Monitoring and Surveillance

Maintaining Stability in Money and Foreign Exchange Markets
The Central Bank is responsible for maintaining stability in the money and foreign exchange markets

Inter-bank Call Money Market
The inter-bank call money market is an overnight market and mainly serves commercial banks in meeting their immediate liquidity needs and reserve deficiencies. Hence, an important task of the call money market is to facilitate liquidity management in the economy.

Therefore the orderly and stable functioning of the inter-bank call money market is important to minimise liquidity risk in the banking system as a whole. The stability of the market is supported by the provision of Repurchase (Repo) and Reverse Repurchase facilities by the Central Bank at its policy interest rates

The Central Bank's policy interest rates - the Repo Rate and Reverse Repo Rate form an interest rate corridor for the inter-bank call money market rates, with the Repo Rate being the lower limit and the Reverse Repo Rate being the upper limit. This reduces potential large fluctuations in the short- term market interest rates. Changes in the Central Bank's policy interest rates have an immediate effect on interest rates in the inter-bank call money market. Changes in the call market rates would lead, within a very short period, to changes in other short-term money market interest rates, such as the yield on Treasury bills, commercial paper and the short-term lending rates of commercial banks. These changes would, with a time lag, affect the medium-term lending rates of banks, the yields on Treasury bonds and the deposit rates offered by banks.

The inter-bank call money market is the first step in the transmission of the Central Bank's monetary policy signals to the economy. Hence, the Central Bank closely monitors the inter-bank market and makes a daily assessment of the liquidity in the banking system. Under the current open-market operations system, the Central Bank will conduct either a Repo or Reverse Repo auction for a determined amount, in order to reduce large fluctuations in the inter-bank call money market interest rate. If there is excess liquidity in the market, the Central Bank will conduct a Repo auction to mop-up the surplus money. Likewise, if there is a shortage of liquidity in the market, the Central Bank will conduct a Reverse Repo auction to inject money into the market. The magnitude of the Central Bank intervention depends on the overall liquidity excess or shortfall.

The daily inter-bank call money market transactions averaged Rs.5 billion in 2005.

Treasury Bill Market
The Treasury bill market is another segment of the Money Market. Treasury Bills are highly liquid money market instruments that provide financial institutions with an alternate source of liquidity and investment. Furthermore, interest rate movements in the Treasury bill market provide a benchmark for the short-term credit market. Hence, changes in the volumes and rates in the Treasury bill market affect the cost, profitability and liquidity of financial institutions. Secondary market transactions in Treasury bills amounted to Rs. 443 billion for outright transactions and Rs. 652 billion for repurchase transactions in 2005. Treasury bills are also the main securities are used as collateral by the Central Bank in the conduct of its open market operations.

Foreign Exchange Market
One of the main purposes of the foreign exchange market is to obtain foreign currency funds for the purchase of imports of goods and services and to service loan repayments. The foreign exchange market consists of the spot market and the forward market. The spot market is the market for purchase/sale and delivery of foreign currency on the same day or within two business days, while the forward market is for the purchase /sale of foreign currency at a price specified now, with delivery and settlement at some future date (usually in 30, 90 or 180 days). The foreign exchange market in Sri Lanka consists of two tiers, the client or retail market and the inter-bank or wholesale market. The transactions in the inter-bank market partly result from transactions that banks have had with their customers in the retail market. The inter-bank market is mainly organized among Authorized Dealers in foreign exchange, which comprise all commercial banks and plays an important role in the Sri Lankan financial system by redistributing liquidity within the banking system. The main risks to the financial system from the foreign exchange market arise from the impact of excessive volatility in the exchange rate on the net open positions in foreign exchange of commercial banks. This risk could arise either from ineffective internal controls or due to excessive volatility brought about by macro-economic conditions, both domestic and external. There is also a possibility of a potential contagion effect as problems in one commercial bank could spread to others.

In the inter-bank foreign exchange market, transactions are conducted on spot, tom, cash or forward basis between the US Dollar and the Sri Lanka Rupee. The daily inter-bank spot transactions averaged US $ 25 million, while the daily forward transactions averaged US $ 8 million in 2005. The role of the Central Bank in the inter-bank foreign exchange market is to maintain an "orderly" market and it fulfils its role by intervening in the market when necessary to reduce excessive volatility in exchange rate fluctuations.

As the floating exchange rate system was adopted in January 2001, the price of the Sri Lanka Rupee, in terms of foreign currencies, is determined by market forces of demand and supply. The US Dollar/SL Rupee exchange rate is determined in the inter-bank foreign exchange market. The Central Bank intervention in the foreign exchange market is mainly to prevent excessive volatility in the exchange rate and to maintain a comfortable level of external reserves. The Central Bank's buying and selling of foreign exchange is done at market exchange rates.

