Class18
THE LARGE VALUE DOLLAR PAYMENT SYSTEM
 Why is the U.S. payment system so important internationally?
o The dollar systems have a significant international as well as domestic
importance due to the importance of the use of the dollar as a reserve and
transaction currency, and the size of the Eurodollar market.
FEDWIRE
 Overview of Fedwire System
o Owned and operated by 12 Federal Reserve Banks
o 7300 bank participants (2008); 23 account for 80% of value
o Real Time
o Gross Settlement
o Transfers $3 trillion per business day (2008), average transaction $5.75
million [US GDP 2008, $14.2 trillion]
o Average daylight funds overdrafts (2008) about $62 billion per day (almost
doubled since 2005), total daily “peak” overdrafts $169 billion
o “Good” funds: even if the OB is over drafted, the money credited to the RB
will not be taken back
Fedwire Risk
 Why not take the money back from RB if OB does not cover its overdraft? Why
not just prohibit overdrafts (Swiss version of Fedwire does so)?
o If RB knew that Fed would take back the over drafted money, then
RB would not credit Payee until OB paid the money to Fed. Fedwire
is aimed to facilitate the large financial transactions which need
certainty. If the payments would be unwound, the system would be
far more complex and expensive. This would also risk a slowdown in
the economy and possible gridlock.
 Fedwire Risk Reduction Measures Pre-2008
Daylight Overdraft Ceilings-Pre 2008
• Maximum is 2.25 x capital per day and 1.50 x capital as a two week
average, no collateral required but caps can be increased with collateral
• Self-assessment of (1) bank credit worthiness; (2) operational controls to
control risk in payment systems and from customers; (3) credit policies
and procedures; and (4) systems/contingency procedure (SOSA)
• Ex-post monitoring (no automatic cutoff if exceed cap)
• Special rules for branches of foreign banks (FBOs)
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– Capital base is a specified percentage of worldwide capital: 35%
for FHCs, and 25% or 10% for other banks based on SOSA (1 or
2 respectively). 5% of net liabilities to other depository
institutions for banks with a SOSA 3
– SOSA factors for foreign banks: financial condition, supervisory
system of home country, support by government of banking
system, ability to access and trasmit U.S. dollars
– Higher if collateralized
FedWire Risk Reduction: Daylight Overdraft Pricing (pre- 2008)
• Price was 36 BP (.0036) annual rate for a 24 hour operating day (actually
21.5 hours)—with a deduction of 10% of capital
• Assume a U.S. bank has $10 billion in capital and $6 billion in daily
average overdrafts over a 24 hour operating day. Price per day will
be:.0036/360 x {6 - (.10 x 10 billion dollars)} = $50,000
 Changes in Daylight Overdraft Policy December 24, 2008
o Collateralized daylight overdrafts for healthy depository institutions
(CAMELS-3 supervisory rating or higher) at zero fee (15 of 20
largest users banks had sufficient unencumbered collateral pledged
for discount window borrowings to cover average daily
overdrafts)—may have changed
o Uncollateralized daylight overdrafts at 50 BP annual rate (old rate
was 36 BP)
o Only single day ceiling for healthy depository institutions (same
2.25 capital) (effectively raises ceiling since 2 week ceiling was
1.50)
o FBOs—FHC or SOSA 1-rated gets a ceiling based on 35 percent of
worldwide capital uncollateralized, plus an additional 65 percent
collateralized (no fee)
 What do you think of the Fed’s shift from pricing to collateralization of
daylight overdrafts?
o The collateralization gives more flexibilities and liquidity to the
participants. It also avoids the problem of banks’ increasingly
delay in payments which might cause the major disruption if a
major bank experienced operational problems late in the day.
 Are foreign banks discriminated against under the Federal Reserve Board’s
new 2008 daylight overdraft policy? If so, is such discrimination justified?
o Yes. It can be justified as Fed does not regulate the capitalization
of the foreign bank which is regulated by their home country
authorities. The foreign banks are concerned with such
discrimination which would affect their capacity to serve clients
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and weaken their competitiveness.
