Wholsale Payment Systems

1 See Emmons (1996) for anoverview of the retail paymentssystem in the United States.See Humphrey, Pulley, andVesala (1996) for a compari-son of G-10 countries’ retailpayments systems or Bank forInternational Settlements(1993b) for details on bothretail and wholesale compo-nents of payments systems inthe G-10 countries.

2 Bank for InternationalSettlements, 1989, 1990,1992, 1993a, 1993b,1995a, 1996, 1997a,1997b.

3 “Secured” net settlement sys-tems (discussed later in thisarticle) are those that can with-stand the failure of the memberfinancial institution with thelargest amount due to othermembers of the system.

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NOVEMBER/DECEMBER 1 9 9 7

RecentDevelopmentsin WholesalePaymentsSystemsWilliam R. Emmons

Payments systems can be divided conceptually into two components:retail and wholesale. The retail pay-

ments system, used primarily by non-banks for making and receiving payments,involves relatively small transfers of mone-tary value. In contrast, the wholesale sys-tem, which banks use to make paymentsto each other, involves relatively largetransfers.1

The Bank for International Settlements(BIS) in Basle, Switzerland (a consultativeforum for major central banks) has recentlypublished a series of reports covering var-ious aspects of the wholesale paymentssystem,2 the purposes of which are, first,to inform central bankers and payments-system participants about current practicesin wholesale payments systems, andsecond, to provide a central-bank perspec-tive on how various changes to thesepractices could enhance the safety and efficiency of wholesale payments systems.This article summarizes the reforms to G-10 wholesale payments systemsdocumented in and spurred by this series of BIS reports.

One general approach has been tostrengthen (or “secure”) existing paymentssystem arrangements based on net settle-ment.3 Net settlement systems accumulatea record of financial obligations amongparticipants over a prespecified period oftime, such as a business day, at the end of

which the net amount of funds, securities,or other financial obligations owed by orto each participant is transferred. The primary shortcoming of traditional “unse-cured” net settlement systems is that notonly do they expose their own members to the risk of default by other members,they also expose financial institutions andother creditors outside the netting system.The danger is that liquidity or solvencyproblems will thus be transmitted quicklyand unpredictably throughout the globalfinancial system.

“Secured” net settlement systems, onthe other hand, are designed so that anydisruptions caused by a single member(even if this happens to be the institutionwith the largest net obligations to othermembers) can be absorbed by the systemand its members with no risk of furtherpropagation. To achieve this goal, suchsystems require that members undertakeextensive and perhaps costly risk-manage-ment measures. These measures typicallyinclude real-time monitoring of counter-parties within the system, net debit caps,collateralization, and additional open-ended financial guarantees in case all other safeguards prove inadequate.

Another approach to strengtheningwholesale payments systems involvesgreater private-sector use of gross settlement.Gross settlement systems include real-timegross settlement payments systems(RTGS), delivery-versus-payment (DVP)systems, and payment-versus-payment(PVP) systems. Recently, many centralbanks have created new RTGS systems orimproved their existing ones to strengthentheir wholesale payments systems. In con-trast to unsecured net settlement systems,gross settlement systems can eliminate virtually all repercussions to other private-sector members when one institutionencounters difficulty. There is a cost, how-ever. Depending on its structure, a grosssettlement system may impose significantliquidity demands on participants, or it

William R. Emmons is a research economist at the Federal Reserve Bank of St. Louis. Kent A. Koch provided research assistance.

may require that the central bank incursubstantial supervisory and risk-management costs in the process ofalleviating liquidity burdens.

Most G-10 central bankers believethat, despite their costs, gross settlementsystems will be important components ofwholesale payments systems in the future.Why, then, have private-sector financialinstitutions very often chosen to upgradeand secure existing net settlement systemsinstead of moving more rapidly to grosssettlement systems? Could (and should)central banks do more to facilitate a morewidespread and rapid transition to grosssettlement systems?

This article does not provide definitiveanswers to these questions. Instead, I offeran overview of recent developments inlarge-value gross and net settlement systemsin the G-10 countries. In the first section,I discuss gross settlement systems, includingRTGS systems, for large-value funds trans-fers; DVP systems, for securities; and PVPsystems, for foreign-exchange settlement.The second section discusses netsettlement systems and explores severalrelated issues, including the risk that net-ting agreements may not be legally bindingin all jurisdictions and the possibility thatliquidity or solvency problems could spillover from one financial institution to anotherand, in turn, to the financial system as awhole, creating a situation termed systemicrisk. The third section concludes with afew tentative hypotheses regarding the rel-atively slow movement to date of wholesalepayments and settlement activity to grosssettlement systems.

GROSS SETTLEMENT SYSTEMS

“Federal Reserve Updates Payments-System Risk Policy, Implements Pricing onFedwire.”

“European Central Banks Reach OutlineAgreement on TARGET.”

“Bank of Japan to Convert BOJ-Net toReal-Time Gross Settlement Exclusively.”4

The common theme in these fictionalbut representative headlines is a desire onthe part of G-10 central banks to influenceprivate-sector behavior in wholesale(large-value) payments systems. In partic-ular, central banks have encouraged theuse of real-time gross settlement paymentssystems and trade-by-trade securities andforeign-exchange settlement systems. Thissituation has occurred because there is virtual agreement among major centralbanks that gross settlement systems makewholesale payments systems more immuneto widespread financial disruption, a key determinant of economic stability and efficiency.

Key Design Issues in Real-TimeGross Settlement Systems

Real-time gross settlement systems are large-value funds transfer services thatoperate continuously during the businessday to provide irrevocable settlement of pay-ments obligations in central-bank money.Irrevocable funds transfers on RTGS systemsoccur when a central bank debits the reserveaccount of the payor and credits the accountof the payee. This transfer of value frompayor to payee is simultaneous and final(i.e., not subject to reversal for any reason).If the funds transfer occurs (at least in prin-ciple) at the time the instructions of thepayor are transmitted to the central bank,then it is said to occur continuously, or in“real time.”

Central banks provide RTGS systemsto commercial banks and other selectedinstitutions such as government agenciesand, in some countries, clearing houses forsecurities and derivatives exchanges (Bankfor International Settlements, 1997a, pp. 33-7; Bank for International Settlements,1997b, p. 14). Funds transfers over RTGSsystems may be for millions of dollars orthe local-currency equivalent, althoughthese systems also handle smallerpayments.

The design and operation of RTGS systems differ considerably from onecountry to another. Two important dimen-sions along which currently operating or

4 Fedwire (the Federal Reserve’sFedwire Funds TransferService), TARGET (the Trans-European Automated Real-timeGross Settlement ExpressTransfer System), and BOJ-Net(the Bank of Japan’s large-value funds transfer service)are all real-time gross settle-ment (RTGS) systems.

NOVEMBER/DECEMBER 1997


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proposed RTGS systems differ are (1) poli-cies toward the granting of central bankintraday credit and (2) the existence andmanagement of queues (see Table 1).Intraday credit is valuable in an RTGSsystem because it can reduce paymentblockages that may arise as one bank’s out-going payment awaits an incoming paymentfrom another bank, which may, in turn, bewaiting on a payment from a third bank.Payments may become blocked in RTGSsystems because of the “cover principle” in gross settlement systems: An outgoingpayment order is executed if and only ifthe sending bank currently has sufficientreserves, or cover, in its reserve account atthe central bank.

The worst case of uncoordinated payment demands is gridlock, in which no bank can make a payment through anRTGS system because all reserve balancesare held by banks due to receive paymentsfrom others. Although unlimited centralbank intraday credit would eliminate grid-lock, it is not offered in any RTGS systemsbecause such a policy would create moralhazard, in that banks might tend to managetheir intraday liquidity less intensively.Such a situation could give rise to an acuteliquidity crisis, into which central bankswould need to intervene in their role aslender of last resort. Ample availability of

central bank intraday credit could alsohamper the emergence of intraday moneymarkets, which are, in principle, a necessarycomponent of a complete and efficient setof financial markets.

