Academic journal article Federal Reserve Bank of New York Economic Policy Review

An Economic Analysis of Liquidity-Saving Mechanisms

Academic journal article Federal Reserve Bank of New York Economic Policy Review

An Economic Analysis of Liquidity-Saving Mechanisms

Article excerpt

1. INTRODUCTION

Large-value payments systems, used by banks to settle financial and commercial transactions, play a key role in the financial system. The importance of these payments systems can be illustrated by the large amounts they settle. Every year in the United States, the systems process value equal to approximately 100 times GDP.

Innovations in the design of large-value payments systems have led to many improvements in their operations. For example, over the last twenty years, many countries have adopted real-time gross settlement (RTGS) systems for their large-value payments. In an RTGS system, each payment is settled individually, on a gross basis, at the time the payment is sent. RTGS systems offer many advantages--for instance, they limit the risk exposure of payments system participants and allow for rapid final settlement of payments during the day. However, RTGS systems require large amounts of central bank balances to function smoothly.

More recent innovations have occurred in the design and implementation of various liquidity-saving mechanisms (LSMs) that are used in conjunction with RTGS systems. (1) An LSM gives participants in the payments system an additional option not offered by RTGS alone: A payment can be put into a queue and then released from the queue if some prespecified event occurs. Such mechanisms can reduce the amount of central bank balances necessary to operate the system smoothly as well as quicken the settlement of payments. As we describe in detail below, an LSM allows banks to send payments conditional on the receipt of payments, and it can accommodate some netting of payments.

Over the past decade, researchers have been able to simulate the performance of various LSMs. In most of these simulations, the researcher makes assumptions about the behavior of the parties in the system and measures various consequences of the assumed behavior. This approach has great potential to yield useful answers to a number of questions.

This article outlines a different approach to the study of LSMs in a payments system. It examines a theoretical model of the behavior of parties, which for simplicity we refer to as banks. Each bank has particular motivations and constraints; as a result, its behavior can be determined as an equilibrium outcome in response to the incentives it faces. The theoretical approach has the advantage of allowing banks' reactions to alternative payments system designs to be determined within a theoretical model, rather than be assumed by the researcher. This approach also allows outcomes to be compared consistently across a number of designs.

Innovations in LSMs are numerous and, in some cases, quite complex. A 2005 report by the Bank for International Settlements, "New Developments in Large-Value Payment Systems," is an authoritative source on the many alternative systems introduced until that time. The research presented here generalizes the various types of LSMs by placing their essential characteristics into one of two categories: balance reactive or receipt reactive.

A simplified description of an LSM's operation is as follows. A bank wishes to make a payment and has a choice of when to submit it to the payments system. Upon submitting the payment, the bank has a second choice to make: It can either submit the payment to a central queue (the LSM part of the payments system, which will be called the LSM channel), or attempt to settle the payment at the time of submission (the RTGS part of the payments system, which will be called the RTGS channel). If the bank submits the payment to the LSM channel, that payment will settle only when certain conditions have been met. If the bank attempts to settle via the RTGS channel and it has sufficient funds available, the payment will settle immediately.

One condition that might trigger the settlement of a payment (and is common to both types of LSMs) occurs when the request in the LSM channel is made in the presence of an offsetting payment in the queue of the bank to which the payment is to be made. …

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