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FINAL VERSION: 5/23/2007
IMF SEMINAR ON CURRENT DEVELOPMENTS IN
MONETARY AND FINANCIAL LAW
“LAW AND FINANCIAL STABILITY”
International Monetary Fund
Washington, D.C.
(October 23–27, 2006)
Legal and Policy Aspects of the Central Bank’s Role in the Payment
System: Some Costs and Benefits of the Choice of Settlement Asset
Christian A. Johnson ∗
Robert S. Steigerwald ≠

Introduction
Standing at the apex of the tiered account relationships through which interbank
payments are typically settled, central banks have long played a critical role as
payments intermediaries. 1 In particular, central banks have long performed the
function of “. . . providing banks with deposits and a means of transferring them
to make interbank payments,” 2 a function Jeffrey Lacker, President of the
∗

Professor, Loyola University Chicago School of Law.

≠

Senior Financial Markets Advisor, Federal Reserve Bank of Chicago. The views
expressed herein are solely those of the authors and do not necessarily reflect those of the
Federal Reserve Bank of Chicago or the Board of Governors of the Federal Reserve System.

1

See, e.g., Millard, S. and V. Saporta, “Central banks and payment systems: Past, present
and future,” Background Paper, Bank of England Conference on “The Future of Payments”
(London, May 2005) at 2; Green, E., and R. Todd, “Thoughts on the Fed’s Role in the Payments
System,” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 25, No. 1 (Winter 2001) at
12, et seq.; see also, McAndrews, J. and W. Roberds, “Payment Intermediation and the Origins of
Banking,” Federal Reserve Bank of New York, Staff Report No. 95 (Sept. 1999)(examining the
important role banks have historically played as payments intermediaries).

2

Lacker, J., “Central Bank Credit in the Theory of Money and Payments,” Remarks at the
Economics of Payments II Conference, Federal Reserve Bank of New York (New York, March 29,
2006) at 2-3 (citing Quinn & Roberds, infra); see also, Quinn, S. and W. Roberds, The Big
Problem of Large Bills: The Bank of Amsterdam and the Origins of Central Banking,” Federal
Reserve Bank of Atlanta, Working Paper No. 2005-16 (August 2005).

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FINAL VERSION: 5/23/2007
Federal Reserve Bank of Richmond, has called “. . . the fundamental core of
central banking. . . .” 3 Of course, payment systems, as the discussion in this
paper will indicate, have specific legal, technical, operational and other
institutional characteristics, which may differ from time-to-time (reflecting
technological and other developments), country-to-country (principally reflecting
legal, regulatory and policy considerations) and system-to-system (reflecting the
needs of payment system users and others). 4 As a result, the precise function
central banks, as opposed to commercial banks, perform in the payment system
may vary considerably depending upon the institutional characteristics of the
payment system.

Some payment systems, such as the Fedwire® Funds Transfer system in the
United States, are “real-time gross settlement” (or “RTGS”) systems, in which
each payment instruction is processed individually (in “gross”), on an instructionby-instruction basis. 5 Each payment is settled individually by means of a credit

3

Id.

4

The Committee on Payment and Settlement Systems of the central banks of the Group of
Ten countries (“CPSS”) defines a “payment system” as: “. . . a set of instruments, banking
procedures and, typically, interbank funds transfer systems that ensure the circulation of money.”
CPSS, Red Book on Payment and Settlement Systems in Selected Countries (Basel: Bank for
International Settlements, April 2003); see also, CPSS, Core Principles for Systemically Important
Payment Systems (Basel: Bank for International Settlements, January 2001)(“technical
infrastructure” is one of the key elements of a typical payment system).

5

For a glossary of key terms relating to payment system design and operation, see CPSS,
A Glossary of Terms Used in Payments and Settlement Systems (Basel: Bank for International
Settlements, March 2003).
For references to other materials relating to payment, clearing and settlement systems, see
Johnson, C. and R. Steigerwald, “The Financial Services Lawyer’s Bookshelf: A Selected
Bibliography Of Payment, Clearing And Settlement Resources,” The Journal of Payment System
Law (October 2006).

2

FINAL VERSION: 5/23/2007
transfer at a Federal Reserve Bank. 6

The Canadian Large Value Transfer

System (“LVTS”), by contrast, is a net settlement system, or more precisely, a
“continuous net settlement” (or “CNS”) system, 7 rather than an RTGS. LVTS
utilizes “real-time net processing,” in which the net (as opposed to gross)
payment obligations among system participants are settled by means of offset
and/or end-of-day credit transfers at the Bank of Canada. 8 Both Fedwire and

6

The CPSS Red Book for the United States explains that:
“The Fedwire funds transfer system, owned and operated by the Federal
Reserve Banks, is a real-time gross settlement system that enables participants
to send and receive final payments in central bank money between each other
and on behalf of customers. Fedwire processes and settles payment orders
individually throughout the operating day. Payment to the receiving participant
over Fedwire is final and irrevocable when the amount of the payment order is
credited to the receiving participant’s account or when notice is sent to the
receiving participant, whichever is earlier.”

CPSS, Red Book (U.S.), supra n. 4, at 443.
7

According to the CPSS Red Book for Canada:
“. . . LVTS is a real-time net settlement system that provides intraday finality for
recipients. Each payment instruction is subject to real-time risk control tests. If
the tests are passed, funds are made available to the recipient on an
unconditional and irrevocable basis intraday. Each participant’s position is
calculated in real time on a payment by payment basis.”

