PrefBlog

The BoC released a fascinating Staff Working Paper by Rodney J. Garratt, Zhentong Lu and Phoebe Tian titled How Banks Create Gridlock to Save Liquidity in Canada’s Large Value Payment System:

Using detailed data from Canada’s new high-value payment system (HVPS), we show how participants of the system save liquidity by exploiting the new gridlock resolution arrangement. These observed behaviors are consistent with the equilibrium of a “gridlock game” that captures the key incentives that participants face in the system. The findings have important implications for the design of HVPSs and shed light on financial institutions’ liquidity preference.
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In this paper, we examine the launch of a new HVPS [High Value Payment System] in Canada called Lynx that substantially alters financial institutions’ incentives to provide liquidity.2 Whereas the previous system adopted liquidity pooling and risk sharing mechanisms to reduce banks’ liquidity needs, the new system requires banks to provide liquidity up front for all payments, with an exception for banks that have insufficient liquidity available in the designated payment stream to make the payment. In this case, payments are queued and settled on a net basis, a process called gridlock resolution. Participants would like to save liquidity by queuing payments (which will be resolved by the gridlock resolution mechanism). However, now they cannot queue payments directly and can only do this indirectly by keeping their liquidity low, so this is a ”friction” for them to access the queuing/gridlock resolution process.

The ”voluntary” queuing would give them direct control. The new system has two payment streams. Both are what payments professionals call real-time gross settlement streams (RTGS), because payments are made on a gross basis and are final and irrevocable once processed. However, one stream includes a gridlock resolution mechanism (we denote this stream by RTGSG thereafter) that has added functionality, and thereby dominates the pure RTGS stream. FIs quickly figured out a clever way to use both streams to their advantage.

In the Lynx system, gridlock resolution is activated only if there is insufficient liquidity in the payment stream to settle payments on a gross basis. Participants cannot voluntarily put payments into the gridlock queue. Hence, the only way for FIs to obtain the liquidity savings associated with netting in the gridlock resolution mechanism queue is to starve that stream of liquidity. By submitting more payments than liquidity to the RTGS stream with a gridlock resolution mechanism, FIs are able to trigger gridlock resolution and settle payments on a net basis.
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Recognizing an opportunity to save liquidity, on September 16, all the major participants jointly reduced their liquidity allocations to the RTGSG. As expected, this joint action created more gridlocks and queued payments, and activation of the gridlock resolution algorithm led to settling queued payments on a net basis, thus achieving the desired liquidity savings. Engaging the gridlock mechanism lead to delay in settlement of some payments. However, our calculations show that this shift in behavior brought down the system-wide liquidity level by about 76% and caused only about 30 minutes’ delay to the system.

The New York Fed updated the Global Supply Chain Pressure Index:

• Global supply chain pressures decreased again in April, falling to 1.32 standard deviations below the index’s historical average. The March value was revised downward from 1.06 to 1.15 standard deviations below the index’s historical average.
• There were significant downward contributions from Euro Area delivery times, Euro Area stocks of purchases, and Korean delivery times. While the overall index declined, there was a notable upward contribution from Taiwan stocks of purchases.
• Looking at the underlying data, the GSCPI’s recent downward trend has been consistently driven by improvements in Euro Area delivery times.

The TD takeover of First Horizon has been terminated:

Toronto-Dominion Bank and First Horizon Corp. have terminated TD’s proposed US$13.4-billion takeover of the Memphis, Tenn.-based bank, killing the Canadian lender’s expansion in the southeast United States.
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First Horizon’s share price fell sharply when markets opened, and was down 36 per cent to US$9.60 in early trading. TD’s share price rose 1.7 per cent to $82.89 on the Toronto Stock Exchange.

In recent months, TD investors had expressed concerns about the valuation and timing of the First Horizon deal because the banking sector is struggling and share prices have dropped. There were also questions about TD’s ability to turn around a business that was generating subpar growth and that had faced integration issues of its own [from] a prior merger, according to National Bank Financial analyst Gabriel Dechaine.

Charlotte Gerken, Executive Director of Insurance Supervision of the Bank of England, gave a speech titled Moderation in all things:

From historic lows of 0.1% in December 2021, the UK Bank rate rose to 4.25% in March 2023. While it could hardly be described as plain sailing for pension schemes or their sponsors, the rise in interest rates has generally reduced the value of their liabilities and boosted funding ratios (see chart 1). This has greatly improved the affordability of buy-outs for many pension schemes.

At the same time, trustees of pension schemes are reported to be increasingly viewing buy-outs as a long-term target[4]. