Interdependence in Payment and Settlement Systems

 

From The Payment System

The payment system – which includes financial market infrastructure for payments, securities and derivatives – is a core component of the financial system, alongside markets and institutions. If modern economies are to function smoothly, economic agents have to be able to conduct transactions safely and efficiently. Payment, clearing and settlement arrangements are of fundamental importance for the functioning of the financial system and the conduct of transactions between economic agents in the wider economy. Private individuals, merchants and firms need to have effective and convenient means of making and receiving payments. Moreover, funds, securities and other financial instruments are traded in markets, providing a source of funding and allowing households, firms and other economic actors to invest surplus funds or savings in order to earn a return on their holdings. Active markets facilitate price discovery, the efficient allocation of capital and the sharing of risk between economic actors.

Public trust in payment instruments and systems is vital if they are to effectively support transactions. In financial markets, market liquidity is critically dependent on confidence in the safety and reliability of clearing and settlement arrangements for funds and financial instruments. If they are not managed properly, the legal, financial and operational risks inherent in payment, clearing and settlement activities have the potential to cause major disruption in the financial system and the wider economy.

Banks and other financial institutions are the primary providers of payment and financial services to end users, as well as being major participants in financial markets and important owners and users of systems for the processing, clearing and settlement of funds and financial instruments. The central bank, as the issuer of the currency, the monetary authority and the “bank of banks”, has a key role to play in the payment system and possesses unique responsibilities. It is therefore no coincidence that one of the basic tasks of the ESCB and the ECB is to promote the smooth operation of payment systems. A safe and efficient payment system is of fundamental importance for economic and financial activities and is essential for the conduct of monetary policy and the maintenance of financial stability.

 

From The Payment System

 

The complexity and – in particular – importance of market infrastructure for the handling of payments and financial instruments has increased greatly in recent decades, owing not only to the tremendous increases observed in the volume and value of financial transactions, but also to the wealth of financial innovation and the advances seen in information and communication technologies. Bilateral barter trade is now largely a thing of the past, and instead economic agents buy and sell goods and services (including financial instruments) in markets, making use of the transfer services made available by market infrastructure.

Payment, clearing and settlement systems may differ from country to country in terms of their type and structure, both for historical reasons and on account of differences between countries’ legal, regulatory and institutional environments. Furthermore, rather than being static, payment, clearing and settlement systems and arrangements are dynamic constructions which have evolved over time and will continue to do so in the future. A key priority for central banks is to contribute to the development of modern, robust and efficient market infrastructure which serves the needs of their economies and facilitates the development of safe and efficient financial markets.

All transactions are exposed to a variety of risks, and this is particularly true for financial transactions. Thus, in order to facilitate enhanced risk management, many countries have introduced real-time gross settlement systems for the handling of critical payments. Progress has been made in the implementation of safer and more efficient systems and procedures for the clearing and settlement of securities. Modern securities settlement systems offer delivery-versus-payment mechanisms and allow the effective management of collateral, while foreign exchange transactions are increasingly being settled on a payment-versus-payment basis. In parallel, stronger international trade links, the increased integration of international financial markets (including global derivatives markets) and large migrant flows have all contributed to increased demand for arrangements allowing the cross-border handling of wholesale and retail transactions, raising new issues from a policy and risk perspective.

From The interdependencies of payment and settlement systems

The global payment and settlement infrastructure has changed significantly over the last decade. The myriad of domestic and cross-border systems that make up the global infrastructure are increasingly interconnected through a web of direct and indirect relationships. Through these relationships, the smooth functioning of a single system often becomes contingent on the performance of one or more other systems. In addition, individual systems are often reliant on common third parties, financial markets or other factors. Consequently, the settlement flows, operational processes and even risk management procedures of individual systems are often materially interdependent with those of other systems. As a result, the numerous systems that make up the global clearing and settlement infrastructure have become more tightly interdependent.

This increasing interdependence is driven by several interrelated factors, including technological innovations, globalisation and financial sector consolidation. In addition, a number of initiatives by the financial industry and by public authorities to reduce the costs and risks of settlement have purposely promoted greater integration among the numerous components of the global payment and settlement infrastructure. For example, the 1989 G30 recommendations for T+3 securities settlement, central bank policies encouraging the development and reliance on systems with intraday finality, and the CPSS focus on reducing foreign exchange settlement risk have provided incentives for more straight through processing and tighter relationships among individual systems.3 While these explicit initiatives explain one aspect of tightening interdependencies, institutions’ profit-seeking and cost management incentives also foster interdependencies.

Interdependencies have important implications for the safety and efficiency of the global payment and settlement infrastructure. Some forms of interdependencies have facilitated significant improvements in the safety and efficiency of payment and settlement processes. At the same time, interdependencies increase the potential for a given disruption to spread quickly to many different systems. This potential was noted in the 2000 G10 report on Financial sector consolidation (the Ferguson report), which suggested that interdependencies might accentuate the role of payment and settlement systems in the transmission of disruptions across the financial system, and is further analysed in this report.

The potential for interdependencies to reduce key sources of risk, and yet create new sources of risk, highlights the numerous trade-offs faced by payment and settlement systems, their participants and public authorities. The reduction of one form of risk often comes at the expense of increasing another source of risk, or of increasing costs.

From Congestion and Cascades in Interdependent Payment Systems

 

The report identifies three different types of interdependencies. System-based interdependency, which includes payment versus payment (PvP) or delivery versus payment arrangements (DvP)4 as well as liquidity bridges between systems. Institution-based interdependence which arises when, for example, a single institution participates in, or provides settlement services to, several systems. The third type is environmental-based interdependency which can emerge if multiple systems depend on a common service provider, for example the messaging service provider SWIFT.