Overseeing the Payment and Settlement System
Payment and settlement systems (PSS) enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions. In a systemically important PSS, a significant proportion of transactions by value consist of transactions conducted in financial markets. Although disruptions to operations of such systemically important PSS are rare, the potential consequences of such a disruption are substantial and widespread and could lead to a systemic disruption and financial shock even beyond the system and its participants, which could adversely affect the stability of the financial sector. Therefore, the safety and efficiency of the PSS, particularly systemically important ones, is critical for the effective functioning and stability of the financial system.

Legal Framework
The Payments and Settlements Systems Act No.28 of 2005 (PSSA) provides for the regulation, supervision and monitoring of payments, clearing and settlement systems, the regulation of providers of money services and the electronic presentation of cheques.

The Central Bank performs three key roles in the PSS namely,

The Payments and Settlements Systems Act >>
Payment Systems in Sri Lanka (The Red Book) >>

LankaSettle - Real Time Gross Settlement(RTGS) System and LankaSecure
The Central Bank operates LankaSettle, the systemically important high value payment and securities settlement system. The LankaSettle system has two components i.e. the RTGS system (which processes large value and time critical payments) and the LankaSecure system (Scrip-less Securities Settlement System). The integration of the RTGS System and LankaSecure System provides the most secured securities settlement mechanism based on Delivery versus Payment for scrip-less securities transactions. Participants of the LankaSettle System, as at end June 2006, are the Central Bank, 23 Licensed Commercial Banks , 8 Non-Bank Primary Dealers , the Employees' Provident Fund and the Central Depository System of the Colombo Stock Exchange. The LankaSecure System is operated by the Payments and Settlements Department of the Central Bank.

Real Time Gross Settlement System (RTGS)
The RTGS System is a computer based fund settlement system which processes and settles each payment instruction individually and irrevocably on real time basis using funds in the participants' RTGS Settlement Accounts in the RTGS System. The value of transactions settled in the RTGS System accounts for about 84 per cent of the non-cash payments in Sri Lanka. The RTGS System settles large value and time critical rupee payments between participants and customer to customer through a participant. The majority of RTGS transactions are relating to: transactions in the inter-bank call money market, the Government securities markets, Open Market Operations, the rupee leg of transactions in the foreign exchange market, urgent payments of customers and net obligations under the clearing system operated by LankaClear.

The Central Bank provides an Intra-day Liquidity Facility (ILF) to participating Commercial Banks and Primary Dealers, free of charge against collateral of scripless securities in the LankaSecure System. The average value of ILF granted by the Central Bank per day during the first half of 2006 was Rs.2 billion.

The RTGS System settles an average of 693 transactions a day, with a daily average turnover value of Rs.73 billion. Of the total number of transactions settled in the RTGS System, about 37 per cent was on account of urgent payments of customers of participants.

LankaSettle - RTGS System >>

LankaSecure - Scripless Securities Settlement System (SSSS) and Scripless Securities Depository System (SSDS)
The LankaSecure System comprises of the Scripless Securities Settlement System (SSSS) and Scripless Securities Depository System (SSDS). LankaSecure facilitates the issue of Government securities and Central Bank securities in electronic or scripless form and settlement of trades of such scripless securities on a Delivery versus Payment (DvP) basis. Accordingly, transactions are settled in the system if the participant who sells securities has sufficient eligible securities in his Securities Account in LankaSecure and the buying participant has sufficient funds in his Settlement Account in the RTGS System to pay for the transaction. All securities transactions settled in the system are irrevocable.

The SSDS is the title registry as well as the custodian for Government securities. The ownership of securities is recorded to the beneficiary level in the SSDS. The holders of scripless securities in the SSDS can obtain up to date details of their investments at any point of time through LankaSecureNet, an internet based facility.

During the first half of 2006, LankaSecure settled about 42 DvP transactions per day. The average number of Delivery Free transactions settled in the system also amounted to 42 a day, while transactions relating to repositioning of securities accounted for about 600 transactions per day.

LankaSecure: Scripless Securities System and Central Depository System >>
LankaSecure - Pamphlet Series No.7 >>

Cheque Imaging and Truncation (CIT) System - Interbank Cheque Clearing
The Central Bank is responsible for providing facilities for the clearance of retail payments, such as cheques, bank drafts and off-line fund transfers. In 2002, the Central Bank authorised LankaClear Ltd , a company jointly owned by the Central Bank and Licensed Commercial Banks to provide cheque clearing facilities. The average number of cheques cleared by LankaClear in the first half of 2006 was 173, 380 per day, while the average value of cheques cleared amounted to Rs. 15 billion per day. The total value of cheques cleared through the LankaClear system represented 16 per cent of the total value of non-cash payments.