CPSS, Red Book (Canada), supra n.4, at 37 and 44.
8

The Red Book states that LVTS uses “. . . claims on the Bank of Canada to settle net
payment obligations among those participants that participate directly in these systems.” Id. at
44. This statement refers to the net imbalances among participants’ multilateral positions at the
end of the LVTS processing day:
“At the end of the daily cycle, the participant’s . . . positions are merged and the
final multilateral net positions are settled across settlement accounts at the Bank
of Canada.”

Id. at 55. Continuous netting with intraday finality of payment, on the other hand, implies the
settlement of payments without the use of any settlement asset. See, CPSS, Core Principles for
Systemically Important Payment Systems, supra n. 4, at 34 (payment “. . . obligations . . . are not
always settled by the transfer of a settlement asset; in some cases, an offsetting process can
discharge obligations.”). Therefore, it appears that settlement in LVTS takes place through a
combination of netting without a settlement asset and settlement in central bank money for those
payment instructions that are not discharged by offset. In that respect, the LVTS system is like

3

FINAL VERSION: 5/23/2007
LVTS result in effective and final transfers of credit money between account
holders. 9 There are, however, important institutional differences between the two
systems – particularly concerning the roles of the Federal Reserve and Bank of
Canada, respectively, in each system. 10

We will discuss only one of those

differences in this paper.

Because

a

payment

system

may

be

characterized

as

a

specialized

communications network, 11 we can use concepts and terminology drawn from
complex network analysis to better understand the relationships among the many
parts of the system.

In particular, we can use the terminology of complex

network analysis to describe the respective roles of public and private sector
banks in the payment system. Using that terminology, we propose a simple
the Clearinghouse Interbank Payment System (“CHIPS”) for U.S. dollar payments. We discuss
CHIPS later in this paper. See infra at text accompanying n. 23.
9

We use the term money in this paper to refer only to “credit money,” which arises from a
deposit relationship between an account holder and a bank (either a central bank or a commercial
bank). Coins and currency are excluded from consideration because they are not commonly
used in the settlement of large-value payment obligations. See, e.g., American Bar Association
(“ABA”), Task Force on Stored-Value Cards, “A Commercial Lawyer’s Take on the Electronic
Purse,” Business Lawyer, Vol. 52, 653 (February 1997)(the “Electronic Purse Report”). We
recognize that this usage is inconsistent with the definition of money contained in the Uniform
Commercial Code (“U.C.C.”), the body of commercial law that is generally applicable to payments
in the U.S. See, e.g., Sommer, J., “A Law of Financial Accounts, Modern Payment and Securities
Transfer Law,” The Business Lawyer, Vol. 53, No. 2 (1998) 1181, 1193, at n. 61.

10

For example, the Federal Reserve Banks own and operate Fedwire. CPSS, Red Book
(U.S.), supra n. 4, at 443. The Bank of Canada, on the other hand, “. . . does not own or operate
any payment or other clearing and settlement systems. . . .” CPSS, Red Book (Canada), supra n.
4, at 44. More importantly, as noted above, Fedwire is not a netting system. Settlement in
Fedwire takes place by means of a credit transfer at a Federal Reserve Bank, not by offset or by
a combination of offset and credit transfers, as in LVTS.

11

See, e.g., Lacker, supra n. 2, at 2 (central bank payment system characterized as a
communications
“. . . network[] in which many paths connect through a central node.”);
Soramäki, K., et al., “The Typology of Interbank Payment Flows,” Federal Reserve Bank of New
York, Staff Report No. 243 (March 2003) at 1 (“. . . the payment system can be treated as a
specific example of a complex network.”).

4

FINAL VERSION: 5/23/2007
descriptive typology of payment arrangements that may clarify the interaction
between central banks and commercial banks in the settlement of interbank
payment obligations.

We start with a brief overview of the payment system and the roles central banks
have traditionally played in their capacity as payment intermediaries.

In

particular, we discuss interbank settlement and the role of bank money as a
settlement asset. We show that the concept of settlement finality, which has both
legal and risk management dimensions, is a key attribute of any form of payment
and is not a unique attribute of payments made through a central bank.

We then consider whether the central bank has a comparative advantage with
respect to private sector banks in its role as a payments intermediary.

In

particular, we consider the respective costs and benefits of emphasizing the
central bank as the provider of a settlement asset and identify certain policy
trade-offs relating to that role. We conclude that there is an inherent tension
between those public policy objectives that are served by maximizing the use of
credit money emitted by the central bank (so-called “central bank money”) as a
settlement asset and those that are better served by maximizing the ability of
transactors to choose from alternative settlement assets (either central bank
money or a variety of commercial bank monies).

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FINAL VERSION: 5/23/2007
This analysis is, we think, timely given recent payment system and related
developments, particularly in the Eurozone. 12

Moreover, it has important

implications for central bank competition with private sector banks, especially
because central banks have articulated the concept of “ultimate settlement, a
conflation of the risk and legal attributes of settlement into what amounts to an
implicit preference for settlement in central bank money.” 13 The existence of
inherent and unavoidable trade-offs in defining the proper role of the central bank
in the payment system is masked, in part, because of persistent confusion
regarding the various meanings of “settlement finality.”

We intend this brief

paper as a step toward a better understanding of “settlement finality,” as well as
the importance of competitive considerations in the choice of whether to expand
the central bank’s role as a provider of interbank settlement assets.

