RTGS, on the other hand, requires financial institutions to hold greater liquidity during the day because payments are not settled on a net basis. In order to support financial institutions' liquidity management, the Bank introduced, at the time of the changeover to the new RTGS system, an intraday overdraft facility, which promptly provides financial institutions with the necessary liquidity within the amount of their collateral deposited at the Bank. This facility has contributed to the smooth operation of the RTGS system to date. However, we should note that there are costs borne by financial institutions in the form of the collateral needed to obtain the necessary liquidity for settlement. These costs can be seen as the price paid for the safety of the funds transfer system, and ultimately the overall financial system, assured by RTGS. Nevertheless, these costs can be reduced if the RTGS system is improved further and measures are taken to enhance efficiency in terms of liquidity without sacrificing the safety of the funds transfer system. In other words, the challenge that lies ahead for the operator and financial institutions is to improve the efficiency of the funds transfer system while maintaining its safety, by devising ways to further reduce the amount of intraday liquidity necessary for smooth operation of the RTGS system.

B. Further Improvement in Large-Value Payment Systems

In March 2004, the Japanese Bankers Association (JBA) released a report titled "Proposal for Reorganizing Fund Transfer Systems in Japan." In the report, the JBA proposed that all transactions that are currently settled on a designated-time net settlement mode through the FXYCS and large-value transactions settled through the Zengin System be shifted to the BOJ-NET Funds Transfer System. At the same time, the JBA suggested that the BOJ-NET Funds Transfer System needed to be enhanced by introducing facilities that would reduce the amount of intraday liquidity market participants have to hold during the day in an RTGS environment. Specifically, the JBA proposed introduction of a "queuing facility" and an "offsetting facility." A queuing facility allows payment instructions to be held pending by the system, without being canceled, until sufficient funds are made available with incoming payments. A system with an offsetting facility automatically checks whether there are outgoing and incoming payment instructions in the queue that can be offset so that they can be settled simultaneously, and if there are, immediately processes those identified. These new facilities have been widely adopted by RTGS systems in Europe and other countries, against the background of progress in IT and users' need for more advanced funds transfer systems.

The Bank is also very much aware that it is vital to achieve both efficiency and safety in payment and settlement systems, and considers the initiatives taken by the JBA very valuable. At the same time, in order to implement the JBA's proposals, we believe a number of issues remain to be discussed among operators and other relevant parties, such as the development of market practices suitable for the new facilities, and the roles to be played by different payment systems within the overall financial system. The Bank is currently studying the proposals thoroughly, taking into account the progress in discussions by those concerned.

C. Reduction of Settlement Risk in Foreign Exchange Transactions

As I mentioned earlier, large-value payments are mostly payments for financial market transactions. Foreign exchange transactions are a typical example of such transactions. Foreign exchange transactions of a tremendous value are conducted in the global financial markets every day. The average daily turnover in global foreign exchange transactions was almost 1.9 trillion U.S. dollars in April 2004, according to the results of the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity released by the Bank for International Settlements (BIS) in September 2004 (see Table 1).

Central banks have been cooperating in measures to reduce foreign exchange settlement risk. They have encouraged financial institutions to reduce this type of risk, and this has led to a private-sector initiative establishing the CLS system, a cross-border mechanism for the settlement of multiple currencies, which started operations in 2002. CLS stands for "continuous linked settlement": it is "continuous" because payment instructions arising from foreign exchange transactions are settled continuously during the settlement periods, and "linked" because "settlement" of one leg of a transaction takes place if and only if a settlement of the other leg takes place.

In order to show how effective this "linked settlement" procedure is, I will explain in more detail foreign exchange settlement risk. Where the CLS system is not used, a transaction to sell, for example, the yen in exchange for the U.S. dollar typically has to be settled through two separate settlement arrangements, one in each country. The time-zone difference between two countries means that the two sides of each transaction are effected at different times--for example, the yen settlement in Japan typically precedes the dollar settlement in New York, as New York time is half a day behind Japan. Because of this time-lag between the settlement of the two legs, the counterparty that has completed delivery of the currency concerned faces the risk of not receiving the currency that it was supposed to be paid in return in the event the other party suddenly becomes bankrupt. This is foreign exchange settlement risk, sometimes called "Herstatt risk." In this example, the seller of the yen, in other words the buyer of the U.S. dollar, faces the risk that it might not receive the dollar for some hours until the settlement is completed in New York. Due to the time-zone difference, Japan is one of a number of countries exposed to significant foreign exchange settlement risk.