Despite the fact that all RTGS systemsare capable of operating continuously,some payment orders in some RTGSsystems are not carried out immediately.For example, when a sending bank hasinsufficient funds in its reserve accountand central bank intraday credit is notavailable, either temporarily for that bankor as a matter of system design, a paymentorder will not be executed. A pendingpayment order is subject to two differentresponses by central banks.

The payment order may be rejectedoutright, in which case the sender mayenter it into an “internal queue” that assignspriority to outgoing payments. Selectedpayment orders are then resubmitted tothe RTGS system when sufficient coveringfunds in the bank’s reserve account becomeavailable, either from payments received orvia borrowing from another bank.

Alternatively, a payment order thatcannot be executed because of insufficientreserve funds may enter a “centralizedqueue” maintained by the central bank.That is, rather than returning the paymentorder unexecuted to the sending institution,



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Intraday Credit Policies and Centrally Located Queues in G-10 RTGS Systems

Countries Whose RTGS Centrally No Centrally Systems Provide: Located Queue Located Queue

Central bank intraday credit Belgium United KingdomFrance United StatesGermanyItalyNetherlandsSweden

No central bank intraday credit Switzerland Japan

No RTGS system: Canada.

SOURCE: Bank for International Settlements (1997a, Table 3, p. 13).

Table 1

the central bank may retain all paymentorders that require incoming cover in acentrally located computer file. Whenadequate reserves become available to execute any of the queued requests, thecentral bank then reenters the paymentorder into the system.

A centrally located and managed queuecan facilitate an orderly flow of paymentsbecause the system operator can identifypayment requests that will offset each otherto some extent. That is, one payment pro-vides cover for the next, which providescover for the next, and so forth. This typeof oversight and queue management istermed “optimization” (Bank for Interna-tional Settlements, 1997a, pp. 24-7).

The existence of a centralized queueand optimization routines may discourageintensive management of intraday liquidityby banks. These factors may also encouragebanks to anticipate payments (i.e., creditthe accounts of depositors to whomqueued payments are directed before finalsettlement actually occurs). Unfortunately,the practice of systematically anticipatingpayments that are being held in queues

tends to increase systemic interde-pendence and settlement risk—preciselythe problems that RTGS systems aredesigned to eliminate.

Overview of RTGS Systems in G-10 Countries

Table 2 lists the RTGS systemscurrently in operation or in preparation inthe G-10 countries. The Federal Reserve’sFedwire funds-transfer service is the oldestRTGS system in the world. Since 1984,RTGS systems have been introduced by allother members of the G-10 group of coun-tries except Canada. Other EuropeanUnion countries (i.e., those not in the G-10) that hope to participate in the initiallaunch of the European single currency in1999, including Greece, Spain, Ireland,Luxembourg, Austria, Portugal, andFinland, are also developing RTGS systems(European Monetary Institute, 1996).Other countries that have recently intro-duced RTGS systems or plan to do soinclude the Czech Republic, Hong Kong,Korea, Thailand, Australia, China, New



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Real-Time Gross Settlement (RTGS) Systems in G-10 Countries

Country Name of RTGS System Year of Implementation

Belgium ELLIPS 1996Canada — —France TBF 1997Germany EIL-ZV 1988Italy BI-REL* 1997Japan BOJ-NET 1988Netherlands TOP* 1997Sweden RIX 1986Switzerland SIC 1987United Kingdom CHAPS 1984

Euro version of CHAPS 1999United States Fedwire 1918

*BI-REL and TOP replace previously existing RTGS systems BISS (implemented in 1989) and FA (implemented in 1985), respectively(Bank for International Settlements, 1993b, pp. 218-19, 302-5).

SOURCE: Bank for International Settlements (1997a), Annex 1.

Table 2

Zealand, and Saudi Arabia (Bank for Inter-national Settlements, 1997a, p. 1).

The Federal Reserve System’s FedwireFunds Transfer Service (commonly knownas “Fedwire”) began operations in 1918and was converted to a fully computerized,high-speed electronic telecommunicationsand processing network in 1970 (Bank forInternational Settlements, 1997a, p. 12).In addition to upgrading Fedwire technicaland communications capabilities, the Fed-eral Reserve has also implemented a seriesof measures to improve Fedwire risk man-agement in recent years (Richards, 1995;Hancock and Wilcox, 1996). One focus of these efforts has been to reduce banks’daylight overdrafts (short-term creditextensions by the central bank) on Fedwire(see shaded insert: “Federal ReserveAttempts to Limit Daylight Overdrafts on Fedwire”).

RTGS systems in European G-10countries differ among themselves butgenerally fall into two categories accordingto whether or not the country expects toparticipate in the initial phase of EuropeanEconomic and Monetary Union (EMU)beginning in 1999. Those countries thatplan to participate (Belgium, France, Ger-many, Italy, and the Netherlands) haveconformed their RTGS systems to acommon set of standards to facilitate theirinterlinking in the TARGET system. Inparticular, fairly liberal policies towardcentral bank intraday credit and centralizedqueuing facilities are envisioned for partic-ipating RTGS systems. Both of thesefeatures enhance the liquidity of RTGS sys-tems. In contrast to Fedwire, the EMUsystems will not assess charges for daylightoverdrafts, although such borrowings mustbe fully collateralized in order to protectthe fledgling European System of CentralBanks against credit risk posed by individualbanks (Bank for International Settlements,1997a, pp. 12-3). European G-10 membersthat do not plan to participate in EMU atthe outset include the U.K. and Switzerland(not a member of the European Union).Liquidity-enhancing measures in thesecountries’ RTGS systems (particularly inSwitzerland) are not as liberal as those of the

other European countries mentioned above,as the discussion below will make clear.

The Bank of Japan is prepared to gofurther than any other G-10 central bankin forcing the pace of change toward RTGSsystems. Currently, banks may submit pay-ments to BOJ-Net to be settled at 9:00 a.m.,1:00 p.m., 3:00 p.m., or 5:00 p.m. on a netbasis; or payment orders may be submittedfor immediate execution via the RTGS modeof BOJ-Net. The BOJ announced at the endof 1996 that it will phase out the net settle-ment capability of BOJ-Net by the year2000 (Matsushita, 1997). Thereafter, real-time gross settlement will be the only modeof settlement available via BOJ accounts.This is a significant policy decision, becausedesignated-time net settlements accountedfor 98.8 percent of volume and 99.9 percentof value on BOJ-Net in 1995, while RTGSaccounted for the remainder (Bank forInternational Settlements, 1997a, Annex 1).

In sum, there appears to be no international consensus regarding theoptimal design of an RTGS system. Thisconclusion is not surprising when onetakes into account significant cross-countrydifferences in central-bank preferences,locally prevailing cash-management tech-nologies, availability of collateral, andsecurities market liquidity (Furfine andStehm, 1996). All existing systems appearto be a compromise between objectivesthat sometimes conflict among banks andinstitutional constraints that may be evalu-ated differently by different central banks.

The Role of Intraday Credit in RTGS Systems

Some RTGS systems allow partic-ipating banks to send payments withfinality for amounts greater than theirreserve balances immediately prior to thetime of the request. In carrying out such apayment request, the central bank extendsa short-term loan to fund the reserveaccount of the sending bank. Since allcentral banks that grant such credit exten-sions require repayment by the end of thebusiness day, these loans are termeddaylight overdrafts.5

5 All G-10 central banks provideovernight lending facilities,some of which can be accessedduring the business day (Bankfor International Settlements,1997a, Annex 1, Part II).Without exception, banks findthem relatively unattractivesources of intraday funds tomeet payments obligations.



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There are several basic models for day-light overdraft privileges on RTGS systems(Bank for International Settlements,1997a, pp. 14-21 and Annex 1, Part II).Among G-10 RTGS systems, daylight over-

drafts on Fedwire within a bank’s net debitcap are unusual in that they do not gener-ally require specific collateral backing.6

This feature is advantageous to banks,which typically do not need to hold or

6 Each bank’s net debit cap is setas a multiple of its regulatorycapital. Branches or agenciesof foreign banks, domesticfinancial institutions that havebeen identified by the FederalReserve as troubled, and non-bank financial institutions thatprovide overdraft funding ofsecurities activities for affiliatesmust provide collateral for overdrafts. Collateral is alsorequired for frequent and mate-rial overdrafters. In total, morethan 50 percent of all intradaycredit extended by the Fed iscollateralized.


