A primer on the settlement of payments in the United States.

George R. Juncker, of the Federal Reserve Bank of New York, and Bruce J. Summers and Florence M. Young, of the Board's Division of Reserve Bank Operations and Payment Systems, prepared this article.

In recent years, the soundness of the U.S. payment system, which can be measured by the certainty that payments will settle on schedule, has become a key public policy issue. Payment, or the transmission of an instruction to transfer value that results from a transaction in the economy, and settlement, or the final and unconditional transfer of the value specified in a payment instruction, need not, and in fact generally do not, occur simultaneously. Therefore, the recipient of a payment may face some uncertainty about receiving value even though a payment has been made to him or her. Efforts to reduce the gap of time between payment and settlement, or to ensure ultimate settlement of the payment, contribute to the integrity of the payment system and the efficiency of a market economy.

Four developments have led to the increased public policy attention to payment system integrity and settlement in the United States. First, the daily value of payments has increased significantly because of increased economic activity, growing sophistication and turnover of financial products, and opportunity costs associated with holding non-interest-earning demand deposits. Second, participants in the payment system have become increasingly aware of the credit and liquidity risks associated with clearing and settling payments. Third, the payment process has become more complex because of technological advances and increased emphasis on the efficient processing of payments and their underlying transactions. Finally, new settlement techniques involving netting are being increasingly employed to reduce liquidity requirements and to control risk.

This article examines the role of banks, including the central bank, in the payment and settlement process and explains the use of netting.1 It also describes large-value netting arrangements that settle using the Federal Reserve and identifies issues arising in cross-border and multicurrency clearing arrangements. The article concludes with a summary of domestic and international public policy issues related to settlement.

PAYMENT AND SETTLEMENT

In a modern economy, payment obligations are discharged through the transfer of an accepted monetary asset. In earlier times, the monetary asset could take the form of a commodity, such as gold or silver. Today, most sovereign nations issue fiat money denominated in a national currency unit. Fiat money serves as a store of value and a medium of exchange because it has the public's confidence.

In the United States, the deposits held with banks by their customers, along with bank deposits held with the Federal Reserve, are the monetary assets most frequently used to discharge payment obligations. Accordingly, banks and the banking system are integral to the payment process. In important ways, the safety of the banking system is itself tied to the integrity of the payment system.

A large proportion of economic obligations are discharged primarily through the transfer of demand deposit claims on banks' books. Because a bank can fail, its depositors may bear some default and liquidity risk as a result of their decision to hold bank balances. Banks face no risk in holding deposits directly with the Federal Reserve, however, since a central bank-reflecting its governmental status-is immune from liquidity or credit problems. Thus, balances held with the Federal Reserve, which are referred to as "central bank money," have special significance when used by commercial banks to settle their payments. Settlement in central bank money is universally acceptable because the resulting deposit claim is free of default and liquidity risk.

Banks and the Federal Reserve together provide the settlement infrastructure for the nation's payment system. Commercial banks hold accounts through which the general public's payments are recorded and settled. The many thousands of payments that bank customers make each day result in transfers of balances between banks and therefore affect banks' positions with each other and with the central bank. Of course, banks also make their own payments in connection with carrying out the business of banking. These add to, and are often major sources of, large daily payment flows among banks. Banks can settle these interbank payments through accounts that they hold with each other or through accounts that they hold with a correspondent bank. However, many interbank payments, especially large-value payments, are made through the transfer of balances on the books of the Federal Reserve.

When a bank receives a payment on behalf of its customer, the account holder obtains a deposit claim. If the bank receiving the payment is satisfied that the payment will settle, the bank may make funds available to its customer, that is, it will allow the customer to withdraw, or typically to retransfer, the funds. When a bank makes funds available to its customers before settlement, it is exposed to credit risk because an account holder may withdraw funds and, if settlement does not occur, the bank may not be able to recover the funds. Banks sometimes guarantee the unconditional use of funds to their customers based on the receipt of payments before settlement. In this case, the bank is providing a credit service as well as a payment service to its customer by assuming the risk that settlement may not occur as scheduled. When settlement occurs at the same time the payment is made, however, settlement risk is eliminated for the bank and its customer.

