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TRANSCRIPT
CentralBanksandPaymentSystems:
TheEvolvingTrade‐offbetweenCostandRisk1
CharlesKahn(UniversityofIllinoisatUrbana‐Champaign)
StephenQuinn(TexasChristianUniversity)
WillRoberds(FederalReserveBankofAtlanta)
InPreparationforNorgesBankconference
OftheUsesofCentralBanks:LessonsfromHistory
Oslo,5‐6June2014
1WethankparticipantsintheBankofNorway’sPre‐ConferenceattheGraduateInstitute,Geneva,25‐26April2013,formanyvaluablecommentsandsuggestions.Theopinionsexpressedherearetheauthors’ownanddonotre lectthoseoftheFederalReserveBankofAtlantaortheFederalReserveSystem.
1
CentralBanksandPaymentSystems:
TheEvolvingTrade‐offbetweenCostandRisk
Central banks and payment systems evolved together. Many early central banks were
foundedaspaymentsinstitutions:examplesincludeBarcelona’s1401TauladiCanvi(Usher
1934),Genoa’s1408BancodiSanGiorgio(Sieveking1934a),Venice’s1587BancodiRialto
(Luzzatto1934),theBankofAmsterdamin1609(VanDillen1934),theBankofHamburg
in 1619 (Sieveking 1934b), and Nuremberg’s 1621 Banco Publico (Denzel 2012). While
somecentralbankswereinitiallyestablishedasgovernment iscalagents(mostfamously,
the Bank of England in 1694; see Clapham 1944), inmost cases these institutionswere
soondrawnintoapaymentsrole(RoberdsandVelde,2014).
Today,paymentsystemscontinuetobeakeypartofcentralbanking,andcentralbanking
remainsatthecenterofpayments.PrivatepaymentsystemsareimportantthroughoutEu‐
ropeandNorthAmerica.Innovativeprivatesystemsareubiquitous,fromsystemsforsmall
retailpayments,suchasPayPalorSquare,throughlargevaluesystemslikeCHIPSandEU‐
RO1,anduptotheinternationalCLSsystem.Butcentralbanksystems—Fedwire,TARGET,
CHAPS,andsoon—continuetobethebackbonefortherestofpayments.
The importanceofpaymentsactivityhasexpandeddramaticallysincethe1970swiththe
growthof inancialmarkets,especiallythegrowthinforeignexchangetradingpost‐Bretton
Woods.Figure1 summarizes thehistoricalevolutionof “payments intensity” for selected
countries,measuredasannualvaluetransferredoverwholesalesystemsrelativetonomi‐
nalGDP.Paymentsactivityat the18th‐centuryBankofAmsterdamwasalreadyabout2.5
timescontemporaneousDutchGDP.This ratiodidnot changegreatlyover thenext three
centuries: by 1960 the U.S. was turning over 4.5 times its GDP through the Federal Re‐
serve’s wholesale system (Fedwire). Post‐Bretton Woods this ratio increased rapidly in
mostdevelopedcountries,butby2012appearstohaveleveledoutatabout90‐100times
2
GDP,atleastforthetimebeing.2Paymentsintensityisstillincreasinginotherpartsofthe
world,e.g.,China’sratiowentfrom20timesGDPin2008to34timesGDPin2012.
Figure :LargevaluepaymentstoGDPratios,selectedeconomies
Notes: Ratiosrepresentsumofannualvaluetransferredoverall large‐valuesystemsforagivencountryorcurrency,dividedbyannualGDP. SourcesareCannon1910,Carteret al. 2006,CommitteeonPaymentandSettlementSystems1980,2002,2013,Dehing2012,DeVriesandVanderWoude1997,Hills,Thomas,andDimsdale2010,Matthews1921,Riesser1911,RitschlandSpoerer1997,andStähler1909.Figuresfor2008and2012includeproratedsharesofCLSactivity.Pre‐1955valuesarehighlyapproximate.
The dramatic expansion in payments activity has created newworries for policymakers.
System‐widedisastersareofcourseofgreatconcern.TheexperienceofFedwireduringthe
eventsof9/11hasledsystemstopayincreasedattentiontobackupandrecoveryfacilities.
Theexperienceofindividualpaymentfailuresinlargevaluesystemsandthepotentialfor
knock‐oneffectshaveledtolarge‐scalereforms,culminatinginmovementtogrosssettle‐
ment(BechandHobijn2007),theintroductionofliquidity‐savingmechanisms(i.e.,queu‐
2IntheU.S.case,about60percentofwholesalepayments(byvalue)canbedirectlyattributedtosettlementofforeignexchangetrades,sincetheytakeplaceoversystems(CHIPS,CLS)thatarespecializedtothisfunc‐tion.WesuspectthatFXhasasimilarshareoflarge‐valuepaymentsinothercountries.
1
10
100
1000
1760 1868 1900‐7 1955 1960 1978 2000 2008 2012
Value transferred ‐to‐GDP (log scale)
Netherlands
Germany
UK
US
Japan
Euro Area
China
3
ing schemes; see Martin and McAndrews 2008), and development of CLS (Continuous
LinkedSettlement;seeKahnandRoberds2001,aswellassection4below).Andonaday‐
to‐daybasis,theoverlapinservicesprovidedbyprivateandpublicsystemsleadstoaper‐
sistent question for regulatory bodies: to what degree should the private systems, that
simultaneouslycompetewithanddependonthepublicbackbonesystems,beencouraged
orrestricted?
Inthispaper,wewillpresentasimpletheoreticalframeworktoillustratetheevolutionof
central bank payment systems and, importantly, their interactionswith private systems.
De iciencies inapaymentsystemcreateopportunities fora centralbank to improveef i‐
ciencybyofferingaprivilegedformofmoney.Successfullyintroducingcentralbankmoney
thencausesthepaymentsystemtoadjusttoitsnewsettlementanchor.Centralbankmon‐
eycontributestotheeffectivenessofthewiderpaymentsystemanditscharacteristicsde‐
pendonthestructureofthecentralbank.Furthermore,thisco‐evolutionoftheelementsof
adomesticpaymentsystemissensitiveto thepressuresandopportunitiescreatedby in‐
ternationaldemandforitspaymentservices.
Todemonstratethesedynamics,weconsiderexamplesofthedevelopmentofpaymentsys‐
temsbefore,during,andaftertheintroductionofcentralbanks.First,weexaminetheEarly
ModernsystemofbillsofexchangeprevalentontheEuropeanContinent.Next,weexamine
theAnglo‐American experiencewith banknotes and checks. Finally,we considermodern
wholesalepaymentsarrangementsforforeignexchange,whichworkthroughmultiplecen‐
tralbanksbutdonothaveaunifyingcentralbank.3
1. Analyticalframework
Inordertomakeatransaction,abuyerandsellermustestablishnotonlythetermsofthe
purchase—price,quantity,quality—butalsothetermsofthepayment:when,where,and,
3Forotherapproacheslinkingthehistoryofpaymentsystemstothedevelopmentofcentralbanks,seeGian‐nini2011andNormanetal.2011.
4
above all, how.4 Nowadays, transactors have a variety of payment methods available to
them:cash,checks,andvariouspaymentcardsandinternetarrangements.Butasillustrat‐
ed in the following sections, economic agents in earlier centuries often faced complex
menusofpaymentmethodsaswell.
Choosingamongthealternativemeansofpaymentinvolvestradeoffs.Asaresult,anecon‐
omyusesavarietyofpaymentmethods.Forexample,cashhashighliquidityand inality,
butpeopleresistusingitbecausecashisexpensivetoacquireandprotect.Creditcards,in
contrast,arecheaperforconsumerstouse,butexpensiveforretailers.Theyarealsocon‐
tingent and have limited secondarymarket liquidity.Wewill call the collection of these
methods at anyparticular time, alongwith their supporting infrastructures, thepayment
system.
Eachmethodofpaymenthasadifferentpro ileofadvantagesanddisadvantages,5makingit
mostsuitableforadifferentsegmentofmoneydemand.6Forexample,ifthepartiestothe
transactiontrusteachother,orifthepaymentisrelativelysmall,theymightpreferatech‐
nique with higher risks but lower costs. As the costs of particular payments methods
change,thosepaymentsmethodsbecomelargerorsmallerpartsoftheoverallsystem.
Conceptually,sourcesofpaymentsfrictioncanbeassignedintotwobroadcamps:resource
costs and risk of use. Payment instruments that have no relative advantage in either re‐
sourcecostorriskareshunned,andthemoniespeopledousehavearelativeadvantagein 4 Integrating themultiple dimensions of transactions into anArrow‐Debreu context presents serious chal‐lenges.OnewayofsolvingthisproblemisillustratedinGeanakoplos2009,whichtreatseachdifferentsetoftermsforapurchase(inthiscasethecollateralrequirements)asadifferentArrow‐Debreucommodity.
5Ahostofrecentresearchhasinvestigatedtheconsiderationsthatleadindividualstochooseonemeansofpayment over another in particular transactions. See, for example, Arango andWelte 2012; Foster,Meijer,SchuhandZabek,2011;KahnandLinares‐Zegarra2012;Klee2008;Kosse2012;Leinonen2008;Schuh,andStavins2010.
6Theterm“money”referstoaliquidassetthatservesinmultipleroles,themostimportantofthembeingameansofpayment.Mostmeansofpaymentcanbeclassi iedasmonies.Usefulnessasameansofpaymentisaprimary driver of demand formoney (the so‐called “transactionsmotive”), although other considerations(“speculative”and“precautionary”motives)alsoin luencedemandformoney.
5
oneortheotherdimension.Thesetofpaymenttechnologiesactuallyusedthusexhibitsthe
tradeoffbetweencostandrisk(Berger,Hancock,andMarquardt1996).
Resourcecostsincludecostsofrecordkeepinginaccounts‐basedpaymentsarrangements
andcostofveri icationinstore‐of‐valuearrangements(seeKahnandRoberds2009).But
themost important resource costs canoftenbe summarizedby the costof the collateral
tiedupintheoperationofthepaymentmethod.7Thereareseveraldimensionstotherisks
inusingapaymentsystem,buttoday,themostrelevantareliquidityrisks8andrisksassoci‐
atedwithfailureofsettlement inality.Historicallytheriskoflossofvalue,throughin lation
or outright default, was also an extremely important consideration when a transactor
adopted a paymentsmethod. This risk is not amajor concern for participants in estab‐
lishedsystemsindevelopedcountriestoday,buttherecentexperiencesofhyperin lationin
Zimbabwe,aswellaspersistenthighratesof in lationinotherdevelopingeconomies,re‐
mindusthattheseconcernsareongoinginsomepaymentsystems.9
Evolutionof thepayment systemoccurswhena technological or institutional innovation
reducesthecostsorrisksofusingapaymentmethod.Increaseddemandfortheimproved
arrangement allows the innovators to earn pro its. Figure 2 puts this into a schematic,
wherepaymentsystemevolution is thatmovementofarisk/cost frontier towardsazero
cost,zeroriskorigin,renderingtheoldfrontierfeasiblebutinferior.
7Inhistoricalcontextsthecostofthecollateralbackingthepaymentsystem(sometimesthecostofspecie)isabsolutely clear aswill be seen below. In practical contexts it is also clear that the disadvantages of somemodernsystemsstemfromtheamountofcollateralorofcentralbankfundsneededtorunthem(MartinandMcAndrews2008).
8Recentapproaches tomodeling liquidity risk includeHolmstromandTirole2011andBrunnermeier andPedersen2009.
9 And despite the remoteness of the risk, the possibility of default by large financial institutions and associated inter-national payment disruption (so-called “Herrstat Risk”) was the underlying driver in the development of CLS.
6
Figure2.Paymentsystemevolution
Source:AdaptationofBerger,HancockandMarquardt1996:700.
Suchevolutionshouldnotbeconfusedwithanyinstantaneousglobaljumptobestpractic‐
es.Thereareseveralreasonsforinstitutionstobesluggishinreachingthetechnologically
feasible frontier. Clearly network externalities and economies of scale are of major im‐
portanceintheadoptionofaparticularmeansofpayment.Thuswhenanincumbentisin
place,entrantsmaynotbeablesuccessfullytointroducenewtechnologieswithcombina‐
tionsofcostandrisk thatare toosimilar toexistingsystems. Instead,outsiders’ innova‐
tionsaremorelikelytoariseinadifferentregionoftheef iciencyfrontier.Politicalpower
canalsorestricttheintroductionofsuperiortechnologies—eitherthroughthestate’suseof
nakedpowertoprotect itsownmonopolyorthroughin luenceofapowerfulprivatesys‐
tem’s lobbying the state. Still, over timewe expect that as inferior payment instruments
remain far enoughbehind themoving frontier, they fall into obscurity, and gradually the
paymentsystemdoesadjustthebettertosatisfytheeconomy’smoneydemands.
1.1StateMoney
Differenttypesofinstitutionsmaycontroldifferentpartsofthepaymentsystem.Atoneex‐
tremearepaymentsarrangementsrunbyprivate,for‐pro itcorporations;attheotherex‐
treme are arrangementswhich are explicitly arms of the state.Mostmodern systems lie
somewhere in between. Central banks today are state institutions, but they are typically
Risk
Cost
7
keptinsulatedfromcontrolbyotherpartsofgovernment.Privatesystemsareoftencoop‐
erative arrangements establishedbyotherwise competing institutions.Typically they are
chargedwiththedualtasksofseekingpro itsandprovidingservicetotheirmembers.Even
state institutions can be interested in operating payment systems so as to turn a pro it..
