Liquidity Considerations in Large-Value Payments Systems

1. Liquidity Considerations in Large-Value Payments Systems James McAndrews Federal Reserve Bank of New York May 29, 2007 For presentation at Exploring Frontiers in Payments Systems Development

2. Liquidity A liquid asset can be sold • rapidly, • with little loss of value, • anytime within market hours. Characteristic of a liquid market: ready and willing buyers and sellers at all times.

3. Large-Value Payment Systems What does liquidity mean in LVPS? • Low-cost access to settlement asset (ability to transform other assets into settlement asset with little loss of value) • Counterparties ready and willing to make payments in timely way. If LVPS system is liquid, payments flow smoothly (rapidly anytime within market hours).

4. Net systems and Gross systems In Netting systems, the need for settlement asset is economized. • Counterparty promises reinforced by pledge of collateral. In RTGS systems, greater need for settlement asset. • Central banks often provide access to “daylight” balances against collateral. • U.S. limits extension of uncollateralized daylight overdrafts, and banks pay fee for use.

5. Liquidity in LVPS Systems The aim is to achieve • a willingness to submit payments in a timely way, • to settle all credit within system at end of day, • Avoids any spillovers into overnight balances and interference with monetary policy objectives • to avoid large counterparty exposures.

6. Liquidity in LVPS Systems Designs for liquidity provision vary, but often include Netting systems: Counterparty limits, collateral backing RTGS systems: Participant credit limits, collateral backing

7. Liquidity in RTGS BIS Report on Real-Time Gross Settlement (1997) Sources of funds are • balances maintained on account with the central bank, • incoming transfers from other banks, • credit extensions from the central bank and • borrowing from other banks through the money markets.

8. RTGS Diffusion Many countries have adopted RTGS during last two decades. • Low-cost assurance of end-of-day settlement and freedom from counterparty credit risk.

9. RTGS Diffusion

10. RTGS Diffusion Many countries have adopted RTGS during last two decades. • Low-cost assurance of end-of-day settlement and freedom from counterparty credit risk. • But some situations may cause “gridlock”– an unwillingness of participants to submit payments.

11. Experience of September 11, 2001 in Fedwire Payments settlement slowed significantly for a few days, partially because of bottlenecks as some banks could not send out payments. Federal Reserve injected large amounts of balances.

12. Mixing RTGS and netting features: Liquidity-Savings Mechanisms BIS Report: New Developments in LVPS (2005) Upper bound Lower bound DNS Delay Pure RTGS Liquidity available/required

13. Advantages and Disadvantages: LSMs Former DNS systems: New CHIPS and PNS Now achieve intraday finality and may be safer than DNS systems but probably more costly Former traditional RTGS system: RTGSplus Now provides continuous offsetting and may be as safe as RTGS and probably less costly in terms of liquidity

14. Advantages and Disadvantages: LSMs • High development costs • Less transparency • Is liquidity really a problem? There is not necessarily a single optimal design for LVPS.

15. Liquidity Considerations There are a range of methods to create a liquid LVPS. A liquid payment system is one that is • allows low-risk access to the settlement asset at low cost, and • adequately controls counterparty risk exposures.