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Behind the money market:
Clearing and settling money market instrument
Whenever a money market instrument is traded, some means must exist for transferring the instrument and for making payment. In other words, there is a necessity for clearing and settling the trade, tasks that are usually referred to as operational, or back-office, functions.
Clearing: it refers to processing a trade and establishing what the parties to the trade owe each other. Settlement refers to the transfer of value between the parties so the trade is completed (Group of Thirty 1989, p. 35). In the clearing and settlement process the first step involves conveying the details of the trade from traders to the back office. Second, the details must be compared and matched between the buyer and seller to ensure that there is an agreement between the buyer and seller regarding what is to be traded and the terms thereof. Failure to do so might lead to delivery problems.
The participants in the money market are linked by clearing and settlement systems.
At the center of the clearing and settlement mechanism for the money market are banks and the interbank payment system. Banks connect the participants in the money market by acting in three capacities. First, banks act as agents for issuers of money market instruments, they therefor perform the physical tasks of issuing and redeeming instruments in the market and of maintaining registration records. Second, banks act as custodians of instruments: they render their services as safekeepers of instruments to investors. The bank's balance sheet does not show like valuables kept in a safe-deposit box, or instruments entrusted to a custodian bank, as either assets or liabilities because they remain the property of their owners.
Finally, and most importantly, some banks specialize in clearing. The responsibilities of a clearing bank is the transferring of securities from one party to another and for transferring payment for securities. Two types of accounts are maintained by dealers at clearing banks: securities account and funds accounts. When a clearing bank is instructed to transfer securities from Dealer A's securities account to that of Dealer B, the bank also transfers payment for the securities from Dealer B's funds account to that of Dealer A. If the same clearing bank is not used by the dealer, the transaction then involves a transfer of securities and funds between two banks.
Transfers between banks take place at the hub of the money market, the interbank payment system. Even when instruments are cleared outside the banking system, as is the case when a dealer firm clears for itself, payment still takes place through banks. The payment system, which links banks to each other, includes both paper checks and electronic funds transfer, although almost all interbank payments now occur electronically over wholesale wire transfer networks.
Fedwire is the main wholesale wire transfer network in the United States , which operates through bank reserve accounts at the 12 Federal Reserve Banks. Fedwire can be used to transfer both funds and book-entry U.S. government securities between banks and other depository institutions. During 1991, about 260,000 Fedwire funds transfers totaling about $766 billion occurred on an average day. This means transfer size was about $3 million. In addition, over 44,000 book-entry securities transfers amounting to about $476 billion occurred daily. The average book-entry transfer was about $10.8 million.
Assume that Bank of Downtown finds itself with $10 million of excess reserves while Midtown Trust is $10 million short of required reserves. A broker matches the two and arranges for Downtown to sell (lend) $10 million to Midtown, thereby Downtown's excess reserves will be used to fund Midtown's shortage. Settlement of the transaction will occur through reserve accounts at their Federal Reserve Bank. When Downtown initiates the transfer, its reserve account at the Fed is reduced by $10 million. Within a split second, Midtown's reserve account is increased by the same amount. Once the transfer is made, the Fedwire payment is final and irrevocable. Notice that the books of the Fed reflects the transfer as a move of reserves from the account of one bank to that of the other. The next day, Midtown uses Fedwire to repay the funds and essentially reverses the process.
An important feature of Fedwire transfers is that they are settled on a bilateral, trade-for-trade basis, also known as gross settlement. If, instead, transfers were consolidated into net positions between banks or between banks and the network in order to reduce the actual number of interbank transfers that take place, the system would be called a netting system. Netting can take two forms. Bilateral netting combines gross obligations between banks into net obligations so each pair of banks in a system exchanges only one settlement payment. Multilateral netting combines each bank's bilateral net positions into "net net" obligations between the bank and the other banks in the system. When settlement occurs, each bank is either a net creditor (one that is owed money by the rest of the system) or a net debtor (one that owes money).