 

From Illiquidity in the Interbank Payment System following Wide-Scale Disruptions

 

At the apex of the U.S. financial system are a number of critical financial markets that provide the means for both domestic and international financial institutions to allocate capital and manage their exposures to liquidity, market, credit and other types of risks. These markets include Federal funds, foreign exchange, commercial paper, government and agency securities, corporate debt, equity securities and derivatives. Critical to the smooth functioning of these markets are a set of wholesale payments systems and financial infrastructures that facilitate clearing and settlement.1 Operational difficulties of these entities or their participants can create difficulties for other systems, infrastructures and participants. Such spill overs might cause liquidity shortages or credit problems and hence potentially impair the functioning and stability of the entire financial system.

 

Key Sources of Research:

 

The interdependencies of payment and settlement systems

BIS

2008

http://www.bis.org/cpmi/publ/d84.pdf

 

The Payment System

ECB

2010

https://www.ecb.europa.eu/pub/pdf/other/paymentsystem201009en.pdf

 

Interdependencies of payment and settlement systems: the Hong Kong experience

HONG KONG MONETARY AUTHORITY QUARTERLY BULLETIN

MARCH 2009

http://www.hkma.gov.hk/media/eng/publication-and-research/quarterly-bulletin/qb200903/fa2_print.pdf

 

Congestion and Cascades in Interdependent Payment Systems

 

Fabien Renault, Walter E. Beyeler,  Robert J. Glass, Kimmo Soramäki,  Morten L. Bech

March 16, 2009

 

http://www.sandia.gov/casosengineering/docs/CongestionAndCascadesInCoupledPaymentSystems3_30_09_SAND2009-2175J.pdf

 

Eurozone payment and securities settlement systems interdependence:

Will consolidation initiatives lead to contagion; who is accountable?

February 2004

http://www.grahambishop.com/DocumentStore/policy_paper_full_120204.pdf

 

Recent developments in intraday liquidity in payment and settlement systems

FRÉDÉRIC HERVO

Payment systems and Market Infrastructure Directorate

 

https://www.banque-france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financiere/etud15_0208.pdf

 

Precautionary Demand and Liquidity in Payment Systems

Gara M. Afonso and Hyun Song Shin

August 2010

 

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr352.pdf

 

Banque de France – European Central Bank: Liquidity in interdependent transfer systems

2008

https://www.banque-france.fr/en/economics-statistics/research/seminars-and-symposiums/banque-de-france-european-central-bank-liquidity-in-interdependent-transfer-systems.html

 

Interlinkages between Payment and Securities Settlement Systems

David C. Mills, Jr.y Samia Y. Husain

September 4, 2009

https://www.newyorkfed.org/medialibrary/media/research/conference/2009/money-payments/2-Mills-Husain.pdf

 

Risk and Concentration in Payment and Securities Settlement Systems

 

David C. Mills, Jr. and Travis D. Nesmith 2007-62

 

https://www.federalreserve.gov/pubs/feds/2007/200762/200762pap.pdf

 

Simulation studies of liquidity needs, risks and efficiency in payment networks

Proceedings from the Bank of Finland Payment and Settlement System Seminars 2005–2006

Harry Leinonen (ed.)

http://www.sandia.gov/CasosEngineering/docs/BoF_2007_Proceedings.pdf

 

Managing Operational Risk in Payment, Clearing, and Settlement Systems

Kim McPhail

 

http://www.banqueducanada.ca/wp-content/uploads/2010/02/wp03-2.pdf

 

Liquidity, risks and speed in payment and settlement systems – a simulation approach

 

Harry Leinonen (ed.)

2005

http://www.suomenpankki.fi/pdf/118263.pdf

 

SELECTED ISSUES ON LIQUIDITY RISK MANAGEMENT IN FEDWIRE FUNDS AND PRIVATE SECTOR PAYMENT SYSTEMS

TECHNICAL NOTE MAY 2010

 

https://www.treasury.gov/resource-center/international/standards-codes/Documents/FSAP_Technical%20Note_Payment%20Systems_Liquidity%20Risk%20Management_Final_5%2011%2010.pdf

 

The role of time-critical liquidity in financial markets

David Marshall and Robert Steigerwald

2013

https://www.chicagofed.org/…/2q2013-part1-marsha…

 

Illiquidity in the Interbank Payment System following Wide-Scale Disruptions

Morten L. Bech Rod Garratt

2006

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr239.pdf

 

Progress in reducing foreign exchange settlement risk

Committee on Payment and Settlement Systems

May 2008

http://www.bis.org/cpmi/publ/d83.pdf

 

Financial market utilities and the challenge of just-in-time liquidity

by Richard Heckinger, David Marshall, and Robert Steigerwald

2009

https://www.chicagofed.org/~/media/publications/policy-discussion-papers/2009/pdp2009-4-pdf.pdf

 

Diagnostics for the financial markets – computational studies of payment system

Simulator Seminar Proceedings 2009–2011

2009

http://www.suomenpankki.fi/en/julkaisut/tutkimukset/erillisjulkaisut/Documents/E45_Chapter_11.pdf

 

Congestion and Cascades in Coupled Payment Systems

Fabien Renault, Walter E. Beyeler, Robert J. Glass, Kimmo Soramäki and Morten L. Bech

October 31, 2007

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.451.8166&rep=rep1&type=pdf

 

 

 

 

 

 

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Author: Mayank Chaturvedi

You can contact me using this email mchatur at the rate of AOL.COM. My professional profile is on Linkedin.com.

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