Clearing and payment systems: the role of the central bank - includes glossary and model payment system

Federal Reserve Bulletin, Feb, 1991 by Bruce J. Summers

Clearing and Payment Systems: The Role of the Central Bank

Two themes of the Central Banking Seminar are directly relevant to consideration of payment system issues. One is the interdependencies of different functions normally performed by a central bank. In this regard, I know of no other aspect of the central bank's responsibility that requires more cooperation and coordination among the various central banking disciplines than the payment system does. A second theme of the seminar is the role of the central bank in dealing with financial crises. Stress on a nation's payment system is often one of the earliest and most direct manifestations of financial crisis. Indeed, the payment system may be a direct channel through which liquidity and credit problems are transferred from one participant in the financial system to another. Such transfers have the potential to create systemic liquidity and credit problems that are of direct concern to the central bank. As a result, central banks are increasingly focusing on proper safeguards to allow payment system participants not only to control their risk, but also to prevent the contagion of systemic risk.

Because it has relevance for a range of central bank disciplines and functions and because it can become a focus of crisis management, the payment system does indeed deserve a prominent place in the thinking of central bankers. Yet, until the last decade or so, interest in payment system issues has been of secondary importance on the central banking agenda. The payment system has traditionally been almost exclusively the province of central bank staff members with operations and automation responsibilities, reflecting the view that the payment system is essentially a mechanical process. Along these lines, the literature on the payment system has traditionally been slanted toward analyses of economic efficiency, with much of the literature framed in the context of the economics of the firm. The payment system has now entered the mainstream for central bankers, although, admittedly, the degree of interest varies from country to country.

This paper has three main parts. First, to provide a common frame of reference, I develop a model of the payment system, with special reference to the essential role of the central bank. Second, I discuss the implications of the public policy and supervisory roles of the central bank in the payment system. These implications include (1) the need to establish public policies to guide the structure of newly developing private clearing and settlement arrangements, in terms of both their integrity and efficiency, and (2) the need for supervision of private clearing arrangements, not only domestically, but also for cross-border systems, in close cooperation with foreign central banks. Finally, I examine the role of the central bank as operator of a large-value, interbank payment mechanism. Special attention is given to the implications of the central bank's role as a source of intraday liquidity to the financial system and to the "safety net" attributes associated with access to a large-value transfer mechanism.

Model of the Payment System

In the simplest terms, the payment system is the apparatus through which obligations incurred as a result of economic activity are discharged through transfers of monetary value. The payment system is used primarily for simple day-to-day activities, such as retail transactions, that may be paid by using a very rudimentary, but nonetheless very effective, payment mechanism, such as cash.(1) If the obligation is not discharged immediately (or in "real time," to use technical language) by using cash, then an alternative payment instrument, such as a paper or electronic credit or debit order, must be used. For payment orders, the process of discharging the obligation can be divided conceptually into two parts. The first part is the clearing process in which payment information is conveyed from the payor to the payee, probably through intermediary banks. The second part is settlement, in which the actual transfer of value associated with the payment order is made, generally not with cash but with a claim on a bank.

The payment system is also used to settle complex and large-value transactions, such as those arising from trading in financial instruments and their derivative products, and to transfer other "commodities." The markets for such instruments are very efficient: In some cases, assets are held for only a few hours or minutes. The size of individual transactions may also be very large. The average secondary market trade in U.S. government securities, for example, is about $9 million. These markets therefore have rapid turnover of high-value transactions. Accordingly, while the model of clearing and settlement described here applies to large-value payments, the form the payment process takes has become rather specialized, often involving clearing organizations that ensure that payment in good funds is made against delivery for the contract in question (delivery-versus-payment systems) and that increasingly perform a multilateral netting of such contracts among those trading in the instruments to reduce the total value of individual deliveries and payments that must be completed.(2)