12

The European Central Bank (“ECB”) has summarized the need for the TARGET 2
Securities Initiative as follows:
“Conscious of the need for further integration in market infrastructures, and
extracting the benefits from the implementation of the TARGET2 payment
system, the Eurosystem is evaluating opportunities to provide efficient settlement
services for securities transactions in central bank money, leading to the
processing of both securities and cash settlements on a single platform through
common procedures.”
http://www.ecb.int/paym/market/secmar/integr/html/index.en.html (February 28, 2007); see also,
European Central Bank, Target 2 Securities (2006); Godeffroy, J., “”Ten Frequently Asked
Questions about TARGET2-SECURITIES,” Speech at the British Bankers Association (London,
September 20, 2006).
13

See, e.g., CPSS, The Role of Central Bank Money in Payment Systems (Basel: Bank for
International Settlements, August 2003). According to the CPSS,
“The term “ultimate settlement” is sometimes used to denote final settlement in
central bank money [reference deleted]. As such, the term combines two distinct
concepts - finality and the nature of the settlement asset used to achieve finality
in payment systems.”
Id. at 14, box 2.

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FINAL VERSION: 5/23/2007

A complete cost-benefit analysis of the roles central banks typically play in
interbank payment systems would require careful consideration of numerous
design and operational characteristics of each system, a task far beyond the
scope of this brief paper. Instead, this paper is simply an introduction for central
bank legal counsel to one set of legal and policy considerations relating to the
role of the central bank in the interbank payment system, based upon the
authors’ presentation at the International Monetary Fund’s Seminar on Current
Developments in Monetary and Financial Law in October 2006.

Discussion
The Role of the Central Bank in the Payment System
Whatever else central banks may do – and the list of functions commonly
performed by central banks is long – they almost always play a foundational role
in the payment system. 14 Indeed, Stephen Millard and Victoria Saporta, in their
background paper to the Bank of England’s May 2005 Conference on “The
Future of Payments,” observe that:
“Central banking and payment systems – systems consisting of a
settlement asset, credit arrangements, infrastructure and rules over
which monetary value can be transferred – are inextricably linked.
In a number of countries, central banking institutions evolved

14

Millard & Saporta, supra n. 1, at 2. There has, of course, been considerable variation in
the functions central banks have performed over the nearly 350 year history of the central bank.
This has lead some commentators to conclude that “. . . we recognize [a central bank] when we
see it.” Capie, F. et al. (eds.), The Future of Central Banking, The Tercentenary Symposium of
the Bank of England (Cambridge: Cambridge U. Press, 1994) at 5. See also, Green & Todd,
supra n. 1 (listing common functions of a central bank).

7

FINAL VERSION: 5/23/2007
naturally or were imposed by the state to provide the ultimate
settlement asset at the apex of the payment hierarchy.” 15
For purposes of this paper, we are concerned with only a single aspect of the
role central banks play in the payment system – that of providing what Millard
and Saporta have called “the ultimate settlement asset at the apex of the
payment hierarchy.” That role has two components: (1) the position the central
bank occupies at the apex of a hierarchical structure of tiered accounts used to
settle interbank payment obligations; 16 and (2) the provision of credit money,
commonly called “central bank money,” as a settlement asset for interbank
transactions.

Before we turn to a discussion of some costs and benefits

associated with the use of “central bank money” as a settlement asset, we need
to understand these components.

In a 2001 article on the Federal Reserve’s role in the payment system, Ed Green
and Dick Todd note that “. . . historically, central banks have been chartered to
perform two functions:”
15

Millard & Saporta, supra n. 1, at 2 (emphasis added).

16

Green & Todd, supra n. 1, at 5 (central banks function “. . . as the trustworthy and neutral
apex of a hierarchy of banks that, in turn, provide the nonbank public with accounts used to settle
financial, business and personal payments by transfer of balances.”); see also, Blommestein, H.,
and B. Summers, “Banking and the Payment System,” in B. Summers (ed.), The Payment
System: Design, Management and Supervision (Washington, D.C.: International Monetary Fund,
1994), at 27 (describing the payment system as an “inverted pyramid”):
“At the top of the inverted pyramid is the broad base of economic actors whose
daily activity in the market economy gives rise to payment obligations. This base
consists of individuals who use retail payment services provided by banks, and a
variety of business enterprises. . . . The next level includes very specialized
firms, such as brokers and dealers, . . . which also rely on bank payment
services.”
Id.

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FINAL VERSION: 5/23/2007
One is to be an intermediary between the government and its
lenders, enabling the government to obtain credit by ensuring that
implicit default through inflation will occur only in genuine national
emergencies. The other is to serve broad public interests as the
trustworthy and neutral apex of a hierarchy of banks that, in turn,
provide the nonblank public with accounts used to settle financial,
business, and personal payments by transfer of balances. 17
Green and Todd conclude that “[t]he role as the apex of the banking hierarchy
puts the central bank in a unique and distinguished position in the payments
business.” 18 Jeffrey Lacker offers a basis for understanding the importance of
that role based upon the insight that “[i]ssuing, clearing and settling payment
instruments are essentially communication and record-keeping activities.” 19 In
payment systems, as in other communications arrangements, Lacker argues:
“Efficient communication arrangements often take the form of
networks in which many paths connect through a central node. A
clearinghouse can be viewed as a natural club arrangement for
such centralized settlement activity. A central bank then represents
a nationalized central settlement node for interbank payments.
Contemporary legal restrictions more or less compel most banks to
settle through the central bank.” 20

17

Green & Todd, supra n. 1, at 5 (emphasis added).

18

Id. (emphasis added).

19

J. Lacker, supra n. 2, at 2. Lacker notes that “[t]he economic function of a payment
instrument is to communicate [information about past transactions] reliably. . . .” And, he points
out that:
“[t]he central role of communications technologies in payment arrangements
points . . . to the importance of economies of scale, common costs and joint
production. These conditions can give rise to ‘network effects’ in which much of
the benefits and costs are shared among multiple participants.

Id. (emphasis added).
20

Id., (“. . . central banks have more or less nationalized the clearinghouses at the ‘apex’ of
the payment system.”)