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FEDERAL RESERVE ATTEMPTS TO LIMIT DAYLIGHTOVERDRAFTS ON FEDWIRE

For more than 10 years, the Federal Reserve has undertaken a campaign to inducebanks to control the amount of their daylight overdrafts on Fedwire. While Fed policy-makers have long believed that relatively liberal provision of central bank intradaycredit on Fedwire was appropriate (Board of Governors of the Federal Reserve System,1988, p. 50), they also felt that some form of market discipline or regulatory restrainton daylight overdrafts could improve the allocative efficiency of such credit withoutsacrificing its overall benefits in terms of enhancing the system’s liquidity. The impetusfor Federal Reserve action to limit Fedwire daylight overdrafts stemmed from threeconsiderations (Richards, 1995, pp. 1066-67):

First, large daylight overdrafts create the potential for large demands for overnightborrowing, thereby complicating the conduct of monetary policy. Since daylight over-drafts are unsecured, but overnight discount-window loans must be secured, a largeoverhang of daylight overdrafts that cannot be repaid by day’s end could create disor-derly conditions in the Federal funds and securities markets as reserves and collateralare sought to eliminate or secure Federal Reserve lending. Alternatively, such an over-hang could force the Fed to allow some uncollateralized overnight overdrafts, thus vio-lating its own risk-management policies.

Second, the Fed became increasingly aware in the 1980s of the substantial creditrisk associated with unsecured daylight overdrafts. The Fed guarantees all paymentsmade on Fedwire, so unlimited, unpriced, unsecured overdrafts allowed sending banksto appropriate the Federal Reserve’s unsurpassed credit rating at no cost to themselves.

Finally, the Fed began to recognize more clearly that substantial daylight overdraft-ing on private large-value transfer systems put the payments system as a whole at risk.In order to control the risk in parts of the wholesale payments system over which theFed had only indirect influence—such as CHIPS † —it was necessary to accumulateexperience and demonstrate progress in managing risk where the Fed did maintain con-trol, namely, on Fedwire. Controlling daylight overdrafts on Fedwire was a step towardimplementing sound intraday credit policies throughout the wholesale payments system.

The Federal Reserve imposed net debit caps on daylight overdrafts in March 1986and began charging explicit fees for daylight overdrafts in accounts at Federal ReserveBanks in April 1994 (Hancock and Wilcox, 1996, pp. 873-76). The Fed also uses real-time monitoring for “problem” institutions and requires these and selected otherFedwire participants to post collateral for daylight overdrafts. Net debit caps weretightened and adjusted several times subsequent to their introduction, while overdraftfees were increased in April 1995. Empirical evidence indicates that these measures—especially overdraft fees—have been effective in curtailing certain banks’ use of day-light overdrafts on Fedwire (Hancock and Wilcox, 1996, pp. 906-7).

† CHIPS (Clearing House Interbank Payments System) is a net settlement system operated by the New York Clearing House Association. See section on net settlement systems for details.

manage significant amounts of reserves orcollateral for payments purposes. Anotherunusual aspect of daylight overdrafts onFedwire is explicit volume-based pricing.The Federal Reserve charges an annualizedrate of 15 basis points on the daily averageoverdraft in excess of the bank’s deductibleamount, which is 10 percent of its regula-tory capital. Only about 90 financialinstitutions typically incurred overdraftfees of more than $100 in any two-weekperiod in 1995 (Richards, 1995, p. 1072),so Fedwire overdraft fees do not constitutea large explicit cost for intraday credit.7

Given the existence of some amount ofunpriced, uncollateralized daylight credit(up to the amount of a bank’s net debit cap)and low explicit costs for overdrafts in excessof an institution’s deductible, the FederalReserve’s intraday credit policy could betermed relatively liberal, overall.

Another model for central-bank exten-sions of intraday credit requires a borrowingbank to fully collateralize the overdraft.8

This approach is typical of existing orplanned European RTGS systems thatpermit daylight overdrafts. Quantitativelimits on overdrafts apply in Belgium andItaly but not in Germany, the Netherlands,or Sweden (Bank for InternationalSettlements, 1997a, Annex 1, Part II).

Intraday credit in the U.K. and Franceis available not through daylight overdraftsper se but rather through intraday sale andrepurchase transactions with the centralbank. This facility was chosen in order tosolidify the central bank’s legal claim to thesecurities involved, rather than for anysubstantive economic reason (Bank forInternational Settlements, 1997a, p. 13).Similarly, daylight credit for the RTGScomponent of Japan’s BOJ-Net is availableexclusively through sale and repurchasetransactions. Given adequate supplies ofcollateral securities in the market, a centralbank intraday credit policy involvingunpriced but collateralized overdrafts (or sale and repurchase transactions) with no quantity limits or relatively highones could also be termed fairly liberal, as is the case in the United States on Fedwire.

Finally, Switzerland alone among theG-10 countries with RTGS systems operatesa very restrictive policy toward centralbank intraday credit. The Swiss SIC systemdoes not allow daylight overdrafts on anybasis (collateralized or not), nor does theSwiss National Bank (SNB) provide facili-ties for intraday sale and repurchaseagreements. The only direct liquidityassistance provided by the SNB is collater-alized overnight borrowing, which, if itarises from a failure by a bank to producereserve funds to cover its queued payments,incurs a penalty rate of interest (Bank forInternational Settlements, 1993b, p. 365).

Delivery-Versus-Payment (DVP) andPayment-Versus-Payment (PVP)Systems

As part of their overall function of providing bank-to-bank large-value fundstransfers, RTGS payments systems frequentlyconstitute one element in a delivery-versus-payment (DVP) settlement system forsecurities or of a payment-versus-payment(PVP) system for settling foreign-exchangetrading obligations (Bank for InternationalSettlements, 1992, p. 15; Bank for Interna-tional Settlements, 1993a, p. 4). Manynew DVP and PVP systems are beingplanned or discussed (Bank for InternationalSettlements, 1997a, pp. 33-7). The threemain models for structuring DVP systemsare outlined below (Bank for InternationalSettlements, 1992, pp. 17-24):

Model 1 DVP Systems. So-called“Model 1” DVP systems consist of linkedgross, simultaneous settlement of a securi-ties transfer (delivery) and the correspond-ing funds transfer (payment). The FederalReserve’s Securities Transfer Service forU.S. Treasury and agency securities (com-monly called the “Fedwire book-entry sys-tem”) operates on the same principle asRTGS systems for funds transfers. That is,the seller of a security (comparable to thepayor of funds above) must post the secu-rities with the system operator before thebuyer of the security (comparable to thefunds payee above) takes final, irrevocable

7 Richards reports that a muchlarger group of banks–about700–appear to keep theiroverdrafts within their net debitcaps by managing intraday liq-uidity, thereby avoiding over-draft fees, as well (Richards,1995, p. 1072).

8 To be fully effective as a centralbank risk-management tool in a real-time payments system, a full-collateralization policyrequires a “Model 1” DVP sys-tem covering collateral-eligiblesecurities. The point is that collateral securities must beavailable for real-time pledges,as well.



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delivery. The Fed’s book-entry and fundstransfer services are linked and togetherconstitute a “Model 1” DVP system (Bankfor International Settlements, 1992, pp. A322-24).

A few other central banks have devel-oped already or are in the process ofdeveloping similar systems. In particular,“Model 1” DVP systems will be critical inproviding the future European System ofCentral Banks (ESCB) with the protectionagainst individual banks’ credit riskenvisioned in the policy of collateralizedintraday overdrafts. Although the ESCBhas no plans to establish a Europe-widegross settlement system for securities, indi-vidual national securities settlementsystems will be linked with TARGET toestablish “Model 1” DVP systems.