THE WAY PAYMENTS ARE MADE Most payments in the United States are still made with cash (currency and coin). In cash transactions, an instantaneous transfer of value occurs, and thus settlement and payment are simultaneous. Cash is used to settle the largest number of transactions, but it accounts for only about I percent of the total value of payments.

Checks are the next most popular type of payment, but they too still account for only a small portion, about 15 percent, of the total value of payments in the United States. When a check is received as payment, the payee must "collect" the value of the check by presenting the check to the bank upon which it is drawn so that settlement can occur. Consequently, payment by check can precede settlement by as much as several days. Banks, including Federal Reserve Banks, treat check deposits as deposit balances based on the ability to present the checks for collection to the banks on which they are drawn. Because checks can be returned, settlement does not truly occur until statutory deadlines governing the return of checks have passed.(2)

The automated clearinghouse (ACH) has been designed as a low-cost substitute for paper payments; and, while still used primarily for consumer payments, this mechanism is increasingly being used for business-to-business payments. Settlement for ACH payments occurs sometime after the payment is made, generally the next day or even the second day after the transaction. ACH payments take two forms. In ACH debit transactions, the receiver of the payment initiates the payment instruction, which must be honored by the party making the payment (like a check). In ACH credit transactions, the party making the payment initiates the payment instruction (like a funds transfer). It is estimated that between 0.5 percent and 1 percent of all payments, accounting for about 1 percent of the value of all payments, are made by using the ACH.

Two electronic funds transfer systems-Fedwire, operated by the Federal Reserve Banks, and the Clearing House Interbank Payment System (CHIPS), operated by the New York Clearing House-account for less than 0.1 percent of the number of all payments in the United States; however, they account for more than 80 percent of the value of payments. When a Fedwire payment is processed, the Federal Reserve debits the account of the sending bank and credits the account of the receiving bank. Payment instructions are for the immediate delivery of "central bank money," and Fedwire payments are settled when the amount of the payment is credited to the receiving bank's account with the Federal Reserve or when the receiving bank is notified of the payment. The Federal Reserve "guarantees" the payment to the bank receiving the Fedwire and assumes any credit risk if there are insufficient funds in the Federal Reserve account of the bank sending the payment.

Payments processed over CHIPS, however, are settled only when CHIPS participants fund their net obligations resulting from the day's payment instructions over CHIPS at the close of the business day. Settlement of CHIPS obligations occurs by Fedwire transfers initiated by those in a net debit position for the day's CHIPS activity. If the bank receiving a CHIPS payment makes funds available to its customers before settlement occurs at the end of the day, it is exposed to some risk of loss if CHIPS settlement cannot occur. To ensure that settlement occurs, the New York Clearing House has put in place risk control mechanisms (see description below).

Book-entry transactions involving U.S. government securities are cleared and settled over Fedwire, through a delivery-versus-payment mechanism. With this mechanism, one form of value (in this case, U.S. government securities) is simultaneously exchanged for another form of value (in this case, a balance with a Federal Reserve Bank). When book-entry transfers are processed, the sending bank's securities account at the Federal Reserve Bank is debited and its funds account is credited for the value of the sale. When the securities are delivered to the receiving bank, the receiver's funds account is debited and its securities account is credited. Payments to the banks sending book-entry securities are settled through the transfer of central bank balances. As with regular Fedwire payments, the Reserve Banks may extend intraday credit to receivers of book-entry securities transfers and therefore expose themselves to some credit risk.1 In the United States, some other types of securities are cleared through privately operated book-entry transfer systems. These systems operate somewhat differently than Fedwire and settle on a net basis at the close of business in a way similar to that of CHIPS.

As indicated, the Federal Reserve Banks extend intraday credit to banks in conjunction with the payment services they provide. Similarly, banks often extend intraday credit when they make payments on behalf of their customers. Thus, both the Federal Reserve and private banks are exposed to credit risk in processing payment transactions. Private banks are also exposed to liquidity risk.

