RDP 2012-06: The Impact of Payment System Design on Tiering Incentives 2. The Benefits and Costs of Tiering

2.1 Benefits

Systems that operate on an RTGS basis require participants to hold substantial liquidity in order to cover payments as they arise. In RITS, intraday liquidity is provided through interest-free repurchase agreements (‘repos’) with the Reserve Bank of Australia (RBA), but participants incur an opportunity cost as collateral posted to access this facility is unavailable for alternative uses.^[2] As discussed in Jackson and Manning (2007), Lasaosa and Tudela (2008) and Adams, Galbiati and Giansante (2010), tiering can reduce the liquidity needs of an RTGS system because:

• Combining payment flows allows more payments to be funded from receipts (liquidity pooling). Unless the client's and the settlement bank's peak intraday liquidity requirements occur simultaneously, tiering requires less liquidity than the sum of their individual peak requirements since payments received by one can be used to fund payments by the other.
• Payments between the client and the settlement bank are settled across the settlement bank's books, rather than being sent to the RTGS system (payments internalisation).

While saving on liquidity is the potential benefit of tiering in which we are primarily interested in this paper, several other benefits are identified in the literature. Jackson and Manning (2007) and Adams et al (2010), for instance, explore the idea that tiering can benefit a system if some participants have lower costs of direct participation than others or if there are fixed costs of direct participation. Also, Chapman, Chiu and Molico (2008) and Kahn and Roberds (2009) suggest that tiering encourages inter-agent monitoring of creditworthiness.

2.2 Potential Impact on Risk

While there are potential benefits from tiering in payment systems, there can also be costs. In particular, tiering can increase a number of types of risk in a payment system. Perhaps the most significant of these is credit risk. Just as moving to an RTGS system decreases credit risk at the expense of increased liquidity costs (Kahn and Roberds 2009), tiering represents the reintroduction of some credit risk. Note that this credit risk is two-way. Both the settlement bank and its client are exposed to the failure of the other; the former because it may offer its client intraday credit and the latter due to the settlement bank's role as holder of the relevant accounts. As the default of a settlement bank would affect all its clients simultaneously, the default of a large settlement bank in a highly tiered system could have a systemic impact.

Harrison, Lasaosa and Tudela (2005) attempt to quantify the credit exposure of settlement banks in CHAPS, finding that the risk is not substantial under normal operating conditions, but has the potential to rise considerably in extreme circumstances. To manage this change in credit risk, settlement banks may well react by reducing the credit they extend to their clients in times of stress. This ‘liquidity dependence’ may have a significant effect on the indirect participant as it no longer has direct access to central bank liquidity.

Tiering can also increase concentration risk. The more liquidity is concentrated among fewer participants, the more likely it is that an operational problem at one participant has a significant effect on the payments system as a whole. On the other hand, as a tiered network depends less on the central infrastructure, it may allow some payments to still go ahead in the event of a failure of the central system. The net effect is ambiguous, but tiering has the potential to significantly alter the effects of system disruptions and participant failures.

While the focus in this paper is on credit and concentration risk, other risks that can arise from tiering include:

• the legal risk that the finality of payments settled across the books of a commercial bank is not protected in the same way as the finality of payments settled in the RTGS system;^[3]
• the business risk that the exit of a settlement bank from the market may cause more disruption to the payments system than would result were tiering not present; and
• the competitive risk involved in a settlement bank also being a competitor with its clients in the market for retail payment services (Lai, Chande and O'Connor 2006).

Footnotes

A repo is an agreement between two parties under which one party sells a security to the other, with a commitment to buy back the security at a specified time for a specified price. In the case of an interest-free intraday repo, the two transactions occur on the same day at the same price, providing the original seller with liquidity to facilitate payments during the day. [2]

For instance, under the ‘zero hour’ rule, a court may date the bankruptcy of an institution from the midnight before the bankruptcy order is made, in which case payments made on the day of default are reversed. In Australia, the Payments Systems and Netting Act 1998 allows the RBA to protect payments that occur in RITS from the application of this rule, but payments settled across the books of a settlement bank do not have the same protection. [3]