Intraday liquidity and the settlement of large-value payments: a simulation-based analysis.

• Author: Enge, Asbjorn

Interbank systems are of great importance to the economy and the financial system. Using simulations based on real data from Norges Bank's settlement system, this article illustrates trade-offs between delayed payments and liquidity usage in interbank settlement systems. The simulations demonstrate, for example, that the speed with which payments are settled may be affected by changes in the liquidity available to settlement participants. The effect of optimisation routines in the settlement system is also simulated.

1. Introduction

   Banks are linked together by interbank systems, through technical systems and agreements for clearing and settling money transfers between banks. Norwegian interbank systems comprise of several systems with different clearing and settlement procedures for retail payments, securities trading and individual large-value transactions. Gross turnover in the Norwegian Interbank Clearing System (NICS), which is the largest system, is on average NOK 200 billion per day. The bulk of these transactions is settled over banks' accounts in Norges Bank's settlement system (NBO). The average daily value of settlements in NBO is over NOK 150 billion. Most large-value payments in NBO are settled in NICS-SWIFT (2) gross settlements. Chart 1 shows that these settlements also account for the bulk of turnover in NBO.

   Settlement systems for large-value payments are central to the financial infrastructure, due to the size of the payment transactions and the fact that it is important that they are executed correctly and at the right time. Smoothly functioning systems for large-value payments are thus crucial to the efficiency of the financial markets, the stability of the financial system and the implementation of monetary policy in a country. As they are typically regarded as systemically important, central banks and supervisory authorities have a particular interest in how these systems are organised and operated (see separate box).

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   In an efficient payment and settlement system, payments are carried out cost efficiently and with low risk. For participants in the financial sector, the cost of carrying out payment transactions includes the cost of producing payment services, the cost of any payment delays and the cost of payment system participants having to keep a different asset portfolio than they might otherwise have done, in order to execute payments. This may, for example, take the form of deposits in the settlement bank and securities that provide borrowing rights for carrying out settlement.

   Berger, Hancock and Marquardt (1996) present a theoretical framework for analysing the trade-off between risk (e.g. delayed completion of payment) and costs in the payment system (e.g. liquidity costs). A payment system is deemed to be technically efficient if costs are minimised at a given risk level and risk is minimised at a given cost level. The simplified illustration given in Chart 2 shows risk (settlement delays) and costs (liquidity usage), where the curve, FF, represents a set of technically efficient points. The curve also shows that risk rises at an increasing rate as costs are reduced (convexity). Innovations in the payment system, for example, technical developments that make it possible to carry out payment faster at a given liquidity level, shift the curve inwards (towards F'F'). Where the outcome on this line occurs depends on the preferences of participants in the payment system, represented by curve II. All points on II are in principle equal for all participants. The curve's concave form reflects the assumption of a decreasing marginal utility of risk reduction, in other words, that participants are less willing to pay for risk reduction from a starting point of low risk, than for a similar reduction from a high risk level. A number of such curves can be drawn inside and outside II, where participants are more satisfied the closer the curve is to the origin in the chart, i.e. the lower risk and costs are. Point A is the outcome here, given the participants' trade-off between delays and liquidity usage and the technical possibilities represented by F'F':

   Using a simulation-based approach, this article will illustrate the trade-offs that exist between payment delays and liquidity usage in interbank settlement systems. A number of key concepts and features of settlement systems are introduced in the next section.

2. Features of settlement systems

   1. Gross and net settlement

      Large-value payments can either be settled individually in gross systems or included in a clearing that is then settled in a net system. Other solutions (hybrid systems) also exist. Gross and net systems entail different risks and costs for settlement participants. Three key risk/cost elements in a settlement system are liquidity, risk of delay and credit risk.

      In a net system, participants settle the result from an earlier clearing of incoming and outgoing payments at designated times. Given the interval that elapses between the time that transactions are submitted for clearing and the final settlement of the clearing, banks receiving funds in the settlement implicitly provide credit to other participants for this period. If a bank that owes money in the clearing experiences solvency problems after the transactions have been submitted for clearing, but before final settlement, other banks will be exposed to credit risk in relation to that bank. In this way, the settlement system may cause the spread of solvency problems from one bank to others. This is often called systemic risk and is potentially a danger to the stability of the financial system. (3) In gross systems, or RTGS (Real Time Gross Settlement), positions between banks are settled on an individual basis continuously throughout the day, as soon as the payment transaction enters the system. A payment transaction can only be settled if the participant has cover (sufficient liquidity) in their account in the settlement bank. When this account is debited, the payment is completed with final effect. The continuous settlement of transactions entails no credit risk in these systems. Settlement systems for large-value payments have increasingly been based on RTGS (see box). (4)

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      From a risk/cost perspective, there are different advantages and disadvantages attached to gross and net settlement systems. Net settlement economises on liquidity, as participants only require the amount needed to cover the results of the clearing. However, as settlement is delayed, net settlement does expose participants to potential credit risk. RTGS settlement is carried out swiftly and does not involve credit risk, but requires more liquidity, as payment transactions are settled individually. Efficient liquidity management throughout the day is therefore important for participants in such settlement systems.

   2. Intraday liquidity and transaction cycles

      Banks...