2.1 Components of liquidity in RTGS systems

In general terms, for an individual participant in an RTGS system the four possible sources of funds are (a) balances maintained on account with the central bank, (b) incoming transfers from other banks, (c) credit extensions from the central bank and (d) borrowing from other banks through the money markets.

Balances maintained at the central bank can be a basic source of liquidity for the purpose of making funds transfers during the day. At a given point in time during the day, the level of the balance for an individual participant is determined by the starting/overnight balance and any payment activities (including both RTGS payments and any other transactions across the account), credit extensions by the central bank and central bank monetary operations that have taken place by that time. Starting balances may be generated by reserve requirements that are usually imposed for monetary policy reasons. Provided they are available for payment purposes during the day, required reserves can be a helpful source of intraday liquidity, as has proved to be the case in several G­10 countries. The importance of required balances may, however, vary between countries, depending on the nature of the reserve maintenance regime (e.g. the level of the required reserve ratio and any averaging provisions).

Incoming transfers can also be an important source of intraday liquidity. The importance of incoming transfers depends on the patterns and predictability of payment inflows and outflows. If, for instance, payment flows tend to result in a specific pattern for a particular bank (such as net payment outflows) or if the intraday timing of incoming and outgoing transfers tends to be asymmetrical, incoming transfers may be less reliable as a funding source for outgoing transfers. Furthermore, the usefulness of incoming transfers may also be affected by the availability of information on them; the more information that is available in real time, the more effectively banks may be able to use incoming transfers in their liquidity management.

Intraday liquidity may be provided by the central bank through credit extensions. As described in Section II.1, many central banks provide intraday credit, typically free of interest charges, through fully collateralised intraday overdrafts or intraday repos. As already noted, Fedwire charges a fee for the use of the uncollateralised intraday overdraft facility that it provides up to a limit based on a bank's creditworthiness and capital. Central banks may also have some kind of overnight central bank liquidity facility that RTGS participants may access under certain conditions. However, overnight credit extensions from the central bank (e.g. overnight loans or overdrafts) may be considered a relatively costly funding source to support intraday payment activities, because the funds only needed for an intraday period must be borrowed overnight and they can in some cases incur an implicit or explicit extra cost (e.g. penalty rate) in addition to the discount or market rate.

Banks in an RTGS system may also be able to obtain funds by borrowing from other banks through the interbank money markets. Money market credit extensions such as overnight and term loans may allow banks to fund intraday payment flows, depending on the time of day that market conventions set out for loans to be arranged, made available and repaid. For example, if banks can borrow from overnight interbank markets throughout the operating hours of the RTGS system, the loan proceeds could be available to fund transfers intraday (i.e. depending on when the funds are credited to the borrowing bank's account). While credit extensions from the central bank can be regarded as external liquidity support that injects additional liquidity into the system, money markets can only serve to redistribute funds already within the system, although that may nevertheless make an important contribution to reducing the reliance on banks' reserve balances and central bank credit extensions.

Intraday money markets could also act as a private sector liquidity source in the RTGS environment. In such markets banks would lend reserve balances on an intraday basis provided that the intraday timing of loans being arranged and repaid could be assured and the transaction costs of such arrangements were not prohibitive. If such a market existed, banks could operate with lower balances because of the ability to redistribute balances across banks during the day. At the moment, however, the only example of an intraday money market in the G­10 countries that has developed from an RTGS environment seems to be that in Switzerland, and even that is a very limited market for special time­critical payments in connection with securities transactions. An intraday interbank market also exists in Japan but this market is not directly related to the intraday liquidity needs under RTGS but rather to the need for bridging liquidity between four designated net settlement times in BOJ­NET. The possibility of the development of intraday money markets in an RTGS environment is considered in more detail in Section III.2.

2.2 Measures of intraday liquidity

On the basis of the four components discussed above, liquidity as applied to the operation of RTGS systems may be measured both from an individual bank's perspective and from a system perspective. From a bank's perspective, intraday liquidity may be taken to be the bank's ability to settle a given value and number of transfers within a given time constraint.

One way to characterise this concept would be to define so­called "net" intraday liquidity on the basis of actual cash flows. As already noted, a bank's actual balance at the central bank at a given point in time during the day is determined by the starting balance as well as any payment or monetary activities and credit extensions that have taken place by that time. This actual balance, however, may not necessarily represent the liquidity immediately available for the bank to initiate new outgoing transfers at that time, because some or all of the transfers that it has already initiated may be queued within its internal system or in the centrally located queue. A bank's net intraday liquidity, which may correspond more closely to its ability to settle its outgoing transfers at a given point in time, could be defined as the actual balance minus the value of all pending transfers.