Model 2 DVP Systems. A “Model 2”DVP system consists of gross settlementsof securities transfers, followed at the endof the day by net settlement of funds trans-fers. The U.K. gilt-edged (Treasury) secu-rities market operated according to thismodel as of 1992 (Bank for InternationalSettlements, 1992, pp. A319-21). In thistype of system, all securities transfers arefinal when executed during the day.However, the corresponding funds trans-fers remain provisional until the end of theday, when final settlement occurs on amultilateral net basis. Failure of a bank ina net-debit position on funds transfers (i.e.,owing funds after calculation of net fundspositions) does not affect the finality ofsecurities transfers that have already taken place.

Model 3 DVP Systems. Finally, “Model3” DVP systems consist of parallel multilat-eral net settlement of securities and fundstransfers. The Bank of Japan’s “DVP-NET”is an example of this type of system (Bankfor International Settlements, 1992, pp. A37-9). Private DVP systems that fol-low this model include the GovernmentSecurities Clearing Corporation, theNational Securities Clearing Corporation,the Depository Trust Company, and theParticipants Trust Company in the United

States, and Euroclear and Cedel Bank inEurope (Federal Reserve System, 1997).As noted above, final settlement of the netobligations on one or both legs (securitiesand/or funds) that arise in these systems istypically accomplished via a gross settle-ment system. This points out an importantcomplementarity that often exists betweenthe various types of DVP systems. “Model3” DVP systems in the U.S. may use theFederal Reserve’s “Model 1” DVP system toprovide final settlement of the net obliga-tions of participants resulting from multi-lateral clearing of securities or fundstransfers.

PVP Systems. PVP systems are analogousto “Model 1” DVP systems because theyallow a pair of financial transfers to be set-tled on a gross basis simultaneously andwith finality. The difference is that eachleg of a PVP transaction consists of a fundstransfer on a different national RTGSfunds-transfer system. That is, instead ofproviding simultaneous transfers of securi-ties and funds in a single currency, PVPsystems allow foreign-exchange transac-tions to be settled with finality in real time.PVP systems could be helpful in reducing foreign-exchange settlement risk, the single largest remaining source of risk in G-10 payments and settlement systems(Bank for International Settlements, 1996, pp. 4-5).

No PVP systems linking nationalRTGS systems are currently operating orbeing planned. Although it may appear tobe such a system, the TARGET system inEurope will link national RTGS systemsoperating in the same currency, the euro.Therefore, TARGET’s interlinking ofnational RTGS systems will constitute acommunications and clearing system only(similar to the financial links between the twelve Federal Reserve Banks in theUnited States).

Private foreign-exchange nettingarrangements provide PVP elementswithout central-bank involvement in amanner analogous to a “Model 3” DVPsystem. For example, in a multilateral for-eign-exchange netting arrangement that



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involved ten banks and four currencies,each of the ten banks would be informedat the end of the day of its net position(debit or credit), in each of the fourcurrencies, vis-a-vis the other members.Settlement of each bank’s obligation ineach currency would then proceed in sepa-rate national large-value payments systems(such as CHIPS or Fedwire in the UnitedStates) and therefore would not be linkedor simultaneous.

A multilateral foreign-exchangenetting agreement that nets currency-by-currency reduces overall settlement risk bylowering the amount of each currencyowed to or by any given bank. That is, allof a bank’s trades involving U.S. dollarscovered by the agreement are reduced to a smaller net U.S. dollar amount due orreceivable, all of the bank’s trades involvingdeutsche marks are netted to a smaller netdeutsche mark amount due or receivable,etc. As in the “Model 3” DVP systems forsecurities settlement, one could think ofthis foreign-exchange netting approach asparallel provisional settlement rather thanlinked final settlement (“Model 1”). Finalsettlement of the net positions in each cur-rency must still be carried out separately.

Both multilateral and bilateral foreign-exchange netting arrangements currentlyexist in the United States and Europe. The Multinet International Bank andECHO (Exchange Clearing House) aremultilateral foreign-exchange netting services, while FXNET, S.W.I.F.T. (Societyfor Worldwide Interbank FinancialTelecommunication), and VALUNET provide bilateral netting services for banksengaged in foreign-exchange trading (Bank for International Settlements, 1996, p. 15-16).

A newly formed venture, CLS Services,Ltd., is an important private-sector initia-tive that will attempt to implement a PVPsystem that is analogous in some respectsto a “Model 1” DVP system but is closer totraditional correspondent banking in otherrespects. CLS Services, Ltd., which isjointly owned by a group of banks activein foreign-exchange trading, plans to createa subsidiary bank to function as a multi-

currency financial institution that can perform simultaneous, matched, “on-us”transfers of various currencies. Formed by the so-called G-20 group of major inter-national banks, this “continuous linkedsettlement” bank (hence CLS Services)would eliminate the time delay betweensettlement of the two legs of a foreign-exchange transaction, which is the sourceof the most serious risk exposures in thismarket (Bank for International Settlements,1996, p. 22; “Global Banks,” 1997). Inaddition to being available for direct useby individual trading banks, the CLS bankcould also assist netting arrangementssuch as FXNET and Multinet in dischargingthe net obligations that remained amongparticipants after netting in individual cur-rencies had occurred.

As in a “Model 1” PVP system, theCLS bank could provide virtually instanta-neous confirmations to trading banks ineach currency on a gross basis. Settlementwould be final, although withdrawals ofindividual currencies might be delayed bythe failure of counterparty banks to fundtheir CLS accounts with the appropriatemix of currencies. Thus, the CLS bankcould not provide unconditional protectionagainst foreign-exchange liquidity risk—as with a true “Model 1” PVP system—because some trades that are settled maynot allow counterparties to withdraw spe-cific currencies immediately (Bank forInternational Settlements, 1996, p. 22).

For example, suppose a Japanese bank and an American bank use the CLSbank for a single foreign exchange tradeduring one day. The Japanese bankpromises to send an American bank yen,and the American bank promises to paydollars to the Japanese bank. If a sufficientamount of yen is not in its CLS account by the end of the day, the Japanese bankmust fund that account with an RTGStransfer to the CLS bank over BOJ-Net. If the Japanese bank is declared insolventbefore funding its yen account, the CLSbank might cancel this trade.9 In any case, if the American bank has beencounting on the trade for fulfilling othertime-critical obligations, the failure of

9 This would occur if the CLSbank operated according to the“guaranteed refund system”(Bank for InternationalSettlements, 1996, p. 22).Alternatively, if the CLS bankoperated under the “guaran-teed receipt system,” a mem-ber bank could receive yen ifand only if it delivered dollarsto the CLS bank. The latter sys-tem would involve a perfor-mance guarantee from the CLSbank requiring capital or loss-sharing commitments by ownerbanks. At present, it appearslikely that the CLS bank willtake the latter approach.



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its counterparty could create disruptionsor delay.

Hence, although the CLS bank couldeliminate the settlement and liquidity risksinherent in a large number of foreign-exchange trades, it would not be operatingas a true “Model 1” PVP system. Instead,the CLS bank would be acting as a corre-spondent bank for each of its accountholders. Thus, it could not uncondition-ally guarantee that all foreign-exchangetrades would be perfectly liquid. Only central banks with the ability to createunlimited amounts of their own currencycan jointly operate a “Model 1” PVP system.

NET SETTLEMENT SYSTEMSThe principal alternatives to RTGS

systems for large-value funds transfers are bilateral correspondent-bankingrelationships and multilateral deferred netsettlement (DNS) systems.10 Bothcorrespondent banking and multilateralnetting systems offset gross paymentsobligations in order to arrive at a muchsmaller net settlement obligation.11

Similarly, the principal alternative to trade-by-trade gross settlement of trades insecurities and other financial obligations is a net securities or financial obligationsettlement system.

The primary benefit to financial insti-tutions of netting is a reduced need forimmediate liquidity or ownership of secu-rities, since final settlement is deferreduntil the end of the clearing cycle (usuallythe end of the business day). Becausedeferral of settlement implicitly requires afinancial institution to extend credit toanother institution from which it expectsto receive funds or securities, longer elapsedperiods between settlements also implygreater exposure of individual payee banksto the credit risks posed by their paymentscounterparties, the payors (Shen, 1997,pp. 48-50). Thus, it is clear that both theprimary benefits and the principal costs ofnetting derive from the use of privatecredit in settlement activity (see shadedinsert: “Private Credit Extensions in NetSettlement Systems”).