Nonetheless,forthissectionwewillsimplifythediscussionbyconsideringtherelationbe‐
tweenastatesectorprovidinganof icialmeansofpaymentandprivateentitiescompeting
withit.
Among competing payment systems,what distinguishes “statemoney,” supplied by gov‐
ernments or their agents, from the rest?Relative to private suppliers, governments have
potential“naturaladvantages.”Asuf iciently‐stablegovernmentcan,throughitstaxingau‐
thorityandcoercivepowers,createadegreeofcredibilityandcoordinationthatotherinsti‐
tutionscannotmatch(Kocherlakota2001,HolmstromandTirole2011,Chapter5).Forex‐
ample,politicalcredibilitymightallowagovernmenttodevelopa iatmoney,avoidingex‐
pensivecollateral.Oralegaltenderlawmightwidelyandcheaplycoordinateabenchmark
fordebtsettlement.Orgovernmentmightusestatepowertoincorporatethemostreliable
andstableprivately‐providedmoneyavailableintoastatemoney.Weclassifystatemoney
assuccessfulwhentransactorschoosetouseit.
Historyshowsthatthesuccessofstatemoneyisnotassured.Astate,orthecentralbank
actingasitsagent,mightlackstabilityoritmightlackamechanismtoconfercredibilityon‐
toitsmoney,soprivatearrangementsmaydominate.Oneimportantsourceoffailureisa
con lictbetween thestate’s short‐termpro its (seigniorage)and its long termgoals fora
paymentsystem.Thehistoryofcoinageprovidesmanyexamples.Formillennia,statespro‐
ducedcoinsandtriedtomonopolizetheirproduction.Successfulmintscreatedcon idence
intheintrinsiccontentoftheircoins,butmanyregimesgainedseignioragethroughthede‐
basementoftheircoins.Yetothercoinsneverbecameestablishedstandards,sothatfewof
themwereeverproducedandlittleseignioragewascollectedbytheirissuers.Otherillus‐
trationsareprovidedby thehistoryof centralbanks. Successful centralbankshavebeen
abletoofferapaymentsmediumwithadvantagesoverprivatearrangements;nonetheless
8
therearemanyexamplesofinstitutionsthateithernevergainedtractionaspaymentpro‐
viders,orthatcollapsedfollowingexcessivemonetaryexpansion.10
Evenifnotabusive,statemoniesmaybedisplacediftheyareinferiortothecompetition.
Statemoniescompetenotonlywithprivaterivals,butwiththemoniesofotherstates.His‐
torically,themostsuccessfulmintscreatedcoinsthatcirculatedaroundtheworld.Similar‐
ly,themoneyofadominantcentralbankcouldattractliquidityfromabroadinexcessofthe
nation’sroleininternationaltrade.ImportantexamplesfromearliererasincludetheBrit‐
ishpound(FlandreauandJobst2005)andtheDutchguilder(Flandreauetal.2009,Dehing
2012).
NowadaystheU.S.dollaristheprimeexampleofthis“reservecurrency”status;itremains
tobeseenwhether theEuro,orpossibly therenminbi,eventuallysupplants thedollar in
thisrole.Ifitbeginstohappen,wecanexpectthatthedollarwon’tgiveinwithouta ight.A
statehasmanytoolsatitsdisposalinsuchastruggle.Itmayattempttosubvertcompeti‐
tion by setting legal restrictions that favor its own money. Such legal tender rules can
strengthen a currency. Promoting usage reinforces network externalities: as a particular
typeofmoneybecomesmorepopular,themarginalbene itsofholdingitincrease.Onthe
otherhand,effortstoimposeaninferiortypeofmoneycandegradeanentirepaymentsys‐
tem.Here,arelevantasymmetry isthat it isusuallyeasierto impose legalrestrictionson
centralizedsystems,solegaltenderwillhavegreatereffectondebtsettlement(wheneco‐
nomicallycentralizedthroughclearingoperationsandlegallycentralizedthroughcontract
enforcement)thanondecentralizedspottransactions.Otherwiseput,itiseasiertouseille‐
galmoneyinaside‐alleypurchasethaninaclearinghouse.Nonetheless,legalrestrictions,if
suf icientlysevere,canevenpushclearingarrangementsintotheshadows—ornowadays,
10 Early (pre‐Napoleonic) examples of public bank failures or collapse include Genoa in 1444 (Sieveking1934a),Venice in1638 (Luzatto1934), Stockholm in1664 (Heckscher1934),Vienna in1705 (Bidermann1859),andthe1720breakdownof JohnLaw’sSystem inFrance(Velde2007).TheNapoleonicerasawthecollapseofmanypublicbanks,e.g.,inAmsterdam(QuinnandRoberds2014)andagaininVienna(Raudnitz1917).More recent examples of hyperin lation‐induced collapse are (sadly) too numerous to list here: seeSiklos1995forasurvey.
9
outofthejurisdictionentirelyandintoforeigncontrol.Accesstoprivatemeansofpayment
constrainsastate’sabilitytoimposecostlypublicpaymentsystems,andthusitsabilityto
conduct restrictive monetary policies (Kahn 2013). Similarly, the state’s powers in the
monetaryandpaymentsarenalimitthekindsofprivatearrangementsthatcandevelop.
1.2Anchor
Nonetheless,therelationbetweentheprivateandpublicspheresofpaymentisnotsimply
competitionbetweensubstitutes.Ifthepublicauthorityprovidesanadequateanchor,then
aprivatesystemcandevelopfromit.Historyprovidesexamplesofsuccessfulcoinsbecom‐
ingpaymentsystemanchors.ForaRenaissanceorEarlyModerncity,coins(andthecity’s
regulations regarding those coins)were the standardof inality and liquidity. Innovators
respondedbydevelopingalternativepaymentsystemsthatreducedcostsrelativetocoins:
mercantile credit, bills of exchange, and bank accounts. These technologies deferred the
need for coin. Additional innovations avoided the use of coin through netting. Bankers
learnedtoclearoffsettingclaimsandmerchantslearnedtoclearoffsettingbillsofexchange
(Velde2009,BornerandHat ield2012).Eventually,multilateralnettingfurtheravoidedus‐
ageofcoin,sobankerscentralizedwithclearinghouses(for theirdevelopment in theU.S.
andintheU.K.,seeCannon1910andMatthews1921respectively)andmerchantscentral‐
izedwithfairs.Innovationmeantthattheanchor,coins,movedlessandless.Buteachinno‐
vationdependedonthestableanchor.
Likecoin,successfulcentralbankmoneycananchorapaymentsystem.Unlikecoin,central
bankmoneydoesnotcontainintrinsicvalue—itisnotitselfmadeofgoldorsilver.Rather,
centralbankmoneyderivesvaluefromitsbacking—beitpreciousmetal,sovereigndebt,or
thestate’sfullfaithandcredit.Comparedtoasystemanchoredbycoin,acentralbankcan
reduceoreliminateusageofcoin.Displacingacommodity‐moneyanchor,however,creates
newchallengesfortheestablishmentofcommitmentmechanisms.Again,sucheffortscan
fail,butwhenacentralbanksucceeds,privateinnovatorsmust indtheirspotontheef i‐
cientfrontier.Relativetosuccessfulstatemoney,privateinnovatorscaneitherlowercosts
(attheexpenseofrisk)orlowerrisk(attheexpenseofcost).Asaconsequence,anewand
10
successfulstatemoneycansetoffrapidinnovation—a“punctuatedevolution”—asthepri‐
vatesideofthepaymentsystemrespondstothenewanchor.
Infact,theprivatesystemusuallydirectsitseffortstowardscostreduction.Whenwellde‐
ployed, thenaturaladvantagesof thepublicprovidermake itparticularly challenging for
privatearrangementstoofferalowerriskpro ile.Thisissomewhatparadoxical—afterall,
aswehaveseen,thestatesystemhasthepowertorenegeonitspromisesinsomanyways.
Butpreciselybecauseof that,asuccessfulstatesystemmustdevelopstrongassuranceof
controlsonitsgrowth—ahighdegreeofcommitment.Thesuccessofstatemoneyusually
reliesoncrediblelimitsonsupply,andalimitedsupplyincreasesthecostsofthismostuse‐
fulresource.
Asaresult,con idenceinanimmediatemeansofpaymenthasgenerallyrequiredassurance
ofsomecontrolsonitsgrowth.Butthenecessarycommitmentmakessuchsystemsintrin‐
sicallyin lexible.Inthecaseofmetals,thein lexibilitywascompoundedbydependenceon
thevagariesofdiscovery.Butmorefundamentally,andparticularlyin iatsystems,theas‐
surancewasdependentonabeliefthattherulesofthegameweredif iculttochange.
Ontheotherhand,thisin lexibilitymeansthatitishardtoimproveonthebackingofasta‐
blegovernmentinperiodsofeconomicstress.Thepublicsystemislikelytobemostexpen‐
sivebutmostreliable,thusservingasarefugeintimesofcrisis. Indeed,thecontrastbe‐
tweentheneedforcommitmentwithinthecentralsystemandtheneedfor lexibilitywith‐
intheeconomyasdemandforpaymentgrowsisthetensionwhichprovidesspaceforpri‐
vatesystemstodevelopandcompete.Theresultingopportunityforprivateinnovationisto
offerpaymentservicesatalowercost(butathigherrisk)thatmanytransactors inddesir‐
able. Figure2givesaschematicviewoftheprocess. Tobegin,anewstatemoneymoves
inwardthehighcost,lowriskendofthepaymentsystemfrontier.Theninnovationgrowsa
newfrontiertowardslowercosts/higherrisks.Thenewprivatesystembuildsonthesta‐
bilityoftheanchor.
11
Figure3.Punctuatedevolution
1.3SystemRisk
Participantschoose thepaymentsmethod that itsbestwith theirpreferences formixing
costsandrisk.Butthesocialcostsofriskmaybegreaterthantheprivatecosts.Therecan
beexternalities associatedwith theuseof apayment system:misuseor failureof apay‐
mentsystemimposingcostsonagentsintheeconomybeyondtheparticipantsinthepar‐
ticulartransaction.Systemicriskisinherentinanypaymentsystem:likenationalsecurity,
theveryexistenceofapaymentsystemenablestheeconomytorelyonittogetthingsdone,
andthereforeencouragesproductionandinvestment;itsdisappearancedamageseveryone.
Morenarrowly,theuseofapaymentsystemrequiresbuyingintoitsspeci icarrangements.
There isvaluetiedupinthis,andsothedestructionordegradationofthesystemcauses
lossestootherparticipantsinthesystem: themorewidespreaditsusethegreaterthese
costs.Theproviderofasystemwillinternalizethesevaluesindeterminingtherightlevelof
safetyinordertomaximizethevalueforthemembershipinitspaymentscommunity,for
example,throughitsspeci icationofamountsofcollateraltobepostedbyparticipants.To
theextentthattherearespilloverstonon‐participants,ortotheextentthatlimitedliability
onthepartofthesystemproviderleaveshimunaffectedbysystemiclosses,thestatemay
demandahigherlevelofcollateralthaneventhesystemoperatorwouldprescribe.
Risk
Cost
New Anchor
12
The other half of this tradeoff, the cost of the protective collateral, is also the potential
sourceofawedgebetweenprivateandsocialcosts.Thecostsofprovidingcollateralarere‐
alenoughtotheparticipantswhoarerequiredtobearthem.Butcentralbankshavenatu‐
ral advantages in the creationof reserveswhich canbeused asbacking inpayment sys‐
tems.Afundamentalpuzzleinmonetarytheoryistheextenttowhichcostsofcentralbank
reservesusedascollateralaretrulysocialcosts.11
Sofarwehavedescribedasituationinwhichthereisastrictdistinctionbetweentheback‐
bonepublicpaymentsystemandperipheralprivatesystems.Thisisanoversimpli ication
inseveralimportantrespects.First,overtime,astheperipheralsystemsbecomemorecen‐
tral totheeconomy, thegovernmentwillextend itsrule‐makingpowerstocoverthemas
well.Reservestobackbanknotesordepositsbecomenotjustamatterofthebank’sdesire
tomaintain its business, but also a requirement of public policy—sometimes, aspointed
outbyGiannini(2011),underpressurefromthemorereliableamongtheperipheralpro‐
viders,intheirquestforqualitycontrol.Moreover,astheperipheralsystemscentralize,the
centralauthoritytendstoprovideitscapitaltothemaswell. Inpartthismakesperfectly
goodsenseeconomically:thecenteristhelow‐costproviderofreputationalcapitalandit
values thepreservationofperipheral systems,at leastundersomecircumstances. There
aretwolimitstothisprocess:moralhazardandsheersize.Themoralhazarddimension
longbeenrecognized,butthesizeproblemhasbecomeimportantinrecentyears,asinIce‐
land,forexample,wheretheperipheralsystembecamesolargeastoswampeventhesov‐
ereign’s reputational capital. Finally of course, the decision to provide that reputational
capitalisonlypartlyvoluntary. (“Toobigtofail”isnotonlyaphenomenonofthecurrent
age;theBankofAmsterdamfeltcompelledtolendtotheDutchEastIndiaCompanydespite
prohibitionsinitscharter;seeUittenbogaard2009).Andsotheneedforrulemakingbythe
centerisinpartadefenseagainstitsinabilitytorefusetobailoutprivateinstitutions.
11ThepresumedpowerofcentralauthoritiestoproviderealmoneybalancescostlesslyunderpinsmuchofthedebateaboutoptimalmoneysuppliesandtheFriedmanrule.SeeLagosandWright2005.
13
1.4TheRoleofInformation
Information is central to theworking of payment systems. As emphasized in Kahn and
Roberds(2008), thesuccessofasystemrequirestheabilityofparticipantstodistinguish
legitimatefromcounterfeittokensin“store‐of‐value”systemsandtheabilitytodistinguish
identitiesofcounterpartiesin“account‐based”systems.Morebasically,itrequirestheabil‐
ity to distinguish onepayment system from its imitators: in otherwords successful pay‐
mentsystemsmustbe“namebrands.”Theabilitytopoliceone’sbrandisacrucialaspect
of thenecessarygenerationof con idence in thesystem.Historically, sovereignsexecuted
counterfeiters for treason, and developed techniques and institutions for preserving the
valueofthecoin.12
Privatearrangementsbandtogetheringuild‐likeorganizations(thinkofVisaandMaster‐
card as their modern‐day equivalents), not only in order to maintain oligopoly power
against rivals, but also to set standards for safety of instruments and guarantee that the
publicnotconfuseinferiorversionswiththeirown.Forbothofthesereasonspaymentsor‐
ganizationsappealtothesovereignforprotectionandexclusivepowers,movingdownthe
roadfrompurelyprivatetoquasi‐publicorganizations.
Oneadvantageemphasizednowadaysin“store‐of‐value”systemsistheirabilitytoprovide
anonymity:paymentsmaybemadesuccessfullywithoutdisclosingtheidentityofthepayer
(Kahn,McAndrews,andRoberds2005). Whilethisside‐bene ithasbecomeof increasing
interestinrecentyearswiththeever‐increasingconcernwithprivacy,thisdoesnotseemto
ustohavebeenaprimarydriverintheoriginationofanypaymentsystembeforetheinter‐
netera.Asidefromcoin,theearliestmonetaryinstrumentthatpermittedprivacywasthe
bearernote.TheintroductionofbearernotesbytheBankofEnglandin1694allowedfor
anonymityoftransactions,butearlynoteswereusedforlargevalue,business‐to‐business
12Themostfamousoftheseisanelaborateprocedurefortestingarandomsampleofnewlymintedcoinforweightandfineness,knowninEnglandas“theTrialofthePyx”(Stigler1999).Thisprocedurewasinuseasearlyasthethirteenthcentury.Virtuallyidenticalprocedureswereappliedinothercountries,see,e.g.,Polak1998foradescriptionofitsuseintheseventeenth‐centuryNetherlands.
14
payments(Clapham1944:22‐3).Theirprimarybene itwastofacilitate inality,byallowing
an alternative to chains of debt transactions. In otherwords the important aspect of the
trailof informationinearlierpaymentsystemsisnotthatan individualdidnot leaveany
trail,butthatnooneneededtoworryaboutfollowingthetrailothershadleft.
The other aspect of information crucial to running a successful payment system is
knowledgeofcounterpartyquality. Consistentwiththedifferenceinrisk,privatesystems
areoftencon inedtosmallergroupsofparticipantsthanthepublicsystem.Theriskassoci‐
atedwith theprivatesystemcanbe reducedbycarefully restrictingmembership to indi‐
viduals deemed suf iciently reliable, or by limiting transactions to those counterparties
whomonecanmonitorreadily.Indeeddemandforpublicsystemswithimprovedguaran‐
teesonlyariseswhentheextentofthecommunityoftransactorsbeginstoexceedthecon‐
inesofsuchgroups.
1.5Preview
Inthefollowingsectionsweconsiderseveralhistoricalexamplesinwhichacentralbankor
centralbankinnovationisintroducedintoanexistingpaymentsystem.Weexaminethead‐
justments thatoccuras therestof thepaymentsystemdevelopsaround thenewanchor.
Wealsoconsidertheverdictontheeffectivenessoftheinnovation,asevidencedbyinterna‐
tionalparticipationinthesystem.
2.Exchangebanks13
The irst generation of central banks in Continental Europe offered accounts rather than
currency.WiththeexceptionsofNaplesandGenoa,theearlypublicbanksdidnotcirculate
monetary liabilitiesoutside theirbank. Instead,Barcelona,Venice,Amsterdam,Hamburg,
andothersofferedonlygirotransferwithineachbank.Theseearlycentralbankswerelim‐
itedbecausetheirgoalwastobolsterbillsofexchange:aprivatepartofthepaymentsys‐
13ThissectionisbasedonDehing(2012)andQuinnandRoberds(2009,2012,2014a,2014b).
15
temthatmovedliquidityoverlongdistances.Exchangebankssoughttoreplacecoinsasa
mediumofdebtsettlement.Theydidnottrytodisplacecoinsfromcirculationasamedium
of exchange. Even so, the Continental exchange banks were mostly ineffectual, or even
counterproductive. An exception was in Amsterdam, where the Bank of Amsterdam did
eventuallyinnovatetocreateasuccessfulanchormoneyforinternationalpayments.
2.1CoinsandBillsofExchange
IntheEarlyModernEra, theanchoroftheEuropeanpaymentsystemswascoin.Coinsof
the inestreputationliketheVenetianducat,theSpanishdollar,ortheDutchrixdollarcircu‐
latedwidelyaslowriskmeansofpaymentforlarge‐valuespottransactions.By“lowrisk”
wemeanthatthelikelihoodofsuchcoinsbeingofalower inenessthanexpectedwaslow
for internationalmerchantsandtheirmoneychangers.GandalandSussman(1997:444),
forexample,puttheaccuracyoftouch‐stoneassayataround3percentandtheaccuracyof
weightat⅓percent, socon idence in the inenessofcoinswasacritical competitivead‐
vantage.
Using trade coins, however, was expensive. For example, for themid‐eighteenth century,
Nogues‐Marco (2013: 468) calculates a two percent cost of acquiring andmoving silver
fromLondon to Amsterdam: perhaps the shortest, safest and busiest international trade
route in theworldat the time.Costs includebrokerage, loading, freight,andassay. Insur‐
anceaddsanother1to2percentduringpeace,andevenmoreduringwar(Nogues‐Marco
2013:469).
Toavoidsuchcosts,merchantsusedbillsofexchange.Abillwasan“orderinstrument,”for
exampleaninstructionbyamerchantinLondontoamerchantinAmsterdamtopayasum
inDutchguilders.Insteadofbuyingandtransportingcoin,amerchantcouldspendEnglish
poundstobuyabilldrawnonAmsterdam.14Usually,theexchangeratewithinthebilldeliv‐
14Thisformofpaymentpersistsinthemodernworld.E.g.,arecentWallStreetJournal(McMahon2014)de‐scribestheuseofbankdrafts(billsdrawnoncommercialbanks,payableatafuturedate)incontemporaryChina.
16
eredmoreDutchguildersperEnglishpoundthancouldbeacquiredbyshippingmetal.The
exchangerateincludedachargefortime,typicallyaround¼percentbetweenLondonand
Amsterdam.Addinbrokerageandpostage,andtotalcostmightreachonepercent,orone‐
thirdthecostofshippingcoin.
Thetrade‐off,however,wasrisk.Foremost,thepersonsupposedtopaythebillinAmster‐
dammightnotpay.Thiswascalledaprotest,anditleftthecreditorseekingcompensation
at law inAmsterdamor evenback inLondon.Micro‐level analysis of bill protest rates is
veryrare,butSantarosa(2010:13)does ind44percentofbillswereprotestedinMarseille
around1780.LondonandAmsterdamprotestrateswerelikelyless,butwehavenogood
estimate,and,aswithotherdebtsusedasmoney,thelikelihoodofdefaultwouldsuddenly
increaseduringacrisis.Forourpurposes,therelevantpointisthatcomparedtocoins,bills
ofexchangewereahigh‐risk,low‐costmeansofpaymentsuppliedbyprivateparties.Gov‐
ernment,however,didplayacrucialrolesupportingthispartofthepaymentsystembyen‐
forcingbillcontracts.Andhereiswheretheearlypublicbanksemerge.
Beyondassuringthatcontractswouldbeenforcedexpeditiously,localitiessoughttoclarify
thetermsofdebtsettlement.Mostcommonly,governmentswouldassignanordinanceval‐
uetocoinsdenominatedinthelocalunitofaccount.Forexample,alegaltenderlawmight
saythataparticularcoinisworthoneguilderforsettlementofdebtspublicandprivate.In
thisway,creditorswouldknowwhatcointheyweredue,andthusbillsofexchangeencour‐
aged. Such legal restrictions could also be self‐serving, for they could create demand for
coinsproducedby localmints, and localmintspaidpro its fromseigniorage todomestic
government.Togainthisadvantage,however,domesticcoinhadtodelivermoreunitofac‐
countperounceofsilver(orgold)thanrivalcoins.Theratioofvalueperounceofmetalis
called themintequivalent. Ifacoin’smintequivalentwashighenough,merchantswould
convert bullion or foreign coin into domestic coin at the local mint (Sargent and Velde
2003).
In spot transactions, merchants could circumvent this process by valuing foreign coins
more thanordinances assigned the coins (Rolnick,Velde, andWeber1996). Indebt con‐
tracts,however,debtorscouldinsistonrepaymentatordinancevalues.Inthis,debtorsand
17
the localminthadashareddesiretocreate localcoinsthatdisadvantagedcreditors.This
dynamicwasacuteintheEarlyModernNetherlandsbecauseanumberofmintscouldpro‐
ducelegally‐favoredcoins.Thecompetitionbetweenmintsdamagedthereputationofcoins
by encouraging incremental debasement. Slightly less silver per coinmeant a largemint
equivalentratio.Inotherwords,legalrestrictionsoftenmadelocalcoinstheanchorofthe
internationalpaymentsystem,butthosesameordinancescouldpromotethedegradation
ofthosesamecoins.Theincentivecamefromanabilitytoshiftthecostofcoindebasement
ontocreditors,soanimperfectanchorunderminedtheprivatesectorpaymenttechnology
builton it. Ineffect,mintsanddebtorsappropriatedsomeof thecost savingscreatedby
billsofexchange.
2.2Enterthepublicbank:thecaseofAmsterdam
Around1600,Amsterdamwasbecomingthecommercialand inancialhubofnorthernEu‐
rope (Gelderblom2013). The quality of Dutch coinage, however,was sufferingmild de‐
basement,andmerchantsinAmsterdamthoughtitbadforthebillbusiness.So,in1609,the
citycreatedabank,theBankofAmsterdam,whosedesignwasbasedonanearlierinstitu‐
tion inVenice. The city required that bills of exchange settle on the bank’s books rather
thanincoin,anditpledgedthatatwithdrawalitsbankwoulddelivercoinsofaconsistently
highquality.TheBankofAmsterdamwouldprotectcreditors.
Todothis,thebankwouldsufferanasymmetry:itwouldacceptatdepositDutchcoinswith
slightly lesssilverpercoin than itwouldsubsequentlygiveout.Topreventarbitrage, the
BankofAmsterdamchargedatwopercentwithdrawalfeeplusadditionalfeesforcoinsin
highdemand.Thesefeesweregreaterthanthedifferencebetweencirculatingcoinsandthe
coinstheBankofAmsterdamwasobligedtodeliveratwithdrawal.Thehighwithdrawalfee
also meant that a secondary market developed. Instead of withdrawing coin, a broker
wouldmatchanexistingbankcustomerwantingoutwithaprospectivecustomerwanting
in.Onepersonwouldtransfermoneywithinthebankatnofee,andtheotherwoulddeliver
coinoutsidethebankatabrokeragefeelessthanthebank’swithdrawalfee.Intime,bro‐
kersbecamemarketmakersreadytobuyorsellatalltimes.
18
Allthisisanexampleofanewtypeofsecondarymarketandprivateintermediarydevelop‐
ing to lower the cost of using anchor (Bank of Amsterdam)money. Risk, of course, also
wentupbecausedealersdidnotassurethequalityoftheircoinagewiththesamecredibil‐
ityastheBankofAmsterdam.Dealersfurtherreducedcostsbyofferingaccountsfornon‐
billpaymentsoutsidetheBankofAmsterdam.ThesecondarymarketnowswappedBankof
Amsterdambalancesforprivatebankbalances.Andagain,riskincreased,fornowcustom‐
ershadtoworryabout theprivatebank’s liquidity inaddition to thequalityofcoin they
mighteventuallygetatwithdrawal.