The Clearing House Interbank Payments System (CHIPS) is a multilateral netting system. It is owned and operated by the New York Clearing House, a private organization. Only funds and not securities are transfered by CHIPS, and is used largely, although by no means exclusively, in connection with international transactions such as Eurodollars and foreign exchange (Clair 1991). During 1991 approximately 150,000 transfers totaling about $866 billion took place on an average day on CHIPS. Average transfer size was $6 million. At the end of 1991, 126 depository institutions, many of them branches of foreign banks, participated in CHIPS.
CHIPS is organized in a hierarchical fashion whereby a subset of participating banks (20 out of 126) settle directly with CHIPS while the others must settle on the books of one of the settling banks. Settlement occurs at the end of the day, when settling banks in net debit positions send (over Fedwire) the funds they owe to a special CHIPS net settlement account at the Federal Reserve Bank of New York. CHIPS then wires funds from the account to settling banks in net.
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) deserves mention because of its role in international payments. It is a nonprofit cooperative chartered under Belgian law and owned by 1,885 participating institutions in 73 countries, this include the United States. SWIFT is, unlike Fedwire or CHIPS, not a funds transfer system. Instead, SWIFT payment messages instruct banks to transfer funds by means of accounts at correspondent banks. Such a transfer might involve transfers among accounts at the same bank. For example, suppose Bank of Downtown serves as correspondent bank for both Midtown Trust and London Bank and that London Bank wishes to make a payment to Midtown Trust. London makes the payment by sending a SWIFT message instructing Downtown to reduce London's correspondent account and to increase Midtown's by the amount of the payment. Alternatively, a SWIFT message might direct that a payment be made between banks. If London wishes to make a payment to Crosstown National, for example, but Crosstown does not have a correspondent relationship with Downtown, then London's SWIFT message would instruct Downtown to transfer funds (from London's correspondent account) to Crosstown by means of an interbank network like Fedwire or CHIPS.
The form in which a money market instrument is issued and traded largely determines the manner in which it is cleared and settled. Federal funds are essentially exchanges of bank reserves between accounts at Federal Reserve Banks, they are therefor settled by means of Fedwire transfers. The clearing and settling of other money market instruments depends on whether they are traded in physical (also called "definitive") form or book-entry form. Trades of physical securities may require that paper instruments move between institutions, while trades of book-entry securities only involve changes in computer account entries.
At present, large certificates of deposit (CDs), bankers acceptances, and some commercial paper issues are issued in physical form; that is, paper certificates are used to represent the obligation of the issuer to the purchaser. The working of clearing physical securities can be explained as follows: Suppose Hoozon First Securities decides to purchase $10 million of CDs from Watson Second Securities. Suppose also that Hoozon uses Downtown as its clearing bank and Watson uses Midtown. After the securities firms' back offices notify their clearing banks of the trade, Midtown pulls the CDs from the vault and a courier delivers them to Downtown. Downtown then sends over Fedwire $10 million in payment to Midtown. Downtown charges Hoozon for the payment while Midtown credits Watson. The trade between the dealers has been cleared and settled. If Hoozon then sells $5 million of the CDs it bought to Zippi Industries, one of its corporate customers, and if Crosstown National serves as Zippi's custodian bank, it will be necessary for Downtown to deliver the securities to Crosstown for safekeeping and for Crosstown to make a payment to Downtown.
A dealer might elect to clear securities itself. In the abovementioned example, self-clearing would mean that securities would be moved directly between the dealers (or between a self-clearing dealer and a clearing bank). Whether a dealer clears for itself or uses a bank depends on whether or not the benefits of possibly faster clearing and greater control over the operation outweigh the additional costs of running a clearing operation. But even if a dealer clears for itself, a bank will still be used for settlement because only banks (or, more accurately, depository institutions) have accounts at the Federal Reserve.