In order to reduce foreign exchange settlement risk, major global financial institutions launched the CLS system in September 2002. Using the previous example, under the CLS system, the yen is settled only when the U.S. dollar is settled and vice versa, greatly reducing foreign exchange settlement risk. This settlement method is called payment versus payment (PVP). The CLS system started operations with seven major currencies, including the Japanese yen, the U.S. dollar, the euro, and the pound sterling, and with the subsequent inclusion of three Scandinavian currencies and the Singapore dollar, it now handles eleven currencies. It plans to include four more currencies, the Hong Kong dollar, the South Korean won, the New Zealand dollar, and the South African rand, by the end of 2004.1

In order to support the private-sector initiatives for reduction of settlement risk in foreign exchange transactions through the CLS system, the Bank gave permission to the CLS Bank, established in New York, to open a current account at the Bank. This has enabled RTGS processing of the yen leg of foreign exchange transactions between the CLS Bank and settlement members of the CLS system over the central bank accounts. In addition, the Bank has extended the operating hours of the BOJ-NET Funds Transfer System and the FXYCS (gross settlement mode) to 7:00 p.m. Japan Standard Time (JST) from 5:00 p.m. for financial institutions that have applied in advance. This has increased the overlap between the operating hours of the Japanese systems and those of RTGS systems in other countries. Today, large values of foreign exchange transactions are settled on a PVP basis among settlement members of the CLS system across the globe. In winter, transactions are settled between 3:00 p.m. and 6:00 p.m. (JST) in Japan, 7:00 a.m. to noon Central European Time in Europe, and early in the morning between 1:00 a.m. and 6:00 a.m. Eastern Standard Time in North America.2

While the CLS system is certainly an effective way of reducing foreign exchange settlement risk, not all foreign exchange transactions are settled using it. The level of foreign exchange settlement risk can be controlled in other ways as well, for example, by appropriately setting a limit on settlement exposure of each counterparty and monitoring the exposures against those limits. Each financial institution should establish its own policy on managing foreign exchange settlement risk, which clearly defines the responsibilities of the senior management; appropriately measure its exposures; decide on the risk reduction and management measures that best suit its business; and make efforts on a continuing basis to improve those measures. The Bank will continue monitoring closely their efforts to this end.

  1. The four currencies joined the eleven existing currencies on December 7, 2004.
  2. Settlement for Asia-Pacific currencies takes place during a three-hour window, which is two hours less than that for other currencies.

V. Securities Settlement

So far, I have looked at developments in payment systems. Now I will turn to securities settlement systems and discuss various efforts made in this area.

Securities settlement is a transfer of securities from the seller to the buyer, but it naturally involves a corresponding transfer of funds from the buyer to the seller. Settlement of securities and funds is so closely related that the design of securities settlement systems has a great influence on the safety of funds settlement. This is why the Bank operates the settlement system for JGSs and also has a strong interest in the risk management measures of settlement systems for other securities.

A. Delivery versus Payment

Various reforms have been implemented on securities settlement systems in Japan over the past few years. One of the goals of these reforms has been the introduction of delivery versus payment (DVP)--a mechanism similar to PVP in the settlement of foreign exchange transactions that I explained earlier. Specifically, DVP is "a link between securities and funds transfer systems that ensures that delivery occurs if, and only if, payment occurs, and vice versa." This mechanism eliminates principal risk attached to the settlement of securities transactions, which may in some situations result in enormous losses. DVP settlement was first realized for JGSs in 1994, by linking the BOJ-NET JGB Services and the BOJ-NET Funds Transfer System. Later, DVP was also introduced for the settlement of other securities, namely corporate bonds, short-term debentures (i.e., dematerialized CP), and stocks, through coordinated efforts between operators of securities settlement systems, the Bank, and other relevant parties. The Bank is currently working with the Japan Securities Depository Center (JASDEC) to introduce DVP for dematerialized corporate bonds, which I will explain later. When this is realized, DVP will be available for all major securities traded in Japan. The Bank has contributed to enhancing the safety of Japan's securities settlement systems through its support for introduction of DVP in these systems.

B. Straight-Through Processing

Another goal of securities settlement reforms is the introduction of straight-through processing (STP), or automated processing of transactions from trade to settlement without the need for re-keying or re-formatting settlement instructions. STP enhances efficiency and safety in the processing of securities transactions. Until recently, Japan had been relatively slow to introduce STP, but STP initiatives in the private sector are now gaining momentum and significant efforts are being made to introduce and link online systems for processing pre-settlement procedures, including confirmation of settlement instructions.