TheBankofAmsterdamwasitselfnotwithoutrisk.Inconcept,theBankofAmsterdamwas
tobeafee‐driven,full‐reserves“narrow”bank.Inpractice,thecityuseditsbanktolendto
thecity’s lendingbank, theDutchEast IndiaCompany, to theProvinceofHolland,and to
importantquasi‐publicpersonssuchasmintmastersandtaxreceivers.Afterafewdecades
ofheavy lending, theBankofAmsterdamlearnedtorestrainitscreditcreation.Thiscon‐
servativepositionallowedthebanktosurvivealargerunin1672whenFrenchtroopsal‐
mostoverranHolland.SimilarlystructuredpublicbanksinotherDutchcities(Mees1838)
andHamburg(Sieveking1934b)didnotfarenearlyaswell,andwereforcedintolengthy
suspensions.
ButeventheBankofAmsterdamfounditdif icultto lourishduringtheDutchGoldenAge.
Highwithdrawal feesmeant coin only infrequently left the bank, but coin depositswere
evenlessfrequent.Asaresult,theBankofAmsterdamwasslowlylosingcoininthe1660s
and1670s.Itoffsettheleakagewithopenmarketpurchases,sothetotalamountofbank
moneyremainedsteady.Stillthedemandforbankmoneywaslimitedandmerchantswere
unwillingtodepositcoinattheBankofAmsterdamforshorttermpurposes.Coins lowed
through the city of Amsterdam to the Baltic, theMediterranean, and especially Asia, but
thosecoinsdidnotpassthroughtheBankofAmsterdam.
19
Figure4.AddingtheBankofAmsterdam
2.3Frompublicbanktocentralbank
Inresponsetothisstagnation,theBankofAmsterdammadeasmallbutimportantchange.
Startingin1683,depositsweregivenaccountbalancesandareceiptforthespeci iccoins
deposited.ReceiptsallowedtheBankofAmsterdamtoseparatetherightofcoinwithdraw‐
al from account balances. After creating that separation, the bank stripped the inherent
rightofwithdrawalfromaccounts.Bythemselves,BankofAmsterdambalancesbecamea
typeof iatmoney.ThisnewsystemprovedpopularwithEurope’smerchants,anddemand
forbankmoneygrewevenamongthosenotcompelledby legalrestrictions.BankofAm‐
sterdammoneybecametheleadinginternationalcurrencyoftheEighteenthCentury,and
newbankingstructuresemergedinAmsterdambecauseofit.
Howdid thenexusof receipts and iatmoney revolutionize theBankofAmsterdamas a
centralbank?Itloweredbothcostsandrisk.Thedevelopmentofreceiptsmadeitpossible
to offerwithdrawals at very low fees (typically¼ percent) because customers could no
longer arbitragebetween typesof coin.Witha receipt, onegot the same coinsoriginally
deposited.Thebankwasscrupulousinnot lendingthesecoins,andreceiptcommitments
seemtohavealsodeterredthecityofAmsterdamfromtakingthesecoinsasseigniorage.
Risk
Cost
Old anchor: coins foreign and domestic
20
Receiptscreatedacrediblenarrowbankwithinthelargerbank,soaccountswithareceipt
gotlowercostsandlessrisk.
Accountswithoutareceiptalsobene itted.Receiptsweretransferable,soaccountholders
couldpurchasethis low‐costoption fromothercustomers insteadofpayingthebankthe
higher traditional fees. As this secondarymarket now served the demand for coinwith‐
drawals,traditionalwithdrawalfellintodisuseexcept,potentially,duringarunontheBank
ofAmsterdam.Mindful of this remaining risk, theBankofAmsterdamquietly ended the
righttowithdrawaccountswithoutareceipt. Withoutareceipt,bankbalancesbecamea
typeof iatmoney.Customerscouldtransferthemwithinthebankbutcouldnotcompelthe
bank to surrenderassets inexchange for them.Limiting thescaleofadeposit run to the
amountof coinunder receiptmeant that theBankofAmsterdamcouldnot bedriven to
failure.Collectiveactionagainstthebankcouldonlyweakentheexchangerate;itcouldnot
forcethebanktosuspendpayments.
The 1683 introduction of quasi‐ iat money had a strong impact on the bank’s payment
business. Dehing (2012: 140) estimates that total “giro” turnover through the bank’s ac‐
countsincreasedfrom204million lorinsin1676to249million lorinsin1695.Payments
throughthebank increasedfurther in theeighteenthcentury,reachingapeakofperhaps
400million lorinsduring theSevenYears’War (1756‐1763).15Asnoted in the introduc‐
tion,this isabout2.5timescontemporaneousDutchGDP,aremarkable levelofpayments
intensityforthetime,equaltothatattainedbytheU.S.roughlytwocenturieslater(Figure
1).
ThepopularityoftheBankofAmsterdam’spost‐1683paymentregimeisalsore lectedin
thepriceofbankmoney.Figure5givesthefeemarketschargedmonthbymonthfromJan‐
uary 1700 to January 1790. During this time, except for periods ofwar, the price to sell
bankmoney(relativetocirculatingcoin)rarelyclimbedover1percentandrarelyfellbe‐
lowzero.
15Authors’extrapolationbasedonpaymentsvolumeestimatesgiveninDehing(2012:82).
21
Figure5.DomesticMarketPriceofBankofAmsterdamMoney
Notes:SourcesareMcCusker;Gillard;AmsterdamMunicipalArchives.Derivedbysubtractingthemarketdo‐mesticexchangerate(currentguilder/bank lorin)fromthedepositrateofthesilverrixdollarcoin(1.05cur‐rentguilder/bank lorin)
Thisprice stability, combinedwithAmsterdam’s lackof capital controls andadvanced i‐
nancialmarkets,madeBankofAmsterdammoneyasuccessfulanchorfortheinternational
paymentsystem.Intermediariesrespondedbydevelopingnewtypesofcreditsystemsthat
settledusingbankmoney.Themost importantnewplayersweremerchantbanks.Unlike
commercialbanksfundedbydeposits,merchantbankswerefundedusingbillsofexchange.
Theyofferedborrowerscreditbyacceptingthebillsofexchangedrawnabroad(knownas
acceptance credit). The merchant bankers then issued new bills to fund the acceptance
credit.Thegreatestof these irms (Hope,Pels, andClifford)became famous in their age.
ThesemerchantbanksusedtheBankofAmsterdamtosettleacreditnetworkthatextend‐
edtomostcommercialhubsinNorthernEurope.
TheBank of Amsterdam’s role in bank settlement also opened the opportunity to act as
lender of last resort.When amajormerchant bank failed in 1763, the acceptance credit
market convulsed. Suddenly, banks couldnot sell newbills to inancebills due, sobanks
rushedcointotheBankofAmsterdamtogettheliquiditytheyneeded. TheBankofAm‐
‐1.5
‐1
‐0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
Jan 1700
Jan 1710
Jan 1720
Jan 1730
Jan 1740
Jan 1750
Jan 1760
Jan 1770
Jan 1780
Jan 1790
Percent Fee
22
sterdam even created a new liquidity facility that helped a couple of especially troubled
banks.Inall,theBankofAmsterdamsucceededinsavingAmsterdam’smerchantbanks,but
itcouldnotassisttheinternationalcustomersofthosebanks.Inotherwords,the inancial
systemthatsettledinAmsterdamextendedwellbeyondHolland,andthismismatchlimited
theBankofAmsterdam’sabilitytoaslenderoflastresort.
AssuccessfulastheBankofAmsterdamwasformostoftheeighteenthcentury,itsuffered
from a brittle design. Receipts created credibility but very limited fee revenue (approxi‐
mately 50 basis points per year). Supplementary bank lending to the Dutch East India
Companybroughtextra revenuebutalso fractional reserve risk.TheBankofAmsterdam
kept such lendingmodestuntil around1780.Dutch shippingunder the lagofneutrality
duringtheAmericanRevolutionangeredBritaintothepointofdeclaringwarin1780.The
warforcedtheDutchEastIndiaCompanytospendheavilytoarmitsshipswhiledisrupting
thereturnofcargofromAsia.To inancethissituation,thecompanyborrowedheavilyfrom
theBankofAmsterdamandothers,butsoonthecompanywasunabletorepay.TheBankof
Amsterdam became insolvent. Fearing some type of default, receipt customers removed
coin.Theremainingcustomers, lackingreceipts,couldnotwithdrawcoins,sothepriceof
bankmoneybroketrend(seeFigure5).TheendofthewarwithBritainin1784didnotre‐
storetheBankofAmsterdam’scredibility.Bankmoneyendured,but itwasno longerthe
“reserve currency” of Europe. One consequencewas thatmerchant banksmoved opera‐
tionsacrossthechanneltoLondon(CarlosandNeal2011).
23
Figure6.MatureBankofAmsterdam
3. Anglo‐Americancontrast
TheAnglo‐Americanevolutionofcentralbanksandpaymentsystemstookadifferentdirec‐
tionthanontheContinent.Insteadofmunicipalexchangebanks,London,andthenPhila‐
delphia, focusedonbanksthat issuedcurrencybackedbysovereigndebt.Privilegednote
issuebrought the centralbanks iscal strength, yet centralbankexistenceand independ‐
enceremainedachallengetosecure.Andwhenthatfailed,commercialbankscreatedqua‐
si‐centralbankingarrangementstosupportthepaymentsystem.Theroleofcentralbanks
inpaymentsmakestheU.S.acompellingcontrasttoEngland(James2012b:289‐291).The
twocountries’paymentsystemhistoriesaresimilarenoughthatthedifferencesoutlinethe
roleofacentralbank’smoneyintheevolutionofapaymentsystem.
3.1 Centralbankinnovation:theBankofEngland
SilvercoinsinSeventeenthCenturyLondonsufferedfromclipping.Thiscreateduncertain‐
tyregardingtheirweightoradditionalassaycosts.SomeLondonersavoidedcoinbyadopt‐
ingwhatwas called the “banking habit.” In the 1650s, goldsmith‐bankers began to offer
Risk
Cost
Quasi-fiat Money
24
checkable deposits for local payments and to arrange bills of exchange for international
payments.Somebanknoteswereissuedatthistime,buttheseappeartohavebeenaminor
payment instrument (Quinn and Roberds 2003). Alternative payment services reduced
costsrelativetocoin,but,ofcourse,banksweresubjecttotheriskoffailure—despitebeing
conservativefractionalreserveoperatorsbymodernstandards.Forexample,in1685,loans
comprised 42 percent of the assets of Child’s bank (Quinn 1994:48), and in 1702 loans
were38percentoftheassetsofHoare’sbank(TeminandVoth2013:67).
Earlybankersalsocreated infrastructure that furtherreducedthecostofpayments.Lon‐
donbankershadbilateral clearingarrangements (Quinn1997).At leastonebankerkept
agentsinforeignportstofacilitatereliableacceptanceofbillsofexchange(NealandQuinn
2001).Andthelargestbankersactedasbothtaxcollectorsandsovereigncreditors,sotaxes
duetheTreasurycouldnetdebtrepaymentsduethebankers.
Exploitingscaleeconomies, theBankofEngland’s incorporationschemeof1694builton
this infrastructure. Unlike banker‐led syndicates, the corporationwas able to raise large
amountsofoutsidecapitalbecause its limited‐liabilitystockwaseasily transferable. And
ratherthandealinlargeamountsofcoin,theBankofEnglandissuedlargeamountsofcur‐
rency when lending and then accepted it back for subscription payments. The business
model was a successful application of network externalities: the Bank of Englandmade
large‐scaleissuancesofcurrencytoacquiresovereigndebtthatthenbackedthecurrency.
AslargeamountsofthecurrencycirculatedinLondon,expectationofacceptancebecame
routine.
WhiletheBankofEngland’smoneycompetedwiththatofotherbanks,itsfavoredposition
meantlowerrisk.Justtwoyearsafteritsfounding,therecoinageofEngland’ssilvercoins
createdaliquiditycrisisandarun.TheBankofEnglandsuspendedpayments,anditwould
dosoagainwhenitwasunabletomeetitsconvertibilityobligations.Whilenotexplicitin
law,theTreasurygrantedthisprivilegein1696,1797and1914.Whileinfrequentlyresort‐
edto,thisopt‐outwasimportant.WhereastheBankofAmsterdamcouldnotfailbecausea
portionofitsmoneywasalwaysinconvertible,theBankofEnglanddidnotfailbecauseall
ofitsmoneycouldbecometemporarilyinconvertible.
25
TheBankofEnglandalsosecuredthestreamofseignioragefromnoteissue.In1697,the
BankofEnglandgainedamonopolyoncorporatebankinginEnglandandWales,andfor‐
geryofitsnoteswasmadeacapitaloffenseanalogoustocounterfeitingcoins.Asaresult,
its seigniorage fromcurrencywould sufferno large‐scale threatuntil joint‐stockbanking
inallyemergedin1833.Eventhen,thenewcorporatebankswerekeptfromissuingcur‐
rencyiftheyoperatedinLondon.This iscalstrengthloweredtheriskofBankofEngland
notes,fortheywerebackedbybothsovereigndebtandbythediscountedpresent‐valueof
currencyseigniorage.