Due to their nature physical securities involve handling and delivery costs as well as risks of theft. Consequently, there are incentives for keeping (or "immobilizing") physical securities in depositories instead of requiring that the securities be physically moved each time they are traded. When a sale of a security held in a depository occur, the depository's files are updated to reflect the change of ownership. In other words, a depository effectively converts an exchange of physical securities into an exchange of book-entry securities (McAndrews 1992). The process can be taken one step further, and the physical security can be eliminated altogether (or "dematerialized"), and the security can be issued, cleared, settled, and redeemed in book-entry form on the computer files of the depository. As more types of money market instruments become eligible for conversion to book-entry form, cost considerations could quickly turn physical securities into an anachronism.
Money market instruments have been moving from physical to book-entry form by means of depositories. The Depository Trust Company (DTC), a New York limited-purpose trust company owned jointly by broker-dealers, banks, and other financial organizations, has been active in making more instruments eligible for conversion to book-entry form. The movement to book entry has been rapid. In 1981 Municipal securities became eligible for book entry and by the end of 1991, 77 percent of the value of municipal notes outstanding was issued through DTC in book-entry form and involved no physical securities (DTC 1991). In 1990 commercial paper became eligible for book entry; by May 1992, 42 percent of the value of the commercial paper market was issued through DTC entirely in book-entry form. And as of this writing, DTC was attempting to make large CDs and bankers acceptances eligible for book entry.
U.S. government securities, including Treasury bills, are now issued only in book-entry form. That is, obligations of the United States are now recorded as entries on the computer files of the Federal Reserve Banks and commercial banks instead of being represented by paper certificates. Because of concerns about security and the costs of processing and moving huge quantities of paper instruments, the Treasury and Federal Reserve System completed a switch to book entry securities in 1986.
An entry on a Federal Reserve Bank's computer represent every Treasury security issued. The Fed keeps track of which bank holds a particular portion of an issue and, at maturity, transfers funds in repayment to the bank holder. The Fed maintains securities accounts in order to keep track of the outstanding issue balance, but these accounts do not show up on the Fed's balance sheet. Rather, they reflect the Fed's custody of the Treasury security issue for the various depository institutions. Similarly, a Treasury security are purchased by a bank for the account of a customer, the bank is not the actual owner even though the Fed's computer assigns a security balance to that bank.
Suppose the Bank of Downtown purchases $10 million of Treasury bills from Midtown Trust. Two offsetting transactions take place simultaneously when the securities are transferred over Fedwire: the exchange of securities and the exchange of funds in payment. The movement of Treasury bills takes place by decreasing Midtown's book-entry securities account at the Federal Reserve Bank and by increasing Downtown's by the same amount. Payment involves a transfer of funds from Downtown's reserve account to Midtown's. As funds and securities are transferred at the same time, such a system is called a "delivery versus payment" system.
The preceding example only shows what would happen if the purchasing bank were holding the securities for its own account. Suppose that Hoozon First Securities purchases the $10 million of Treasury bills from Watson Second Securities. If Hoozon uses Downtown as its clearing bank and Watson uses Midtown, Downtown increases Hoozon's securities account by $10 million and decreases its funds account by the same amount in payment. Thereby, Midtown decreases Watson's securities account and increases its funds account by $10 million. On Fedwire the securities move from Midtown to Downtown and the payment moves in the opposite direction. Note that actual ownership of the security does not rest with either bank but moves from Watson to Hoozon. The banks and the Federal Reserve are simply the conduit through which ownership of securities is passed.
Trades involving Eurodollar deposits differ from those of domestic instruments as they entail corresponding transactions in the United States and overseas and also are likely to involve the CHIPS and SWIFT networks. Eurodollar deposit are dollar deposits held outside the United States in either a foreign bank or an overseas branch of a U.S. bank. Inside the United States, only international banking facilities of domestic or foreign banks can hold Eurodollars. When Eurodollar deposits move between banks, they normally involve corresponding entries on the balance sheet of some organization located in the United States.