Banks typically control their risk by establishing intraday credit limits for their customers and by monitoring their customers' use of such credit. In some cases, banks require their customers to pledge collateral to cover daylight credit exposures. The Federal Reserve Banks have also adopted risk control procedures: They use "net debit caps" (or ceilings for net debits) to limit the amount of credit extended to individual banks that use Federal Reserve payment services. The Reserve Banks monitor the use of intraday Federal Reserve credit for healthy banks, in most cases, by examining historical data through an ex post monitoring system. Online, real-time account monitoring is used for the continuous control of intraday credit for certain institutions, especially those under financial stress. Real-time monitoring enables the Federal Reserve to reject or hold funds transfer requests pending the availability of funds to cover them. In some cases, the Reserve Banks may also require banks to pledge collateral to secure the intraday credit they use.

GROSS VERSUS NET SETTLEMENT

The settlement of payments occurs on either a gross or a net basis. When payments are settled on a gross basis, each transaction is settled individually. For example, Fedwire is a gross settlement system. When payments are settled on a net basis, the parties to the payments offset the amounts they are due to pay and receive with each other (or with a central party, or clearinghouse) and maintain a running balance of the netted amounts. The offsetting of payable and receivable amounts can occur between two parties (bilateral netting) or among many parties (multilateral netting).

In markets characterized by a high volume or high value of transactions among a fixed group of participants, net settlement typically improves the efficiency of payment processing; reduces liquidity needs; and, depending on the type of legal foundation and risk controls used, can help control credit exposures. Netting may be applied in many real and financial markets. For example, petroleum companies active in trading crude oil have bilaterally netted their oil trades for many years and have also participated in a multilateral netting arrangement. Many organized exchanges for commodities and securities also employ forms of netting, usually through formal clearinghouses. Banks themselves actively participate in clearinghouses through which they exchange and net payment transactions.

Bilateral Netting

Interbank payments are often cleared and settled in bilateral arrangements. For example, two banks that exchange large volumes of payments may agree to exchange certain types of payments, such as checks or ACH items, and settle the net value of the payments between themselves at a specific time. This type of agreement reduces the value of settlement between the two banks participating in the exchange because they can total the net value of customer transactions payable to and receivable from each other and substitute a single, smaller, net settlement (see box 1). Two banks may also enter into an agreement to net financial contracts, such as those involving foreign exchange, and settle the net amount resulting from the trading. Multilateral Netting When three or more institutions participate in a clearing and settlement arrangement with netting, the arrangement is called multilateral netting. Banks form multilateral netting arrangements for various payments and financial contracts, including checks, ACH transactions, and large-value funds and securities transfers. Such arrangements typically have the potential to reduce the number and the overall value of settlements well beyond the reductions that can be realized through bilateral netting (see boxes 1 and 2 for examples).

Participants in multilateral netting arrangements may exchange transactions either at a single designated time (which is typical for a paper-based payment system, such as checks, or for electronic systems that process in a batch mode, such as ACHS) or within a specified period of time (as with some large-value funds and securities transfer systems). An agent for the netting group typically calculates each participant's position based on the value of payments that the participant has made and received within the netting cycle, which is usually one day. Institutions that have made a greater value of payments than they have received must transfer money to the clearing group, whereas participants that have received a greater value of payments than they have made receive money from the clearing group. The sum of all participants' obligations must equal zero.

Box 2 shows a simple numerical example of a funds transfer netting arrangement involving four participants; it illustrates settlement from the perspective of the clearinghouse. In this example, if the four banks did not participate in the clearinghouse, they would collectively need to make a total of ten interbank settlement payments with an aggregate value of 800 in connection with the underlying customer payments. As a result of multilateral netting, only one participant (Bank D) has an obligation to transfer money to the clearinghouse, and the clearinghouse must transfer money to three participants. Multilateral netting and the use of a clearinghouse have allowed these efficiencies to occur.