TheprimaryriskfortheearlyBankofEnglandwaspolitical.TheBankofEngland’scharter
wasnotperpetual,andthegovernmentrepeatedlynegotiatedextensionswhentheTreas‐
uryneedednewfundsfromtheBankofEngland(BrozandGrossman2004).Ineffect,the
state clawed back some seigniorage through new, below‐market borrowing.What is re‐
markable,however,ishowmuchthegovernmentdidnottake.TheBankofEnglandregu‐
larlypaidseignioragepro its toshareholders throughdividends(Clapham1944:292). In
contrast,theBankofAmsterdampassedallitspro itstothecity,justascentralbankstoday
paytheirpro itstotheircontrollingpoliticalauthorities.
HowtheBankofEnglandgainedsecureseigniorageappearstohavebeensomethingofan
accident.TheBankofEngland’sstartasacorporationwasagambleatatimeofintense is‐
calstressontheEnglishstate.Then,thecorporateformprovedusefulin1697tothestate
asaninstrumentfordebt‐for‐equityswaps.TheswapslettheTreasuryconvertshort‐term
debtduringarollovercrisis.Politicalwinds,however, thenblewagainsttheBankofEng‐
landwhentheTorypartycametopowerin1710(Stasavage2008:99‐129).Torygovern‐
ments issuedExchequerbills that competedagainstbanknotes, and supported theSouth
SeaCompany’sgambittodisplacetheBankofEnglandin1720(Kleer2012).Butthecol‐
lapseoftheSouthSeaBubbleswungpoliticalsupportbacktotheBankofEngland,andthe
moodoftheera,embodiedintheBubbleActof1720,emphasizedtheimportanceofstabil‐
ity (Harris 1994). The Bank of England endured as a for‐pro it quasi‐arm of the British
Treasury.
26
Withstablepoliticalbackingafter1720,BankofEnglandnotesbecametheanchorofLon‐
don’spaymentsystem.Again,sovereigndebtandseignioragemadethemlowrisk,butscar‐
citymadethemcostlytouse.Before1760,theBankofEnglandfocusedonsovereignlend‐
ing, so thesupplywas inelastic toaggregatedemand (butelastic towar inance).Private
lending was small and limited to customers who lived in London and were engaged in
commerce.WhentheBankofEnglandrelaxedstandardsenoughtolendtobanks(calledre‐
discounting),theBankofEnglandstill limiteditselftobuyinghighqualitypaperfromthe
fewbanksthatkeptanaccount.Aslateas1793,onlyathirdofLondoncommercialbanks
hadbalanceswiththeBankofEngland(James2012b:297).
3.2Failedattemptsatinnovation:BanksoftheUnitedStates
Againstpoliticalopposition,AlexanderHamiltonsucceededincharteringEnglish‐stylecen‐
tralbankinginthenewUnitedStatesin1791.TheFirstBankoftheUnitedStateswasana‐
tionallychartered,for‐pro itcorporationwhoseprimaryassetwassovereigndebt.Itspri‐
maryliabilitywasprivilegedbanknotes.TheU.S.bankhadtheonlyinterstatecharterwhile
moststate‐charteredbankscouldnotevenopenintra‐statebranches.Furthermore,theU.S.
bank’snoteswerelegalpaymentsforalldebtstotheU.S.government.
Unlike inEngland, theFirstBankof theUnitedStatesdidnothaveawar‐timecrisiswith
whichtonegotiate its irstcharterrenewal. Instead, thewarcameayearafterPresident
Jeffersonblockedrenewalof theFirstBankof theUnitedStates.Financingandsupplying
theWarof1812overthelengthoftheAtlanticseaboardconvincedmany,includingmilitary
leaders,oftheneedforacentralbankasanagentoftheTreasury.Inthemeantime,theU.S.
Treasury issuedemergencynotes, in lationsurged, andstatebanks suspendedspecie re‐
demption(Rockoff2000:654‐5).
Afterthewarandtheelectionofanewpresident,theSecondBankoftheUnitedStateswas
charteredfor20yearsstartingin1817.TheSecondBankwaslargerthanitspredecessor,
but similar otherwise, and again political opposition was unrelenting. Andrew Jackson
campaignedforPresidenttwicewiththegoalofendingtheSecondBank,and,in1832,he
famouslyvetoedthere‐charterauthorization.TheU.S.thenenteredalongperiodwithouta
27
centralbank,and,inthe1840s,theU.S.Treasurywithdrewgovernmentfundsfrombanks
andthe inancialsystemaltogether.Thisoutcomeisinsharpcontrasttothepost‐1720po‐
liticalequilibriumthatsupportedtheBankofEngland.
3.3Privatesectorinnovationincheckpayments
InLondon,asasubstituteforBankofEnglandnotes,banksofferedaccesstobankpayment
servicesonlessrestrictiveterms. Most lendingwasat,ornear,usurylimits,socreditra‐
tioningwasthebindingconstraintoftheera(TeminandVoth2013:73‐94).Thepayment
instrument of choice, however, was the check. London bankswith six or fewer partners
couldissuenotes,andsomedidinlimitedamounts,butnonedidinanysubstantialquanti‐
ty.PerhapsLondonbankslackedthecredibilitytodirectlycompetewiththeBankofEng‐
land, perhaps the Bank of England somehow threatened issuing banks, or perhapsmost
wholesalecustomerspreferredchecks. Incontrast,BankofEnglandnotesdidnotusually
circulateoutsideofLondon,andcountrybanks(locatedoutsideofLondon)issuednotesfor
regional payments. The primary country bank payment service, however, was to supply
billspayableonaLondoncorrespondentbank(James2012a).
BecauseLondonbanksusedcheckstolowercosts,thepaymentsystemdevelopedathick
interconnectedness.Checksgainnetworkexternalitiesaslocalbanksacceptchecksdrawn
ontheirrivals.Intheprocess,banksgainroutineobligationsoneachotherintheformof
checksdueforpayment.ThisnewsystemmadeextensiveuseofBankofEnglandnotesasa
settlementasset.BankswerelikelysettlingchecksbilaterallyinBankofEnglandnoteseven
beforetheycreatedtheLondonClearinghousein1776.Theclearinghouseadoptedmulti‐
lateralnetting in1841,andsoreducedtheamountofBankofEnglandnotesthatpartici‐
pantsneeded(James2012a:135).Inthisway,BankofEnglandnotesbecametheanchorof
theLondonbankingsystemand,intime,thecenteroftheEnglishbankingsystem.Country
banksandforeignbanksusedLondoncorrespondentbankstosecureacceptanceof their
billsinLondon,tosecureaccesstothestockanddebtmarkets,andtosecureaccesstothe
internationalpaymentsmarket.Londonclearingarrangementsloweredcostsandcentral‐
izedriskforthenationandmuchoftherestoftheworld.Whencorporatebanksemerged
28
inmid‐19thcenturyEngland,branchnetworkscenteredonLondon,andthesystem’sreli‐
anceontheBankofEnglandcontinued.
IntheU.S.,thenote‐checkdividewasovertimeinsteadofoverspace.BeforetheCivilWar,
state‐charteredbanks issuedbanknotes, so commerce could avoid theuseof coin.While
U.S.banknoteswerecheaper toacquire thancoin, theycertainlywereriskier.Theera fa‐
mouslyhadsuchadiversityofnoteissuingbanksthatentrepreneurspublishedguidesto
helpmerchantsjudgeauthenticityandquality,anddealersusedsuperiorinformationina
mannersimilartocoin‐basedmoneychangers.Still,suchcost‐andrisk‐reducingoperations
developedbecausestatebanknotesdidcirculatewidely.Withinacity,mostnotespassedat
par,andrailroadsandtelegraphsreducedthediscountsofnotesthattraveledbeyondtheir
cityoforigin(Gorton1996;Jaremski2011).Countrybankssetupcorrespondentrelation‐
shipswith trade‐centerbanks (Weber2003). In some respects, at least, the centralbank
anchorwasnotmissedin itsabsence: Inter‐cityexchangefeeswere lessaftertheSecond
BankoftheUnitedStatesthanunderit(Bodenhorn1992;Knodell2003).And,aswithEng‐
land,theU.S.inter‐regionalsystemofnotesandbillsgrewincreasinglycenteredontheme‐
tropolis.BytheCivilWar,NewYorkbankswerethehubofinter‐regionalpayments(James
andWeiman2011).
TheNationalBankingActsof1864and1865drovestatebanksintocheckingandlimited
thestockofnotesthatnationalbankscouldissue.Checkusehadbeengrowingbeforethe
civilwarinlocal,wholesalepayments(JamesandWeiman2010:238).Indeed,by1860,the
levelofdepositsintheU.S.roughlyequaledthelevelofbanknotes,andbanksinmanyma‐
jorcitieshadalreadycreatedclearinghousestosettlethem.AftertheCivilWar,thevolume
ofcheckscontinuedtogrowfasterthannotesandsurgedwellpastnotesafter1890.New
YorkwasthecenterofsettlementasbanksacrosstheUSusedcorrespondentsinNewYork
for inter‐regional transfers,accessto themarkets,andfor foreignexchange.LikeLondon,
theepicenterwastheclearinghouse.
ThelackofacentralbankdidnotstopthegrowthoftheAmericanbankingsystem,andthe
prevalenceofunit‐bankregulationscausedthatthatgrowthtobeinthenumberofbanks.
29
Figure7givesthenumberofstatebanks,andnationalbanksafter1863.Thesurgeinstate
banksafter1880reliedontheinter‐regionalsystemofcheckclearing.
Figure7.NumberofUSBanks,1790to1913
Sources:Wright2001(1790‐1820),Bodenhorn2001(1820‐1860),Grossman2003
(1863‐1913).
3.4SystemicImplications
Despitetheirdifferences,thenineteenthcenturyBritishandAmericancheckpaymentsys‐
temsappear tohavesupportedcomparable levelsofpaymentsactivity. In1868(the irst
year forwhichdatabecomes available, since settlement occurs throughBankofEngland
accountsratherthanwithnotes),theLondonBankers’ClearingHousesettled£3.4billion
in London‐area payments through the Bank of England (Matthews 1921: appendix II),
which isabout3.6 timescontemporaneousGDP(seeFigure1).That sameyear, theNew
YorkClearingHousehandledpayments of $28.5 billion or 3.3 timesGDP (Cannon1910,
217). TheBritish systemexpanded to all of Englandby1907and cleared over six times
GDP,whiletheU.S.ratio(basedonNewYorkonly)declinesslightlyto3.1.However,bythe
early twentiethcentury therewereover200regionalcheckclearinghousesoperating in
theU.S.(forwhichstatisticsareunavailable),sotheaggregateratiofortheU.S.maybesub‐
stantiallyhigher.
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
1790
1800
1810
1820
1830
1840
1850
1860
1870
1880
1890
1900
1910
State Banks
NationalBanks
30
Checks,bills,andtheirsettlementinfrastructureloweredcostsandincreasedvolume,but
alsocreatedsystemicrisk.Troubleswithanindividualbankcouldspreadviaclearingand
settlementtootherbanks.Inthisway,thesupplierofmoneyusedforclearinghousesettle‐
mentgainedtheopportunitytoactasasystemiclenderoflastresort.InLondon,thisrole
wasplayedbytheBankofEngland.InNewYork,theclearinghouseitselfbecameaLOLR.
Andherecrucialdissimilaritiesdevelop.
TheBankofEngland’s(implicit)abilitytosuspendpaymentsbackstoppedthesystemand
couldprevent commercial banks from suspending (James2012b).Moreover, theBankof
Englandcouldexpandlendingtobanks.ThisitdidaggressivelywhenitsuitedtheBankof
England’soperationalgoals, suchaswhenconvertibilitywassuspended (1797‐1825)be‐
causeoftheNapoleonicWars.Suchlending,however,waslimitedwhenitwentagainstthe
BankofEngland’s internal interests, suchasduring thePanicof1825 (Neal1998).Even
whentheBankofEnglanddidclearlylendtosupportthesystem,itdeniedanyobligationto
doso(Bignon,Flandreau,andUgolini2012).
InNewYork,theclearinghousecould,anddid,createemergencyliquidityduringcrises,but
theamountitcouldproducewaslimitedtothecollectiveassetsofitsmemberbanks.The
NewYorkclearinghousehadnoexternalreservesthewaytheBankofEnglandhaditsown
holdingsofgoldandsovereigndebt,separatefrommembersoftheLondonclearinghouse.
Asaresult,whenacrisispushedtheEnglishsystemtoitsbreakingpoint,theBankofEng‐
landcouldsuspendconvertibilityintogold,soLondonbanksdidnothavetosuspendtheir
convertibility intoBankofEnglandnotes. Incontrast,whenacrisispushedtheNewYork
clearinghouse to suspend convertibility, it tookmember banks with it. “Such temporary
suspensions were staple strategies of American bankers in times of crisis. … In London
therewas never a general suspension of payments during times of panic (James 2012b:
290).”
James,McAndrews, andWeiman (2013) argue that the U.S. system had gravemacroeco‐
nomic consequences. With general suspensions, localmeans of payment suddenly came
intoshortsupply,sobothpayrollanddebtservicingwereimperiledforotherwisehealthy
irms.Also,interregionalpaymentspropagatedthesuspensiontoothercities,asrespond‐
31
entbankshadtoscrambleforalternativesourcesofliquidityordefaultontheirownpay‐
mentcommitments.
