The Payment System and Derivative Instruments
HBS Working Paper 95-028
Posted: 16 Sep 1999
This paper examines the basic mechanisms in the financial system that function to manage the risks and costs associated with the clearing and settlement of securities transactions. Transactions risk arises because of failure to consummate a trade, perhaps because the buyer could not arrange financing or because the seller failed to deliver. Transactions costs arise in the form of processing fees and the costs of financing or maintaining collateral. Key mechanisms for managing these costs and risks include mobilization of securities, netting, delivery versus payment, performance guarantees, and the extension of credit.The paper takes a broad view of the payment system, to include not just systems for clearing and settlement, but also derivative instruments, traditionally not viewed as integral to the payment system, except with the respect to their own clearing and settlement. The paper establishes that derivative instruments serve as an important extension of the payment system because they substitute in a variety of ways for trading in cash-market instruments. The paper explicitly compares the payment system demands of cash-market strategies with those of derivatives-based strategies, showing how derivatives-based strategies typically transform payments demands from a small number of large payments to a large number of small payments spread over time. By reducing the occurrence of large funds and securities transfers, derivatives usage can lower substantially the risk of payments failures. The paper concludes by focusing on the interbank foreign exchange market and examining alternatives for dealing with credit risk induced by different time zones ("Herstatt risk"). It illustrates how these alternative approaches the reduction of this risk, including netting and the use of derivatives, can serve as functional substitutes with very different implications for institutional change.
JEL Classification: G13
Suggested Citation: Suggested Citation