In multilateral netting arrangements that do not involve banks, each participant's net money position is typically settled through a "settlement bank." When the parties to the arrangement are themselves banks, the settlement bank may be but does not have to be-the central bank. If the settlement bank maintains accounts for all participants, settlement can occur by the posting of each participant's net debit or credit position to its account. Alternatively, if participants rely on several settlement banks, institutions in net debit positions may be required to fund their positions by transferring money to the settlement banks of participants that are in net credit positions.

When the central bank acts as the settlement bank, a special settlement account may be used to collect the settlements made by the parties with net debit obligations. The special settlement account is opened at a designated time, and institutions in net debit positions send Fedwire payments to fund the account. After the account is fully funded, the agent for the clearing group originates Fedwire transfers from the account to participants in net credit positions. After all funds transfers have been made and the account balance is zero, settlement of all underlying payments is complete.

Risks in Netting Arrangements

Two types of risk arise in bilateral and multilateral netting arrangements: namely, credit and liquidity risk. A third type of risk, systemic risk, may also be present in multilateral netting arrangements. These three types of risk are described in box 3.

In the case of bilateral netting arrangements, banks must evaluate the credit and liquidity risk assumed with the bank on the other side of the bilateral netting arrangement-the "counterparty." If there is doubt about a counterparty, a bank receiving payments from the counter-party on behalf of a customer may choose not to allow the customer access to the funds until settlement has occurred.

A mutualization of the credit risk occurs when more than two banks participate in a netting arrangement. In particular, the timely completion of all the underlying gross transactions that are included in a multilateral netting depends on the ability of each party to meet its single net settlement obligation arising from the netting. If even one participant fails to meet its net settlement obligation, then settlement for all the underlying transactions could be delayed or otherwise disrupted, creating credit and liquidity risks for the participants. Indeed, even a bank that has no dealings with the participant in a multilateral netting that does not settle may be exposed to risk. For example, in the situation described in box 2, participant A has no direct dealings whatsoever with participant D: A does not make payments to D, nor does it receive payments from D. Nonetheless, participant D has a net obligation to the clearinghouse of $150, and participant A's net credit of $75 would be funded from participant D's settlement. Accordingly, participant A depends on participant D to meet its settlement obligation, even though the two have exchanged no payments.

The risks created by privately operated netting arrangements cannot be eliminated, but they can be effectively controlled and limited. The risks cannot be eliminated because extensions of credit between privately owned institutions are an inherent part of such arrangements, and these extensions of credit are subject to some degree of default risk. Two types of risk control systems are used-decentralized and centralized. In netting arrangements based on a system of decentralized controls, the individual participants are responsible for controlling their risk vis-a-vis the other participants with whom they deal as counterparties in the individual transactions (CHIPS is an example of a decentralized risk control arrangement).4 In contrast, systems with centralized controls typically rely on a central body that becomes the counterparty-usually a clearing-house-to every transaction cleared through the system: The central counterparty becomes a "buyer" to every seller and a "seller" to every buyer (clearing bodies in the futures and options markets are examples of centralized risk control arrangements).

Clearing arrangements that use either decentralized or centralized risk controls use combinations of the following techniques. To protect participants against credit risk, many clearing organizations establish membership standards, which are used to screen participants when they apply to participate in the arrangement and which are monitored on an ongoing basis. Some clearing organizations require each participant to establish bilateral credit limits with every other participant whereby the volume of payments received from each other participant can exceed the volume sent to each other participant only by a predetermined amount. Bilateral credit limits thus provide a mechanism for controlling the risk that the participants face in exchanging payments with each other participant in the arrangement. To the extent that participants agree to share losses arising from the default of one or more other participants and that these loss-sharing arrangements are tied to the bilateral credit limits, incentives are created for each participant to manage its bilateral credit positions prudently.

Credit and liquidity risks may also be controlled by imposing limits on the net debit position of each participant. Such limits reduce the risk that any one participant may impose on the group and may be related in principle to each participant's ability to fund its dady settlement obligation. Assuming that such limits, or net debit caps, are set realistically, their use reduces the potential that an individual participant will be unable to settle its position at the close of business.