Howseriouswasthisdifferenceindeep‐crisisperformance?Theultimatejudgmentseems
torest in the foreignexchangemarkets.Theworld’smoneyfavoredLondon,andAmster‐
dambeforeit,butnotNewYork(Flandreauetal).Indeed,onereasontheNewYorkbanks
campaignedforadoptionoftheFederalReserveSystemwastoimprovethedollar’sinter‐
nationalattractiveness(Broz1999).Despitesimilarpaymentsystems,howtheEnglishan‐
chor disconnected from coin (the Bank of England suspending payments) seems an im‐
portantadvancerelativetohowtheU.S.’sdisconnected(generalbanksuspensions).
Inourconceptualframework,boththeUKandtheUSdevelopedanchorsdistinctfromcoin,
buttheBritishanchorwaslesspronetosuspension,andsowastheresultingpaymentsys‐
tem built upon it. As a result, igure8 shows London’s check‐based payment operating
withlesssystemicrisk(atanygivencostpro ile)thanNewYork’s.Asaresult,theBritish
pound became a reserve currency, andmuch of theworld’s inance occurred in London
(FlandreauandJobst2005:990).
Figure8.Anglo‐AmericanContrast,circa1900
When the FederalReservewas inally created a century ago, its initial structurewasde‐
signed to address both domestic and foreign payment system challenges. Foremost, the
Risk
Cost
Bank of England Coin
NY Clearinghouse
32
newsystemheldreservesdistinctfromthoseofmemberbanks.Itcreatedasystemofinter‐
regionalcheckclearingthathelpedreducepropagationofliquidityshocks(Gilbert2000).16
It actively promoted the international banker’s acceptances (Ferderer 2003).As a result,
thedollarslowlybecameaworldreservecurrency(EichengreenandFlandreau2012).
4. CLS17
Theriseofnationalcentralbanking inthenineteenthandtwentiethcenturiesdidnotdo
awaywiththeoldproblemofhowtomoveinternationalliquidity.Underthegoldstandard,
in principle individuals could acquire foreign exchange by redeeming local currency for
gold,andthenshipping thegoldabroad inorder toacquire foreigncurrency.Fewdidso.
Instead, bankersavoidedthosecoststhroughavarietyof inancial instrumentsfor inter‐
banktransfer,suchasbillsofexchangeandbanker’sacceptances.
Post‐BrettonWoods,peoplecouldno longer redeemgold, and interbank inancial instru‐
ments became the onlymethod available for transmission.Meanwhile, technological ad‐
vancesrapidlydecreasedthecostofinterbanktransfer.Indeed,themoststrikingempirical
regularityinpaymentsistheworldwideincreaseinpaymentsintensitysince1970(Figure
1).Judgedbythismetric,thenatureofthepaymentsbusinesshaschangedmoreduringthe
past44yearsthanduringtheprecedingtwocenturies.Theincreaseinpaymentsintensity
mirrors the increase in inancialmarkets trading, particularly trading in themarkets for
foreignexchange(FX).Butwhilethevolumehaschangeddramaticallyoverthisperiod,the
natureofthetransactionshasnot.FXtransactionsarecommonlythoughtofasinstantane‐
oustradesof iatmoney—onecentralbank’sliabilitiesagainstanother.But,atleastupun‐
til2002,theyweresimplyfasterversionsoftheoldinterbanktransfermechanisms.
16 Thoughstillimperfectly,seeRichardson2007,MitchenerandRichardson2013.
17ThediscussionofCLShereisbasedonKahnandRoberds(2001).SeeCommitteeonPaymentandSettle‐mentSystems(2008)andtheCLSwebsite(www.cls‐group.com)foradditionalinformation.
33
Since2002,however,centralbankshaveincreasinglydetachedthemselvesfromFXtrades,
bydelegating their settlement toaprivate institution, theCLSBank.Traditionally, banks
usedbilateralfinancialinstrumentstobridgedifferentunitsofaccount.NowCLScanmake
thoseconnections,anditsaccounttransfersreplacetheinstruments.Byoperatingsimulta‐
neously inmultiplecurrencies,CLS isable tocontrolrisksofsettlement inawaythatno
single central bank could. CLSmay be themost unusual financial institution ever estab‐
lished.Byday,itisthelargestinstitutionontheplanet.Bynight,ithardlyexists.Ithandles
abouthalfoftheworld’sforeignexchangetransactions,butitisalsoprivatelyownedand
operateswithfewerthan500employees.Itwasoriginallydesignedtodoonejob—settle
international payments—and it does it with extraordinary efficiency. Pressure from the
world’scentralbanksmore‐or‐less forcedCLS intoexistence,but itsposition leadstoex‐
tremelythornypolicyquestionsforthosesamecentralbanks.
Intermsofourconceptualstructure,CLSisatwist.Fromthepointofviewofafinancialin‐
stitution“paying”forthepurchaseofforeignexchange,CLSbecomestheanchortechnolo‐
gy:conductingthetransactionthroughCLSislessrisky(andslightlymoreexpensive)than
payingdirectlywithcentralbankmoney.Inordertoeconomizeonthecollateralcostsof
conducting itsbusiness,CLShas incorporateda largenumberofcollateral‐savingdevices
(some of them inducing slight increases in the risk of the system). Finally banks have
availabletothembilateraltransactions(“in‐outswaps”)officiallyoutsideofCLS,whichcan
furtherreducethecollateralcostsofusingCLS,againwithincreasesintheriskofdelivery
failure.Figure9illustratesthisspaceofalternatives.
34
Figure9.CLSSpanningDomesticPaymentSystems
4.1CLS,aprivatesectorinnovation
CLS came intobeing in2002, asa result of regulatorydissatisfactionwith traditional ar‐
rangementsforsettlingforeignexchangetransactions(CommitteeonPaymentandSettle‐
mentSystems1996,1998).Settlingforeignexchange(FX)tradesposesspecialchallenges
bothbecauseofthesheersizeofthepost‐BrettonWoodsFXmarkets,andbecausetheun‐
derlying nature of foreign exchange creates risks that are resistant to traditional risk‐
limiting strategies such as netting and counterparty substitution. The initial impetus be‐
hindCLSwastomovethepaymentsusedtosettleFXtradesawayfromtraditional large‐
valuesystems (mostly runbycentralbanks) toa specialized institution that couldbetter
handletheserisks.AlthoughinmanycasesthereisnolegalcompulsiontouseCLS, ithas
nonethelessenjoyedconsiderablesuccess.ThemostrecentstatisticsavailableontheCLS
website (as of thiswriting, February 2014) indicate that CLS is currently settling a little
over $5 trillion daily (counting transactions on both sides) or roughly 50 percent of the
world’sdailyFXturnover(BechandSobrun2013).Measuredbyvaluetransferred,itisthe
world’slargestpaymentsystem(CommitteeonPaymentandSettlementSystems2013,Ta‐
blePS3),surpassingeventhelargestsingle‐currencysystems.
Risk
Cost
CLS
Direct payment through Central Bank Funds
CLS plus In-Out Swap
35
PaymentsmadethroughCLSoccurastransfersonthebooksofalimited‐purposeU.S.bank
(CLSBank) supervisedby theFederalReserve in cooperationwithother centralbanks.18
CLShasaccesstotheFed’s large‐valuesystem(Fedwire)andalsoto large‐valuepayment
systemsinallofthecurrenciesitoperatesin.“Deposits”into(knownaspay‐ins)and“with‐
drawals”fromCLSBank(pay‐outs)occurincentralbankfundsandoccurimmediatelyvia
the appropriate large‐value, real‐time gross settlement (RTGS) system.19 Thus, CLS func‐
tions as a “daylight bank”withnodeposits in its accounts overnight. Payments (account
transfers)overCLScanbemadeby“member”commercialbanksinanyofitsparticipating
currencies,withabout45percentofCLSpaymentsoccurringinU.S.dollars.
Approximatelyseventy‐ ivebanksaremembersofCLS.20Re lectingtheimmenseturnover
intheFXmarkets,dailyturnoveratCLSisalsoenormous.Followingdaysofheavymarket
activityorU.S.legalholidays(whentwodaysofsettlementsmustbecompressedintoone),
the value of paymentsmade through CLS can be breathtaking—the current record daily
valueis$10.3trilliononMarch19,2008,inthewakeoftheBearStearnscollapse.21
4.2HowCLSoperates:examples22
ThespecialproblemsofFXsettlement,theoperationofCLS,anditsinteractionwithtradi‐
tionallarge‐valuepaymentsystemscanbeillustratedthroughaseriesofexamples.
18ActualprocessingofpaymentsiscarriedoutbyaseparateU.K.company(CLSServices).BothCLSBankandCLSServicesareownedbyaholdingcompany,thatisinturnownedby75financialinstitutionsworldwide(CommitteeonPaymentandSettlementSystems2008a).
19Anotableexceptionoccursforpay‐insandpay‐outsinCanadiandollars,whicharesentthroughanetset‐tlementsystem(theLargeValueTransferSystemorLVTS),whosepaymentsareguaranteedbytheBankofCanada.Forpurposesofthediscussionhere,thesecanberegardedastheequivalentofRTGSpayments.
20CLSalsoprovidesindirectsettlementservicestoover11,000“thirdparties,”i.e.,customersofCLSmemberbankswhomustsettlethroughadesignatedmember.
21Giventhesemagnitudes,itcomesasnosurprisethattheCLSBankhasbeendesignateda“systemicallyim‐portant inancialmarketutility”byU.S.regulators.
22 The examples and discussion in this section are taken from Kahn and Roberds (2001), section 2.1.
36
Example1.OndayT,atraderforBankAbuysdollarsfromatraderforBankBinreturnfor
pounds.Forsimplicity,saythattheagreed‐uponexchangerateis$2/£,andthat$2million
istradedfor£1million.Eventhoughthisisa“spot”tradeofonecurrencyforanother,like
most inancialmarkettrades it isreallyanexchangeofpromisestodeliversomething(in
A’scase,dollars;inB’scase,pounds)inthenearfuture—dayT+2forthecanonicalspotFX
trade.23
The irstdif icultyinsettlingFXtradesoccursbecausethereislimitedscope(inthisinitial
example,none)forreducingA’sandB’ssettlementexposuresthroughnetting:Bhasprom‐
ised to deliver something (dollar funds)which is (traditionally) only deliverable through
theU.S.bankingandpaymentsystems,subjecttoU.S.law,whileA’sdeliverymustberouted
throughU.K. institutions.24Thereexistsnonatural choiceof a “thirdasset”ornumeraire
thatcouldserveasthebasisfornetting.Theseconddif icultyishowtoenforceconditional‐
ityofsettlementwithouttheuseofacentralcounterparty—tospanbothsides(“legs”)of
anFX transaction,a traditionalcentral counterpartywouldneed tobeable to simultane‐
ously replace trading obligationswithin the constraints imposed by the national institu‐
tionsofeachlegofthetrade.Forthepresenttime,suchcentralizationremainsanimpracti‐
caloptionformostFXtrades;seehoweverthediscussionbelow.
The traditionalmethod forsettlinga foreignexchange tradereliesonseparate,uncoordi‐
natedsettlementactionsbyeachpartytothetrade.Toillustratethetraditionalprocess,the
irstpairofaccountsinTable1showsthesituationafterthetradeondayT.25
23FXtradesalsocommonlyoccurasforwardtransactionsorFXswaps(aspotcombinedwithaforward).Is‐suesinvolvingsettlementofthesetypesoftradesaresimilartothosearisingfromspottrades.
24Again thereareexceptions.One is in thecaseofnon‐deliverable forwards,whichare forwardtradesofaconvertiblecurrency(e.g.,dollars)againstanothercurrencywhichmaybethinlytradedornotfullyconverti‐ble(e.g.,yuan).Non‐deliverableforwardsaretypicallysettledintheconvertiblecurrency,asacashpaymentinthedifferenceinthecontractedvalueagainstthespotvalueofthenonconvertiblecurrency.
25Forpurposesofillustration,Example1assumesthateachbankdirectlymakespaymentsoveralarge‐valuepaymentsystemtosettlethehypotheticaltrade.Infact,banksofteneffectsettlementbyinstructingacorre‐
37
BankA
Assets Liabilities
+$2MduefromBankB +£1MduetoBankB
BankB
Assets Liabilities
+£1MduefromBankA +$2MduetoBankA
Table1a.SettlementofspotFXTrade:traditionalsystem
BankApurchases$2MfromBankBfor£1MShownarebanks’positionsaftertrade,beforesettlement
OndayT+2,BankA isobligated to send£1million toB over theU.K. largevalue system
(CHAPS)andBankBisobligatedtosend$2milliontoAoveradollarpaymentsystem(tra‐
ditionally,CHIPS).Supposethat,duetotimezonedifferences,thesterlingtransactionhap‐
penstobeexecuted irst(Table1b).
BankA
Assets Liabilities
£1MinCBfunds
+$2MduefromBankB
BankB
Assets Liabilities
+£1MinCBfunds +$2MduetoBankA
Table1b.Traditionalsystemaftersettlementofoneleg
Inmostcases,thedollarfundstransferthenoccurs,settlingthetrade,soattheendofthe
dayT+2wehave:
spondenttomakesuchpayments.Hencethetraditionalmethodisreferredtoasthecorrespondentbankingmethodofsettlement.
38
BankA
Assets Liabilities
+$2MCBFunds
£1MCBFunds
BankB
Assets Liabilities
$2MCBFunds
+£1MCBFunds
Table1c.Traditionalsystemaftersettlementofsecondleg
Clearly,thetraditionalsystemcanleadtoproblems,giventhe inalityofpaymentsmadein
eachcurrency.26Forinstance,ifBankBiscloseddownbeforeitsfundsaresenttoBankA,
thereistheriskthatBankAmayloseitsentireprincipalinthetrade.27Ontheotherhand,
supposeitisBankAthatisshutdownearlyondateT+2.Then,inpractice,BankB isalso
likely to suffer a loss even if the shutdownoccursbefore any settlement takesplace, be‐
causeitcanbedif icultforeitherbanktocancelitslegoftransaction,shoulditlearnofthe
failureofitscounterparty.28
ThekeypreceptofCLSistoavoidthepossibilityoflossofprincipalbyrequiringbothlegs
of an FX transaction to settle simultaneously, on the books of a single institution (CLS
Bank).WhileCLSdoesnotformallyoperateasacentralcounterpartyacrosscurrencies,its
abilitytoenforcethisconditionalityallowsittofunctioninmanycircumstancesasa“virtu‐
alcentralcounterparty.”
26Thepaymentsinthisexampleoccuroverlarge‐valuesystemswhereallpaymentsareirrevocable.
27Intheliteraturethisriskisvariouslyreferredtoasprincipalrisk,Herstattrisk,and(cross‐country)settle‐mentrisk.
28Thesedifficultiesareoftenattributedtothehighdegreeofautomationinsettlementprocesses.Forexam‐ple,KfWBankengruppe,aGermanstatebank,isreportedtohavesent€300milliontoLehmanBrothersasanautomatedsettlementofaswap,onthesamedayLehmanfiledforbankruptcy(Kulish,2008).
39
Forpurposesofillustration,assumethatBanksAandBarebothmembersofCLS,andthat
noothertransactionstakeplaceondayT.OnthemorningofdayT+2,eachCLSmemberis
requiredtomakeapayment(i.e.,apay‐in)onitsshortpositions.Forthemomentwewill
assumethatthepaymentsrequiredareequaltothefullvalueofthetrade;morecomplicat‐
edcasesareconsideredlater.
Table2illustratestheprocess.NotethatA’sandB’sinitialpositionsfollowingthetradeare
thesameasinthepreviouscase.
BankA
Assets Liabilities
+$2MduefromBankB +£1MduetoBankB
BankB
Assets Liabilities
+£1MduefromBankA +$2MduetoBankA
CLSBank
Assets Liabilities
0 0
Table2a.SettlementofspotFXtrade:CLSwithfullpay‐in
BankAPurchases$2MfromBankBfor£1MShownarebanks’positionsaftertrade,beforesettlement
Eachbankbeginsthesettlementprocessbymakingitspay‐intoCLS.Thesepaymentsare
made throughRTGSsystems in centralbank funds—in theexample, throughFedwire for
thedollarpaymentandthroughCHAPSforthesterlingpayment.
40
BankA
Assets Liabilities
+$2MduefromBankB
+£1MduefromCLSBank
£1MCBFunds
+£1MduetoBankB
BankB
Assets Liabilities
+£1MduefromBankA
+$2MduefromCLSBank
$2MCBFunds
+$2MduetoBankA
CLSBank
Assets Liabilities(Accounts)
+£1MCBFunds
+$2MCBFunds
CurrencySubAccts.
£$
BankA£1M
BankB$2M
Table2b.CLSsystemafterfullpay‐in
OnceCLShasbothcurrenciesavailabletoit,settlementiseffectedthroughapairedsetof
paymentsonthebooksofCLS,asisshowninTable2c.29Thesepaymentsoccurautomati‐
cally once there are suf icient funds in eachbank’s account.Note that settlement is on a
grossbasis;eachbankpaysandreceivesthefullamountofthefundsdueinthetrade,inthe
formofbalancesonthebooksoftheCLSBank.
29Formally,paymentoverCLSdoesnotconstitutelegalsettlementofFXtradesbutof“thepaymentinstruc‐tions arising from the trades” (Committee on Payment and Settlement Systems2008a, 24, fn 31). For ourpurposes,thedistinctionisinessential.
41
BankA
Assets Liabilities
+$2MduefromCLSBank
£1MCBFunds
BankB
Assets Liabilities
+£1MduefromCLSBank
$2MCBFunds
CLSBank
Assets Liabilities(Accounts)
+£1MCBFunds
+$2MCBFunds
CurrencySubAccts.
£$
BankA$2M
BankB£1M
Table2c.CLSsystemaftersettlement
Afterthat,thecurrenciescanbesentouttothebanksviathesameRTGSsystemsthatwere
usedforthepay‐ins:
42
BankA
Assets Liabilities
+$2MCBFunds
£1MCBFunds
BankB
Assets Liabilities
+£1MCBFunds
$2MCBFunds
CLSBank
Assets Liabilities
0 0
Table2d.CLSsystemafterpay‐out
UnderCLS, inalsettlementofeachsideofatransactionissimultaneousandmutuallycon‐
ditional(inpaymentsjargon,thisfeatureisknownaspaymentversuspaymentorPVP,simi‐
lartodeliveryversuspaymentorDVPfordomesticsecuritiestransactions).Asthisexample
shows,withCLSthereisneverapointatwhichonelegissettledandtheotherisnotset‐
tled.Underthetraditionalarrangementthereisaninstantwhereonebank(BankAinTa‐
ble1b)haspaidoutfundstoitscounterpartybutnotreceivedfundsinreturn.WereBankB
tofailatthismomentthenBankA,asitscreditor,wouldbevulnerable.Bycontrast,atno
pointintheprocessinTable2iseitherbankanetcreditoroftheother.UnderCLS,ifBankB
failsbeforesettlement,thetransactiondoesnotgothrough,andthefundspaidinbyBank
AarereturnedtoBankA.IfBankBfailsaftersettlement,BankAisunaffected.
Ofcourseaftersettlement,BankAisnowacreditorofCLSuntilCLSsendsitthepayments
toBankA.CLSisanimprovementovertraditionalarrangements,becauseCLSBankisabet‐
tercreditriskthananyindividualbank.Inthissimpleexample,becauseCLSBankisnever
the creditorof anybank, it is invulnerable to failuresof otherbanks.The inalityofpay‐
mentsonRTGSsystemsiskeytothisarrangement.BecausetheCLSBank’sassetsaresimp‐
43
ly “good funds,”not “due froms,” theywon’tdisappear if thebank thatpaid them ingoes
bankrupt.
Example1isanextremecase:bothsidespayinfullbeforesettlement.Inpractice,CLSal‐
lowsmemberstooverdrafttheiraccounts,sothatsettlementmayoccurbeforeallnetfunds
havebeenpaidin.30Asaresult,a(verymodest)levelofriskcreepsbackintothearrange‐
ment.Thenextexampleconsidersacasewheresettlement takesplaceafteronlyasmall
initialpay‐in.Table3belowillustratesthesettlementprocessforthisexample.
Example2.Asbefore,butsupposethatinitiallyBankBpaysin$200,000or10%ofitsdue‐
topositioninitsshortcurrency,andBankApaysinacorrespondingamount:£100,000.As
before,settlementoccursbytransferringtherequiredbalancesbetweenthesub‐accounts
ofthetwobanksonthebooksofCLS:£1MfromBankA’ssterlingsub‐accounttoBankB’s
sterling sub‐account and $2M from Bank B’s dollar sub‐account to bank A’s dollar sub‐
account.Now,however,thesetransactionsleaveoverdraftsinasub‐accountforeachofthe
banks.Oncesuf icientpay‐insaremade,thesituationisthesameasinExample1,andpay‐
outcanproceedsafely.Butuntilpay‐iniscompleted,thesystemisvulnerabletoafailureby
eitherofthebanks.Forexample,ifBankBfailsbeforecompletingitspay‐in,CLSBankwill
oweBankA$1millionbutwillonlyhave$100,000ingoodfunds.
30CLShoweversetsaminimumpay‐inscheduleforeachmemberonadailybasis.
44
BankAAssets Liabilities
+$2MduefromBankB +£1MduetoBankB
BankBAssets Liabilities
+£1MduefromBankA +$2MduetoBankA
CLSBankAssets Liabilities
0 0
Table3a.SettlementofspotFXtrade:CLSwithdelayedpay‐In
BankApurchases$2MfromBankBfor£1MPositionsshownareaftertrade,beforesettlement
Assets Liabilities
+$2MduefromBankB+£0.1MduefromCLSBank£0.1MCBFunds
+£1MduetoBankB
BankBAssets Liabilities
+£1MduefromBankA+$0.2MduefromCLSBank$0.2MCBFunds
+$2MduetoBankA
CLSBankAssets Liabilities(Accounts)
+£0.1MCBFunds+$0.2MCBFunds
CurrencySubAccts.£$BankA£0.1MBankB$0.2M
Table3b.Afterinitialpay‐inbyBankA
45
BankAAssets Liabilities+$2MduefromCLSBank£0.1MCBFunds
+£0.9MOverdraftatCLS
BankBAssets Liabilities+£1MduefromCLSBank$0.2MCBFunds
+$1.8MOverdraftatCLS
CLSBankAssets Liabilities(Accounts)+£0.1MCBFunds+$0.2MCBFunds
CurrencySubAccts.£$BankA£0.9M$2MBankB£1M$1.8M
Table3c.Aftersettlement
Table3d.Afterfinalpayin(IdenticaltoTable2c)
Table3e.Afterpay‐out(IdenticaltoTable2d)
AlthoughCLSpermitsmemberbankstohaveoverdraftsduringthesettlementprocess,the
overdraftsaresubjecttolimits.Atransactionisnotsettledifitcausesamembertoexceed
itsposition limits; insteadboth legsof thetransactionareheld inaqueueuntilsuf icient
funds lowintothebank’saccount.Theoverdraftlimitsincludelimitsoneachsubaccount,
aswellasaseparatelimitonthesumofoverdrafts.31Mostimportantly,amember’snetpo‐
sitionacrossallcurrenciesisrequiredtobepositiveatalltimes.Again,CLSBankisneverin
thepositionofbeinganoverallcreditortoanymemberbank.ThusfailureofBankBdoes
notadverselyaffectthevalueoftheCLSBank.
31Thelimitonthesumoftheoverdraftsiscalledthemember’saggregateshortpositionlimit.ItisadjustedbyCLSaccordingtofactorssuchascapitalandcreditratingofthemember(CommitteeonPaymentandSettle‐mentSystems2008a,79‐80).
46
Inordertohandlethepossibilityofafailurebyabankwithanoverdraft,theCLSBankhas
arrangedlinesofcreditineachofitscurrencieswithasetof“liquidityproviders.”32Since
CLS essentially carries no credit risk, it can obtain these credit lines at extremely small
costs.ItisclearwhytheliquidityproviderscantrustCLSBank;itislessclearwhytheCLS
Bankshouldbesatis iedwiththereliabilityofitsliquidityproviders—whoturnouttobe
ownersoftheCLSBank,thatis,thememberbanksthemselves.Thenmighttheprotection
offeredbythembeillusory?Therearetwocounterarguments: irstitisthegroupofliquidi‐
typrovidersasawholethatprovidesprotectiontotheCLSbankagainstfailureofanyindi‐
vidualmember.Second,thelimitsonoverdraftsunderCLS,whileexplicitlyprotectingexist‐
ingliquidityproviders,alsoservetoconvinceanypotentialadditionalliquidityproviders—
conceivablyincluding,inextremesituations,centralbanks—oftheultimatesafetyoftheir
liquidityinfusions.
In the absenceof exchange rate luctuations, settlement couldbeginbefore thepay‐inof
anyfunds,withoutviolatingtheprinciplethatabank’snetpositionatCLSmustnotbeneg‐
ative.When exchange rates luctuate, the “out‐of‐the‐money party” (at least)mustmake
somepay‐inbeforesettlementcanbegin.33
Example2,continued.SupposethatondayT+1thevalueofthepoundfalls,sothatbythe
closeoftradingondayT+1,£1isnowworthonly$1.80,sothatBankB’spositionvis‐a‐vis
BankA is “outof themoney.”CLS thencalculates thedayT+2settlementscheduleas fol‐
lows:BankBisshortdollarssohasaminimumpay‐inobligationof$200,000or10%ofits
due‐topositioninitsshortcurrency,beforeprocessingofitstransactionscanbegin.34
32CLSgenerallyhascontractswithatleastthreeliquidityprovidersineachcurrency.
33Thusthenetpositivebalancerequirementplaysmuchthesameroleasmarginrequirementsunder“mark‐ing‐to‐market”inafuturesclearingarrangement.Seee.g.,Baer,France,andMoser,(2004),orMoser(1998).
34Inpractice,CLSleviesanadditionalhaircuttoprovideacushionagainstexchangeratevolatilityduringdayT+2.
