The Trade-off between liquidity and Credit Risk in a Settlement System
Jonathan M. Hazell
How does a settlement system work? Somehow everyone has to get paid. The easiest means for an exchange to be settled is at the point of sale. Commerce though does not generally operate in face to face transactions. Separate parties, such as banks, must process the exchange. In a real-time exchange, (RTGS) these banks must have immediate access to the parties' funds to make the transaction. This factor is the liquidity of the account. The banks cannot wait for the party to produce the funds. It must have the immediate access of the funds. Otherwise the banks are subject to the credit risk of the transaction parties. The challenge becomes how fast can one transaction party produce the funds to settle the owed amount to the other party?
Banks today are members of sophisticated settlement systems such as Fedwire in the United States and CHAPS in the United Kingdom. The Central Banks within these settlement systems guarantees the payments of their member banks. These Central Banks do carry a degree of credit risk for short periods of time during a business day. The objective of the RTGS system which Fedwire, CHAPS, Target2 in Europe, etc, maintain is to process payments immediately. The structural challenge for the RTGS system is the sheer volume of transactions which results in an equal high volume of fees. It is the high cost of liquidity.
A net settlement system does not require an immediate transaction settlement. Transactions therefore can be pooled and settled at the end of the day. This system therefore can be less fee intensive for parties and a reduction in continuous system management for the settlement exchange. This was the traditional means of settlement up until the 1980's. The challenge with this system is credit risk. Will the transaction party actually have the funds to settle at the end of the day? This issue is what prompted the rise of the RTGS system.
The other option is the hybrid settlement system. In this system, the RTGS method for transactions is still the preferred means of settlement. In a hybrid system though, different transactions can be identified and set aside for a net settlement at the end of the business day. This identification lowers systemic costs related to transaction fees. It also, can obviously benefit the individual parties by reduced fee rates.