To handle settlement defaults, some clearing groups rely on settlement recasts and unwinds. In a recast, all of the defaulting participant's payments are deleted from the settlement, and the net settlement positions of the remaining participants are recalculated. As a last resort, if a clearing group is unable to achieve settlement after more than one recast, then it may decide to unwind all transactions. This procedure essentially requires all the participants to settle independently with each other.

For small-value arrangements, settlement recasts may be able to address both liquidity and credit risk without serious systemic implications. If a participant defaults, the clearing group relies on the resources of each remaining participant to fund its adjusted settlement position on the settlement day. Further, by removing all of the transactions of the defaulting participant, a settlement recast automatically allocates the losses associated with the default to the participants that dealt with the defaulting participant. Such an approach to resolving a settlement default is viable only when the value of payments exchanged is relatively low and the potential change in participants' settlement obligations is relatively small and can be funded easily by the remaining participants.

In a large-value netting arrangement, the recast of the settlement could remove significant credits that other participants were relying on to meet their own obligations and thus cause them to be unable to settle. Therefore, recasts or unwinds can be a significant source of systemic risk.

To avoid the undesirable effects of a recast, large-value multilateral netting arrangements-such as CHIPS-may provide special "assurances" of settlement akin to "guarantees." The nondefaulting participants may, for example, agree in advance to share the burden of meeting the defaulting participant's obligation to allow settlement to occur on schedule. Lines of credit or pools of collateral may be maintained, either of which can be used for overnight borrowing to provide the funds to achieve settlement on the day of the occurrence. In such arrangements, the nondefaulting participants would share losses after the settlement had occurred, based on some method of loss allocation agreed upon in advance. Such arrangements would help prevent the sudden market disruptions that might otherwise occur with recasts or unwinds.

Legal Basis for Netting

Netting must have a sound legal basis for the settlement to be certain. In particular, in the event that a participant in the netting becomes insolvent, it is important that the net obligations of the participants be legally recognized so that a receiver of the insolvent participant is not able to cherry pick," that is, accept incoming payments while voiding outgoing payments.

A variety of legal approaches may be used to net obligations. For example, netting by novation would substitute a new legal obligation each time an additional payment instruction is sent or received. Netting among several participants in an arrangement may be accomplished by placing an intermediary between the counterparties so that all obligations are due to or from this new intermediary. These approaches are applicable to the netting of financial contracts, such as foreign exchange deals, as well as to payments. Recent work by the Group of Ten central banks has emphasized the need for significant netting arrangements to have sound legal foundations.1

LARGE- VALUE NET SETTLEMENTS USING CENTRAL BANK SERVICES

In the United States, central bank net settlement services support two quite different types of private sector large-value netting arrangements. The first type is a "pure" payment netting arrangement in which credit transfers are processed among participants, with settlement across the Federal Reserve's books at the end of the day. The second type of netting involves payments arising from the exchange of a certain type of asset, such as securities transactions. As with the first type, the net payments arising from the asset transfers may be settled across the Federal Reserve's books at the end of the day.

Payment Netting Arrangements

At present, CHIPS is the only "pure" payment netting arrangement for large-value transfers operating in the United States.6 It is the largest payment netting system in the world and processes nearly $1 trillion in payments daily. It has about 130 participants, the majority of which are branches or agencies of non-U.S. banks. Only twenty U.S. participants, however, are settling participants that actually send or receive net payments to settle on behalf of themselves and other, nonsettling participants.

Since its inception in 1970, CHIPS has adopted a variety of measures to control and reduce credit and liquidity risk. Currently, it employs admission standards; bilateral credit limits, which are used by each participant to establish its maximum exposure to each other participant in the event of a default; net debit caps, which are based on all bilateral credit limits established for each participant; explicit loss-sharing rules, which are based on the bilateral limits; and collateral requirements to ensure timely settlement.