Alternatively, a bank's net intraday liquidity could be defined on the basis of the sum of actual and potential cash flows. Such a concept has been adopted in some RTGS systems as a measure of available liquidity, although in some other cases it has been felt that incorporating potential cash flows may be too difficult. Potential cash flows refer to potential funds which a bank could mobilise or use for cover. For example, a bank might include queued incoming transfers as a source of liquidity that it expects to be available shortly for its own outgoing transfers. In this case, a bank's net intraday liquidity is defined as the actual balance plus the value of queued incoming transfers minus queued outgoing transfers. As potential sources of liquidity, a bank might also include, for example, unused credit lines or liquid collateral.

Concepts of illiquidity. If net intraday liquidity is negative, the bank can be viewed as being illiquid in the sense that it is unable to settle some or all of its queued outgoing transfers. However, care needs to be taken in interpreting the concept of a bank's illiquidity. Although transfers processed over an RTGS system have some degree of time­criticality, not all transfer orders are time­critical in the sense that they must be settled either at or by a specific point in time during the day or within a specified and limited interval of time during the day. Some funds transfer orders may be time­critical only in a same­day sense even in an RTGS environment. Time­criticality and intraday time constraints may be influenced by the nature of the transfers, transaction pricing policy (see below) and rules relating to end­of­day closing procedures. Accordingly, even if a bank becomes illiquid, it may be able to delay certain less time­critical transfers in order to allow subsequent incoming transfers to provide the necessary liquidity. The scope for such liquidity management will vary, and typically will narrow towards the end of the day. In practice, therefore, for illiquidity to have a significant impact on a bank, it must occur over some "significant" interval of time.

System liquidity and gridlock. From a system perspective, the concept of intraday liquidity could be related to the "amount" of funds that enables the system to process transfers between all or most of banks in a timely manner. However, it is more difficult to analyse system liquidity because it is not simply the sum of each bank's net intraday liquidity as defined above. Whether the system is liquid or not also depends crucially on the distribution (or concentration) of liquidity among banks in relation to their payment needs. For instance, gridlock could be characterised as a case of system illiquidity in which the failure of some transfers to be executed prevents a substantial number of other transfers from other participating banks from being executed. Of course, gridlocks could occur when the aggregate liquidity is insufficient, but they might occur even if the liquidity in the system, taking into account all queued incoming and outgoing transfers, was adequate overall but poorly distributed. Suppose two systems had the same aggregate sum of bank liquidity: one might be liquid while the other might be in gridlock if liquidity was concentrated among a few banks in that system (see Box 2). Because of this, some systems provide banks with ways of breaking gridlock.

Another important issue in connection with system liquidity is that there might be negative externalities relating to the use of a bank's liquidity. For instance, a bank may deliberately be slow in processing transfers in order to economise on its own liquidity by relying on the receipt of incoming transfers from others. If such behaviour is widespread, there is the potential for a kind of self­imposed gridlock as each bank delays sending its payments until others do so, with the result that (in an extreme case) none are sent.

2.3 Management of intraday liquidity: an individual bank's perspective

The need to have intraday liquidity typically entails a positive cost for banks in the form of funding costs and/or opportunity costs. Banks therefore have incentives to manage intraday liquidity by attempting to minimise it subject to certain constraints. Constraints on intraday liquidity management vary from system to system. In general, banks are likely to try to avoid undue delays in time­critical transfers (both because of customer relations and on account of possible legal liabilities) as well as to try to minimise end­of­day overdrafts or processing penalties. For these purposes, for example, banks may hold precautionary balances to guard against urgent and unexpected transfers. Reserve requirements could also be a constraint, particularly if the requirement has to be met each day.

An optimal level of intraday liquidity for an individual bank may be determined by the balance between the costs of obtaining or maintaining liquidity and the costs of delaying settlement. As noted in subsection II.1.1, the former (liquidity costs) may include direct funding costs, opportunity costs of maintaining funds in the central bank accounts and opportunity costs of tying up collateral or securities for central bank credit. The opportunity cost associated with collateral for obtaining intraday liquidity could be relatively low if banks already hold the relevant types of asset in sufficient quantities, which they might do as part of their portfolio strategy or for other reasons. Although it may not be easy to measure in practice, from an analytical point of view the concept of "settlement­delay costs" could be defined as the potential or actual economic costs incurred if the settlement of funds transfer orders were delayed. The degree of settlement­delay cost in a particular RTGS system may depend on the time­criticality of the underlying transactions, transaction pricing policies as described below and, more generally, market practices. Given the level of liquidity costs, banks are likely to have stronger incentives to obtain or maintain intraday liquid funds as delaying settlement becomes more costly.