9

FINAL VERSION: 5/23/2007
There is much here that deserves close attention.

For present purposes,

however, we focus upon the explanation Lacker gives, based upon the efficiency
of centralized communications networks, for the development of the hierarchical
structure characteristic of most account-based payment systems and the position
the central bank (or a private sector clearinghouse) typically occupies at the apex
of that structure. It is noteworthy that this explanation does not depend upon the
existence of a public sector institution such as a central bank. Indeed, Lacker
explicitly equates the structural role played by central banks with private sector
clearinghouse arrangements. 21

Lacker’s explanation for the position central banks occupy at the apex of the
payment system appears to be consistent with the historical development of
central banks, as described by Millard and Saporta:
“Historically, the evolution of central banking can be traced back to
the market’s natural demand for an efficient way to make
payments. This natural demand can lead to the development of a
hierarchy or pyramid in payments with the liabilities of a proto
central bank at its apex, as the ‘settlement asset’ of choice. In
other words, central banks can emerge naturally from their
payments role.” 22
This description connects the two components of what we have identified as the
role of the central bank as the provider of “the ultimate settlement asset at the
apex of the payment hierarchy.” Lacker’s “network analysis” explains why the

21

Lacker notes that there is a range of views regarding whether the transition to central
banking from earlier networks of private sector institutions (i.e., “clearinghouses”) enhanced
efficiency. Id.

22

Millard, S. and V. Saporta, supra note 1, at 2.

10

FINAL VERSION: 5/23/2007
payment system is configured as a hierarchical structure, with a payments
facilitator (either public or private sector in nature) at the apex.

Millard and

Saporta connect that structural position to the role played by a settlement
institution as the provider of a settlement asset. That role can, as they note, be
performed either by a private sector bank or a central bank.

Central banks, in their role as payment intermediaries, typically function as
“hubs,” with spoke-like connections (account relationships) to all of the “nodes”
(private sector banks that have accounts at the central bank) in the system,
forming a network that is described as a “star” (the interbank payment system). 23
The Fedwire funds transfer system is an example of a payment system in which
the central bank functions as a network hub.

There are also private sector

interbank payment networks, such as the Clearinghouse Interbank Payment
System (“CHIPS”) for U.S. dollar payments 24 and the Continuous Linked
Settlement (“CLS”) 25 system for foreign currency settlements. And banks have
historically maintained so-called “correspondent” relationships which they use to
transfer money on a bilateral basis, without the intermediation of a hub (either
private or public sector).

Although these arrangements are probably less

23

See, e.g., Soramäki, K., et al., “The Typology of Interbank Payment Flows,” Federal
Reserve Bank of New York, Staff Report No. 243 (March 2003). As Soramäki and his co-authors
point out “. . . the payment system can be treated as a specific example of a complex network.”
Id. at 1.
24

See, e.g., CPSS, Red Book (U.S.), supra n. 4, at 444; information available
online at CHIPS: http://www.chips.org/home.php .

25

See, e.g., CPSS, Red Book (International Payment Arrangements), supra n. 4, at 462 et
seq.; Galati, G., Settlement Risk in Foreign Exchange Markets and CLS Bank, BIS Quarterly
Review (December 2002); information available online at CLS Group: http://www.cls-group.com/.

11

FINAL VERSION: 5/23/2007
important today than the network alternatives, they still exist and still serve their
original function.

Based upon this description, we can develop a simple typology of institutional
arrangements for the settlement of interbank payment obligations in credit
money. Such settlements may be conducted through: (1) “central bank-centered
networks,” such as Fedwire, where a central bank serves as the network hub and
provides the underlying settlement asset;

26

or (2) “private sector networks,”

27

such as CHIPS 28 and CLS, 29 where the network hub, if there is one, is provided

26

For the reasons explained above, see, supra n. 8, the Canadian LVTS probably should
be considered as a private sector network because settlements conducted through LVTS on the
basis of offset do not involve the use of a settlement asset. To be sure, LVTS is supported by the
Bank of Canada in a variety of ways, not least of which involves the use of central bank money
for purposes of the end-of-day settlement of payment instructions that are not discharged by
offset within LVTS. However, LVTS does not differ from CHIPS in that respect.
27

Soramäki, et al., supra n. 23, at 1 (referring to private sector payment systems as
“ancillary networks”).
28

CHIPS is a private sector network in which payment instructions are offset on a
continuous net basis, with intraday finality of settlement:
Since January 2001, CHIPS has been a real-time final settlement system that
continuously matches, nets and settles payment orders. On a daily basis, the
new system provides real-time finality for all payment orders released by CHIPS
from the CHIPS queue. To achieve real-time finality, payment orders are settled
on the books of CHIPS against positive positions, simultaneously offset by
incoming payment orders, or both.
CHIPS is not a bank, does not take deposits, and does not create a settlement asset in the form
of credit money. Settlement in CHIPS takes place, as it does in the Canadian LVTS through a
combination of netting without a settlement asset and settlement in central bank money for those
payment instructions that are not discharged by offset. See supra, n. 7.
29

CLS Bank International (“CLS Bank”) is an Edge Corporation formed under U.S. law
which functions as a bank, with the power to take deposits and create credit money. Settlement
of foreign currency transactions through CLS takes place on the books of CLS Bank in
commercial bank money – a fact that is often misunderstood because the CLS funding process
involves transfers of central bank money through the national payment system for each currency
cleared by CLS (although, as noted, Canadian dollar settlements through LVTS remain
anomalous from this point of view – though not from a risk management perspective). The 2003
CPSS report on the Role of Central Bank Money clarifies this point:

12

FINAL VERSION: 5/23/2007
by a private sector institution (either a bank or a bank service provider) and the
settlement asset, if there is one, is provided by a commercial bank; or (3) through
direct bank-to-bank correspondent arrangements, in which there is no network
and the settlement asset is provided by commercial banks (through the
management of “nostro” and “vostro” accounts for each other). 30

Based upon this simple typology, we can draw the following conclusions:
Payment obligations can be discharged without the use of a settlement asset
(as in net settlement systems, such as CHIPS and LVTS); 31 and
Both commercial banks and central banks take deposits and create credit
money (called “central bank money” and “commercial bank money,”
respectively) 32 that can be used as an interbank settlement asset (as in
RTGS systems, such as Fedwire, and private-sector systems, such as CLS,
as well as in bilateral correspondent relationships).