C. Dematerialization of Securities

Securities in the form of physical certificates are an obstacle to achieving DVP and STP. For example, for DVP, the processing of the transfer of securities and funds cannot be linked if securities are delivered physically while funds are settled online through the BOJ-NET Funds Transfer System. In addition, STP cannot be realized if the burdensome delivery of physical certificates has to be carried out. Dematerialization of securities is therefore an important step in laying the groundwork for securities settlement reforms. In fact, more than 99 percent of JGSs have for many years existed not in physical but in book-entry form--as electronic records on the books of the Bank--but the law concerning JGSs was until very recently based on the assumption of their existence in physical form. In January 2003, the Law Concerning Book-Entry Transfer of Corporate and Other Debt Securities, which provides the uniform legal framework for securities settlement in Japan, came into effect. By enabling dematerialization of various types of debt securities, namely JGSs, corporate bonds and debentures, and CP, the law establishes a solid legal framework to support the reform of securities settlement in Japan. Subsequently, a law rationalizing settlement of stocks was enacted in 2004, providing a legal basis for dematerialization of stocks. Dematerialization of stocks is scheduled to be realized by 2009.

Significant progress has been made in securities settlement in the past few years with the introduction of DVP and STP arrangements and establishment of a legal framework enabling dematerialization of securities. As a result, securities settlement in Japan now approaches the high level of safety and efficiency needed to meet, and in some aspects exceed, international standards.

D. Shorter Settlement Cycles

In addition to achieving more efficiency through the promotion of STP, one of the major tasks that remain for improving securities settlement in Japan is a further reduction of settlement risk by shortening settlement cycles. In Japan, outright sales/purchases of JGSs are settled three business days after the trade and repurchase agreement (repo) transactions two business days after the trade. In the United States, the same transactions are completed on the next business day and on the trade date. Government securities are generally the safest and most liquid financial assets, but the potential advantages of JGSs cannot be fully enjoyed by market participants unless settlement cycles are shortened. The promotion of STP and other measures to improve securities settlement systems will provide the environment necessary for shorter settlement cycles. The Bank plans to work cooperatively with operators of securities settlement systems and other relevant parties to explore what other measures are necessary to shorten settlement cycles.

VI. Strengthening Business Continuity Planning

I have outlined the situation and issues facing Japan's payment and settlement systems and how the Bank has been supporting their development. Foreign central banks are also striving to improve payment and settlement systems in their countries. As part of these efforts, central banks are recently putting emphasis on strengthening their business continuity planning in order to be prepared for emergencies, including natural disasters and terrorist attacks. This is because business continuity planning is important for increasing the safety of payment and settlement systems, as the events of September 11, 2001 in the United States made all too clear. The terrorist attacks had devastating effects on the financial markets. For example, three stock exchanges in New York had to be closed for four business days. Trading in U.S. Treasuries was suspended for two business days, and even after it resumed, a large volume of transactions remained unsettled for almost a week.

The Bank has a long history in preparing for disasters, as it has many times overcome tremendous difficulties in past emergencies to fulfill its responsibilities as the nation's central bank. Back in 1923, when the Great Kanto Earthquake hit the Tokyo area, the Bank continued to provide its services in the Head Office building, which withstood the earthquake, without even a day's interruption. In 1995, the Great Hanshin and Awaji Earthquake hit major cities in western Japan, and the damage it caused was so severe that the Kobe Clearing House ceased to operate for five business days and about half of the branches of financial institutions in the area were temporarily unable to carry out business operations. The Bank's Kobe branch strove to restore banking services in the area by, for example, ensuring a smooth supply of cash and offering private financial institutions temporary counters on its own premises. The lessons learned from these and other experiences have been reflected in the Bank's contingency planning to enable it to perform its function of providing "last resort" support for maintaining stability in the overall financial system in times of emergency.

In recent years, the Bank has been strengthening its arrangements for business continuity and recovery to be prepared for not only natural disasters but also terrorist attacks and other types of threats. Specifically, the Bank has identified a number of emergency scenarios, determined which of its business operations should be given high priority in each case, and prepared the necessary backup facilities. The Bank has also established arrangements for setting up a disaster management team and made staffing arrangements so that it can secure necessary personnel in order to initiate disaster response procedures and carry out critical business operations both at the Head Office and branches promptly in emergencies. The Bank is also equipped with a wide range of means of communication, including ones which will not be swamped with calls, to ensure smooth and swift communication within and outside the Bank.

