The Design of Wholesale Payments Networks: The Importance of Incentives

Charles M. Kahn
William Roberds
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Economic Review
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Most people are familiar with retail payments systems such as checks and credit cards. Less familiar are wholesale payments systems, which consist of electronic networks used for sending large sums among banks. A feature common to all wholesale networks is that settlement is carried out by exchange of funds held in banks' reserve accounts at a central bank, though the rules for settlement vary. This article considers the question of what is the best design for a wholesale payments system, in particular whether it should settle on a net or a real-time gross basis, and some of the difficult policy questions facing both participants and regulators of wholesale systems. ; The authors show that for the benchmark case in which bank asset quality is fixed and bank assets can always be liquidated at book value, the advantages of some type of net settlement dominate real-time gross settlement. However, the optimal net settlement scheme may necessarily involve some chance of default. The discussion also examines the case in which the quality of bank assets is a choice variable and finds that the potential costs of net settlement rise because of negative effects on bank asset quality. The authors conclude that the design of a wholesale payments system must take into account numerous policy trade-offs, the most critical being the one between the costs of liquidity versus the costs of default.

This paper was presented at the Optimal Design of Payments Systems Workshop in May of 2011.

Financial Institutions
Payments Systems