“CLS Bank, a private utility which meets the international norms for risk
management laid out by the G10 Governors, is the settlement institution for CLS
– i.e. settlement is not in central bank money. However, all payments to and
from CLS are made through the issuing central bank, so central bank money
retains a necessary role, pivotal but not central, in the settlement of foreign
exchange transactions in CLS.”
CPSS, The Role of Central Bank Money in Payment Systems supra n. 13, at 3.
30

The CPSS Glossary of Terms defines correspondent banking as “an arrangement under
which one bank ([the] correspondent) holds deposits owned by other banks ([the] respondents)
and provides payment . . . services to those respondent banks.” CPSS, Glossary of Terms,
supra n. 5.
31

We discuss below the legal meaning of “discharge” for purposes of interbank payment
obligations. See text accompanying n. 33.
32

Consistent with the terminology employed in the CPSS report on the Role of Central
Bank Money, we refer herein to “central bank” and “commercial bank monies,” respectively.
CPSS, The Role of Central Bank Money in Payment Systems, 13.

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FINAL VERSION: 5/23/2007
Users of the payment system, therefore, have a choice whether to transmit
payments through a system in which the central bank functions as a hub (and
settlement is in central bank funds) or through some other mechanism. In the
next section of this article, we expand our explanation of the choice of settlement
asset and attempt to clarify one of the key attributes of a payment in any form of
money, from cash to checks to credit money, namely, the “finality” of payment.

Assets for the Settlement of Interbank Payments
Payment obligations can be settled in a variety of different ways. Each has its
own unique characteristics, benefits and disadvantages. The CPSS Red Book
summarized these alternatives as follows:
“[A] variety of payment instruments and settlement mechanisms are
available to discharge payment obligations between and among
financial institutions and their customers.
These payment
instruments vary considerably in their characteristics, such as cost,
technology, convenience, funds availability and finality, as well as in
orientation towards consumer, commercial and interbank
transactions.” 33
A settlement asset is generally defined as “[A]n asset used for the discharge of
settlement obligations as specified by the rules, regulations or customary practice
for a payment system.” 34

33

CPSS, Red Book, supra n. 4, at 439.

34

CPSS, A Glossary of Terms Used in Payments and Settlement Systems, supra n. 5.
Discharge, is defined as: “release from a legal obligation imposed by contract or law.” Id.

14

FINAL VERSION: 5/23/2007
The two major settlement assets could be summarized as cash (i.e. specie and
paper currency) or credit money.

Cash is the oldest and probably best

understood settlement asset. For thousands of years, specie in the form of gold,
silver and other precious metals, and paper currency, was used to meet payment
obligations. Settling payment obligations through cash is particularly useful for
small purchases and payment obligations that are done in routine face to face
transactions. However, in our modern society, cash is logistically difficult to use
with respect to large transactions.

Both the storage and delivery of large

amounts of cash presents difficulty. For example, it would require the delivery of
200,000 US$100 bills to meet a US$20 million obligation in cash.

Credit money represents a claim on an intermediary and is considered to be just
as important a settlement asset as cash:
“In the commercial world, large transactors consider bank credit to
be the functional equivalent of money. In fact, bank credit may be
even better than money when one considers the feasibility of
closing a $200 million acquisition with federal reserve notes.” 35
Credit money is typically divided into commercial bank funds or central bank
funds.

Commercial bank funds result from deposits made in commercial banks. The
depositor then receives in return a new settlement asset such as a demand
deposit account that can be used as a settlement asset. Through the use of

35

ABA, Electronic Purse Report, supra n. 9, at 668.

15

FINAL VERSION: 5/23/2007
checks and wire transfers, individuals can settle payment obligations easily and
efficiently.

Just as depositors deposit funds in commercial banks and receive in exchange a
settlement asset in the form of a demand deposit or similar account, large
financial institutions can also deposit funds in central banks and receive a
settlement asset in the form of central bank funds. A financial institution can then
direct a central bank to move these central bank funds from its own account into
the account of another financial institution to settle its payment obligations, either
to that financial institution, or to a customer of that institution.

Participants often consider central funds as being riskless due to safety and
liquidity advantages that these funds enjoy over commercial bank funds. Central
bank funds are often thought to be safe because they are considered to be “more
creditworthy institutions than commercial banks in their own currency” and
because they have “explicit state support”. 36

Central bank funds are also

considered to be more liquid because of a central bank’s “ability to inject very
large amounts of liquidity, where appropriate, in order to facilitate the smooth
operation of large-value payment systems.” 37

The following is a representation of the Interbank Payment system that results in
the creation of credit money:
36

CPSS, The Role of Central Bank Money in Payment Systems, supra n. 13 at 13.

37

Id. at 14.

16

FINAL VERSION: 5/23/2007

Interbank Payment System
Central
Bank

Commercial
Bank

Depositor

Tiered
Account
Structure

Depositor

Commercial
Bank

Depositor

Depositor

Finality
One of the principal claims of the advantage of payment and settlement in central
bank funds over other settlement assets is that of finality. While the satisfaction
of payment obligations through the use of central banks does enjoy a special
status in some jurisdictions that is often referred to as “ultimate settlement”, the
finality advantages are typically a function of the legal rules governing finality as
opposed to the type of settlement asset selected.

