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

At the other end of the spectrum of payment system operations, a central bank may play a very minor role in the operation of its nation's payment system. In Canada and the United Kingdom, for example, payment processing is largely carried out by private enterprises and is governed by a ruling body composed of representatives of the financial services sector. The central bank, while not directly involved in the operations of the payment system, typically plays a coordinating role in these arrangements and, under certain terms and conditions, may make its books available for the settlement of payment transactions.

My purely personal point of view, which is conditioned by more than a decade of involvement in the payment system, both as a practitioner and as a policy advisor, is that the benefits of placing operations in the hands of the private sector should not be underestimated. Indeed, in virtually every other market for goods and services, the benefits of competition in ensuring a continuous high standard of performance are best attained through a free market approach. Assuming for the moment that principles governing the safe operation of the payment process are clearly laid out and that compliance with these principles is adequately supervised by the central bank, then, all other things equal, the process should generally work best when ruled by competitive forces in a market environment.

I say "generally" because of the notable exception of the large-value payment mechanism that provides immediate settlement on the books of the central bank. This payment mechanism may be considered an instrument of financial policy and is therefore best controlled by the central bank. It is virtually impossible for the private sector to provide the same degree of safety and liquidity for the transfer of money balances that can be provided by the central bank. Interbank systems for the transfer of large amounts of funds are discussed later.

Supervision of Private Clearing and Settlement Systems

The central bank's involvement in establishing principles for, and, when necessary, in supervising and regulating private clearing and settlement arrangements that support large-value transactions, is especially critical. I will not recount here the financial, structural, and operational features that should characterize these systems and in which the central bank must have an essential interest.(9) Most important, however, are features that commit the private participants in the specialized clearing systems, especially in multilateral clearing arrangements, to provide guarantees for the final settlement of the net positions that arise from the clearing. Such guarantees must be founded upon carefully constructed entrance criteria for participation in the arrangements. Moreover, members of such clearing arrangements must have the incentives and capabilities to make their own credit judgements about the parties with whom they will do business. In addition, concrete commitments are needed in the form of loss-sharing arrangements backed by either collateral or lines of credit to ensure the liquidity and resources to guarantee settlement in the event of default by one or more participants.