Joint Determination of Counterparty and Liquidity Risk in Payment Systems

Autor: Jorge Cruz Lopez
Coautor(es): 1. Charles Kahn (University of Illinois at Urbana-Champaign College of Business) 2. Gabriel Rodriguez Rondon (McGill University)
We propose a methodology to assess how banks jointly manage their funding liquidity and counterparty risk. Our methodology is developed in the context of a centralized payments exchange that uses a deferred net settlement (DNS) system. This setup allows us to simultaneously evaluate critical features of the financial system that are usually analysed in isolation, such as the issuance of secured and unsecured credit obligations and the use of collateral and capital requirements. Throughout the day, banks issue payment orders that represent claims on central bank balances. These claims, or credit obligations, must be settled at the end of the day. A payments operator processes all payment orders and acts as the central counterparty. To remain risk neutral, the operator collects collateral from either the issuer or the recipient of a payment order. Thus, from the point of view of the recipient (i.e., the creditor), orders are secured if they are collateralized with the assets of the issuer (i.e., the debtor) using a defaulter-pay arrangement, and unsecured if they are supported with its own assets using a survivor-pay arrangement. These arrangements closely resemble collateral and capital requirements in the wider banking system. We hypothesize that banks coordinate the issuance of payment orders to jointly manage their liquidity and counterparty exposures. Coordination leads to netting of credit exposures and unencumbering of collateral assets, which increases liquidity. Using intra-day data from the Canadian wholesale payments system, known as the Large Value Transfer System (LVTS), our results show that banks prefer to issue unsecured payments and do not see secured and unsecured payments as substitutes. However, banks coordinate the issuance of both types of payments. For unsecured payments, banks rely on both bilateral and multilateral coordination, whereas for secured payments, they rely almost exclusively on multilateral coordination. The differences in coordination arise because unsecured payments are contingent on the performance of a given counterparty, whereas secured payments only depend on the value of the collateral supporting them. Thus, to the extend that collateral is homogenous, secured payments are fungible regardless of the issuer. Coordination and netting incentives increase with risk exposures and the cost of funding. We conclude that coordination disruptions may increase risk exposures and lead to collateral shortages and funding constraints, particularly among small participants, who tend to net less and require relatively more collateral to issue and to receive payments. In an extreme scenario, coordination disruptions could lead to gridlock and systemic risk. Therefore, coordination is an important risk management tool that should be considered when designing market infrastructures and regulations aimed at enhancing financial stability.