Finality can perhaps be best understood through the use of a simple example
using cash as the settlement asset. For example, when an individual purchases
a newspaper outside of his hotel using cash, finality exists:

17

FINAL VERSION: 5/23/2007
“[I]f a consumer pays with cash, the ‘payment’ is final at that
moment, in the sense that the consumer cannot recover the
cash.” 38
What is typically meant by finality is that the recipient of the settlement asset has
immediate use of the funds, doesn’t have to wait for conditional payments to
become final and it reduces buffer stock (i.e. cushion) of money for liquidity. The
Committee on Payment and Settlement Systems states that “[finality] is achieved
when settlement of an obligation is irrevocable and unconditional.” 39

Just because the transaction has finality, however, doesn’t mean that the
individual does not have a claim against the newspaper vender however. Ron
Mann summarized the newspaper’s position as follows:
“Of course, the consumer might obtain a separate right to payment
from the merchant by establishing some separate claim under the
contract in question. That is quite a different thing from a right to
retract the payment itself.” 40
The payment was final between the purchaser and the newspaper vender when
the purchaser turned over the cash, meaning that the vender had immediate use
of the funds and the purchaser could not stop payment or claw the payment
back. However, if the newspaper was yesterday’s news or otherwise deficient,
the purchaser may have some claim for breach of contract against the vender,
regardless of how “final” payment was.

38

Mann, Ronald J., "Making Sense of Payments Policy in the Information Age,"
Georgetown Law Journal, Vol. 93, p. 633, 2005, available at SSRN: http://ssrn.com/abstract=507822
39

CPSS, The Role of Central Bank Money in Payment Systems, supra, n. 12, at 14.

40

Mann, supra n. 38, at 643.

18

FINAL VERSION: 5/23/2007
Finality is important because it minimizes systemic risk. Finality avoids payments
from being unwound (i.e. disallowed after reliance). It also avoids the cascading
effect of unwound payments.

Finally, as payment systems become more

interrelated and larger, it helps minimize systemic risk and maximize legal
certainty.

Finality also increases legal certainty in payment systems.

It increases

confidence of participants in using payment systems. It increases legal certainty
regarding the treatment of payments in litigation.

It can result in increased

payment system volumes, providing greater liquidity. It also provides a sound
foundation for systemically important payment transactions. Finally, it minimizes
migration to other payment systems.

Finality of payment can best be understood when it is compared with provisional
settlement. The defining characteristic of a provisional or conditional payment is
the ability of the transferor to stop or claw back a payment made. Finality of
payment is delayed for example, when a paper check is written on a U.S. Bank.
Under U.S. law, the payor may stop payment on a payer check until the
presentment of the check at his bank. 41 This effectively places the recipient of
the check at risk until the check has cleared the payor’s bank

41

N.Y.U.C.C. § 4-403(1); see also 9 N.Y. Jur. 2d Banks § 382 (discussion of stop
payment rights). We refer here to New York law, which governs many of the most
important payments transactions in the United States.

19

FINAL VERSION: 5/23/2007
Provisional or conditional payment also existed in several deferred net settlement
payment systems.

Although these systems are now obsolete, they are

illustrative of provisional settlement. For example, both CHIPS and the Canadian
International Interbank Payment System (now superseded by LVTS) provided for
varying periods of finality (either at the end of the day or the next business day).
In contrast, in current payment systems, finality typically is achieved on a real
time basis as each payment is cleared and settled.

The legal basis for finality is not a function of whether payments are settled in
cash, through commercial bank funds or through central bank funds. Instead, it
is a function of the legal rules that affect that system.

The Committee on

Payment and Settlement Systems notes that “finality within an interbank payment
system is generally determined by the system’s rules and the legal framework
within which the rules function.” 42 Thus there are alternative bases for finality:
A contractual basis, in which the parties to a banking relationship
(namely, a bank and its customer) or the participants in a payment
system may agree that payments will be considered final under the
circumstances defined by the contract between or among them; and
A statutory or common law basis, in which applicable law governs the
finality of payments where an effective agreement does not exist
among the relevant parties.

42

CPSS, The Role of Central Bank Money in Payment Systems, supra n. 13, at 14.

20

FINAL VERSION: 5/23/2007
For example, finality for checks and funds transfers is governed in the United
States by each state’s uniform commercial code.

Finality for Fedwire is

determined by Article 4A of the UCC 43 and Regulation J 44 promulgated by the
Federal Reserve.

Finality for CHIPS is a function of both contract law and

applicable statutory law. 45 For TARGET, finality is governed by the Settlement
Finality Directive 46 promulgated by the European Union. National legislation also
governs finality in various Eurozone Countries.

Finally, finality in Canada’s

payment system is governed by the Canadian Payments Act. 47

If a particular form of settlement asset enjoys greater finality than a different
settlement asset, such advantage is not the result of whether it is central bank
funds or commercial bank funds. Instead, such a result typically stems from
special statutory or regulatory rules put in place by policy makers.

The

Committee on Payment and Settlement notes that “[i]n general, the law does not
distinguish between assets in this respect: settlement finality is no easier or
harder to achieve in central bank money than in any other asset.”48

43

New York Uniform Commercial Code Article 4A.

44

12 C.F.R. Part 210.

45

[INSERT: Discussion].

