Author: Tey ElRjula
Describing the tradeoff between liquidity and credit risk in a settlement system and highlighting how different RTGS, net and hybrid systems address this topic:
Interbank payment mechanisms also known as “settlement systems” are used to transfer large value payments between financial institutions on a domestic and international level.
Bank of Finland Studies E:31 · 2005 report described these systems as complicated, interactive, and critically interdependent.
Although the objectives of a particular system are set to be suitable, safe, and efficient, considering the variables of time and region. Yet the credit risk and liquidity are major trade-offs that characterize the three main types of wholesale payment systems.
Real Time Gross System
An RTGS can be best characterized as fund transfer system that is able to provide continuous finality occurring in the course of business day, for every single transfer. Each payment order is settled as soon as it enters the system on a real-time basis – assuming the payer’s funds are sufficient.
Such systems increase the need of high liquidity to meet final settlement requirements. Liquidity usually is sourced from the Central Bank, or other incoming payments from other participants. The need of high liquidity is important in covering balances of debit and credit between participants, and minimizing delay time between payments.
Although liquidity poses extra costs (whether it’s the cost of collaterals delegated against loans or interest charges) “real time transfer system” minimizes credit risks since settlement is final and on spot.
In the age of globalization and e-commerce, RTGS is the common large value payment system among many countries, because of the growing need for a real time settlement with zero credit risks.
Net settlement systems were the primary form of fund transfer systems back in the eighties. Unlike RTGS, payments net settlement systems are netted out at the end of the business day. By reducing the number payments between participants, netting reduces the usage of capital/principal money (usually central bank money).
However, such systems have a major weakness, high credit risks are present because the finality of settlement is only achieved at the end of the day and there is no certainty that the payments will be settled. This mechanism keeps participants exposed to the risk of one bank or more failing to meet its obligation.
Bank of Finland Study on Liquidity, Speed, and Risk in Payment and Settlement Systems gave the example of a typical net settlement simulation were the bank is crediting funds to its clients based on incoming payment messages and before payment is settled. Later in the business hours if settlement doesn’t happen the receiver bank is exposed to liquidity shortfall and a high credit risk.
In an attempt to combine the advantages of net and real-time gross settlement to suit the fast increasing demand and requirements of current financial markets: High Liquidity at low cost and Low credit risk. Hybrid Systems took off.
We agreed on that payments are settled one by one in an RTGS system and enough liquidity needs to be available to fund each payment, and true that real-time gross settlement reduces credit risks yet it was discovered that increased need for intraday liquidity is costly.
Hence benefiting from the net settlements low liquidity need and real-time gross settlement elimination of credit risks – Hybrid systems took another approach in balancing risks, and liquidity needs. Payments may be settled individually, as in RTGS, while other usually less urgent payments, may be queued, accumulated and netted.
At the end, payment systems are likely to continue evolving as technological innovation enables more efficient coordination and synchronization among payment system participants, allowing them to process more payments with less liquidity, while limiting settlement risk.