Journal of Financial Market Infrastructures

Last week a student asked me the following question: "How are the two top floors of the warehouse connected?" She had attended a lecture on real-time gross settlement (RTGS) systems settling in central bank money and a lecture on central securities depositories and TARGET2 Securities. The answer I gave her was that there are at least three ways in which the large-value payments floor is connected with the securities settlement floor (for readers new to this journal, the warehouse as a metaphor for financial market infrastructures (FMIs) was introduced in my editor's letter precisely one year ago).

Firstly, settlement of securities transactions should take place in a delivery-versus payment manner. As number 12 of the Principles for Financial Market Infrastructures puts it: "The FMI should eliminate principal risk by conditioning the final settlement of one obligation upon the final settlement of the other." In the case of securities transactions the two linked obligations are settled on different floors of thewarehouse: the securities settlement takes place on the second floor and the money settlement on the first floor.

Secondly, participants (usually banks) need to have settlement accounts with both floors (directly or indirectly) in order to receive or deliver securities they have bought or sold. Through these participants a large number of connections between the two floors are in place. Such connections are a prime example of so-called institution based interdependencies.

Thirdly, a slightly less obvious connection in the warehouse stems from FMI principle number 9, which states inter alia that an FMI should conduct its money settlements in central bank money where practical and available. Here I told the student to think back to the earlier lecture in which we discussed the question of how central bank money is actually produced in systems such as TARGET2. Luckily, she remembered that the Eurosystem is only able to provide central bank money against eligible collateral and that central securities depositories (CSDs) are the places where a large part of the collateral is held. This also results in a vertical connection between the two floors.

The topic of our winter issue's first paper, "Optimal central securities depository reshaping towards TARGET2 Securities" by Fabien Mercier and Stephan Sauer, is TARGET2-Securities. In terms of the connection between the two floors, TARGET2-Securities can be described as a super connector, connecting many CSDs and at present two RTGS systems. The authors use a game theoretic approach to model the decision problem of CSDs: whether or not they should join TARGET2-Securities and, if so, how their operations and business strategies should be adapted. In the solutions of their model they investigate the degree of optimal reshaping and the optimal prices with finite and infinite horizon.

The second paper in the issue, "Payment system design and participant operational disruptions" by Ashwin Clarke and Jennifer Hancock, focuses on the Reserve Bank Information and Transfer System (RITS), which is the Australian RTGS system. More specifically, the authors investigate the influence of so-called liquidity-saving mechanisms on the potential systemic impact of operational disruptions of participants. Clarke and Hancock find that both the bilateral-offset algorithm and the sublimit feature in RITS generally have a favorable influence, even if there is less liquidity committed to the RTGS system.

The issue's third paper, "Toward a uniform functional model of the financial infrastructure" by Ron J. Berndsen, has a holistic warehouse perspective. Its aim is to provide a uniform way of describing functional concepts for the whole field of financial infrastructures. The basic idea is to have three interacting domains: settlement risk exposures, where settlement risk is initiated; the value space, where it is eliminated; and, thirdly, messages that instruct on how settlement risk should be handled (represented as the information of the instruction life cycle). The framework is applied to a number of examples including the credit transfer, correspondent banking and an over-the-counter securities transaction.

I hope you enjoy reading this issue of The Journal of Financial Market Infrastructures.

Ron Berndsen
De Nederlandsche Bank and Tilburg University

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