There are for clearing and settling other Eurodollar instruments, specialized networks and facilities. For example, Euro commercial paper, Euro-notes, and Eurodollar CDs are commonly cleared and settled in both the Euroclear and CEDEL systems. Euroclear, owned by a Belgian cooperative and operated under contract by the Brussels branch of Morgan Guaranty Trust Company, is originally formed to clear Eurobond trades. Securities are immobilized in a network of depositories and settled in book-entry form; funds transfers in connection with book-entry settlement take place through deposits on Morgan's books.
CEDEL is a Luxembourg corporation, specially chartered as a clearing organization. As with Euroclear, securities settled over CEDEL are immobilized in depositories; unlike Euroclear, funds transfers in connection with book-entry securities settlement take place through deposits with the CEDEL clearing organization itself.
Finally, banks can clear and settle Eurodollar instruments. For example, the First Chicago Clearing Centre in London provide custodian, agent, and clearing bank services for Eurodollar instruments, primarily dollar-denominated CDs. Funds transfers associated with movements of Eurodollar instruments take place on the books of First Chicago's London branch.
The opportunities for loss as the result of default or operational problems are potentially huge given the daily volume and value of transactions that occur in the money market. Over the last decade both market participants and regulators have devoted a great deal of effort to formulating policies for keeping risks within acceptable limits.
Policy discussions often distinguish among several forms of risk (Parkinson et al. 1992). Credit risk: it refers to potential losses arising from a clearing and settlement system participant defaulting on some or all of its settlement obligations. Liquidity risk: it arises from the possibility that settlement could be delayed because of temporary unavailability of funds. The distinction between credit risk and liquidity risk lies in the temporary nature of illiquidity as opposed to the permanent nature of default. Systemic risk: it refers to the danger that the failure of one participant to settle its obligations could lead to liquidity problems or settlement failure on the part of others. Operational risk: it stems from the possible breakdown of computer systems or other elements of the clearing and settling mechanism.
The most transparent example of credit risk are provided by Fedwire.. The Fedwire transaction omits an important point: For the transfer to take place, it is not necessary for the sending bank to have sufficient funds in its reserve account to cover the transfer. Suppose the Bank of Downtown has only $5 million on deposit as reserves, at the time of the transfer, Downtown incurs a "daylight overdraft" of $5 million. Daylight overdraft: a banks reserve account is allowed to go negative during the day so long as the deficit is made up before close of business. The receiving bank will have final payment at the time of the transfer regardless of whether the overdraft is ultimately covered. The Federal Reserve Bank assumes the credit risk of Downtown's failing to provide the necessary funds, until the overdraft is covered. While credit risk has effectively been socialized by transferring it to the Fed, systemic risk has been eliminated because there is no avenue for losses to spread to other banks in the system.
Credit, liquidity, and systemic risks can all arise on CHIPS. For example, suppose the Bank of Downtown receives a CHIPS transfer message from Crosstown National for a payment to one of its corporate customers. Although CHIPS does not settle until the end of the day, it may be Downtown's practice to allow its customer to withdraw the funds prior to settlement. In allowing such access to funds, Downtown assumes the risk that Crosstown might fail to meet its net settlement obligation at the end of the day. More serious, the failure of Crosstown to settle a particularly large net debit position could conceivably cause a chain reaction of settlement failures among other participants, some of which might depend on the receipt of payments from the failing bank in order to fund their obligations (Humphrey 1986). Measures to control such risk will be discussed.
Operational risks may be illustrated with the following incident that occurred in 1985. The Bank of New York, acting as a clearing bank for book-entry Treasury securities, had an internal computer problem that allowed the bank to accept securities but not to process them for delivery to dealers, brokers, and other market participants. The bank's reserve account was debited for the amount of the securities, but the bank was unable to re-send them and collect payment. The result was a growing daylight overdraft in the Bank of New York's reserve account. As it became increasingly clear that the problem would not be fixed by close of business, the bank borrowed from the discount window. The problem was fixed during the night so the loan was repaid the following day.
