Payments and Mechanism Design

We use mechanism design to study efficient intertemporal payment arrangements when the ability of agents to perform certain welfare-improving transactions is subject to random and unobservable shocks. Efficiency is achieved via a payment system that assigns balances to participants, adjusts them based on the histories of transactions, and periodically resets them through settlement. Our analysis has several implications for the design of actual payment systems. Efficiency requires that, in order to overcome informational frictions, agents participating in transactions that do not involve monitoring frictions subsidize those that are subject to such frictions. Optimal settlement frequency should balance liquidity costs from settlement against the need to provide intertemporal incentives. Settlement costs must be borne by agents for whom the incentives to participate in the system are highest. Finally, an increase in settlement costs implies that, in order to counter a higher exposure to default, the frequency of settlement must increase and, at the same time, the volume of transactions must decrease.