In addition to creating risky privateintraday credit, however, netting arrange-ments also reduce the absolute amount ofsettlement activity that must ultimatelyoccur. In general, the longer the periodbetween successive settlements, the greaterthe reduction in settlement obligations.Consequently, the direct credit exposuresthat build up over an extended clearingcycle in a netting system are, at the sametime, reduced by the process of netting(Board of Governors of the FederalReserve System, 1988, p. 4). The greater isthe amount of two-way trading among aset of counterparties during a clearingcycle (i.e., buying and selling of the samefinancial instrument), the more likely it isthat the risk-reducing aspect of nettingwill outweigh the risk-increasing nature ofdeferred settlement. Thus, when bilateraland multilateral netting arrangements aresoundly structured in appropriate circum-stances, regulators generally welcomethem. This conclusion is particularly truetoday after the decade-long efforts by theCommittee on Payments and SettlementSystems of the Bank for International Set-tlements, and by individual central banks,to upgrade the soundness of existing andproposed multilateral net settlementsystems in the G-10 countries.

Deferred Net Settlement (DNS)Large-Value Funds Transfer Systems

Table 3 lists the major DNS large-valuefunds transfer systems in the G-10 countries.The largest private DNS payments system inthe world is the Clearing House InterbankPayments System (CHIPS) in the UnitedStates (see Tables 4 and 5). CHIPS is operated by the New York Clearing HouseAssociation and includes over 100 domesticand foreign banks as its members. Fedwire,by way of contrast, connects roughly10,000 financial institutions in the UnitedStates to the Federal Reserve and therebyto each other.

Private-sector large-value paymentsclearing houses like CHIPS are not aprominent feature of the Japanese or mostEuropean payments systems, for largely

10 It is important to note that RTGSand DNS systems are not directcompetitors in all respects.DNS systems typically rely onthe national RTGS system forfinal daily settlement of themultilateral net (or “Net Net”)obligations incurred by partici-pants in the netting system.

11 In correspondent banking, onebank holds deposit balances atanother (or they hold balanceswith each other) that can bedebited or credited for fundstransfers, foreign exchange,securities, derivatives, or othertransactions. Accumulated netcredits or debits may be settledperiodically through transfers ofcentral bank reserves. Theserelationships are very importantin foreign-exchange tradingbecause they form the only linkbetween different nationalRTGS or DNS systems. For anoverview of payments and set-tlement in the foreign exchangemarket, see Gilbert (1992).For detailed discussions of mar-ket practices and risks in theforeign-exchange market, see Bank for InternationalSettlements (1989, 1990,1993a, 1996).



32

historical reasons. There are a few excep-tions, however. The United Kingdom’sClearing House Automated Payment System(CHAPS) settled large-value funds transfersin pounds sterling on a multilateral netbasis between 1984 and 1996. Subse-

quently, the system became a real-timegross settlement interface between privatebanks and the Bank of England (EuropeanMonetary Institute, 1996, p. 627).

Another private DNS payments systemin Europe is the ECU Clearing and


FEDERAL RESERVE BANK OF ST. LOU I S

33

PRIVATE CREDIT EXTENSIONS IN NET SETTLEMENT SYSTEMS

Deferring final settlement requires an implicit extension of credit from payee to payor in net settlement systems. Intraday loans are economically important eventhough there is no explicit private intraday credit market in most countries. That is,the time value of an intraday loan may be zero (more precisely, no market price exists),but net settlement systems require them in order to function, and lenders in such systems bear the sometimes substantial credit risks imposed by borrowers.

Consider an example in which three banks, called Banks A, B, and C, are the mem-bers of a DNS system. They enter payment orders at different times during the busi-ness day, which extends from 9:00 a.m. to 5:00 p.m. (the time of each payment requestis listed in parentheses in the table below). Final settlement occurs at 5:00 on a multi-lateral net basis. All three banks know the amount and timing of upcoming paymentflows at the beginning of the business day:

Receiving Bank (Lender)Paying Bank (Borrower) Bank A Bank B Bank CBank A $100 (9:05 a.m.)Bank B $100 (4:59 p.m.)Bank C $100 (9:10 a.m.)

Final settlement occurs at 5:00 p.m., so Bank B is effectively lending Bank A $100during the period from 9:05 a.m. to 5:00 p.m. Typically there is no explicit cost for thisintraday credit, although collateral requirements may impose some opportunity cost onthe payor. Similarly, Bank C receives an intraday loan of $100 from Bank A between9:10 a.m. and 5:00 p.m., while Bank B receives an intraday loan of $100 from Bank Cbetween 4:59 p.m. and 5:00 p.m. Viewed at the end of the day, all banks are in an iden-tical position with zero net debits or credits vis-à-vis the system. In other words, noactual payments are required to settle the day’s transactions if the netting agreement haslegal standing (see the section on the legal status of netting agreements below) or if allbanks are solvent at the end of the day.

This end-of-day symmetry masks the fact that Bank B was a net lender to Bank Cfor most of the business day, whereas it received a promise for $100 from Bank A earlyin the day. If Bank B had not entered its payment order to Bank C before 5:00 p.m., and had Bank C been unable to settle its resulting net debit of $100, Bank B would beforced to recover its $100 claim against the netting system. Bank C would have a netdebit position in the system of $100, so Bank B would have a claim against Bank C andany other resources already committed to support the netting system, such as collateral,capital, or back-up lines of credit underwritten by surviving members. Thus, relativelymodest end-of-day net settlement amounts in a multilateral netting system (zero in thisexample) may disguise substantial intraday credit exposures faced by individual banks.

Settlement System operated by the ECUBanking Association (EBA) since 1983(European Monetary Institute, 1996, pp. 692-96). After clearing interbank pay-ment obligations denominated in ECU(the European Currency Unit, a fixedbasket of European currencies) on a multi-lateral net basis, final settlement takesplace in accounts at the Bank forInternational Settlements (BIS) in Basle,Switzerland. The BIS acts as a correspon-dent bank for all the clearing banks in the arrangement, who agree to maintainclearing accounts without overdraftfeatures. The private ECU clearing systemdoes not currently meet the Lamfalussyminimum standards for netting schemes.12

However, reforms including sender caps,liquidity-sharing, and loss-sharingagreements are being implemented toincrease the safety of settlement procedures(European Monetary Institute, 1996, p. 695). The EBA plans to convert theECU clearing system to one that will settleinterbank euro payments on a multilateralnet basis beginning in 1999, or wheneverthe single currency is introduced. The

new system will be called EURO 1 and isexpected to play a role in Europe analogousto that of CHIPS in the United States,providing large-value multilateral net settle-ment services alongside TARGET, theRTGS system for euro.

Finally, the major banking groups inmany European countries (for example,private commercial banks, state-ownedsavings banks, or co-operative banks)either clear interbank payments throughthe national central bank or operate their own centralized correspondent (or bankers’ banks) that provide clearingand other services to the sector’s members(see Bank for International Settlements,1993b, pp. 166-78, for a discussion of the German case). These private-sectorarrangements handle primarily small-valuetransactions, however.

In Japan, the Foreign Exchange YenClearing System (FEYCS) was establishedin 1980 by the Tokyo Bankers Association(TBA) to handle yen settlement of cross-border transactions, comparable to the roleof CHIPS in the United States. However,the TBA transferred the operation of FEYCS

12 The Lamfalussy standards specifythe minimum criteria any pri-vate net settlement systemmust meet to be acceptable toa G-10 central bank (Bank forInternational Settlement,1990). See the discussion andTable 6 for an overview ofthese standards.