After September 11, 2001, central banks began to review and reinforce their business continuity plans taking into account the possibility of wide-scale disruptions. Up until then, they had developed their plans mainly assuming emergency situations in which damage occurred in certain limited areas or facilities such as their head offices and computer centers. The terrorist attacks, however, demonstrated the need for business continuity planning addressing wider disruption. The Bank had been prepared for this kind of damage for many years through its preparation for earthquakes. Even before September 11, it had made arrangements to continue critical business operations as Japan's central bank even in such case as when an earthquake hits a large part of the Kanto region, where the Tokyo metropolitan area is located, and no contact can be made between Tokyo and Osaka, Japan's second largest city which is located 500 kilometers from the capital, for two days. Among other arrangements, the Bank established a backup computer center in Osaka. By using this facility and staff at the Osaka branch and nearby branches as backup, the Bank would be able to continue operating the BOJ-NET and other business operations critical for maintaining the functions of payment and settlement systems in Japan. To make sure that staff can implement these emergency measures smoothly, the Bank has prepared operating manuals, carried out drills, and arranged housing and accommodation for key personnel near the Tokyo Head Office and the backup facilities in Osaka.

In emergencies, it is crucial to ensure provision of electricity, water, and gas. Likewise, it is extremely important to continue to provide the basic functions of payment and settlement systems since they underpin economic activity. In the "Strategic Framework for Fiscal 2004," which outlined the issues that should be tackled by the Bank in fiscal 2004, it was stated that the Bank would enhance its crisis management capability to prepare for disasters and other emergency situations. The Bank will continue to improve its business continuity plans. However, we cannot by our efforts alone increase the overall resilience of Japan's financial system and financial markets. Coordinated efforts by private financial institutions, payment and settlement system operators, and the Bank are essential. It is, therefore, very encouraging that frequent discussions are taking place in the private sector on measures to strengthen business continuity arrangements. The Bank is committed to enhancing the resiliency of Japan's payment and settlement systems and will continue its efforts, working in close cooperation with the private sector.

VII. Oversight of Payment and Settlement Systems by the Bank of Japan and Efforts of the Private Sector to Improve Payment and Settlement Systems

Today, I have talked mainly about the Bank's role as a provider of settlement assets and settlement services. Another important role of the Bank related to settlement, as with other countries' central banks, is to promote the safety and efficiency of private-sector payment and settlement systems. Central banks monitor and analyze the systems, and when necessary, encourage operators to improve them. This is referred to as "oversight." The Bank holds discussions and exchanges views with operators of private-sector systems, encouraging them to take appropriate measures to manage and reduce risks associated with the design and operation of the systems. Through its oversight activity, the Bank aims to ensure that the smooth operation of Japan's payment and settlement system as a whole is not disrupted, even if a problem materializes in a payment and settlement system or at an individual participant. The Bank conducts oversight in accordance with internationally accepted safety and efficiency standards that payment and settlement systems are recommended to meet.

Payment and settlement systems subject to central banks' oversight are not limited to domestic systems. Due to the globalization of financial markets and payment and settlement systems, a framework for cooperative oversight has been established among the G-10 central banks. Thus, for example, the Bank conducts oversight of the CLS system, the cross-border payment system that I discussed earlier, in cooperation with the issuer central banks of the currencies the system handles.

I must emphasize that while central bank oversight of private-sector payment and settlement systems plays an important role in enhancing their safety and efficiency, the primary responsibility lies with the operators and participants. The safety and efficiency of the systems depend primarily on their discipline and efforts. To make this point clearer, I will briefly describe the risk management measures of payment and settlement systems. Major international standards for the risk management of designated-time net settlement systems are minimum standards for netting schemes set out in the Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (the Lamfalussy Standards). In the case of Japan's systems, the Zengin System and the FXYCS are both designated-time net settlement systems, and they have striven to meet the standards. Some of the key recommendations in the Lamfalussy Standards are as follows. First, multilateral netting systems should have clearly defined procedures for the management of credit risks and liquidity risks which specify the respective responsibilities of the netting provider and the participants, and these procedures should also ensure that all parties have both the incentives and the capabilities to manage and contain each of the risks they bear. Second, limits need to be placed on the maximum level of credit exposure that can be produced by each participant. And third, multilateral netting systems should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net debit position. In line with the recommendations, the Zengin System has in place risk management measures which require member banks to submit collateral totaling almost 11 trillion yen to cover the maximum level of credit exposure. It is agreed that in the event a participant becomes unable to settle, the collateral is used to cover the net settlement position of the participant. These risk management measures based on market discipline should be maintained even under the new deposit insurance framework, which fully protects interbank settlement obligations arising from customer payments. The Bank will continue to support the initiatives of private-sector payment and settlement systems for the management of settlement risk.

