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

(1)Although cash payments may appear rudimentary, they actually embody essential features that are sought in more sophisticated electronic payment mechanisms, including large-value funds transfer systems. When an obligation is discharged by using cash, and assuming there is confidence in the government issuing the currency, the payment and final settlement are simultaneous and immediate.

Apart from the physical restrictions that make cash payments practical only for small-value transactions, much may be learned from the principles embodied in the use of this form of payment. See Goodfriend (1990). (2)See Parkinson (1990). (3)Some markets and central banks still rely on "next day" settlement, in which the transfers of value nominally occur on a given day but remain provisional--that is, they could be reversed--until some specified time the next day. Next-day settlement is particularly common in securities markets and is being addressed by the Group of Thirty recommendation to move all securities to same-day settlement. (4)As it has in the United States, where daylight overdrafts on the books of the Federal Reserve Banks now total about $70 billion for funds transfers and another $90 billion for book-entry securities transfers. (5)Examples of the effects that malfunctions in the clearing and settlement process, even those resulting from mundane operational problems, may have for financial markets and central bank policy are not hard to find. In August 1990, a power outage on Wall Street led to disruptions in money market operations, including Fedwire. These operating disruptions resulted in interest rate swings due to banks' inability to move balances efficiently. Similarly, in November 1985 an internal software problem at the Bank of New York involving the securities transfer application led that bank to incur massive daylight overdrafts with the Federal Reserve and an overnight discount window loan of $23 billion. (6)The 1974 Herstatt case has given rise to the term "Herstatt risk," which describes the temporal dimension of the credit risk assumed by the counterparty in a foreign exchange deal when payment of one currency becomes final some time before the payment of the second currency is completed. Herstatt risk arises in part because the operating schedules of national payment systems are not synchronized. In addition, there is no mechanism today that offers the benefits of concurrency that could be derived from a delivery-versus-payment mechanism. In the case of the U.S. dollar, final settlement each day of roughly $425 billion in foreign exchange is delayed up to fourteen hours (for deals originated in the Far East) until the final settlement of CHIPS transfers on the books of the Federal Reserve Bank of New York at about 5:30 p.m. eastern time in the United States. (7)This estimate does not include any imputed cost associated with the risks assumed by banks (including the central bank) in granting credit as part of the payment process. See Humphrey and Berger (1990). (8)See Johnson (1990). (9)For an excellent review of these features, see the May 1988 address given by E. Gerald Corrigan at the Williamsburg payments symposium sponsored by the Federal Reserve Bank of Richmond. See Corrigan (1990). (10)See Bank for International Settlements (1990). (11)The Federal Reserve Board has proposed phasing in a charge of 25 basis points at an annual rate for daily average daylight overdrafts as an appropriate starting point for daylight overdraft pricing. (12)See Board of Governors of the Federal Reserve System (1990).