The abovementioned risk categories overlap considerably. For example, at a bank operational problems could lead to liquidity problems, which in turn might cause systemic problems with other banks. In addition, operational problems could extend to accounting systems and thereby make it difficult for system participants to monitor their credit exposures to other participants. Finally, at the time a participant fails to meet its settlement obligations, the other participants are unlikely to be able to determine whether the problem is the result of default or illiquidity. The distinctions are however important to policymakers because each category of risk requires different solutions. For example, credit risks: might suggest loss-sharing arrangements and limits on risk exposure; liquidity risks: might call for emergency lending arrangements and operational risks: might lead to policies designed to create incentives to develop backup facilities and procedures to keep systems running.
Risk-control: its measures cover a wide spectrum. Membership standards are the simplest, it seek to head off settlement problems by excluding from a system those participants lacking the financial strength and operational expertise to assure that settlement obligations are met. Once a participant is admitted, the clearing organization should monitor the participant's financial condition to ensure that it does not pose losses to the other members.
Quantitative limits on risk exposure is another form of risk control. Examples: net debit caps and bilateral net credit limits. Net debit caps are limits on the size of a bank's combined daylight overdraft on Fedwire and net debit position on CHIPS. They therefore attempt to control the risk a bank poses to the payment system by limiting how much a bank can, on balance, owe others over the wire transfer networks. Bilateral net credit limits: specify the maximum net transfer a bank on CHIPS is willing to receive from a particular sending bank; therefore they provide a means for a bank to control its own exposure to other banks. Net debit caps on Fedwire and CHIPS and bilateral net credit limits on CHIPS were part of the original Federal Reserve risk-control policy adopted in 1986.
Risks to a clearing and settlement system can also be limited by requiring system participants to put up collateral to cover their obligations to the system. If a participant defaults, the collateral is used to cover the losses. In effect, such a requirement amounts to a performance bond that a participant forfeits if it defaults on its settlement obligations.
A form of risk-control policy that seeks to create economic incentive to control risks is explicit pricing of daylight overdrafts (Mengle, Humphrey, and Summers 1987). The rationale for pricing is that it will impose a cost on using intraday credit and thereby provide incentives to reduce risk exposures and to more efficiently allocate intraday credit. The Federal Reserve approved a charge on daylight overdrafts that exceed 10 percent of an institution's risk-based capital in 1992. By 1996 the charge will be $6.85 per day per $1 million (that is, an annual rate of 25 basis points) of average Fedwire daylight overdrafts arising from funds transfers and book-entry securities transfers that exceed 10 percent of an institution's risk-based capital.
A fifth form of risk-control policy is loss sharing among members of a net settlement system. Under a loss-sharing agreement, banks that are members of a system share the losses caused by another member's failure to settle. Two characteristics are generally required to make a loss-sharing agreement work: That is: settlement finality; assurance that settlement entries will not be reversed in the event of one bank's failure to settle. Banks are generally required to contribute collateral to a clearing fund in order to make the loss-sharing agreement credible. It can be drawn upon in the event of a settlement failure and can also serve as security for an emergency line of credit. A loss-sharing agreement can create incentives for banks to monitor the soundness of other banks in the system by imposing costs on system participants if a failure occurs. CHIPS adopted settlement finality and a loss-sharing agreement in 1990.
A sixth means of risk control is obligation netting, it is, combining a set of offsetting gross payment of securities obligations into net obligations. Netting, be it bilateral or multilateral, can reduce operational risks by reducing the volume of transactions that actually pass through a clearing and settlement system. And provided that the underlying legal obligations between participants are netted along with the positions, netting can reduce credit risks between banks by reducing the total amount of funds and securities that actually must be transferred between banks (Gilbert 1992).