47
Thusfar,theexampleshavedealtwithasinglepayment.InfactparticipantsinFXmarkets
makelargenumbersofexchangesduringtheday,repeatedlyswappingcurrenciesbackand
forthinoffsettingornear‐offsettingtrades.
Example3.SupposethatBankAbuys$4millionfromBankBfor£2millionduringthe irst
tradeofdayT,andthenbuys£1millionfromBankBfor$2millionduringthesecondtrade
of the sameday,with all trades at $2/ £.As before, assume that the dollar rises to £1=
$1.80 by the close of trading on dayT+1, so that each bank’s initial pay‐in requirement
wouldbethesameasinexample2.Thatis,atthebeginningofdayT+2,BankBisnetshort
$2millionandlong£1million,soonceagainBwouldneedtopayin$200,000.
Whensettlementsoccurdependson the sizeof the twobanks’permittedoverdrafts. For
simplicitywewillassumethatoverdraftsaresuf icienttohandleeachtrade.Nonetheless,a
tradecannotsettleuntilthepay‐insareadequatetoensurethateachbankhaveanetposi‐
tivepost‐tradebalance.SincebankB isoutofthemoney$400,000onthe irsttrade,that
tradewillnotsettleuntilbankBputsa further$200,000in itsaccount.Once itdoes, the
irsttradewillsettle.AlthoughAisoutofthemoneyonthesecondtrade,thesettlementof
the irsttradeleavesthenetpositionofAsuf icientlypositivetoenablethesecondtradeto
settleaswell.
Althoughthetradesaresettled,theCLSBankstilllacksthefundstomakeapayout.These
mustawaitthepay‐inofadditionalfundsbyeachofthebanks.Asthosefundsappear,pay‐
outsaremadeonsettledtradessubjecttotworestrictions:1)theCLSBankcanneverover‐
draw its accountwith any RTGS system, and 2) all settlement banks’ accountswith CLS
mustremainnetpositive.Pay‐ins,settlement,andpay‐outscontinueonanongoingbasis
untilalltransactionshavebeensettledandallfundspaidout.35
35Theexactchoiceofwhichtransactionstopayoutfirstismadeaccordingtoaproprietaryalgorithm.Thealgorithmaccordspreference tomembersandcurrencieswith thehighestbalancesandtocurrencieswiththe earliest large‐value payment system closing times (Committee on Payment and Settlement Systems2008a,78).
48
4.3LiquiditysavingandIn‐OutSwaps
FormanyofitsparticipantsamajoradvantageoftheCLSsystemistheopportunityitpro‐
vides to economizeon theuseof currency through the “liquidity recycling” arrangement
describedinexample3above.ForthepurposeofsettlementtheCLSarrangementisnota
nettingarrangement.Eachtradesettlesorfailsseparately:Givenapairofbilateraltrades
betweentwobanks,itwouldbepossibleforonetosettleandtheothernotto,dueforex‐
ampletoasubsequentfailureofabanktomakeapay‐in.Onthesettledtrade,payoutsbe‐
cometheresponsibilityofCLSBank.Ontheunsettledtrades,eachbankisreturneditsini‐
tial pay‐ins. Nonetheless, CLS shares one important feature with traditional netting ar‐
rangements: iteconomizesontheuseofcentralbank funds. Inoursimpleexample,each
bankonlyneedpayinitsnetpositionintheshortcurrencyforCLStobeabletocomplete
thepaymentprocess.Withstrictercapsonoverdraftpositionsagreaterpay‐inmaybere‐
quired, but as a bank engages in larger numbers of transactions the difference becomes
small.
This“quasi‐netting”propertyofCLSsettlementgeneratesliquiditysavingsthatarecompa‐
rable to the savings available through multilateral net settlement. According to the CLS
website,quasi‐nettingreducespay‐inamountstoaboutfourpercentofthegrossamounts
due.But(.04)$5trillionisstillalotofmoney,evenbytherare iedstandardsoftoday’s
large‐valuepaymentsystems.CLS’sneedforliquidityisexacerbatedbyitsneedforimme‐
diacy:toenablesimultaneousworldwidesettlement,CLSmustbeginprocessingpayments
veryearlyintheAmericanandEuropeanbusinessdays,whentraditionallylittleliquidityis
availableexceptthroughcentralbanks.36
CLS’sliquiditydemandcould,inprinciple,beentirelymetbyborrowingfromcentralbanks,
butCLSmemberbankshavebeenreluctanttotieuptheiravailableintradaycreditcapacity
inthisfashion.Instead,asawayofreducingtheliquiditycostsofCLSpay‐ins,theyhavede‐
36Pay‐instoCLSbeginat7a.m.CentralEuropeanTime.Settlementbeginsatthesametimeandisnormallycompleteby9a.m.CET,butpay‐outs(andadditionalpay‐ins)maycontinueuntil10a.m.CETforAsiancur‐rencies,andnoonCETforallothercurrencies.
49
velopedaprivateintradaylendingmechanismknownasthein‐outswap.In‐outswapsare
coordinated throughCLSbut are technically side agreements that are outside of theCLS
system.Anin‐outswapconsistsofapairoftransactionsthatoccuronthesameday.Inthe
irsttransaction,aCLSmemberexchanges,withinCLS,apositioninacurrencyinwhichit
is longagainstacurrency inwhich it isshort, therebyreducingboth itspay‐insandpay‐
outs.Thesecondtransactionhappens later thesamedayandoccursoutsideCLS,andre‐
versesthe irsttransactionatexactlythesameexchangerates.Aswithotherintradaycredit
mechanisms, these intraday swaps are not priced and traded; CLS identi ies potential
swapsthenightbeforeandmembersarefreetoagreetoexchanges“atpar”ornot.
Byusingin‐outswaps,CLSsettlementmembershavebeenabletoreducetheliquidityre‐
quiredfortheirpay‐instolessthantwopercentofgrossamountsdue(CommitteeonPay‐
mentandSettlementSystems2008a), i.e., lessthan$100billionequivalentacrossallcur‐
renciesonan“average”CLSday.37Asusualthereisnofreelunch:sincethe“outside”trans‐
actioninanin‐outswapissettledthroughthetraditional“correspondentbanking”method
of settling FX transactions, the use of in‐out swaps represents a partial retreat from the
conditionalityguaranteeoftheCLSsystem.Discussionsofthisissueusuallypointoutthat
theresidualamountofprincipalorHerstattriskthathasbeenreintroducedbytheuseof
in‐outswapsissmallrelativetotheriskpresentbeforetheintroductionofCLS.
4.4Policyissuesforcentralbanks
TheforegoingdiscussionshowshowpaymentsmadethroughCLScansubstitute forpay‐
ments in central bankmoney, and provide protection against principal risk in situations
wheretraditionalformsofFXsettlementcouldnot.ThedesignofCLS,whilerobust,cannot
protect against all types of risks in FX trades in all situations. In particular, CLS cannot
guaranteetheliquidityofitsparticipants.ACLSmembermight,forexample,failtopayin
itsobligation,inwhichcaseCLSdeletesthatmember’stradesfromitssystem.Thisprotects
37Forsingle‐currency,large‐valuepaymentsystemsacommonratioofnettogrosspaymentsisapproximate‐lyonepercent(BechandHobijn2007),whichwouldrepresentalowerlimitonliquidityneededforCLSset‐tlement.CLSdoesnotquiteattainthislimitbutcomesclose.
50
theprincipaloftheremainingmembersbutmaysubjectthemtoliquiditypressuresdueto
unexpectedshiftsintheirpay‐inrequirements.Similarly,afailureofmultipleliquiditypro‐
vidersinagivencurrencycouldleadtowidespreadstresses.ThankstotherulethatCLSis
neverinanegativenetposition,suchaneventwouldnotendangerthesolvencyofCLS,but
itsabilitytomakepay‐outsintheaffectedcurrencycouldbeimpaired.Insuchcases,CLS
rulesallowfortheCLSBanktocompletepay‐outsincurrencieswheresuf icientliquidityis
available.Thisagainwouldpreserveprincipalbutpossiblysubjecttheremainingmembers
tounexpectedliquiditydemands.
The examples presented earlier should also make clear that any CLS‐induced liquidity
strainswouldnotnecessarilybecon inedtoasinglecurrency.Afailurebyonememberto
payinsay,EurotoitsCLSaccount,couldleadtoashortofliquidityandcausedisruptionsto
large‐valuepaymentsystems inothercurrencies.DefendersofCLShavepointedout that
cross‐currencylinkagesexistedbeforebutwereonlylessapparent,and,becausetheydid
notcontrolprincipalrisk,werepotentiallyevenmoredisruptive.However,theultimateal‐
locationofresidualrisks,andtheextenttowhichthesearebornebycentralbanks,isyetto
beresolved.
Todate,doubtsabouttheintegrityofCLSsettlementhaveremainedintherealmofthehy‐
pothetical.Notably,CLSwasable tocontinuenormalsettlementprocesses in thewakeof
themarketdisruptionsof2007and2008.AwatershedeventwastheSeptember2008fail‐
ureofLehmanBrothers.Lehmanwasa“usermember”ofCLSthatreliedonanotherCLS
member(Citigroup)forsettlementservices.ThedecisionbyCitigrouptocontinuetosettle
thefailedmember’stradesenabledCLSsettlementtoproceedwithoutdisruption.However,
useofin‐outswapsisreportedtohavecontractedinwakeoftheLehmanbankruptcy,lead‐
ingtosomereductioninliquiditysavings(ForeignExchangeContactGroupandOperations
ManagersGroup2009).
CLS’ability towithstand theshocksexperiencedduring the recentcrisisappears tohave
bluntedmovementtowardadditionalcentralizationofFXclearing.Notably,arecentruling
byU.S.regulators(UnitedStatesTreasury2012)hasgrantedFXmarketsaspeci icexemp‐
51
tion from the clearing requirements of the 2010 Dodd‐Frank Act. The rulingmakes fre‐
quentmentionoftheef icacyofCLSincontrollingsettlementrisk.
ThemainbusinessofCLSissettlingforeignexchangetransactions,butithasbranchedout
intootheractivities. Inearly2008 it launchedaservice (incooperationwithDTCC38) for
settlingcreditderivativestrades.ByvirtueofCLS’connectionstomultiplelarge‐valuepay‐
mentsystems,thereisnotechnologicalbarriertousingittosettleothertypesoftradesas
well.AnotherunresolvedpolicyissueistowhatextentfutureexpansionsofCLSwouldbe
consistentwithitsoriginalpurposeofmanagingrisksinFXmarkets.
5. Conclusion
Fromtheirbeginnings,centralbankshavehadaroleinpayments.Thisrolehasrarelybeen
static,however,andascentralbankshaveinnovated,theseinnovationshavebeenmatched,
andindeedinmanycasesoutpaced,bytheprivatesector.Theresulthasbeenasteadyifnot
alwaysmonotoneprogressiontowardlowercostsandreducedrisksinpayments.Wehave
consideredthreeexamplesofthisprocess.
The irstexampledescribedthepaymentsroleoftheBankofAmsterdam,themostpromi‐
nentoftheEarlyModern“exchangebanks”—account‐basedpublicbankswhoseprincipal
functionwassettlementofaformofprivatepayments(billsofexchange)prevalentduring
thatera.In1683,theBankofAmsterdamenactedareformwhichprovideditsuserscheap
accesstoliquidity,andsowasabletotakeonadominantpaymentsrolewithineighteenth‐
centuryEuropeancommerce.UltimatelytheBankfailed,however,becauseitcouldnotsuc‐
cessfullyreconcileitspaymentsrolewithdemandsonitfrom iscalauthorities.
Oursecondexampledescribedthepaymentsroleofanultimatelymoresuccessfulinstitu‐
tion,theBankofEngland.Liketheexchangebanks,theBankofEnglandofferedaccounts,
butmore important to itsoperationswerethebearernotesthat it issuedonanunprece‐
38DepositoryTrustandClearingCorporation,whichownsseveralmajorU.S.financialmarketutilities.
52
dentedscale.Lackingthelegaland inancialresourcestocompeteasnoteissuers,private
banksrespondedbydevelopingcheckpaymentsintoaviablealternativetonotes.However,
theprivatebanksremaineddependentontheBankofEnglandforsettlementservices,and
especiallyforaccesstoliquidityduring inancialcrises.Thenineteenth‐centuryU.S.bank‐
ingsystemsoughttoimitatetheBritishsuccesswithchecks,butalackofastrongcentral
bank made the highly fragmented American system susceptible to frequent crises, and
thereforelessattractivetointernationalparticipants.
ModernRTGSsystemsretainaspectsofbothoftheseearliersystems,andremaintheback‐
bone of payments inmost countries. Yet our third example shows how a private‐sector
paymentsystem,CLS,hasbeenable to takepaymentsbeyond the con inesofany single‐
currencysystem.Throughaninnovativedesign,CLShasreducedthechancesthatFXmar‐
ketparticipantswillsufferalossofprincipalinatrade.ForFXtransactions,CLSisnowthe
anchor;centralbanksplayavital,butsecondaryroleinthisdesign.ButCLShasalsohelped
to increase the interconnectedness of theworld’s large‐value payment systems. The end
resultmaybeonlytoextendcentralbanks’responsibilitiesfortheintegrityofpayments.
53
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