A Model of Tiered Settlement Networks

Authors


  • We have benefited from the comments and suggestions of Carlos Arango, Neville Arjani, Walter Engert, Marco Galbiati, Alexandra Lai, Lucy Liu, Dinah Maclean, Cesaire Meh, Sean O’Connor, William Roberds, Randall Wright, two anonymous referees, and seminar participants at the Bank of Canada, the Bank of England, Federal Reserve Bank of Chicago, Federal Reserve Bank of Kansas City, University of Wisconsin-Madison, 2008 Economics of Payments III at the Federal Reserve Bank of Atlanta, and 2008 North American Summer Meeting of the Econometric Society. The views expressed in the paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada.

Abstract

Payment and settlement networks typically involve various tiers of intermediation. This paper develops a model of settlement system to study the endogenous structure of tiered settlement networks, and the welfare consequences of clearing agent (CA) failure. We offer two explanations for tiering: private information regarding participant’s credit worthiness and economies of scale in the participation in the settlement system. CAs play a monitoring and cost-saving role in the settlement network. As a result, a failure of a CA can lead to a large and persistent welfare loss to the economy.

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