Since moving to same-day settlement in 1981, CHIPS has used a special settlement account with the Federal Reserve Bank of New York to settle each day. Immediately after the system closes for the day at 4:30 p.m. eastern time, participants are notified of their final net settlement obligations. The settlement payments for the twenty U.S. banks that settle directly for themselves and the other participants are made over Fedwire into the special settlement account at the Federal Reserve Bank of New York.

If any participant fails to settle, the loss-sharing rules are invoked. In essence, an additional settlement obligation (ASO) is calculated for each participant that dealt that day with the defaulting member to make up that member's unpaid obligation, and the participants are given a reasonable period of time to cover this ASO. If any participant faded to meet its ASO, U.S. government securities held in a special CHIPS collateral account at the Federal Reserve Bank of New York would be tapped to collateralize a loan in the market to use for ensuring timely settlement. Sufficient collateral is kept in the special CHIPS account to cover any one participant's largest potential uncovered net debit. In certain cases, there would be sufficient collateral to cover several simultaneous defaults by participants with smaller uncovered net debits.7 Thus, the CHIPS collateral account ensures timely settlement for all but cataclysmic default situations.

Delivery-versus-Payment Arrangements

In contrast to a payment-only netting system like CHIPS, the Federal Reserve also directly supports net settlement for two arrangements in which payments associated with the clearing of financial instruments are netted and settled across Fedwire. The Participants Trust Company (PTC), a specialized clearing and settlement arrangement for mortgage-backed securities, uses a risk-control system and settlement process roughly similar to those of CHIPS. Like CHIPS, PTC monitors intraday positions in real time and allows transfers of securities only if the amount of the resulting settlement obligations is within specified limits. Unlike CHIPS, which employs decentralized risk management techniques, PTC employs a centralized risk management system in which PTC is the central counterparty to each transaction accepted into the system and is responsible for the settlement obligations. To ensure timely settlement, PTC retains collateral rights to the securities it is transferring and stands ready to pledge this collateral to obtain liquidity by borrowing against prearranged credit lines should a participant fail to cover a settlement obligation at the end of the day.

PTC's settlement procedures at the end of the day are similar to those of CHIPS. Settlements are made over Fedwire into a special PTC settlement account at the Federal Reserve Bank of New York. After participants in a net debit position fully cover their obligations, PTC initiates transfers to the net creditors. In the event that a participant failed to cover its net debit position, PTC would activate its secured credit lines to achieve settlement.

Depository Trust Company (DTC) operates a swne-day-funds settlement (SDFS) system, which is used to clear and settle new issues, redemptions, and trades for a variety of installments, including commercial paper. This system uses Fedwire to settle and operates much like PTC. Unlike PTC and CHIPS, however, DTC's SDFS system does not employ a special settlement account but rather relies on DTC's regular account at the Federal Reserve Bank of New York to receive transfers from and make transfers to settlement banks acting on behalf of system participants. DTC does, however, provide the New York Reserve Bank with settlement data and notifies it when the settlement is complete. Like PTC, it uses securities held in the system as collateral to support credit lines that supplement its own liquid reserves to ensure timely settlement.

CROSS-BORDER AND MULTICURRENCY SETTLEMENT

The U.S. dollar is a key international currency. Many U.S. dollar payments are made "off shore" in connection with a variety of real and financial transactions. Banks around the world use a variety of techniques to settle these payments.

In general, the simplest form of clearing payments outside the home country of a currency is across the books of a single correspondent bank. That is, if X, a bank located in London, wishes to pay U.S. dollars to Y, a bank located in Germany, and both X and Y hold accounts at the same correspondent bank in New York, X may order (typically electronically) the New York correspondent bank to transfer funds from its account to that of Y. If X and Y do not hold accounts at a common correspondent bank, further intermediation will be involved. The correspondent bank need not be resident in, or even chartered in, the United States to perform these account transfer functions involving the U.S. dollar. Interbank settlement for off-shore U.S. dollar payments may become even more elaborate. A concrete example may help explain how interbank settlement occurs for cross-border payments involving the U.S. dollar.

