Trade-off between credit risk and liquidity risk in different settlement systems (NET, RTGS and Hybrid)

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By Othman Darwish

Introduction



According to the report prepared by the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries in 1997: "Settlement is the actual transfer of funds between the payer's bank and payee's bank. Settlement discharges the obligation of the payer bank to the payee bank in respect of the transfer. Settlement is irrevocable and unconditional and is described as final settlement". Thus, settlement systems are used to transfer large value payments between financial institutions, aiming to streamline funds transfer in secure, effective and less risk manner.
As mentioned by the Bank of Finland Studies (2005), two main risks the participants in the settlement systems expose to; the credit risk and liquidity risk. Credit risk takes place when a defaulted counterparty of the payment "The Debtor" cannot meet the obligation of the full value of the transaction either when settlement date is due or in the future. On the other hand, the liquidity risk  happened when a counterparty will not meet the obligation of the full value of the payment at settlement due date, but he will at some time specified later.
Settlement systems is basically classified according to the timing (and frequency) of settlement to Net settlement systems and gross settlement systems (RTGS). Alternative system designs (such as real-time gross settlement systems or hybrid systems) are then increasingly being adopted to reduce or eliminate the risks in the settlement systems, as per Kai Barvell (2002).

The Details


This section describes the settlement systems individually, and how the settlement risks (credit and liquidity) is being addresses by each.

NET Settlement  

        

In  NET settlement system, the actual funds transfer (settlement ) is delayed and to take place in net basis at predetermined intervals (usually one interval at the end of business day). At the settlement time, all participating banks net positions are calculated, as the summation of all the received payments values (total credit) subtracting the summation of all the sent payments (total debit) values, the resulted net value (net settlement position) could be either a net credit or debit position.
The advantage of the NET settlement system is that it increases the participants liquidity and decreasing its risk, as - during the business day - they may be receiving credits and applying them to debit payments (transactions sent by other participants at the same business day). On the other hand, the NET settlement system disadvantage  is that it increases the credit risk; since at the settlement time, if any of the participating banks is defaulted, no settlement for all payments exchanged during that interval will be executed. To overcome this issue, the system deletes all or some of the defaulted bank transactions, and creates new settlement net position, this  operation is called unwinding, and it is  not easy decision, since unwinding the defaulted bank transactions may lead to other banks defaulting (domino effects), which may impact the stability of the entire financial market, as per Kai Barvell (2002).

Real Time Gross Settlement (RTGS)


In the RTGS system, each individual payment instruction (Gross) is settled at the moment  it enters the system immediately (in real time) basis, effectively the RTGS system provides settlement finality during the business day.  RTGS system essentially eliminates credit risk since there is no delay between the time of sending the message instruction and the time of processing and settling that instruction, as per Antoine Martin (2005). In such system, to meet final settlement requirement, holding high liquidity is needed in order to meet all payments obligations in real time, this may lead to liquidity risk and failure in meeting those obligations during a business day. However, to mitigate the liquidity risk  problem, the RTGS system could apply rules which set how fast the execution of the payment should be, other approach is to develop a set of payment queuing features that engaged together in calculating the proper order of payments execution, this is to avoid liquidly shortage and resilience flow of payments, as per Kai Barvell (2002).


Hybrid System


Hybrid settlement system is a temp to combine the advantages of the RTGS system (that eliminates the credit risk) and the netting system (that decreases the liquidity risk). In order to achieve this, the hybrid system prioritizes payments according to its urgency, it assumes a payment should be set to either a normal payment or an urgent payment. Urgent  payments are settled in gross real time, those payments  may have special exclusive time window and participants (those that exchange transactions between central bank and commercial banks for example), this is in order to implement monetary policy. Normal payments will be typically hold in a central queue to net/offset them continuously or at frequent interval against payment from other participating banks. To an extent, the resulting net debit positions are fully covered by the balances of the participants settlement accounts or by the incoming credit payments, and they could be settled immediately. Those payments that could not be settled are kept in a queue for the next cycle of netting and settlement. At the end of the day, the remaining items will be returned to initiating participants. Frequent netting in hybrid system aims to reduce the liquidity needs in relative to RTGS settlement, as per Kai Barvell (2002).

Conclusion


This paper displayed a trade-off between the settlement risks, credit and liquidity,  that are addressed differently in the different settlement systems; the Netting system decreases the liquidity risk requirements and associated cost but increases the credit risk, while the RTGS eliminates the credit risk, but increases the liquidity requirements, finally, the Hybrid system tries to compromise between the  liquidity and credit risks by increasing liquidity and minimizing (not eliminating) the credit risk  .

     References

1.       Report prepared by the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries (1997), REAL-TIME GROSS SETTLEMENT SYSTEMS, Bank for International Settlements

2.       Antoine Martin (2005), Recent Evolution of LargeValue Payment Systems: Balancing Liquidity and Risk, FEDERAL RESERVE BANK OF KANSAS CITY

3.       Kai Barvell (2002), Risks and Developments in Payment Systems, The International Monetary Fund (IMF)


4.       Bank of Finland Studies (2005), Liquidity, risks and speed in payment and settlement systems – a simulation approach, E: 31 · 2005

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