34

Deferred Net Settlement (DNS) Systems in G-10 Countries

Country Name of DNS System Year of Implementation

Belgium CH (Clearing House of Belgium) NACanada LVTS (Large Value Transfer System) 1998France SNP (Systeme Net Protégé) 1997Germany EAF2 (Elektronische Abwicklung Frankfurt) 1996Italy ME (Electronic memoranda); SIPS 1989, 1989Japan Zengin (Zengin Data Telecommunications System);

FEYCS (Foreign Exchange Yen Clearing System); BOJ-Net 1973, 1989, 1988Netherlands 8007-SWIFT (Society for Worldwide Interbank

Financial Transfers); FA 1982, 1985Sweden — —Switzerland — —United Kingdom CHAPS (Clearing House Automated Payment System) 1984United States CHIPS (Clearing House Interbank Payments System) 1970Cross-border ECU Clearing System 1983

SOURCES: Bank for International Settlements (1997a), p. 4 and Annex 2; Bank for International Settlements (1995b), Table 10a; Bankfor International Settlements (1993b), pp. 305-06; pp. 498-501.

Table 3

to the Bank of Japan in 1989 (Bank forInternational Settlements, 1993b, pp. 261-68).

Monitoring and Risk Managementin Deferred Net Settlement Systems

The BIS and individual central bankshave strongly encouraged the members ofmany DNS systems to intensify their risk-management efforts in recent years, henceincreasing the private-sector costs of usingthem. In Europe, the central banks of the(then) European Economic Communityset down recommendations regarding theminimum common features of domesticpayments systems in 1993 (Bank for Inter-national Settlements, 1997a, p. 40). In theUnited States, the Federal Reserve updatedits payments-system risk policy for thedesign and operation of privately operatedlarge-value multilateral netting schemes in1994 and again in 1997 (Bank for Interna-tional Settlements, 1997a, p. 40; McConnell,1997, p. 2).

Many G-10 central banks now distin-guish between “secured” DNS systems —

essentially, those that meet the Lamfalussystandards — and all other DNS systems (see Table 6). A secured DNS system isone that is capable of settling all net oblig-ations at the end of a clearing cycle, evenwhen the member with the largest net-debitposition is unable to settle (Standard 4).Banks may establish a “failsafe” settlementguarantee by posting collateral in advance,lodging capital funds at the clearing house,forming a joint back-up settlement agree-ment with the members, obtaining agovernment guarantee, or some combinationof these elements (Bank for InternationalSettlements, 1997a, pp. 39-42).

In principle, direct monitoring by banksof other banks is a potentially significantbenefit associated with private multilateralnet settlement systems. This is becauseprivate financial institutions may obtainfiner levels of detail, in a more timelyfashion, about other market participantsthan is possible for central banks or otherbanking supervisors. The financial expo-sure one bank creates for another in such asystem provides a strong incentive for thecreditor bank to monitor the debtor bank.



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Milestones in the Development of CHIPS (Clearing House InterbankPayments System)

Event Date

Computerization of message transfers for participants April 1970

Paper Exchange Payment System (PEPS) implemented for non-members March 1972

Larger computer installed; all PEPS-using banks become CHIPS participants October 1974

Same-day settlement implemented through special reserve account at the Federal Reserve Bank of New York October 1981

Bilateral credit mechanism implemented October 1984

Sender net debit caps installed March 1986

Loss-sharing arrangement among all participants implemented; collateral requirements to support each participant’s contingent liability October 1990

New criteria for settling participants adopted March 1992

New message format adopted August 1992

Settlement-finality improvements announced, including reduced net debit caps, increased collateral requirements, and modified loss-sharing procedures July 1995

SOURCES: Hook (1994); Richards (1995).

Table 4

Reliance on direct bilateral monitoringby banks in multilateral payments and set-tlement systems is subject to at least twoshortcomings, however. Most importantly,decentralized monitoring in multilateralDNS systems suffers from a fundamental“free-rider problem.” Each participatingbank realizes that any losses created by amember in excess of its own resources will be shared among all the remainingmembers in some fashion. Any individualbank’s financial exposure to a counterpartyin the system is therefore attenuated by the co-insurance feature of the multilateralsystem; consequently, that bank’s incentiveto monitor is reduced. Some elements of shared financial responsibility remaineven in systems that attempt to allocateresidual risks to members in proportion to their dealings with the defaulting participant. Therefore, diffused financialrisks in a multilateral payments and settlement system necessarily imply areduced intensity and quality ofmonitoring relative to purely bilat-eral relationships.

An additional shortcoming is that the monitoring efficiency of a net settlementsystem is likely to be sensitive to the sizeof the membership. Increasing the numberof participating banks increases the moni-toring burden on each bank, a situationthat may lead to a decreased quality ofmonitoring. This problem exists indepen-

dently of the free-rider problem identifiedabove; in fact, it becomes more acute theless the system shares risk among all partic-ipants. To see this, consider a multilateralDNS system that provides no risk sharingat all among its surviving members andwhich “unwinds” (cancels) all transactionsinvolving a defaulting bank. Each memberis fully exposed to the losses created byeach of its transactions with a failed coun-terparty, so it must monitor all of them asif no multilateral system existed at all. Ifthe increased monitoring burden results ina lower quality of monitoring, the end resultis a greater risk of unanticipated disruption(Bank for International Settlements, 1997a,pp. 39-43). Restricting the membership of any payments or settlement system toencourage better monitoring incentives islikely to run afoul of antitrust regulations,however. This conflict between restrictingaccess in order to preserve monitoringincentives and the need to remain open to new members to promote competitionis likely to become more serious as finan-cial markets become more global andinterconnected.

Centralized monitoring (i.e., delegationof monitoring responsibilities to a centralauthority, such as a clearing house) may bea viable option in some cases, but central-ization entails difficult issues in its ownright. These include the need to “monitorthe monitor” and to decide on a formula



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Participants, Number, and Value of Transfers on CHIPS

Year-End Number Annual Number Annual Dollar Value Year of Participants of Transfers (millions) of Transfers (trillions)

1971 15 0.8 11975 63 6.0 111980 100 13.2 371985 142 24.9 781990 131 37.3 2221991 126 37.6 2171992 122 39.1 2381993 121 42.2 2661994 115 45.6 2951995 111 51.0 3101996 104 53.4 332

SOURCE: CHIPS (1997).

Table 5

for allocating any losses that cannot becovered by the pool of resources (collateralor equity capital) held at the central insti-tution. The centralized monitor must alsoguard against exposing members to moralhazard: When freed from the direct scrutinyof other members, they might be moretempted to act in ways that would increasethe system’s overall risk. In sum, private-sector risk management in net settlementsystems is promising but problematic.Participating banks possess some naturaladvantages over regulators in providingmonitoring services, but private monitoringis likely to be costly and imperfect, regard-less of how it is done.

Financial-Obligation Netting Systems

Table 7 lists some important nettingsystems and agreements for securities,derivatives, and foreign exchange. Thesearrangements are collectively known asfinancial-obligation netting arrangements(in contrast to payments netting arrange-ments). The basic mechanics of netting

are similar for multilateral payments andobligation netting systems. In particular,each member of the netting arrangemententers trades with counterparties, whichare recorded in real time. It then settles itsfinal obligation to the system—either a netcredit or a net debit—only at the end ofthe clearing cycle. Settlement occurs eitherseveral times during the day or once at theend of the day.

In addition to providing periodic netsettlement of financial obligations, organizedderivatives exchanges also require firms topost and maintain margins. That is, mem-bers must make available to the clearinghouse cash or other liquid assets sufficientto cover likely changes in the net value ofthe firm’s positions implied by movementsin financial markets (Bank for InternationalSettlements, 1997b, pp. 21-4). Marginmanagement is an important risk-controltool of derivatives exchanges that requiresefficient banking operations (so-called“money settlement”) to function effectively.In this sense, financial-obligation nettingsystems can be compared to DVP systemsfor securities settlement.



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The Lamfalussy Standards

Area of Concern Proposed Standard

Table 6

1. Legal basis of netting schemes

2. Participants’ understanding of financial risks

3. Credit- and liquidity-risk management procedures

4. Settlement capability

5. Admission criteria

6. Operational reliability

Netting schemes should have a well-founded legal basis under all relevant jurisdictions.

