Are non-banks really a greater risk to settlement?

The draft of the second Payment Services Directive (PSD2) takes further steps in levelling the playing field between banks and non-banks within the financial infrastructure. But oddly (as I wrote about here) the EU does not go all the way in allowing non-banks access to the clearing and settlement mechanisms (CSMs).

The EU’s reasoning remains unclear to me; perhaps it is a misplaced measure to reduce risk.

Naturally, there are risks involved in admitting non-bank into the ranks of clearing and settlement participants. But then there are risks in every human endeavour. Life is about recognising the risks and then taking the appropriate measures to reduce the chances of the risk occurring or minimising the consequences if it does occur.

But do non-banks really pose a greater risk to settlement or to the system as a whole?

The main risk when considering participation in clearing and settlement is that payment will not be settled as expected and that this will cause counterparties to incur losses. This is settlement risk. If the losses are large enough they may cause a domino effect that could threaten the system as a whole. This is systemic risk.

Settlement risk can occur as the result of a wide variety of causes. The main risks that could be amplified by the admittance of non-banks to the CSMs are:

• that the non-bank defaults and the payment cannot be completed;
• that the non-bank has insufficient cash, or liquidity, in its settlement account and the payment cannot be completed;
• that something in the operational process goes wrong preventing the proper execution of the payment.

Hard lessons in the history of money transfers have made the European clearing and settlement system very robust and resilient in dealing with all facets of settlement risk.

A watershed moment was the default of the Herstatt Bank. On June 26th, 1974 the German bank was unable to cover its liabilities and defaulted. Unfortunately, a number of counterparties with which Herstatt had conduced foreign exchange transactions had already transferred large sums of Deutsch Mark to the bank and were expecting to receive payment in US Dollars later in the day. While the counterparties were waiting to receive payment, Herstatt defaulted and the counterparties would not receive a cent.

The Herstatt default triggered a large number of changes in banking supervision and payment processing. Although the Herstatt losses were especially associated with foreign exchange, similar settlement risk applied to domestic transfers.

Now, forty years and much iteration later, the settlement risk associated with euro payments within the euro zone is minimal, irrespective of the participant.

Firstly, clearing houses that exchange the payment information between counterparties have been using multilateral net settlement since the 1820’s specifically to reduce the liquidity requirements (bilateral netting was already common practice in the Middle Ages).

If a bank has to pay 100 but will also receive 80, the required liquidity that must be freed up in a net settlement system is only 20 (100 minus 80) as opposed to liquidity of 100 if gross settlement is used. Net settlement thus requires less liquidity which reduces transaction costs and reduces the liquidity and settlement risk.

Secondly, clearing houses have been designed to minimise settlement risk in through their method of operation.  During the clearing cycle, the clearing house can remove and reject individual payments if that payment cannot be settled for any reason. This reason can be the default of a clearing participant or insufficient liquidity in the settlement account.

After removing the payment in question, the clearing house will recalculate the remaining batch’s net settlement value and continue with the settlement process. Because the payment was still in the clearing stage and no money changed hands, it is merely an inconvenience as opposed to causing a loss.  

Thirdly, in the Herstatt case, the time difference between the bilateral exchange of value created a lengthy exposure to risk. If the exchange of value between counterparties is done in real-time, this risk is eliminated. As a result, the European payment systems began migrating from deferred net settlement (DNS) systems to real-time gross settlement (RTGS) systems in the 1990’s.

Nowadays, the settlement of Euro payments takes place in Target2, the Eurosystem’s real-time gross settlement system. The fact that it is a RTGS-system means that payments are exchanged immediately, individually and with finality. This also applies to the netted sums of the batch payments that have been processed by the clearing houses that are multilaterally and instantaneously settled in Target2. If the counterparty has insufficient liquidity or has defaulted, the payment will simply be rejected without any exchange of funds.

Finally, the risk of operational errors is not larger for non-bank than it is for banks. To be eligible for a payment institution license or direct participation in a payment scheme, non-bank must prove to regulators and scheme owners respectively that they have robust internal processes. What is more, any CSM participant must complete a mandatory test set to prove their operational capabilities when connection to the CSM.

In short, the European clearing and settlement mechanisms are fairly resilient in dealing with settlement risk.

In my assessment, admitting non-banks as direct participants does not increase the risk associated with settlement or the risks of the system as a whole.

Why then not allow non-bank access?