Chase-To o Dollar Clearing

In Tokyo, the Chase Manhattan Bank (Chase) operates a dollar clearing arrangement primarily to serve the Japanese and Asian interbank markets. Operating during the Tokyo business day before U.S. markets open, correspondent customers of Chase move dollar payments by sending and receiving payment orders that result in credits and debits to customer accounts at Chase's Tokyo branch throughout the day. Once Chase posts a payment to an account, the payment is final, Chase stands behind it, and the customer may withdraw funds. Some customers are allowed to overdraw their dollar accounts at the Chase-Tokyo branch during the Tokyo business day within specified limits, with the understanding that such overdrafts will be covered in New York during the U.S. business day. U.S. dollar account balances held at Chase-Tokyo at the end of the Tokyo business day can be moved by advising Chase-Tokyo to transfer part or all of the balance in New York during the U.S. business day beginning some fourteen hours after the Tokyo business day begins. These funds typically are transferred by Chase and its customers in Tokyo through their U.S. branches or through U.S. correspondent banks over CHIPS.

The Chase-Tokyo clearing arrangement for U.S. dollars is based on correspondent banking relationships with customers. Nonetheless, it differs from traditional correspondent banking in at least two ways. First, Chase's customers contract to participate in a specific loss-sharing arrangement to reimburse Chase on the next business day if a participant defaults. Second, in part because of the mutualization of risk resulting from the loss-sharing, the arrangement operates as a system with some of the same kinds of interdependencies that arise in a multilateral netting arrangement.

Foreign Exchange Settlements

The latest international estimate (as of April 1989) of the size of the foreign exchange (FX) market put average daily turnover conservatively at $650 billion.8 The settlement of these transactions may represent the single largest global demand for payment services and is believed to account for a substantial proportion of payments made over the large-value funds transfer systems in countries with key international currencies. The traditional settlement practices for foreign exchange contracts, however, present special risks, since the settlement of these contracts typically involves payments and counter-payments that are settled at different times in different countries. For example, in a yen-dollar transaction, the yen leg must be settled in a yen arrangement and the dollar leg in a dollar arrangement. The party making the yen payment would be exposed to settlement risk from the time the payment was made during the Japanese business day until the dollar counterpayment was received during the U.S. business day. At a minimum, this period represents about an eight-hour exposure and could reach almost twenty hours or more, depending on when individual payments were actually processed.9 This temporal risk, during which payment has been made in one currency but not yet received in another currency because of time zone differences, is often termed "Herstatt" risk, as a result of the 1974 failure of a German bank, Bankhaus Herstatt. Bankhaus Herstatt failed at the end of the German business day, after mark payments had been made on the mark leg of a mark-dollar transaction, but before the end of the business day in the United States and thus before U.S. dollar payments in the United States were fully completed. Therefore, parties that had made payments and were owed dollars for the transactions did not receive dollar payments as scheduled.

Recently, the private sector has made strides in addressing risks in the FX market by developing bilateral netting arrangements that reduce both the number and value of payments necessary to support the settlement of the underlying contracts. The central banking community has been monitoring existing and proposed arrangements out of concern that the netting arrangements should in fact reduce risks and not just disguise them. In fact, in November 1990 the Group of Ten central banks adopted minimum. standards for cross-border multicurrency interbank netting schemes.10

While the bilateral netting of FX transactions appears to be gaining market acceptance, such an arrangement does not exhaust the operational efficiencies or potential risk reductions that well-designed multilateral netting could offer. Two groups of banks, one in Europe and one in North America have explored multilateral netting of FX contracts. These groups have also explored the appropriate risk management facilities and operational capabilities to support multilateral netting and cross-border, multicurrency settlement for FX transactions.

Major challenges appear to remain. Indeed, finding a safe and efficient delivery-versus-payment mechanism that ensures the simultaneous settlement of payments in two or more currencies and virtually eliminates Herstatt risk remains both a goal and a challenge for market participants.

