Risks and efficiency gains of a tiered structure in large-value payments: a simulation approach

The large-value payment system in the United Kingdom (CHAPS) is highly tiered: a few settlement banks make payments on behalf of many customer banks. This paper makes use of a simulation approach to quantify by how much tiering affects, on the one hand, concentration and credit risk and, on the other, the liquidity needs of CHAPS. We do so by creating scenarios where current settlement banks become customer banks and thus we increase the degree of tiering. The results show that concentration risk would rise substantially in what is already a highly concentrated system. As for credit risk, the size of intraday exposures compared with settlement banks' capital is very small and therefore the likelihood of contagion remote. More importantly, the increase in credit risk brought to the system by settlement banks leaving CHAPS bears little relationship to the values settled by each individual bank. We find that increasing the degree of tiering in CHAPS leads to substantial liquidity savings - although the liquidity saved is only a fraction of the spare liquidity currently posted in the system. Most of the savings are due to liquidity pooling rather than to internalisation of payments. There is a strong relationship between changes in values settled and liquidity needs. This relationship can be used to forecast the impact on liquidity needs if more banks were to join CHAPS. The quantification of the trade-off between risk and efficiency in different scenarios provides policymakers with a useful analytical framework for analysing the effects of tiering.