Academic journal article Federal Reserve Bank of St. Louis Review

Recent Developments in Wholesale Payments Systems

Academic journal article Federal Reserve Bank of St. Louis Review

Recent Developments in Wholesale Payments Systems

Article excerpt

Payments systems can be divided conceptually into two components: retail and wholesale. The retail payments system, used primarily by nonbanks for making and receiving payments, involves relatively small transfers of monetary value. In contrast, the wholesale system, which banks use to make payments to each other, involves relatively large transfers.(1)

The Bank for International Settlements (BIS) in Basle, Switzerland (a consultative forum for major central banks) has recently published a series of reports covering various aspects of the wholesale payments system,(2) the purposes of which are, first, to inform central bankers and payments-system participants about current practices in wholesale payments systems, and second, to provide a central-bank perspective on how various changes to these practices could enhance the safety and efficiency of wholesale payments systems. This article summarizes the reforms to G-10 wholesale payments systems documented in and spurred by this series of BIS reports.

One general approach has been to strengthen (or "secure") existing payments system arrangements based on net settlement.(3) Net settlement systems accumulate a record of financial obligations among participants over a prespecified period of time, such as a business day, at the end of which the net amount of funds, securities, or other financial obligations owed by or to each participant is transferred. The primary shortcoming of traditional "unsecured" net settlement systems is that not only do they expose their own members to the risk of default by other members, they also expose financial institutions and other creditors outside the netting system. The danger is that liquidity or solvency problems will thus be transmitted quickly and unpredictably throughout the global financial system.

"Secured" net settlement systems, on the other hand, are designed so that any disruptions caused by a single member (even if this happens to be the institution with the largest net obligations to other members) can be absorbed by the system and its members with no risk of further propagation. To achieve this goal, such systems require that members undertake extensive and perhaps costly risk-management measures. These measures typically include real-time monitoring of counterparties within the system, net debit caps, collateralization, and additional open-ended financial guarantees in case all other safeguards prove inadequate.

Another approach to strengthening wholesale payments systems involves greater private-sector use of gross settlement. Gross settlement systems include real-time gross settlement payments systems (RTGS), delivery-versus-payment (DVP) systems, and payment-versus-payment (PVP) systems. Recently, many central banks have created new RTGS systems or improved their existing ones to strengthen their wholesale payments systems. In contrast to unsecured net settlement systems, gross settlement systems can eliminate virtually all repercussions to other private-sector members when one institution encounters difficulty. There is a cost, however. Depending on its structure, a gross settlement system may impose significant liquidity demands on participants, or it may require that the central bank incur substantial supervisory and risk-management costs in the process of alleviating liquidity burdens.

Most G-10 central bankers believe that, despite their costs, gross settlement systems will be important components of wholesale payments systems in the future. Why, then, have private-sector financial institutions very often chosen to upgrade and secure existing net settlement systems instead of moving more rapidly to gross settlement systems? Could (and should) central banks do more to facilitate a more widespread and rapid transition to gross settlement systems?

This article does not provide definitive answers to these questions. Instead, I offer an overview of recent developments in large-value gross and net settlement systems in the G-10 countries. …

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