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Retail Payments and Methodology
Introduction
First of all, why would someone want to
study financial market infrastructures
(FMIs) and payments? Since
infrastructures are always taken for
granted (until they stop). Financial market
infrastructures are not an exception. We
will mostly relate to regulation and
exposure to a certain risk. A warehouse
will be used as a metaphor for the financial
infrastructure (see picture). On the retail
payments floor, all the payments between individuals and corporations are located, where
‘retail’ in this case isn’t the same as our ordinary definition. The large-value payments floor
includes all payments between banks. On the upper floor, all the securities & derivatives
trading can be found, and all transactions and settlements of this trading are located on this
floor as well. The visualisation clearly shows that the lower floors have higher trading volumes
but smaller values. On the right-hand side of the warehouse, you see the stock. The green
amount in brackets pertains to banknotes and coins (the other green is in bank accounts). The
small little thing on top is the innovation shack. You can also see some air vents which are
included because most parts of the warehouse are digital nowadays → need cooling. The
purpose of the warehouse is to eliminate all financial obligations due on the value date, or in
other words to increase settlement efficiency. The function of the warehouse can be
summarised in one sentence, namely “the settlement of all financial transactions in an
economy and the safekeeping of money and financial assets.” This includes 1-sided financial
transactions (exchange of goods/services against money) and 2-sided financial transactions
(exchange of financial assets against money). 1-sided transactions partially occur within the
warehouse, and partially occur outside the warehouse. 2-sided transactions occur fully in the
warehouse. Settlement can be defined as a transfer of money from the payer/debtor to the
receiver/creditor to discharge a financial obligation (of a debtor to a creditor)
Risks
The inherent micro risk consists of settlement risk and pre-settlement risk. Where settlement
risk is defined as the risk of a transaction going wrong. The pre-settlement risk is the risk of
not settling between the day you agree to a trade and the actual moment of settling. To
illustrate pre-settlement risk let’s say your firm and a counterparty agree to a trade and
between the date you reach an agreement and the day it’s settled the counterparty goes
bankrupt. Now the counterparty can not meet its financial obligations, probably causing losses
for your firm. If we aggregate these (micro) risks we get the main warehouse risks. For the
ground floor, the biggest (ultimate) risk is social unrest, which could lead to a bank run. Only
during the social unrest do people differentiate between different sorts of private money, if
everything is working as it’s supposed to then we do not differentiate between different types
of money. On the middle and upper floors, systemic risk is the biggest risk.
1
,Ground Floor
Banks are conducting two important
roles on the ground floor, on the
consumer role they play the issuer role,
where they let you open a bank
account. If a merchant opens a bank
account the bank plays the acquirer
role. Most banks fulfil both roles. Now
let’s introduce the payment
instruments, the first one consists of
banknotes, coins and cheques. The
second instrument consists of credit
transfers and direct debits. The third
one pertains to card payments (debit,
credit, prepaid cards). On the other
side of the ground floor, we find different forms of infrastructure. The largest one is the
automated clearing house (ACH) which aggregates and accumulates all the payments on the
ground floor, additionally, they perform netting. The process of the ACH can be seen as the
bundling of all the payments, where they will be sent a level up. Another payment infrastructure
on the ground floor is the electronic money institution, which has a license to issue electronic
money (usually you find these on prepaid cards). It can be seen as a ‘light bank’ since it only
allows you to put in money, use this e-money for transactions, and then possibly take out the
money. These institutions do not have credit departments, etc. like normal banks. Another
infrastructure is a payment institution, which again operates on a license. This institution
mostly operates on the merchant side. When the merchant wants to accept many different
brands of a card, he can choose to outsource that payment business to a payment institution.
The last part of the infrastructure consists of ATMs and the internet. The types of money on
this floor include commercial bank money, and central bank money (coins and bills).
N-corner models
Let’s start with introducing
the basic n-corner model:
the three-corner model.
The red lines are operated
by the bank. We can only
use three agents when the
payer and receiver have an
account at the same bank.
The exposure of the
receiver on the payer,
denoted by “a”, can be
removed once everything is settled. Everything is settled once “F2” is completed. Now let’s
look at the 4 corners model where again the transaction is done by a credit transfer.
2
,As you can see a lot of things are the same as in the three-corner model, however, we now
have two transactions of money. One on the mirror account, especially this transaction makes
the bank very vulnerable to bank runs. Again “a” disappears after everything is settled. This
model is functional since we (for now) assume that the bank of the payer is a client of the bank
of the receiver. When this is the case we speak of so-called ‘corresponding banking. Now
again let’s look at 4-corner but now with direct debit.
The following graph visualises a transfer
consisting of one agent, there is no
exposure since the payer is the receiver
and by definition, you can’t be exposed to
yourself. Furthermore, there is no
payment since you’re not obliged to pay
for a good/service, it’s more an instrument
that consists of transfers from personal to
saving accounts, etc. On the next page,
the process of a card payment is
visualised. First, we see the initiation
stage followed by the actual payment
stage.
3
, If we want to aggregate all
the individual transactions
done at the retail level we
need a clearing house. The
ACH establishes what every
bank has to pay to other
banks. This process can be
analysed by visualising the
6-corner model. This is a
much more efficient way of
processing transactions than
for example individually
aggregating all transactions
from the 4-corner model.
Important to note is that the automatic clearing house is an infrastructure and not a bank,
which means it’s an information processor, not a transaction processor. Also in the 6-corner
model “a”, which can also be seen as the “problem” to be resolved, disappears after
everything is settled.
As visualised in the picture we have
three different basic relations that
define the why, what, and how of the
warehouse. The where and why of the
warehouse are represented by the
first relationship and the how is
represented by the relationship at the
bottom. Let’s take a look at some
examples. First, when you open your
banking application to see how much
money is in your account. This number
is defined as information since it’s just the number representing how much is on your account.
Moreover, entering a transfer in your e-banking application is a transfer of information since
you’re initiating a payment, which has nothing to do with the value itself. Second, paying with
a contactless card in a shop. This is a transfer of information since you initiate the payment
process and do not transfer value. These examples illustrate the crucial difference between
value and information. An institution that holds value for its clients needs to have a license.
4
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