In May 2006, LankaClear introduced the Cheque Imaging and Truncation (CIT) system, which facilitates the electronic presentment of cheque images and clearance of cheques. The CIT system introduced an uniform cheque clearing time schedule of T + 1 throughout the country, enabling Commercial Banks to credit proceeds of cheques to their customers' accounts on the following business day. Under this system, dishonoured/returned cheques have been replaced with a Cheque Return Notification (CRN). The net clearing balances under the CIT system are settled in the RTGS system at 8.30 a.m. on each business day, while those of the Settlement Clearing System of the CIT system (which handles CRNs) are settled in the RTGS system at 2.45 p.m. on each business day.

Sri Lanka Inter-bank Payment System (SLIPS)
LankaClear also operates the Sri Lanka Inter-bank Payment System (SLIPS), an off-line retail fund transfer system for the Central Bank and Commercial Banks. SLIPS handles pre-authorised small value bulk payments (direct credit and debit transfers). SLIPS facilitates the routing of transactions with value date T +1 or more, with a maximum value date of 14 days ahead. Transactions are cleared electronically on a multilateral net settlement basis and inter-bank net balances arising from SLIPS transactions are settled in the RTGS at 8.30 a.m. on each business day.

Rupee Draft Clearing System and US Dollar Cheque Clearing System
LankaClear also operates a Rupee Draft Clearing System and US Dollar Cheque Clearing System. In the Rupee Draft Clearing System, cheques and drafts of foreign banks drawn on their "nostro" accounts with Commercial Banks in Sri Lanka and in favour of customers of Commercial Banks in Sri Lanka are cleared manually by LankaClear. The net clearing balances of this system are settled at the RTGS at 2.15 p.m. on each business day. The daily average value of cheques cleared by this system was Rs. 17 billion in 2006.

The US Dollar Cheque Clearing System was launched in 2002 and is a semi-computerised clearing system for cheques and drafts in US Dollars issued by Commercial Banks in Sri Lanka and payable to Sri Lankan individuals and institutions and issued by banks exchange houses abroad and drawn on Commercial Banks in Sri Lanka. This system reduced the time lag for clearing and settlement of US Dollar cheques and drafts from 3 weeks to about 4 days. The system also reduced the clearing charges by banks significantly, as previously cheques and drafts had to be dispatched to correspondent banks abroad for realisation, whereas now they are exchanged over the counter locally. The settlement of inter-bank clearing balances of the US Dollar Cheque Clearing System takes place through the accounts of participants maintained in a private Commercial Bank. A daily average of 440 cheques worth US $ 833 is cleared in the system.

Equities Trading System and Debt Securities Trading System
The Colombo Stock Exchange operates two on-line systems: i.e. the Automated Trading System (ATS) for real time trading of equity (shares) and the Debt Securities Trading System (DEX) for trading of beneficial interest of Government securities and corporate debt securities. Stockbrokers licensed by the Securities Exchange Commission (SEC) perform as direct participants in the ATS and DEX. At the end of May 2006, there were 18 direct participants, 15 stockbrokers and 3 trading members permitted to trade in the DEX System.

Equities traded in the ATS are debited and credited to/from the buyers'/sellers' securities accounts at the CDS on a real time basis. However, the fund settlements for equity transactions are not on a delivery versus payment (DvP) basis, but are effective on T+3 for buyers and T+4 for sellers. Final settlement of inter-participant net obligations on equity transactions takes place on T+4, at accounts maintained in the settlement bank. Settlement of net clearing obligations on corporate debt securities and 'beneficial interests' of Government securities also takes place through the settlement bank, on the specific settlement date, decided by the parties of the transactions (the settlement cycle for transactions on DEX is flexible and may be effected on DvP basis). During the first quarter of 2006, the average turnover of equity transactions at ATS per day was about Rs.444 million, while the average value of transactions at DEX amounted to about Rs.3 million a day.

Surveillance of Financial Conglomerates
The existence of large financial conglomerates, especially those that have banks as part of the conglomerate, is another area that has attracted increased supervisory concern in recent times. The regulation and supervision of such financial conglomerates is becoming increasingly more important and complex, due to the potential systemic risk that could arise from the interrelated nature of their activities. Large numbers of cross shareholdings, common directors and inter company transactions are areas that are of key interest in this regard, as it could result in conflicts of interests and abuse of power, which would not augur well for the stability of the financial system.

Since there are multiple regulators in the financial system, the supervision of conglomerates often falls under the purview of several regulators, requiring close co-operation and supervision.

Therefore, a Working Group of Regulators for Financial Conglomerates comprising of the Central Bank, the Insurance Board of Sri Lanka, the Securities and Exchange Commission of Sri Lanka, the Accounting and Auditing Standards Monitoring Board and the Department of Registrar of Companies has been established to monitor the systemic risk of conglomerates. The mandate of this working group includes identifying and defining financial conglomerates; identifying the functions of the separate regulators; assessing the systemic risk of such conglomerates by sharing necessary information among regulators, recommending a course of action for regulation and supervision of the respective institutions in a consolidated manner; and proposing necessary legal reforms to address the existing limitations relating to regulation and supervision of financial conglomerates.

The initial report of the Working Group will be completed in early 2007.