In 1986 the Government Securities Clearing Corporations (GSCC) was established to provide netting of government securities trades for banks and other securities brokers and dealers. The GSCC works as follows. Participants submit data on all securities transactions to be settled on a particular day. First, the trades are compared. Then, each participant's transactions of each issue are added up into a net credit or debit security settlement position for each issue and a single funds settlement position. The netting process is the same as the multilateral arrangement, except for GSCC the numbers would refer to sales or purchases of a specific issue of government securities instead of CHIPS funds transfers. Settlement occurs over the Fedwire book-entry system: Clearing banks deliver (against payment) net securities positions to GSCC; in turn GSCC sends (against payment) the netted amounts of each issue to receivers.
Netting , has the potential to increase systemic risk although it can reduce operational risks as well as credit risk. The GSCC has in response to concerns about systemic risk, adopted three measures to deal with the default of a participant. GSCC first requires that members contribute to a clearing fund. Second, it maintains a line of credit on which to draw in the event of liquidity problems. Finally, it has in place rules for sharing losses in the event of a default.
A final means of reducing risk, one that is applicable to systems for clearing and settling securities, is moving securities to book-entry, delivery-versus-payment form. Credit risk exposure is reduced by delivery versus payment because making the exchange of funds and securities simultaneous (or nearly so) eliminates (or greatly reduces) the time between delivery of securities and payment of funds during which a participant could fail to meet its obligation. Furthermore, book entry reduces operational risks by eliminating physical delivery of instruments.
Although book entry and delivery versus payment reduce exposure to a defaulting participant, they do not eliminate it entirely. In order to provide additional protection against losses if a participant defaults, the Federal Reserve has issued guidelines for risk controls on privately operated book-entry systems (Federal Register, June 21, 1989). A specific example of such controls is in DTC's book-entry commercial paper facility. DTC's safeguards include a clearing fund contributed to by participants, net debit caps and a requirement that a participant maintain collateral on its net debit position (Federal Register, October 17, 1990).
The design of a program for risk reduction entails to some extent trade-offs between various types of risk. For example, until 1981 CHIPS did not settle until the day after the transfer messages were made. This gave rise to overnight credit risk. When CHIPS was moved to same-day settlement, credit risk was reduced (or made shorter in duration), but operational risk most likely increased, at least temporarily, since there was less time to prepare for settlement. In practice, the challenge in developing new clearing system technologies is to reduce credit and systemic risks while avoiding operational risks.
The information in this chapter was last updated in 1993. Since the money market evolves very rapidly, recent developments may have superseded some of the content of this chapter.
Clair, Robert T. "The Clearing House Interbank Payments System," Research in Financial Services. JAI Press, 1991.
Depository Trust Company. Annual Report, 1991.
Federal Reserve Bank of New York. "Large Dollar Payment Flows from New York," Federal Reserve Bank of New York Quarterly Review, vol. 12 (Winter 1987-88), pp. 6-13.
Gilbert, W. Alton. "Implications of Netting Arrangements for Bank Risk and Foreign Exchange Transactions," Federal Reserve Bank of St. Louis Review, vol. 74 (January/February 1992), pp. 3-16.
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Juncker, George R., Bruce J. Summers, and Florence M. Young. "A Primer on the Settlement of Payments in the United States," Federal Reserve Bulletin, vol. 77 (November 1991), pp. 847-58.
McAndrews, James J. "Where Has All the Paper Gone? Book-Entry Delivery-Against-Payment Systems," Federal Reserve Bank of Philadelphia Business Review, November/December 1992, pp. 19-30.
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Humphrey, and Bruce J. Summers. "Intraday Credit:Risk, Value, and
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73 (January/February 1987), pp. 3-14.
Parkinson, Patrick, Adam Gilbert, Emily Gollob, Lauren Hargraves, Richard Mead, Jeff Stehm, and Mary Ann Taylor. "Clearance and Settlement in U.S. Securities Markets." Staff Study 163. Washington: Board of Governors of the Federal Reserve System, 1992.
Stigum, Marcia. After the Trade: Dealer and Clearing Bank Operations in Money Market and Government Securities. Homewood, Ill.: Dow Jones-Irwin, 1988.
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