Academic journal article Economic Perspectives

Understanding Intraday Credit in Large-Value Payment Systems

Academic journal article Economic Perspectives

Understanding Intraday Credit in Large-Value Payment Systems

Article excerpt

Introduction and summary

A large-value (or wholesale) payment system is a contractual and operational arrangement that banks and other financial institutions use to transfer large-value, time-critical funds to each other. It is operated either by a central bank or by a coalition of banks and financial institutions. In the U.S., the two largest and most commonly used large-value payment systems are Fedwire and CHIPS (Clearing House Interbank Payments System). Fedwire is a service provided by the Federal Reserve banks to about 10,000 depository institutions and government agencies for transferring funds and federal and agency securities. CHIPS is owned and operated by the Clearing House Interbank Payments Company L.L.C., whose members consist of 79 of the world's largest commercial banks.

The growth of the payment industry has been phenomenal. For example, the combined annual value of transfers through Fedwire and CHIPS was about 67 times U.S. gross domestic product (GDP) in 1988 and climbed to 89 times in 1999. The average daily value of transfers processed by the two systems reached $3,257.15 billion, about 35 percent of annual GDP, in 1999.

These staggering numbers give a glimpse of the increasing importance of large-value payment systems to the health and efficiency of the financial systems that our fast growing and ever more integrated national and international economies depend upon. The Federal Reserve, as well as other central banks around the world, has long recognized this importance, and continues to design and implement policies to ensure the proper and efficient operation of payment systems.

In this article, I examine the key issues in large-value payment systems and the optimal payment system design that addresses these issues. First, I discuss the main conflict faced by a large-value payment system--shortage of settlement liquidity versus potential credit risk--through the mechanics of the two main classes of payment systems. Customers of a real-time gross settlement (RTGS) system are constantly in need of liquidity to settle payments in real time, while those of a net settlement (NS) system face the uncertainty of potential settlement failure. The focus of this article is the remedy for liquidity shortage in a real-time gross settlement system, the provision of intraday liquidity by the central bank, and the policies designed to reduce the central bank's resulting exposure to credit risk. I describe three intraday-credit policies commonly used by central banks: a cap on an institution's net debit position during the day, an interest charge on the usage of intraday credit, and a collateral req uirement to back the extension of intraday credit. In particular, I discuss the experience of Fedwire after the introduction of the first two policies.

The way a large-value payment system works and its key issues define the criteria for theoretical modeling, a common approach adopted by modern day economists to study optimal institutional design. I propose four main criteria that a payment system model should satisfy. First, it should directly model the underlying transactions of goods or financial assets for which payments have to be made so that the system design affects the allocation of real resources. Having met the first requirement, the model should treat consumption/investment debt, which is generated by the underlying real resources transaction, as distinct from payment debt, which is created only for payment needs. The final two criteria have to do with the two sides of the main conflict; the model should incorporate both settlement liquidity shortage and credit risk, preferably generated endogenously by agents' choice or action.

The existing theoretical research on payment systems typically does not meet all four proposed criteria. It mostly focuses either on liquidity or risk and rarely models demand for settlement liquidity as a derived demand. Nevertheless, the literature provides significant insights into the merits of the three intraday-credit policies. …

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