PUBLIC POLICY ISSUES

The United States has for decades had a payment system that achieves timely and reliable settlement. The banking system, including commercial banks, their clearing organizations, and the Federal Reserve, have played an active part in supporting the payment and settlement needs of the economy.

As noted in the introduction, however, public policy concern about the U.S. payment system has increased, especially with regard to the integrity of the settlement process. In large measure, this concern is related to the dramatic increase in daily payment flows, which in 1980 represented only about twelve times average reserve balances held with the Federal Reserve and today represent about fifty-five times reserve balances.

The increased demand for payment services is explained partly by the extensive reliance throughout the world on the U.S. dollar as a reserve currency and as a vehicle currency in foreign transactions. This reliance on the U.S. dollar is illustrated by the predominance of CHIPS payments that are related to settling the U.S. dollar part of FX transactions-an estimated $650 billion of the $1 trillion of daily CHIPS payment flows are related directly to FX settlement. However, the attractiveness of the U.S. dollar as an international currency depends partly on the efficiency and soundness of its settlement arrangements. Moreover, from an international standpoint, the efficiency and soundness of national payment systems are becoming increasingly interlinked because of the need to make and settle the growing number and variety of off-shore, cross-border, and multicurrency payments.

The current context of public policy therefore is global. Participants in the payment system rely on settlement banks that engage in various businesses and provide services to domestic and foreign customers who rely on several currencies, the most important being the U.S. dollar. As technology and designs for settlement systems have evolved and have permitted more efficient interbank settlement of payments, there has been a commensurate increase in the sharing of risks among the participants in such arrangements through their clearinghouses and clearing organizations. Ensuring that these risks are properly managed presents an enormous challenge. Account holders at a bank whose particular patterns of payment may not directly require the use of a complex interbank netting arrangement are at least indirectly dependent on the successful operation of such an arrangement through the settlement bank on which it relies.

For these reasons, the Federal Reserve, as well as other central banks, has become more interested in and concerned about the safe and reliable operation of various types of interbank netting and settlement systems. The Report of the Central Banks of the Group of Ten Countries on Interbank Netting Schemes identifies minimum standards that netting systems should meet. Moreover, central banks have a great and continuing interest in the safe, efficient, and reliable operation of payment systems, such as those described in this article.

This review of U.S. netting and settlement systems suggests four public policy issues that will likely occupy the attention of bankers. First, how safe should netting arrangements be? At a minimum, the risk management systems for these arrangements should be designed to ensure settlement in the event of the default of the single largest participant. Should the risk management systems do more? If so, what is the trade-off between the costs incurred by banks to strengthen these systems further and the benefits to be gained by banks and the public?

Second, to what extent should the interdependencies among settlement systems with common participants be recognized in the calculations regarding risk management? For example, the same institution may have settlement obligations and settlement credits arising each day across netting and settlement systems associated with different markets (say, CHIPS for FX, PTC for mortgage-backed securities, DTC for commercial paper, and so forth). The sound and efficient management of settlement risk may well be a cross-system issue.

Third, to what extent can the temporal risk related to cross-border, multicurrency settlement be addressed through improved international settlement arrangements? The formation of multilateral foreign exchange clearinghouses is one possibility; this approach, however, itself raises fundamental questions about the payment infrastructure in different countries that must be used to effect actual settlement. The key issue here may be the desirability of extended payment system operations by central banks-perhaps even around-the-clock operations.

Finally, in the normal course of business, U.S. banks participate in off-shore payment and netting systems and assume large settlement obligations, or receive large payments, denominated in foreign currencies. The soundness of these banks may depend to some extent on the exposures and risk controls in these systems. Much needs to be known in the United States about the operation of these systems to develop the same understanding that authorities have about U.S. systems.

In conclusion, the integrity of the U.S. financial system depends on the safety and soundness of the settlement process for U.S. dollars. Much progress has been made to increase confidence in the proper functioning of the arrangements that together constitute the settlement process. But, as the questions raised here suggest, much remains to be done.