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.

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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.

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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.

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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

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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

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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.

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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

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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.

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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.

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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.

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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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