With a given starting balance, banks may operate intraday by adjusting the use of intraday or overnight credit, sequencing incoming and outgoing transfers or, in limited circumstances, selling assets for same­day settlement. Of these possibilities, sequencing transfers is a way of controlling intraday payment flows by scheduling the timing of outgoing transfers according to the supply of liquidity provided by incoming transfers. Importantly, to the extent that incoming and outgoing transfers are successfully sequenced, it could generate virtual "offsetting effects" on RTGS payments and hence contribute to substantially reducing the necessary liquidity. The most common way of sequencing is to use queuing arrangements. Regardless of whether it is centralised or decentralised, queuing allows banks to sequence transfers in a systematic way. Queuing is described and discussed in detail in Section II.4.

Another method of sequencing transfers may involve message codes indicating the time of day that an individual outgoing transfer should be settled. Such time­of­day message codes may be used to store transfer orders within the central processor in the system or within the internal system of the sending bank. Time­of­day message codes might allow banks to better forecast liquidity requirements by increasing the certainty of the timing of debits and credits associated with transfer orders involving a standard time­lag between the transaction date and the settlement date (e.g. securities and foreign exchange transactions), intraday and overnight loans and other time­critical transfers such as those for the settlement of balances in net settlement systems.

Even if they attempt to coordinate incoming and outgoing transfers as closely as possible, banks may still face several limitations in minimising intraday liquidity requirements. First, as noted above, if transfers are time­critical, that limits the extent to which banks can delay them. Second, individual transfer orders are often very large. Breaking down a particularly large transfer into two or more smaller amounts may facilitate sequencing, and in some RTGS systems this is actually done as a standard means of liquidity management. Nevertheless, the resulting transfers can still be large, which would make closer sequencing difficult. Third, banks cannot have complete information about the transfers they are due to receive and send on that day, so that they have to sequence transfers more or less on the basis of predictions.

2.4 Management of intraday liquidity: a system perspective

The management of intraday liquidity from a system perspective may concern both management of the aggregate level of liquidity relative to payment requirements in the system and management of the distribution of liquidity among banks. For the former purpose, the central bank may typically provide individual banks with credit directly for settlement purposes or indirectly through monetary operations according to its policy.

It is possible that the optimal liquidity management from an individual bank's perspective may not necessarily be best for the system as a whole. As noted earlier, a bank may make a deliberate attempt to delay the processing of transfers to economise on its own liquidity by relying on the expected receipt of liquidity from others. To minimise the possible negative effects of such behaviour on system liquidity, RTGS systems sometimes incorporate mechanisms to discourage "selfish" behaviour and to encourage early processing and/or settlement of transfers. One way is to lay down rules governing banks' outgoing payment flows, such as guidelines requiring banks to send a certain proportion of their daily payment messages by specified times. Such a rule would discourage banks from delaying transfers. However, it may be inappropriate in some cases; for instance, some banks may have atypical intraday patterns of transfers, making it unrealistic for them to observe such a rule. Or it may be that the rule is incompatible with the pattern of transfers deriving from DVP or (future) PVP arrangements, where the timing of transfers is critical. At the least, therefore, some flexibility may be needed in setting and applying such a rule.

An alternative method may be to apply a transaction pricing policy that would encourage the early processing (input) and settlement of transfer orders. For instance, SIC applies a pricing schedule for sending banks that penalises (i.e. sets a higher charge on) late input and settlement of transfer orders, while the receiving bank is subject to a flat pricing schedule. This has led banks to send and settle their bulk low­value payments as early as possible, ahead of large­value funds transfers. Some proposed systems are also considering the possibility of adopting a pricing policy that would set a higher charge on queued or late transfers (i.e. transfers that are entered only shortly before the close of the system). Charging a penalty fee on the transfers that remain unsettled at the end of the day could be used to complement such a transaction pricing policy.

Monitoring system liquidity. Central banks (or system centres) are in many cases concerned with monitoring and managing liquidity in RTGS systems so as to maintain a smooth flow of payments and to detect and prevent possible gridlocks. There are significant differences in central banks' technical approaches to monitoring system liquidity. For example, the Bank of Italy envisages an "indicator approach" to real­time monitoring whereby the central bank will pay particular attention to synthetic indicators calculated on the basis of several key parameters such as the total amount of liquidity available in the system, the volume of transfers entered into the system and the volume of settled transactions. The indicators will be used to observe the queues and intraday liquidity in the system as a whole and also to identify any potential gridlocks which may require further investigation of an individual bank's net liquidity position. On the other hand, the Bank of France will take a more "micro approach" whereby it will monitor in real time each bank's net intraday liquidity. In contrast, the Swiss National Bank does not systematically monitor system liquidity in SIC. This reflects its view that monitoring liquidity is mainly the responsibility of participants and that there should be no intervention by the central bank or the system in the centrally located FIFO queue.

