Current Trends in Payment Systems: A Microstructure Approach Presentation at the Future of Payments Conference Bank of England May 20, 2005 James McAndrews Federal Reserve Bank of New York Payments Studies Function The views expressed in this

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Current Trends in Payment SystemsA
Microstructure ApproachPresentation at the
Future of Payments ConferenceBank of EnglandMay
20, 2005James McAndrewsFederal Reserve Bank of
New YorkPayments Studies FunctionThe views
expressed in this presentation do not necessarily
reflect the views of the Federal Reserve Bank of
New York or the Federal Reserve System.
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Definitions of Payment Economics

• 1. The industrial organization of money.

2. The market microstructure of money.
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Inside and outside money

• The study of the microstructure of outside money
  focuses on the study of large-value payment
  systems and the money market.
• The study of the microstructure of inside money
  focuses on the study of small-value payment
  systems.

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Analogies to security market design

• An RTGS is analogous to a continuous auction
  market.
• Transfers of funds occur throughout the day.
  Prices are fixed. Information is revealed about
  counterparties over time.

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Analogies to security market design

• An DNS is analogous to a call market.
• Transfer orders are cumulated throughout the day,
  and net amounts are transferred. Fund transfers
  are economized because of netting of offsetting
  transfer orders.

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Analogies to security market design

• A limit payment order system, such as RTGS, is
  analogous to a limit order book.
• Transfer orders are prioritized into limit and
  express orders. Express orders can cross or
  hit preexisting limit orders.

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Microstructure of LVPS

• Participation is typically restricted to banks.
• Funds typically available from central bank (for
  public systems) during the day.
• Typically intended to settle debt of fixed
  nominal value.
• With costly liquidity, or counterparty risk, can
  result in a situation of supplying funding
  strategically.

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Clustering

• Clustering of trades occurs in securities
  markets.
• Similar effects have been shown for Fedwire,
  where clustering of transfers reduces funding
  costs.
• DNS can select among multiple equilibria in
  clustering.

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Transparency

• Transparency in limit order book security markets
  has been an important issue in financial market
  microstructure.
• In some theoretical models transparency can
  reduce information problems, but empirical
  results are mixed.

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Payment systems and the money market

• Public LVPS usually are the settlement system for
  money market transactions.
• The demand and supply for overnight funds are
  heavily influenced by the net flow of payments
  for a bank.
• Other microstructure factors are the availability
  of intraday funds, the reserve accounting rules,
  presence of a discount window, design of payment
  system, presence of brokers,

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Inventory effects in the money market

• A number of papers in the microstructure
  literature suggest that inventory effects can be
  important in securities markets.
• In dealer markets, dealers prices are monotone
  decreasing in inventory
• Low inventory an increased willingness to buy,
  and a decreased willingness to sell. Raise both
  bid and ask prices.

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Inventory effects in the money market

• Furfine (1999) showed that there was considerable
  concentration in the federal funds market the
  top 5 participants bought 34 percent of fed
  funds, and sold 38 percent of fed funds.
• I treat several large participants as dealers and
  test whether their prices are sensitive to
  inventorytheir balances at a particular time of
  day.

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Inventory effects in the money market
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Inventory effects in the money market
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Inventory effects in the money market

• Data all trades from October 2001-December 2004
  (Furfine 1999).
• Balances of banks divided by their transactions
  deposits.
• The value-weighted average of the midpoint of the
  interest rate on fed funds sales and fed funds
  purchased over a 15 minute period.

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Inventory effects in the money market

• I regress the midpoint minus the target rate over
  the period 400-415 p.m. on the banks
  transaction balances at 400 p.m., and many
  calendar effects, fixed effects, and indicator
  variables for days of rate increases and
  decreases.
• I then redo the exercise for the period 430 to
  445.

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Inventory effects in the money market
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Inventory effects in the money market
Many significant effects were found for reserve
maintenance days, with softer quotes later in
the period. Many calendar effects are
significant. Rate change days are associated with
(midpoints target rates) that are, for example,
slightly lower on days of rate increases.
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Microstructure and payment systems
How would effects change were Fedwire a DNS
system? One principle of large-value payment
system design is that the money market effects of
the design should be carefully considered.
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Trends in payment systems
Long-run move to RTGS. Move to greater
interlinkages. Recent move to limit payment order
systems. Technological developments could affect
best way to trade federal funds.
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Summary
Payment systems can be studied using modeling and
empirical lessons of financial market
microstructure. Viewed this way, the importance
of the relationship between the money market and
the payment system is apparent. Trends toward
greater flexibility in payment submission and in
linkages between systems are reflected in other
financial markets.