VIII. Conclusion

I have talked about the environment surrounding Japan's payment and settlement systems and some of the challenges they face in the short term. In closing, I would like to present some of my thoughts on improving and advancing reforms.

Generally, reform of payment and settlement systems in any country does not happen until it becomes urgent due to an incident or incidents, which push it forward. For example, conversion to the book-entry system for the settlement of U.S. Treasuries was driven by the so-called "paper crisis" of settlement backlog in the 1960s, which was caused by the securities being issued in physical form, and by the so-called "insurance crisis" triggered by an insurance company's refusal to insure securities in transit. In Japan, the changeover to the RTGS system for the BOJ-NET at the beginning of 2001 was achieved as a result of an increasing awareness of settlement risk due to a string of events in the 1990s that had given rise to concerns about financial system stability. While the pace of improvement differs from country to country, it is reasonable to assume that the level of payment and settlement systems around the world will converge at some point in the future given the ongoing globalization of financial markets. At the same time, I believe that the speed with which a country identifies and adapts to changes in trends in the global financial markets will determine the competitiveness of its economy, and of course its financial system. I imagine that Masayoshi Matsukata held these views when, as Minister of Finance, he submitted documents in 1882 recommending the establishment of the Bank.

Why is it then that at times improvement and reform of payment and settlement systems are delayed? There are a number of reasons. The main reason is that while benefits brought about by improvement in payment and settlement systems are something that is shared by everyone as benefits to the overall economy and society, both the change and the benefits are more or less invisible to the general public. We must note, however, that if payment and settlement systems are inefficient, financial institutions, and ultimately the public, suffer great inconvenience. And if they are not safe, the credit intermediary function of financial institutions is hampered, adversely affecting economic activity. The second reason is that the costs involved in improving payment and settlement systems are obvious, and thus in the short term efforts for improvement do not seem to pay. And third, given the wide range of parties involved in payment and settlement systems, the process of reaching an agreement is complicated and time-consuming. However, as I said earlier, efficiency and safety cannot be achieved at no cost; both money and manpower are required.

Risks to Japan's payment and settlement systems are expected to increase and become more diverse in the future. It is essential, therefore, to build and maintain safe and efficient payment and settlement systems that can withstand emergencies, and also can contribute to increasing Japan's financial and economic competitiveness. To this end, a wide range of parties, including the audience here today, will need to continue their collaborative efforts.

I must stress that in order to enhance the safety and efficiency of payment and settlement systems, it is essential that everyone concerned make steady and determined efforts with a long-term perspective. For example, at present, it may be difficult to appreciate the potential benefits of improving liquidity efficiency through investment in the systems, since the borrowing cost of funds for settlement is negligible in the current situation where short-term interest rates are almost at zero percent with provision of ample liquidity by the Bank. However, we must not forget that improvement of payment and settlement systems cannot be achieved in a day. The changeover to the new RTGS system in January 2001 took more than four years from the announcement of the plan in December 1996.

Payment and settlement systems evolve in response to changes in the environment over time. Some might consider that the pace of improvement in Japan's systems has not been fast enough, due in part to the decline in the financial resources of financial institutions as a result of the long-standing problem of nonperforming loans and also to the ample liquidity provided to the market. Major European countries and the United States introduced RTGS to large-value funds transfer systems from the second half of the 1980s to the first half of the 1990s. Since 2000, they have been moving toward hybrid systems, which achieve both risk reduction and efficiency in terms of liquidity; examples are the Clearing House Interbank Payments System (CHIPS) in the United States and RTGSplus in Germany. In Japan, the environment surrounding the financial system is finally improving. Now is the time to strengthen the international competitiveness of its financial markets and payment and settlement systems by keeping abreast of the global trend to further improve the systems. Since the measures will cost time and money, it is crucial that top management is committed to the project. I would like to end this speech by emphasizing the strong commitment on the part of the Bank to continue doing everything it can for the improvement of payment and settlement systems in Japan.

Thank you for your kind attention.