Netting scheme participants should have a clear understanding of the impact of the par-ticular scheme on each of the financial risks affected by the netting process.

Multilateral netting systems should have clearly defined procedures for the managementof credit risks and liquidity risks that specify the respective responsibilities of the nettingprovider and the participants. These procedures should also ensure that all parties haveboth the incentives and the capabilities to manage and contain each of the risks theybear and that limits are placed on the maximum level of credit exposure that can be produced by each participant.

Multilateral netting systems should, at a minimum, be capable of ensuring the timelycompletion of daily settlements in the event of an inability to settle by the participantwith the largest single net-debit position.

Multilateral netting systems should have objective and publicly disclosed criteria foradmission that permit fair and open access.

All netting schemes should ensure the operational reliability of technical systems and theavailability of back-up facilities capable of completing daily processing requirements.

SOURCE: Bank for International Settlements (1990, p. 5).

Organized derivatives exchanges usetwo primary models for carrying out tradingactivities and settling margins: the centralbank model and the private settlementbank model (Bank for International Settle-ments, 1997b, pp. 12-15). In the centralbank model, the derivatives exchangeand/or its members hold reserve accountsdirectly at the central bank; these accountscan be debited and credited in real time to effect cash transfers in support of tradingand margining activities. Most continentalEuropean G-10 derivatives exchangesfollow this model (Bank for InternationalSettlements, 1997b, Annex 2). Thismoney-settlement model for derivativesexchanges is similar to the “Model 2” DVPsecurities settlement system noted above(gross securities settlement followed bydeferred net settlement of payments),except that the roles of the two financialinstruments are reversed. That is, in the

central bank model of money settlementfor derivatives exchanges, the traded finan-cial obligations are settled on a deferrednet basis, while cash payments—includingmargins—are carried out in the nationalRTGS system. Of course, cash paymentsto effect margin and open-position adjust-ments are not carried out in real time onany derivatives exchange; the point is thatthe central bank model of money settlementcan provide continuous marking-to-marketin the cash account.

The second type of money-settlementmodel for derivatives exchanges involvesprivate settlement banks. This approach—which is used in the United States, theUnited Kingdom, the Netherlands, andJapan (Bank for International Settlements,1997b, Annex 2)—is comparable to a“Model 3” DVP system in which bothfinancial obligations and funds transfersare settled on a net basis some time after



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Private-Sector Financial-Obligation Netting Arrangements

Netting System or Agreement Organizers Description

Table 7

SOURCES: Richards (1995, p. 1075); Labrecque (1996, p. 21); Foreign Exchange Committee (1995); Federal Reserve System (1997).

Futures and options exchanges (ChicagoBoard of Trade, Chicago Mercantile Exchange,Chicago Board Options Exchange, LondonInternational Financial Futures Exchange,Deutsche Terminboerse, Marché a TermeInternational de France, etc.)

Government Securities Clearing Corporation (GSCC)

National Securities Clearing Corporation (NSCC)

Model Interbank Foreign Exchange Netting Agreement (IFEMA)

International Securities Dealers Association(ISDA) obligation-netting agreements

Foreign Exchange and Options MasterAgreement (FEOMA)

Member firms

Member firms

Member firms

Foreign Exchange Committee(FEC) and the British BankersAssociation (BBA)

ISDA

FEC and BBA

Clearing Corporations are central counter-parties for all transactions with end-of-daymark-to-market and daily settlementthrough a single settlement account acrossall exchange-traded contracts.

Government securities clearing agencyoffering automated trade comparison, net-ting, and risk-management services

Clearing agency for U.S. equities, long- andmedium-term corporate and municipalbonds, guarantees settlement

Master agreement for bilateral close-outnetting, netting by novation, or paymentnetting of foreign-exchange obligations inan over-the-counter (off-exchange) setting

Framework agreements for implementingobligation netting in an over-the-countersetting

Master agreement for bilateral close-outnetting of over-the-counter options

the trades (or margin calls) are issued.Continuous marking-to-market in centralbank funds is not feasible in this modelunless private settlement banks are preparedto give derivatives exchange membersessentially direct access to RTGS systemsvia deposit accounts. This approachwould approximate the indirect access toFedwire that non-bank securities dealersobtain in the United States via theirclearing banks.

Systemic Risk in Gross and NetSettlement Systems

If settlement lag is the “building block”of risk in the DNS systems, then systemicrisk represents the collapse of the edifice.Systemic risk in its narrowest sense refers tothe possibility of a chain reaction of settle-ment failures in an interlinked payments orsettlement system. In more general terms,systemic risk encompasses situations inwhich the credit or liquidity problems forone or more market participants create substantial credit or liquidity problems for participants elsewhere in the financialsystem (Berger, Hancock, and Marquardt,1996, p. 706). It is largely the specter of systemic risk that has preoccupiedpayments-systems experts at G-10 centralbanks for the last decade or so, generatingthe veritable cascade of BIS reportsmentioned earlier. The most noteworthy of these reports may have been theLamfalussy Report of 1990. Under thesestandards, so-called secured DNS systemsare characterized by specific risk-management provisions their membersmust have implemented to reduce systemic risk (Table 6).

Gross settlement systems seek to elim-inate systemic risk by inserting “circuitbreakers” into payments and settlementchains. The key is that an institutionattempting to make a payment or effect asettlement over a gross settlement systemis required to post “cash in advance” (orcollateral or securities, depending on thetype of payments or settlement system).13

Gross settlement systems do not allow theinsolvency of one financial institution to

be transmitted to others through the pay-ments system, because settlements arenever conditional on a paying institution’ssolvency.14

By way of contrast, DNS systemsmerely accumulate records of “IOUs”—that is, credit extensions—issued by banksto each other during the business day.These IOUs are netted against each otherand settled in cash or by delivery of therelevant securities or foreign currency atthe end of the clearing cycle—as long asnone of the participants in a net debit posi-tion defaults. In case of such a default, theentire set of transactions may be unwoundand re-entered after all of the defaultinginstitution’s transactions have been deleted.

Another factor that makes settlementlag a source of risk is that a party due toreceive a payment may prematurely considerthe payment final. Since the payee mayreceive some information about the pendingpayment during the settlement lag, eitherfrom the payor directly or from the DNSsystem, there may be a temptation, orindeed an established local business prac-tice, to take the payment for granted.Clearly, decoupling the payment informa-tion from the final settlement increasesDNS flexibility and the flexibility of finan-cial institutions that use it, but it alsocreates the potential for complex scenariosof disruption.15

Legal Status of NettingArrangements

As noted, the ultimate source of risk in DNS systems is settlement lag, the timethat elapses between the inital transmissionof a payment request from the sendingbank to the DNS system and the finalreceipt of good funds or securities by thereceiving bank (Bank for International Set-tlements, 1997a, pp. 7-9; Shen, 1997, pp. 48-53). In addition, legal uncertaintysurrounding netting agreements in manyjurisdictions makes the risk of settlementfailure costly. Rather than being exposedto the smaller risk that a valid nettingagreement implies, some banks could losethe larger gross amount due from a coun-

13 Fedwire allows payors to over-draw their reserve accountswithout posting specific collater-al; for this reason, some havecompared it to a DNS system(Kahn and Roberds, 1996, p. 3). From the payee’s (andthe systemic-risk) perspective,however, Fedwire functions asan RTGS system, since everypayment is final when received.

14 Unfortunately, in a gross settle-ment system a distressed finan-cial institution’s illiquidity canbe transmitted to other partici-pants, resulting in a systemicliquidity crisis or gridlock.

15 Some RTGS systems are alsovulnerable to this problem, asnoted above. In particular,those that place outgoing butunexecuted payment orders ina queue and allow receivingbanks to “look into the queue”may encourage banks to antici-pate payments before theybecome final.



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terparty if the netting agreement did notstand up under legal challenge.