46

Settlement Finality Directive 98/26/EC (EU 25). For a discussion of the directive, see
Commission of the European Communities, Report from the Commission-Evaluation Report on
the Settlement Finality Directive 98/26/EC (EU 25), 27 March 2006, available at
http://ec.europa.eu/internal_market/financial-markets/docs/settlement/evaluation_report_en.pdf
(Feb. 28, 2007).
47

Canadian Payments Act ( R.S., 1985, c. C-21), available at:
http://laws.justice.gc.ca/en/showtdm/cs/C-21.
48

CPSS, The Role of Central Bank Money in Payment Systems, supra n. 13, at 14.

21

FINAL VERSION: 5/23/2007
Finality Through Interbank Payment Systems
This section will discuss achieving finality through interbank systems and will
discuss briefly the costs and benefits of clearing and settling through central bank
funds versus commercial bank funds.

We conclude that the costs and benefits

of each should be weighed carefully before selecting one settlement asset over
the other. Although central bank funds may enjoy some benefit with respect to
finality over commercial bank funds, such benefits may be outweighed by other
costs incurred in using central bank funds.

Payment System Characteristics and Finality
Finality is achieved in an interbank system either by settling through a central
bank in central bank funds, through commercial banks in commercial bank funds,
or through a combination of the two types of settlement assets. There are many
different large-value payment systems currently in use throughout the world. The
most common ones would include Fedwire, CHIPS, LTVS (Canada), TARGET
(Eurozone), 49 and CLS.

Each of payment system can be characterized by

several different characteristics:
•

Ownership or Operation
–

•

Operational Considerations
–

•

Public or private

Gross, Net or Hybrid

Settlement through

49

For a discussion of TARGET, see CPSS, Red Book (Euro Area), supra n. 4, available at:
http://www.bis.org/publ/cpss53p04eu.pdf

22

FINAL VERSION: 5/23/2007
–
–
•

Central Bank Money or
Commercial Bank Money

Finality (the one constant)
–

All provide for legal finality

The following chart provides a summary of these characteristics and selected
large-value payment systems:
CHARACTERISTICS

LARGE-VALUE
SYSTEMS
(SELECTED)
United States
Fedwire Funds
Transfer System
Clearinghouse
Interbank Payment
System (CHIPS)

Canada
Large-Value Transfer
System (LVTS)

Ownership/
Operation

Form of
Settlement
Asset

Intraday
Finality (or
Provisionality)
of Settlement

Central bank
money

Final settlement

(1) Netting:
N/A
(2) Residual
settlement
in central
bank
money

Final settlement

Operational and
Data Processing
Environment

Federal Reserve
Banks
Real-Time Gross
Settlement (RTGS)
CHIPCo. (New York
Clearinghouse
Association)
Continuous (RealTime) Net Settlement
(Hybrid)

Canadian Payments
Association
Continuous (RealTime) Net Settlement
(Hybrid)

23

(1) Netting:
N/A
(2) Residual
settlement
in central
bank
money

Final settlement

FINAL VERSION: 5/23/2007

LARGE-VALUE
SYSTEMS
(SELECTED)
Eurozone
TARGET

Other
CLS (Continuous
Linked Settlement)

Derivatives
Settlement
Arrangements (U.S.)

Form of
Settlement
Asset

Intraday
Finality (or
Provisionality)
of Settlement

Central bank
money

Final settlement

(1)
Commercial
bank money
(2) Central
bank money
(1)
Commercial
bank money
(2) Central
bank money
(3) Other
assets (e.g.,
IEF)

Final settlement

(2) Interbank Wire
Transfer (via Fedwire
and/or CHIPS)

CHARACTERISTICS

Various Forms of
Ownership/Operation;
Various Operational
and Data Processing
Environments

Central bank
Final settlement
or commercial
bank money;
netting; other
assets

Ownership/
Operation
Operational and
Data Processing
Environment

European Central
Bank/ESCBs
Real-Time Gross
Settlement (RTGS)

CLS Shareholders
(Major International
Banks, etc.)
(1) Real-Time Gross
Settlement (RTGS)
(2) Designated Net
Settlement (DNS)
N/A
(1) Book Transfer

SUMMARY

∗

Final settlement
Final
settlement ∗
Final settlement
Final settlement

Settlement is final as of the time the relevant settlement banks undertake an irrevocable
contractual commitment to make payment.

24

FINAL VERSION: 5/23/2007
As noted in the chart, many of these payment systems still benefit from finality,
even though the settlement asset is commercial bank funds.

Finality and Commercial Bank Money
Finality occurs through the use of commercial bank money in numerous different
payment systems. These payments enjoy the same kind of finality as do central
bank funds, except in the case of legal rules that provide ultimate settlement, as
will be discussed below.

The most common clearing and settlement using commercial bank funds is
through commercial bank “book entry” transfers such as “on us” transfers or
correspondent banking. CLS clears huge volumes of foreign currency trades
through its account system. 50

Millions of dollars of derivatives payments are

cleared each day through clearinghouses for exchange traded derivatives such
as futures and options and through over-the-counter derivatives (done typically
through commercial bank book entry transactions). 51

“Internalized” payment,

custodial and related transactions are also in large volumes in situations such as
triparty repo transactions. 52

50

On January 16, 2007, “CLS Bank settled 705,582 payment instructions with a gross value
of US$ 5.22 trillion.” www.cls-group.com (Feb. 28, 2007).
51

Through its clearinghouse, the Chicago Mercantile Exchanged cleared over 13.8 million
of exchange traded futures and options contracts on February 27, 2007. See www.cme.org.

52

For a discussion of Tri-party custodial agreements in the repo area, See Paul Harding
and Christian Johnson, A Practical Guide to Using Repo Master Agreements, (Euromoney
2004), at 262-307.

