What To Do about Bilateral Credit Limits in the LVTS When a Closure Is Anticipated: Risk versus Liquidity Sharing among LVTS Participants
The authors examine the effect of a trade-off between shared credit risk and liquidity efficiency, among participants in Tranche 2 of the Large Value Transfer System (LVTS T2), on their decisions to leave open, or close, their bilateral credit limits (BCLs) to a participant at risk of imminent closure. The authors' analysis considers a network of three banks, in a settlement system similar to the LVTS T2. Although it is widely believed that closure of one bank is imminent, the exact timing of the closure - during or after the settlement cycle - is uncertain. The other two banks face an "open or close" choice regarding their BCLs to the problem participant. Based on the expected net payoff of each choice, which includes the value of network externalities, the analysis shows that, when the expected credit loss is sufficiently low, an open-BCL pure-strategy Nash equilibrium can exist and can be Pareto efficient. This result dispels the generality of the frequent assertion that participants in the LVTS T2 will close their BCLs to a participant that is subject to imminent closure.
New developments in large-value payment systems - May 2005
iii Foreword Large-value payment systems (LVPS) play a key role in the financial infrastructure, by discharging payment obligations between banks. The 1990s experienced a major transformation in the design of these systems: from deferred net settlement (DNS) systems, which settled only at the end of the day, to real-time gross settlement (RTGS) systems, which settle on a continuous basis. This revolution was largely due to the possibilities offered by information and communication technology and to the measures taken by central banks to reduce systemic risks in these systems. The Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries reflected these changes by publishing in 1997 the report Real-time gross settlement systems. The purpose of this report is to present the state-of-the-art in LVPS, taking stock of the developments which have taken place since the 1997 report. It is written so as to be free-standing and not require reference to previous reports. The central message of the report is that interbank payments today settle faster, with a lower amount of liquidity (mainly central bank money), and at a lower cost. Indeed, whereas the key achievements in the 1990s were speed and safety of payments, the focus since the turn of the century has been to reduce liquidity costs and to provide users with more flexible intraday liquidity management. In parallel, new systems have emerged to meet an expanding demand for cross-border payments. The primary example is CLS (Continuous Linked Settlement), which was established to reduce credit risk in the settlement of foreign exchange transactions. Another example is the emergence of new infrastructures in countries where a foreign currency plays an important role. Standardised arrangements have been established that enable financial institutions to settle foreign currency transactions through a correspondent bank while using the same system design as the local RTGS system. While certain trade-offs exist between achieving lower risks and achieving lower costs, recent developments in LVPS design allow more flexibility in addressing various risk and cost trade-offs than previously available in traditional architectures. Central banks on their side have continued to seek a balance between more stringent risk controls and the need for systems to be cost-efficient. The analysis in this report shows that the complexity of trade-offs between risks and costs implies a wide range of possibilities for the design of an LVPS. There is therefore no single solution fitting all …
Congestion and Cascades in Payment Systems
We develop a parsimonious model of the interbank payment system. The model incorporates an endogenous instruction arrival process, a scale-free topology of payments between banks, a fixed total liquidity which limits banks’ capacity to process arriving instructions, and a global market that distributes liquidity. We find that at low liquidity the system becomes congested and payment settlement loses correlation with payment instruction arrival, becoming coupled across the network. The onset of congestion is evidently related to the relative values of three characteristic times: the time for banks’ net position to return to 0, the time for a bank to exhaust its liquidity endowment, and the liquidity market relaxation time. In the congested regime settlement takes place in cascades having a characteristic length scale. A global liquidity market substantially attenuates congestion, requiring only a small fraction of the payment-induced liquidity flow to achieve strong beneficial effects.