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

Economizing on Liquidity with Deferred Settlement Mechanisms

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

Economizing on Liquidity with Deferred Settlement Mechanisms

Article excerpt

* Real-time gross settlement (RTGS) systems such as the Federal Reserve's Fedwire Funds Service enable participating banks to settle payments immediately and in the full amount; however, the high level of liquidity inherent in the systems requires large intraday credit extensions.

* An examination of several deferred settlement mechanisms that could potentially complement RTGS systems considers a novel mechanism - a receipt-reactive gross settlement system-that bases the settlement of a bank's payments on the value of its receipts over a given time, rather than on the bank's balance.

* The receipt-reactive mechanism can potentially reduce intraday credit extensions significantly while modestly delaying the average time of payment settlement; the mechanism also provides good incentives for banks to submit payments earlier in the day.

1. INTRODUCTION

On a typical day, the total value of payments settled by the Federal Reserve's Fedwire Funds Service exceeds $1.8 trillion. On average, credit extended to banks using Fedwire is about $30 billion over the course of the day, while the peak intraday amount reaches $86 billion. Given this high level of credit extensions, it is worthwhile asking whether payment settlements could be managed with a lower level of outstanding credit, thus allowing system operators to economize on liquidity.1

Fedwire operates as a real-time gross settlement (RTGS) system. RTGS systems transfer the full amount of payment orders between commercial bank participants immediately upon receipt, thus avoiding short-term debt obligations between participants. This is a desirable feature that has prompted many central banks worldwide to implement these systems over the past decade. However, because payment transfers between participants are made immediately in the full amount, and because of the asynchronous timing of payments by participants, maintaining the liquidity needs of RTGS systems can be costly. Indeed, some system operators have altered their RTGS systems in recent years to economize on the funds needed to complete settlements.

One way to reduce a system's liquidity needs is by using deferred settlement mechanisms such as netting. In netting systems, payment orders are deferred until some designated time-usually late in the day-when the participants exchange only the net amounts they owe or are owed. If all participants successfully submit these net amounts, the system settles all the payments accumulated during the day with the least amount of funds possible-that is, just the net amounts. To achieve this economy in funds use, a netting system delays the settlement of payments so that all orders remain pending until the net settlement payments are completed successfully. This delay feature creates distinct liquidity and risk management characteristics.

Another type of deferred settlement mechanism queues payments as they enter the system. Some European RTGS systems use these "queue-augmented RTGS systems," or hybrid systems.2 Such systems save on liquidity-as in a netting system-but with less delay than end-of-day netting imposes.

In this article, we propose alternative ways of settling payments submitted to the Fedwire Funds Service that would result in lower intraday credit extensions. We analyze the effects of complementing an RTGS system with various deferred settlement mechanisms by performing simulations on historical Fedwire data. Although others have studied the effects of such modifications on payments systems, this is the first examination in the context of Fedwire.

One function of a payments system design could be to minimize the combined cost of delaying payments and the risk of extending intraday credit to commercial banks-that is, the credit risk that a central bank assumes by providing intraday credit. We do not use an explicit, objective function to evaluate the various alternatives to an RTGS system because we do not know banks' preferences regarding delays or specific default risks. …

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