25

FINAL VERSION: 5/23/2007
The Advantages of Central Bank Funds: Ultimate Settlement
The case for using central banks funds is often justified based on what is referred
as “ultimate settlement” enjoyed by central bank funds in certain payment
systems. “The term ‘ultimate settlement’ . . . combines the concept of settlement
being final with the concept of the settlement asset being the least risky
possible.” 53

Jurisdictions have sometimes provided ultimate settlement to central bank funds
through special legal rules. For example, in some jurisdictions, payments made
in central bank funds are not subject to preference payment or claw back rules,
providing additional assurances that a payment cannot be unwound after the
payment is completed.

It is important to understand, however, that similar finality could just as easily be
given to commercial bank funds by a legislature. For example, statutes could
provide the same finality to a type of transaction that is cleared and settled in
commercial bank funds. This is what has been done in the United States with
respect to protecting transactions entered into through a bilateral netting
contract. 54

A bankruptcy or insolvency system could also be reformed to

eliminate preference payments and clawbacks for payments made in commercial
bank funds. Some of this has already been done with respect to essentially

53

CPSS, The Role of Central Bank Money in Payment Systems, supra n. 13, at 14.

54

12 USC §§4401-4407.

26

FINAL VERSION: 5/23/2007
eliminating the application of preference payment to swap payments under the
U.S. Bankruptcy Code. 55

Weighing the Costs of Central Bank Funds
Although participants can point to the advantages of ultimate settlement through
using central bank funds, there are clearly other costs of using central bank funds
over commercial bank funds that often are not highlighted. Unless one factors in
these other costs, one cannot measure the trust benefits of expanding the role of
central banks.

There are a wide variety of considerations that should be taken into account
before expanding the role of central bank funds in settlement and clearing of
payment obligations.

For example, using central bank funds requires a high

degree of centralization.

All payments would need to be cleared through a

central authority, risking operational resiliency in the event there was a failure at
the central bank level.

Using central bank money would also greatly expand the role of the central bank
in a jurisdiction’s payment system and economy.

This could result in the

disintermediation of private sector banks and the weakening of the commercial
banking sector of a jurisdiction.

55

11 USC §546(g) (preference payments) and §548(d)(2) (fraudulent transfer).

27

FINAL VERSION: 5/23/2007
Using central bank funds also introduces moral hazard issues. There is some
concern that having access to central bank money may in turn provide “semiautomatic access to emergency liquidity from the central bank.” 56

Finally and perhaps most importantly, ultimate settlement may not be important
for many participants in the market. For all but the very largest transactions,
participants may value the convenience, flexibility, speed and industry knowledge
that commercial banks can provide over the somewhat theoretical benefits
provided by ultimate settlement using central bank funds.

Conclusion
There is clearly a case to be made and a place for using central bank funds in
clearing and settlement of payment obligations. The settling of particularly large
payment obligations may dictate or even require the benefits of ultimate
settlement. However, there is no right answer for structuring payment systems
involving the use of central bank money versus commercial bank money based
upon a comparison of the costs and benefits. The optimal payment systems will
take into account the costs and benefits of using central bank money versus
commercial bank money, and rely upon one or the other depending upon the
risks involved in the particular transaction.

56

CPSS, The Role of Central Bank Money in Payment Systems, supra n. 13, at 15.

28

FINAL VERSION: 5/23/2007
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653 (February 1997)(the “Electronic Purse Report”), published as A Commercial
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B. Summers (ed.), The Payment System: Design, Management and Supervision
(Washington, D.C.: International Monetary Fund, 1994)
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http://laws.justice.gc.ca/en/showtdm/cs/C-21.

C-21,

available

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at:

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(eds.), The Future of Central Banking, The Tercentenary Symposium of the Bank
of England (Cambridge: Cambridge U. Press, 1994)
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March 2006, available at: http://ec.europa.eu/internal_market/financialmarkets/docs/settlement/evaluation_report_en.pdf
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Systems (Basel: Bank for International Settlements, January 2001), available
online at: http://www.bis.org/publ/cpss43.pdf
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for International Settlements, March 2003), available online at:
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Bank for International Settlements, April 2003), available online at:
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International Settlements, August 2003), available online at:
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http://www.ecb.int/paym/market/secmar/integr/html/index.en.html
European Union, Settlement Finality Directive, 98/26/EC (EU 25)

29

FINAL VERSION: 5/23/2007
Galati, Gabriele, Settlement Risk in Foreign Exchange Markets and CLS Bank,
BIS Quarterly Review (December 2002), available online at:
http://www.bis.org/publ/qtrpdf/r_qt0212f.pdf
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30

FINAL VERSION: 5/23/2007
Soramäki, Kimmo, Morten L. Bech, Jeffrey Arnold, Robert J. Glass, and Walter
E. Beyeler, "The Topology of Interbank Payment Flows," Federal Reserve Bank
of New York, Staff Report No. 243 (March 2006), published in Physica A:
Statistical Mechanics and Its Applications 379, No. 1 (June 2007)
United States Bankruptcy Code, 11 U.S.C. §546(g) (preference payments) and
§548(d) (2) (fraudulent transfer)

31

FINAL VERSION: 5/23/2007
SELECTED BIBLIOGRAPHY
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(Cambridge: Cambridge U. Press, 2003)
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International Settlements, September 1993), available online at:
http://www.bis.org/publ/cpss07.pdf
Goodhart, Charles A. E., The Evolution of Central Banks (Cambridge, MA: The
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Green, Edward J., “We Need to Think Straight about Electronic Payments,”
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--- “Central banking and the economics of information,” Federal Reserve Bank of
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Sardoni, Claudio, “Why Central Banks (and Central Bank Money) ‘Rule the
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32


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