The role of central bank money for large value payment systems

1. The role of central bank money for large value payment systems Robert Lindley Deputy Head, CPSS Secretariat Regional workshop on reforming payment and securities settlement systems for the Middle East and North Africa Bahrain, Wednesday 16 March 2005 1

2. Overview • Some stylised facts about central bank money • Who must use central bank money • Who can use central bank money • Services on central bank accounts

3. Some facts about central bank money Importance of money • Almost every economic transaction involves money • Economic agents free to choose means of payment • Most money is “fiat” money – so acceptance depends on trust • Key role of central bank is to maintain trust in money – both its value (monetary policy) and its circulation (payment systems)

4. Money, money, money …. 1 Coins are usually issued by the Ministry of Finance (this complication is ignored in the rest of the presentation)

5. Central bank cash • Central bank has monopoly • But universal “access” – everyone can use cash • Why? • Cash is a bearer instrument • Safe and convenient for users to have central bank monopoly – no need to worry about the riskiness of the issuer • A monopoly? Inefficient? Cost may not be too high.

6. Central bank deposits • Central bank and commercial banks both issue deposit money but access to central bank deposit money is usually very limited (eg mostly banks and government). Why?

7. Central bank Monobanking Safe but less efficient? B C A D B C A D “Free” banking More efficient but less safe? Architectureof deposit money A balance between safety and efficiency Central bank Central bank and commercial bank money Efficient - competition between banks (more important than with cash) Safe – banks (and customers) indifferent about where payments come from

8. Advantages and disadvantages of settling in central bank money Advantages for banks • Safety (credit and liquidity risk, business continuity) • Liquidity (routine and emergency) • Efficiency (single settlement institution) • Neutrality (central bank is not usually a competitor) • Other perceived benefits (safety net) Disadvantages for banks • No interest paid • Regulatory costs

9. “The singleness of the currency” One dollar is one dollar is one dollar … regardless of whose liability it is. Originally a result of • central bank monopoly of cash … • … and, for deposit transfers, interbank settlement at the central bank More recently also supported by: • deposit insurance • banking supervision which mean we worry less about bank failures

10. B C A D Three issues • Who must use central bank money – who must have a central bank account? • Who can use central bank money – who is allowed to have a central bank account? • What services should the central bank provide on the accounts?

11. Who must use central bank money Payment systems • Systemically important payment systems “Assets used for settlement should preferably be a claim on the central bank; where other assets are used they should carry little or no credit or liquidity risk” Core principles for systemically important payment systems (SIPS) • Reason: safety • In practice, almost all SIPS do settle in central bank money • Main exceptions: foreign currency systems (nb: CLS as key example)

12. Other payment systems? • Usually allowed to settle in central bank money but do not have to • In practice, most usually do • Efficiency and neutrality particularly important • Sometimes discouraged (particularly if system includes non-banks as participants)

13. Second tier banks (indirect participants) E A First tier banks (direct participants) D C F B Central bank Two-tier structure Individual banks? C D B E Central bank A F Single-tier structure

14. Tiering • Extent of tiering depends partly on costs • Partly on tradition • Partly on cartels (especially in the past) • … but rarely forbidden. (NB Hong Kong.) Usually central banks leave it up to individual banks to decide. Why? • Big banks typically do use central bank money • Efficiency benefits may outweigh safety costs • Difficult to enforce • But ……

15. A C D B Is this a quasi-system? Concentration …… Flows via central bank: A↔B A↔F B↔C B↔D B↔E B↔F C↔F D↔F E↔F Flows via central bank: A↔B A↔C A↔D A↔E A↔F B↔C B↔D B↔E B↔F C↔D C↔E C↔F D↔E D↔F E↔F E C D B E Central bank A F Central bank F Single-tier structure Two-tier structure

16. Quasi-systems • Central banks still considering what (if anything) to do • Unlikely to lead to limits on tiering • May lead to oversight of quasi-systems (ie some payment system standards applied to Bank A) • Practical issues (eg how big do you have to be to be a quasi-system) • Cooperation with banking supervisors likely

17. Key: increasing trend no change decreasing trend Who can use central bank money Who can have access?

18. B C A D Increasing trend (1) Non-bank securities firms and other non-bank financial institutions May be similar to banks – the border line is not always clear Advantages of allowing access • systemic risk? • competitive disadvantage? • central bank neutrality? Disadvantages of allowing access • moral hazard? • disintermediation? • risk to central bank?

19. Bank Bank Bank Bank Bank Bank Increasing trend (2) Remote access Main issue is risk (especially if credit is available) Is there demand? NB CLS as key example Germany United States USD Hong Kong

20. Decreasing trend Government (central and other), central bank staff, general public, corporates Advantages of allowing access • “Experience” for the central bank • Neutrality (for government) Disadvantages of allowing access • Unfair advantage? (re general public and corporates) • No particular advantage – better to have a competitive tender (re government)

21. What services should central banks provide? Services on accounts • Credit • Account may be of little benefit without it • Risk to central bank (so collateral, limits, fees) • Reducing credit costs • System design (eg hybrids) • Wider range of collateral • Technical changes • Standards • Easier connectivity • Operating hours • CLS as an example

22. USD BANK A ZURICH BANK B BAHRAIN JPY CLS: a key example Continuous Linked Settlement is an example of settlement in commercial bank money, remote access, and the need for longer opening hours (1) A foreign exchange deal

23. Bank A's JPY correspondent Bank B's JPY correspondent USD payment system Bank A's USD correspondent Bank B's USD correspondent USD USD USD BANK A ZURICH BANK B BAHRAIN JPY JPY JPY JPY payment system (2) The current settlement method X

24. Bank A’s USD corresp-ondent USD USD Bank B’s JPY corresp-ondent JPY JPY CLS has remote access to RTGS systems around the world to receive and make these payments … … and needs all systems to be open at the same time … Settlement is on the books of CLS Bank (ie not central bank money) (3) Under CLS Bank B’s USD corresp-ondent USD C L S B A N K USD BANK A ZURICH BANK B BAHRAIN Bank A’s JPY corresp-ondent JPY JPY CLS BANK NEW YORK

25. Day 2 Day 1 (4) Payment system hours First day (in Japan) Second day (in Japan) Japan “Core” CLS hours (7 to 12 CET) Day 1 Switzerland Day 1 USA (NY) 6 Time in Japan 24 12 0 6 12 18 22 Time in Switz. 16 4 16 22 4 10 Time in USA 10 16 22 4 10 16 22

26. B C A D Conclusion A mixture of central bank and commercial bank money is important to achieve a balance between safety and efficiency. But there are no clear rules about who can or must use central bank money. It is a matter of judgement about where the best balance lies.