Morten L. Bech, Antoine Martin, and James McAndrews Settlement Liquidity and Monetary Policy Implementation—Lessons from the Financial Crisis • The U.S. dollar clearing and settlement 1.Introduction system performed dependably during the financial crisis, processing record volumes he U.S. dollar clearing and settlement system was little and values of trades executed in stressed Tnoticed during the recent financial crisis, mainly because financial markets. it performed dependably, processing record volumes and values of trades made in stressed financial markets.1 Its • Emergency policy measures employed by successful operation was in part a result of the collaborative the Federal Reserve to provide liquidity and efforts undertaken by stakeholders over decades to improve stability to the financial system during and risk management and operational resiliency. Under the smooth after the crisis had important effects on surface, though, the dollar clearing and settlement system settlement liquidity and thus on the efficiency experienced important changes during the crisis. of clearing and settlement system activity. This article focuses on the ease with which market participants can discharge their payment and settlement obligations. We denote this as settlement liquidity. Our main • The measures led to a substantial decrease interest is on the settlement liquidity of the Federal Reserve’s in daylight overdrafts extended by the Fedwire Funds Service, the major large-value payment system Federal Reserve and an improvement in in the United States. We discuss how to measure settlement payment settlement timing. liquidity, and document the evolution of some of its key drivers over time. In particular, we show how the policy measures • The reduction in overdrafts lowered the Federal aimed at achieving financial and economic stability during and Reserve’s credit risk while the earlier settlement after the financial crisis have had a major impact on settlement time suggested significant efficiency gains and diminished operational risks. 1 Exceptions include the tri-party repo market (see Copeland, Martin, and Walker [2010]), the settlement fails that plagued several fixed-income markets, and the uncertainty that initially surrounded the settlement process of credit default swaps following credit events. Ultimately, the process was orderly (Senior Bank Supervisors Group 2008). Morten L. Bech is a senior economist at the Bank for International The authors thank Adam Biesenbach for excellent research assistance and the Settlements; Antoine Martin is an assistant vice president and James Payments Risk Committee’s Working Group on Intraday Liquidity Flows for McAndrews an executive vice president and the director of financial fruitful discussions. The views expressed are those of the authors and do not research at the Federal Reserve Bank of New York. necessarily reflect the position of the Bank for International Settlements, Corresponding authors: [email protected], the Federal Reserve Bank of New York, or the Federal Reserve System. [email protected] FRBNY Economic Policy Review / March 2012 1 liquidity and thus on the efficiency and inherent risks of Our study proceeds as follows: Section 2 provides an payment and settlement system activity. overview of the clearing and settlement system. The system is The massive expansion of reserve balances since fall 2008 viewed as a network of platforms connected via funding links. and the payment of interest on reserve balances have altered the In section 3, we introduce the concept of settlement liquidity— intraday liquidity management practices of financial the ease with which financial institutions can discharge their payment and settlement obligations. Section 4 discusses measurement of settlement liquidity and section 5 shows how The massive expansion of reserve such liquidity has varied over time and improved recently. In section 6, we argue that changes in monetary policy balances since fall 2008 and the payment implementation were the main driver of the significant of interest on reserve balances have enhancements in settlement liquidity, while in section 7 we altered the intraday liquidity management draw some policy lessons going forward. Section 8 concludes. practices of financial institutions. This has led to a notable quickening of settlement relative to the prior period and a 2. The Clearing and Settlement Network substantial decrease in daylight overdrafts extended by the Federal Reserve. An often overlooked, but crucial, part of the financial system is the clearing and settlement system.3 Clearing refers to “the process of transmitting, reconciling and, in some cases, institutions. This has led to a notable quickening of settlement confirming payment orders or security transfer instructions relative to the prior period and a substantial decrease in prior to settlement, possibly including the netting of daylight overdrafts extended by the Federal Reserve. instructions and the establishment of final positions for Importantly, the earlier time at which payments are settled settlement” and settlement refers to the “act that discharges implies significant efficiency gains as well as a reduction in operational risks. Moreover, the decrease in daylight overdrafts reduces credit risk for the Federal Reserve and the public sector The clearing and settlement system for more broadly, when taking into account the effects on the U.S.-dollar-denominated wholesale deposit insurance fund in the case of a bank failure. Interestingly, both of these improvements were the desired transactions is the largest and arguably goals of the revisions to the Federal Reserve’s Payment System the most important in the world. It is Risk policy, proposed in March 2008, adopted in late 2008, and probably also the most complex. implemented on March 24, 2011.2 By offering collateralized overdrafts at no fee, the Federal Reserve aimed to facilitate intraday risk management and efficient payment flows for the obligations in respect of funds or securities” (Bank for banking system while mitigating the credit exposures of the International Settlements 2003).4 Often a distinction is made Federal Reserve Banks from daylight overdrafts. To a large between systems that process retail and wholesale transactions. extent, the desired outcome was achieved ahead of the policy The clearing and settlement system for U.S.-dollar- changes. denominated wholesale transactions is the largest and arguably The amount of reserves available to the banking system and the most important in the world. It is probably also the most the opportunity cost of holding such reserves are at the center complex, in part due to the greater diversity of financial of any monetary policy implementation framework. Hence, we products traded in dollars than in any other currency. In any believe that this period offers important lessons for the choice case, the clearing and settlement system consists of a multitude of such a framework, especially now that the Federal Reserve 3 has the authority to pay interest on reserves. A system for The clearing and settlement system is at times referred to as the “plumbing” of the financial system. The analogy is fitting in the sense that—as with implementing monetary policy that keeps the opportunity cost plumbing—very few people know how it works, but everyone realizes that it is of holding reserves very close to zero may contribute messy when it does not. significantly to a more efficient and safe payment system. 4 Some clearing and settlement systems are vertically integrated with a single trading platform or exchange, while others are horizontally integrated across 2 http://www.federalreserve.gov/newsevents/press/other/20100930a.htm. different products. 2 Settlement Liquidity and Monetary Policy Implementation The U.S. Dollar Wholesale Clearing and Settlement Network Clearing Houses and Central Counterparties Large-Value Payment Systems LCH. CME ICE Trust clearnet OCC USD CHATS Settlement Banks Settlement Bank CLS Fedwire Funds CHIPS Fedwire Securities Settlement Banks Clearing Banks FICC Euroclear Clearstream DTC U.S. Government and Central Securities Depositories Agency Securities of different platforms that have evolved over time and stretches Federal Reserve. Fedwire Funds is a real-time gross settlement across borders and time zones. Together, these clearing and (RTGS) system that provides irrevocable and unconditional settlement platforms form the nodes in an intricate network, settlement during 21.5 hours of a business day. (It is described with the nodes linked together by funding relationships. A in more detail in Box 1.) The remaining platforms are grouped simplified graphical representation of this network is shown in into four categories, based either on the type of clearing and the exhibit; it includes the most important wholesale clearing settlement platforms they contain or the type of financial and settlement platforms. instruments that platforms settle in unison.5 The Federal Reserve’s Fedwire Funds Service (Fedwire Funds) sits at the center of the network. Fedwire Funds is the system that commercial banks use to send large-value or time- 5 In the exhibit, note that clearing banks (blue boxes) can also be critical payments to each other across the accounts of the settlement banks (gray boxes). FRBNY Economic Policy Review / March 2012 3 Box 1 The Fedwire Funds Service The Federal Reserve’s Fedwire Funds Service is a real-time gross Chart 1 settlement (RTGS) system that enables participants