CHIPS
 CHIPS Overview
o Until 1998 owned and operated by NYCHA (10 NYC banks: Bank of New
York, Chase, Citibank, Morgan Guaranty, Bankers Trust, Marine Midland,
U.S. Trust Company of New York, Fleet Bank N.A., European American,
Republic National)
o As of 2007 owned by CHIPCo. which is owned by 22 large banks, several of
which are U.S. affiliates of foreign banks.
o 48 participants (majority foreign from 19 countries) (2008)
o Intra-day continuous bilateral and multilateral net settlement (2001)
o End of day net settlement
o Transfers about $2 trillion per business day (2008), average transfer about
$5.5 million (2008) (compared with $5.75 million average on Fedwire)
o More international than Fedwire (95% market share of foreign bank
transfers)
 Net Settlement Risk
• Bank A’s Overall Position
–Funds owed to others (sends): 25 to B and 50 to C = 75
–Funds owed to it (receives): 50 from B and 100 from C = 150
–Net: net claim (creditor) for 75 (150 receives - 75 sends)
• Bilateral Positions with A
– B: net debtor for 25 (sent 50 - received 25)
– D: no position (no sends or receives)
What happens if D fails? What will the Fed do?
D’s transactions will be all deleted and unwound. Fed has to rescue the bank
and pay the money.
 Why CHIPS a source of systemic risk?
o If one of the net debtors bankrupts, it would affect other banks’
receiving the money. The net debtor’s transactions would be
deleted and unwound so that Fed has to pay the money.
 CHIPS Risk Reduction Measures – Pre 2001
o Bilateral Credit Limits: Set by each participant on each other participant (net
of receives - sends) Example: X sets 1000 limit on Y, so that receives from Y
- sends to Y cannot exceed 1000
o Net debit caps: 4% of the sum of all bilateral credit limits extended to
participants
o Collateralized Additional Settlement Obligations (ASO)—loss sharing
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 The New CHIPS Arrangements (2001)
o Prefunded Balances based on past activity, can be increased during day
(average $2.8 billion per day, 2007— compared to $1.4 trillion total transfers
at time of measurement)
o Balances cannot go below zero or over two times initial balance
o Payments settled during day by bilateral or multilateral netting against
balances by a balance release algorithm designed to get the most settlement
out of the available balances
o End of day net settlement: unsettled messages returned to sender (if largest
two banks did not settle, would have to unwind $2.8 billion)
 Netting: Issues for CHIPS
o Suppose Bank F, a CHIPS participant, fails at the end of the day.
o Suppose Bank A has sent $7 billion to Bank F (the failed bank) during the
day and received $6 billion (the difference funded by A’s pre-funded
balance)
o If netting respected by F’s bankruptcy trustee, no claims either way (paid for
excess in sends with $1 billion)
o If netting not respected by F’s bankruptcy trustee, A might have to pay $7B
(sends) and claim $6B (receives) in B’s bankruptcy
o U.S. banks still have a significant risk that netting would not be respected by
a foreign bank’s bankruptcy trustee
o The participants are normally required to give CHIPS the legal opinion
stating that the home country respects the netting. The opinion, however,
might not have any authority in the countries where the law is not clear on
this issue.
Herstatt Risk
 Herstatt Risk
o Herstatt risk is a settlement risk on foreign exchange transactions. The
amount at risk for a bank when settling a foreign exchange trade equals the
full amount of the currency purchased and lasts from the time payment
instruction for the currency sold can no longer be cancelled unilaterally until
the time the currency purchase is received with finality.
 Response to Herstatt Risk
o CLS Bank which settles foreign exchange simultaneously is established to
eliminate the Herstatt risk.
 Will CLS Bank eliminate the risks?
o The participation in CLS Bank is not mandatory and it is expensive so not
everyone is in the system;
o CLS Bank does not fully eliminate Herstatt risk since not everyone is in the
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o
system;
CLS Bank is a concentration of risk and its failure would pose a great danger
The following three questions are not specifically discussed in class but appeared in
the syllabus. The answers provided below are my subjective understanding.
 What is the difference between Fedwire and CHIPS (The Clearinghouse
Interbank Payment System)?
The differences are illustrated in the overview of the Fedwire and CHIPS above.
 Should regulators actively favor “gross settlement” systems like Fedwire
over “net settlement” systems like CHIPS?
According to the study carried out by D. Schoenmaker and another by Kahn, the
“gross settlement” systems are more expensive than the “net settlement” systems;
the “net settlement” systems have less settlement risk than the “gross settlement”
systems; netting in effect replaces a difficult-to-enforce debt obligation with
another. As such, I am of the view that regulators should actively favor “net
settlement” systems.
 Should central banks have any involvement in offering payments system
services?
As the principals set out by Basel Committee on Payment and Settlement
Systems, the central banks’ primary role is to oversee the payment system,
promote the payment safety and efficiency as well as cooperate with other central
banks and with any other relevant domestic and foreign authorities. Therefore, the
central banks should not have any involvement in offering payments system
services which will rise conflict of interests when the central banks are exercising
their oversight duties.
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