2.5 Structural factors affecting liquidity requirements and management

There are various structural factors that may affect liquidity requirements and management in an RTGS system. First, the number of participants may be of significance. Compared with a system with a larger number of participants, an RTGS system with relatively fewer participants might internalise a greater proportion of third­party payments and therefore have a lower level of interbank transfers sent over the system; as a result, less intraday liquidity might be required at the system level to process a given volume of payments. Such a system may also have more concentrated, offsetting payment flows between banks and thus incoming transfers would be a relatively more important source of liquidity. Furthermore, it might technically be less complicated for banks to monitor, control and sequence payment flows in a system with relatively fewer participants.

Second, the relative market size (in terms of payment activity) or asset size of participants may affect liquidity. An RTGS system with a mixture of large, medium and small participants may have a different set of intraday liquidity requirements from a system consisting of participants of broadly equal size. Larger banks, for instance, may have a more balanced intraday flow of incoming and outgoing transfers, so that incoming transfers can provide the liquidity needed to fund outgoing transfers, while smaller banks may process fewer transfers or tend to be net senders/receivers of funds in the RTGS system. Larger banks may also find it easier to obtain the necessary liquidity if they have better access to funding and credit markets or a larger deposit base than smaller banks.

Third, participants' areas of specialisation may matter. If an RTGS system is composed of banks that specialise in a variety of different market segments (such as merchant banking, credit card transactions, deposit­taking, clearing activities, foreign exchange transactions and securities transactions), payment flows and patterns and the resulting liquidity requirements may differ from those in systems where participants tend to offer a more uniform range of products and services.

Fourth, the structure of the payment systems and flows outside the RTGS system may affect RTGS liquidity. Non­RTGS payments can be an important "exogenous" factor affecting a bank's RTGS liquidity. In practice, the mechanism through which non­RTGS payments influence RTGS liquidity may take a variety of forms. Typically, net settlement obligations resulting from other settlement systems (e.g. cheque clearing, other large­value transfer systems, ACH transactions and securities settlement systems) are settled periodically over the RTGS system or at least processed through the same central bank account as that on which the RTGS system relies for intraday liquidity (see Section III.1). In such circumstances where RTGS payments and the settlement of non­RTGS payments are interrelated and "competing" uses of liquidity could therefore arise, banks may use internal systems capable of integrating their RTGS and non­RTGS payment activities on an intraday basis to manage their overall liquidity. At the same time, since the settlement of foreign exchange transactions accounts for a substantial part of the total value handled by many RTGS systems, existing or proposed netting arrangements for such transactions (e.g. FXNET, ECHO and Multinet) may, by requiring only the net value of the transactions to be settled, also have an effect on the value and timing of transactions, and consequently on the liquidity, in some RTGS systems.

Fifth, the structure of central bank accounts may be an important factor influencing RTGS liquidity. As the comparative table in Annex 1 shows, there are differences between G­10 countries in the way central bank accounts are organised: central bank accounts for RTGS may be unified with or segregated from central bank accounts for other purposes, for example for required reserves. Moreover, central bank accounts may be centralised (i.e. banks hold accounts for making transfers at only one office of the central bank) or decentralised (i.e. they are permitted to hold accounts at more than one office).

One question is whether, under a decentralised account structure, banks are able to monitor balances and shift them efficiently between accounts on a real­time basis for liquidity purposes. In general, the structure of central bank accounts in a country is determined by a number of different considerations and therefore an optimal account structure will not necessarily depend only on the settlement arrangements for RTGS systems. However, in countries that have a decentralised account structure and where RTGS systems are operating or planned, there seems to be a broad tendency to centralise/consolidate central bank accounts, or at least to centralise the arrangements for processing the account data. This may suggest that a more centralised structure is sometimes a more efficient and straightforward structure for an RTGS environment, in particular in terms of liquidity management. For example, in preparation for TBF, the Bank of France is moving from a decentralised account structure in its branches to a centralised one at the head office. In Germany the Bundesbank has so far provided several facilities to help banks manage liquidity in a more centralised way in EIL­ZV under the decentralised account structure. In addition, it plans to convert the current decentralised electronic data­processing structure into a new centralised one and to take further steps to provide more comprehensive information about queued payments with a view to enabling banks to conduct more efficient liquidity management. In the United States the Federal Reserve is taking the approach of using centralised accounts but with distributed sub­accounts to provide for segregation and flexibility as regards transaction information.