The legal status of interbank nettingagreements in the United States resultsfrom four different bodies of insolvencylaw: (1) the U.S. bankruptcy code asamended in 1990, (2) the Financial Institu-tions Reform, Recovery, and EnforcementAct of 1989 (FIRREA), (3) New York Statebanking legislation (including Article 4Aof the Uniform Commercial Code applyingto wholesale electronic funds transfers,drafted in 1989), and (4) the Federal DepositInsurance Corporation Improvement Act of1991 (FDICIA).16

In general in the United States, nettingor set-off arrangements are stayed (i.e., notallowed to proceed) in bankruptcy becausenetting imposes a de facto seniority struc-ture where none exists de jure (Rochet andTirole, 1996, p. 837). Similarly, securedcreditors are prevented from repossessingtheir security after a Chapter 11 bankruptcyfiling (Sharpe and Nguyen, 1995, p. 275).From this perspective, netting is inconsis-tent with the overall intent of formalbankruptcy proceedings, which is tosatisfy all creditor demands in an orderlyand equitable manner according to strictpriority rules. However, certain financialcontracts are exempted from this generaldisallowance of netting in bankruptcybecause Congress and many statelegislatures have accepted the argumentthat some netting arrangements should beallowed to proceed to avoid triggering sys-temic failures in the financial system.

The bankruptcy code, FIRREA, andNew York State banking legislation(including Article 4A) are similar withrespect to netting agreements, including“safe harbors” for swap agreements, secu-rities contracts, commodities contracts,forward contracts, and repurchaseagreements (Russo, 1996, p. 98). In addi-tion, Article 4A and the Federal Reserve’sRegulation J (governing large-valueelectronic funds transfers, including Fed-Wire) explicitly permit net settlement ofwholesale electronic funds transfers amongbanks in order to encourage banks toaccept payment orders from financially

weak sending banks (Patrikis, Bhala, andFois, 1994, pp. 36-7).

In contrast to the previous case-by-case legal approach to netting, the FDICIAof 1991 essentially permits all nettingagreements among financial institutions(including clearing houses) to proceednotwithstanding bankruptcy or insolvency.In other words, netting agreements nowhave a firm legal foundation in U.S. lawwith the implication that the de factoseniority created by a netting agreementamong financial institutions has become de jure and enforceable in transactions for which U.S. law prevails.

In general, the legal status of nettingagreements in countries outside the United States is uncertain (Bergsten, 1994,pp. 451-52; Padoa-Schioppa, 1994, pp. 30-5; Bureau of National Affairs, 1997,pp. 721-22). The United NationsCommission on International Trade(UNCITRAL) adopted the UNCITRALModel Law on International Credit Trans-fers in May 1992, which could have givenan impetus to international efforts tosolidify the legal standing of netting. Themodel law was developed under the influ-ence of the drafters of Article 4A of theU.S. Uniform Commercial Code, whichgives explicit legal standing to netting ofwholesale electronic funds transfers. Inthe end, however, the UNCITRAL modellaw did not include any provisions on theapplicability of netting agreements. Con-sequently, there are still gaps in mostcountries’ insolvency laws concerning the enforceability of netting agreements(Bergsten, 1994, p. 452).

In Switzerland, provisional paymentorders issued by a bank that is subsequentlydeclared bankrupt are deemed revoked(the “zero-hour rule”)—that is, anynetting agreement including such a bankmust be unwound. This rule makesnetting agreements unreliable for the par-ticipants (Hess, 1994, p. 334). Zero-hourrules exist in other countries, as well.

In Japan, settlement of net positions in FEYCS, the Foreign Exchange YenClearing System, is not explicitly insuredby the Bank of Japan. A loss-sharing

16 This section follows discussionsin Russo (1996, pp. 97-100),Cohen and Wiseman (1994,pp. 53-9), and Patrikis, Bhala,and Fois (1994, pp. 36-7).



40

arrangement is in place, but beyond this,there is uncertainty about the implicationsfor participants of the default of a member(Saito, 1994, pp. 223-24). The Bank of Japan’s implicit guarantee of settlementis widely assumed, however.

In the United Kingdom, finality ofpayment is determined by common law.In the absence of clear precedents in variouskinds of netting arrangements, the legalstatus of the participants in any givenagreement is not entirely clear (Beaves,1994, p. 364).

In France, the wholesale paymentsnetting system, SAGITTAIRE, is based on S.W.I.F.T. (Society for Worldwide Inter-bank Financial Telecommunication)messages, which are irrevocable from thepoint of view of the sender once they havebeen received. However, the Banque deFrance may revoke some exchanges. Thenet positions of members are drawn upafter the close of the accounting day, thendebited or credited on the books of theBanque de France. Transactions do notbecome final until 10:00 a.m. the followingday. Hence, the legal status of participantsin SAGITTAIRE in the face of a default of a participant is unclear (Perdrix, 1994, pp. 148-49). Recently, however, changeshave been made in the legal system toassure the legal enforceability of bilateralnetting agreements (Padoa-Schioppa,1994, p. 33).

In the European Union as a whole,only four countries (Belgium, Germany,France, and Italy) currently provide legalassurance for the enforceability of bilateralnetting, while multilateral nettingagreements have no firm legal standing inany E.U. country.17 Some progress towardrecognition of netting agreements for banksupervisory purposes has been achievedrecently at the E.U. level. In particular, theso-called “EC Netting Directive” was issuedby the European Parliament and the Councilof the European Union in March 1996(Deutsche Bundesbank, 1996, pp. 146-47).This allows national bank supervisors toadjust banks’ capital requirements downwardon the basis of close-out netting agreementscovering over-the-counter derivative

instruments if the concerned banks obtainlegal opinions stating that the agreementsare likely to be legally binding in allrelevant jurisdictions. This is, of course,far short of the solid legal basis for nettingagreements available in the United Statessince 1991 and required by a strict inter-pretation of the Lamfalussy Standards.

CONCLUSIONThe wholesale payments and settlement

systems of G-10 countries have undergonesignificant change in recent years. Recog-nizing the inherent limitations andvulnerability to disruption of bilateral andmultilateral netting arrangements for pay-ments and settlement, private financialinstitutions and central banks alike haveimplemented measures to make them safer.Secured net settlement systems pose less threat of systemic disruption to G-10payments and settlement systems thanunsecured systems. Further progress inestablishing legal foundations for domesticand cross-border netting arrangements will further solidify their contributions to the global financial system. The largestcosts associated with secured netsettlement systems today are those of day-to-day risk management incurred by participating banks.

A different approach to strengtheningthe wholesale payments system is to createand/or improve trade-by-trade (gross) set-tlement systems for large-value fundstransfers and securities settlement. Grosssettlement systems can be very effective inreducing and isolating the sources of riskthat make netting systems vulnerable.From the point of view of private-sectorparticipants, gross settlement systems virtually eliminate the need to managecounterparty credit risk. However, thesesystems may impose significant liquiditycosts on users, or they may requiresubstantial risk-management measures onthe part of central banks, depending onthe design of the system.

There are several plausible hypothesesfor why the quantitative importance of grosssettlement systems remains limited at this

17 Table 1 in Padoa-Schioppa(1994, p. 32) summarizes thelegal standing of various typesof netting arrangements in themajor European Union nationsas of 1994.



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point. First, gross settlement systems havebecome available in most G-10 countriesonly recently. It takes time for paymentsand settlement practices to change, althoughthey probably will continue to do so overthe next few years, in large part because cen-tral banks continue to encourage greater useof gross settlement.

Second, existing net settlement systemsare well-established in most countries, andthey generally have a disruption-free trackrecord (even if they are or were unsecured).Proponents of gross settlement systemstherefore have little actual evidence withwhich to bolster their claims that netsettlement is excessively risky.

Finally, gross settlement systems mayhave been adopted slowly because of theirsignificant liquidity costs. These costscould be lessened if central banks paid amarket rate of interest on reserve balancesor pursued monetary policies that ensuredprice stability and, hence, lower nominalinterest rates than would otherwise obtain.Either approach might encourage financialinstitutions to hold larger clearing balances(i.e., central bank reserves in excess of legalminimums). These balances could serveas the basis for greater participation inRTGS payments systems at little or noopportunity cost. They would also provideready collateral for intraday securitieslending to support gross settlement ofsecurities transactions.

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