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Liquidity Risk in Securities Settlement

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  • Mitchell, Janet
  • Devriese, Johan

Abstract

This paper studies the potential impact on securities settlement systems (SSSs) of a major market disruption, caused by the default of the largest player. A multi-period, multi-security model with intraday credit is used to simulate direct and second round settlement failures triggered by the default, as well as the dynamics of settlement failures, arising from a lag in settlement relative to the date of trades. The effects of the defaulter's net trade position, the numbers of securities and participants in the market, and participants' trading behaviour are also analysed. We show that in SSSs ? contrary to payment systems ? large and persistent settlement failures are possible even when ample liquidity is provided. Central bank liquidity support to SSSs thus cannot eliminate settlement failures due to major market disruptions. This is due to the fact that securities transactions involve a cash leg and a securities leg, and liquidity can affect only the cash side of a transaction. Whereas a broad program of securities borrowing and lending might help, it is precisely during periods of market disruption that participants will be least willing to lend securities. Interestingly, settlement failures continue to occur beyond the period corresponding to the lag in settlement. This is due to the fact that, upon observation of a default, market participants must form expectations about the impact of the default, and these expectations affect current trading behaviour. If, ex post, fewer of the previous trades settle than expected, new settlement failures will occur. This result has interesting implications for financial stability. On the one hand, conservative reactions by market participants to a default - for example by limiting the volume of trades ? can result in a more rapid return of the settlement system to a normal level of efficiency. On the other hand, limitation of trading by market participants can reduce market liquidity, which may have a negative impact on financial stability.

Suggested Citation

  • Mitchell, Janet & Devriese, Johan, 2005. "Liquidity Risk in Securities Settlement," CEPR Discussion Papers 5123, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:5123
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    Cited by:

    1. Galbiati, Marco & Soramäki, Kimmo, 2011. "An agent-based model of payment systems," Journal of Economic Dynamics and Control, Elsevier, vol. 35(6), pages 859-875, June.
    2. Giulia Iori & Christophe Deissenberg, 2008. "An Analysis of Settlement Risk Contagion in Alternative Securities Settlement Architectures," Springer Books, in: Erricos J. Kontoghiorghes & Berç Rustem & Peter Winker (ed.), Computational Methods in Financial Engineering, pages 299-315, Springer.
    3. Leinonen, Harry (ed.), 2007. "Simulation studies of liquidity needs, risks and efficiency in payment networks: Proceedings from the Bank of Finland Payment and Settlement System Seminars 2005-2006," Bank of Finland Scientific Monographs, Bank of Finland, volume 0, number sm2007_039, December.
    4. Michele Manna & Carmela Iazzetta, 2009. "The topology of the interbank market: developments in Italy since 1990," Temi di discussione (Economic working papers) 711, Bank of Italy, Economic Research and International Relations Area.
    5. Li, Fangmin & Yang, Tianle & Du, Min & Huang, Miao, 2023. "The development fit index of digital currency electronic payment between China and the one belt one road countries," Research in International Business and Finance, Elsevier, vol. 64(C).
    6. Son, Bumho & Jang, Huisu, 2023. "Economics of blockchain-based securities settlement," Research in International Business and Finance, Elsevier, vol. 64(C).
    7. Serge Jeanneau & Camilo E Tovar, 2008. "Financial stability implications of local currency bond markets: an overview of the risks," BIS Papers chapters, in: Bank for International Settlements (ed.), New financing trends in Latin America: a bumpy road towards stability, volume 36, pages 65-87, Bank for International Settlements.
    8. Milne, Alistair, 2007. "The industrial organization of post-trade clearing and settlement," Journal of Banking & Finance, Elsevier, vol. 31(10), pages 2945-2961, October.
    9. Pedro Gurrola-Perez & Jieshuang He & Gary Harper, 2019. "Securities settlement fails network and buy‑in strategies," Bank of England working papers 821, Bank of England.
    10. Panourgias, Nikiforos S., 2015. "Capital markets integration: A sociotechnical study of the development of a cross-border securities settlement system," Technological Forecasting and Social Change, Elsevier, vol. 99(C), pages 317-338.
    11. John P Jackson & Mark J Manning, 2007. "Comparing the pre-settlement risk implications of alternative clearing arrangements," Bank of England working papers 321, Bank of England.
    12. Morten L. Bech & Rodney J. Garratt, 2012. "Illiquidity in the Interbank Payment System Following Wide-Scale Disruptions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(5), pages 903-929, August.
    13. Geert Langenus, 2006. "Fiscal sustainability indicators and policy design in the face of ageing," Working Paper Research 102, National Bank of Belgium.
    14. Merrouche, Ouarda & Schanz, Jochen, 2010. "Banks' intraday liquidity management during operational outages: Theory and evidence from the UK payment system," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 314-323, February.
    15. Silva, Walmir & Kimura, Herbert & Sobreiro, Vinicius Amorim, 2017. "An analysis of the literature on systemic financial risk: A survey," Journal of Financial Stability, Elsevier, vol. 28(C), pages 91-114.

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    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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