Application Background: Coupled Payment Systems

• Goal /Aspiration for Project
• Identify the basic parameters that control the quality of operation of payment systems, and characterize the problems that can arise when performance degrades; identify the effects of coupling among payment systems, and how different policies influence their performance.
• Approach/Methods/Models:
• Develop a parsimonious CAS model of the interbank payment system to study congestion and the role of liquidity markets in alleviating congestion. The model incorporates an endogenous instruction arrival process, scale-free topology of payments between banks, fixed total liquidity that limits banks' capacity to process arriving instructions, and a global market that distributes liquidity.
• Develop a model of multiple payment systems interating through coupled transactions, such as foreign exchange transactions
• Status, Accomplishments and Next Steps
• We find that at low liquidity, the system becomes congested and payment settlement loses correlation with payment instruction arrival, becoming coupled across the network. The onset of congestion is evidently related to the relative values of three characteristic times: the time for banks' net position to return to zero, the time for banks to exhaust their liquidity endowments, and the liquidity market relaxation time. In the congested regime, settlement takes place in cascades having a characteristic size. A global liquidity market substantially diminishes congestion, requiring only a small fraction of the payment-induced liquidity flow to achieve strong beneficial effects.
• Completed development of Loki Transact for 2 connected payment systems in 2009. Loki Transact allows us to evaluate liquidity and credit risks in the context of interdependent interbank payment systems interlinked through foreign exchange transactions. Further interdependence is created by a Payment versus Payment (PvP) constraint that links the two legs of the foreign exchange transactions. Using this model, the team identified conditions under which payment settlement in the two systems becomes correlated and showed that large credit exposures can be generated as the result of liquidity pressures in one of the two systems. PvP can eliminate this credit risk but creates a new interdependence by making settlement of payments in both systems dependent on the level of liquidity available in the other system.
• CASoS Goals: General Capabilities
• Loki-Transact 
• Interacting, adaptive networks
• CASoS Goals: Other Potential Applications
• Design transaction treaties to reduce the risk of unintended, negative or counter-productive outcomes (e.g., use to evaluate carbon trading or monetary policy options).
• Acknowledgements
• This application has been funded the Department of Homeland Security through the NISAC program and builds on capabilities and knowledge developed from working with the New York Federal Reserve Bank and the Bank of Finland staff on model design and problem description.