Payments in the wholesale financial markets can be made in central or commercial bank money. The co-existence of these two settlement assets basically reflects a trade-off between the objectives of containing systemic risk and enhancing the efficiency and (in particular) the effectiveness of payments.
Systemic stability, efficiency and effectiveness depend crucially on the ability to make payments safely and smoothly. The malfunctioning of a payment system would be likely to pose systemic risk. A chronically underperforming payment system would make individual financial transactions riskier and impose frictional costs on the financial markets and the underlying economy.
A safe and smooth payment system is critically reliant on:
• the operational soundness of the settlement institution;
• the credit and liquidity of the settlement institution and its settlement asset.
It is in order to mitigate these operational, credit and liquidity risks that central banks — for whom systemic stability, efficiency and effectiveness are core objectives — act as settlement institutions and offer central bank money as the settlement asset in their own currencies. Central banks are able to provide a higher level of assurance than can commercial banks of continuity in the provision of payment services and liquidity. Nor are they exposed to commercial risks.
However, notwithstanding the inherent advantages of central bank money, all developed economies now use central bank and commercial bank money in tandem, in other words, central and commercial bank money are interconnected. Central banks only encourage or require the use of central bank money in systemically-important payment systems (SIPS), which are at the apex of payment activity in each economy, where exposures are generally highest and most concentrated, and where participants have the least control over their exposures. Thus, in most central bank payment systems, only some banks are direct participants and settle in central bank money, whereas the others use the cash settlement agency services of a direct participant to make and receive payments from other banks, producing a tiered architecture in payment activity.
The Interconnectivity of Central and Commercial Bank Money in the Clearing and Settlement of the European Repo Market [ICMA]
(See Annex: Illustrating the flows of central and commercial bank money in repo clearing and settlement in Europe)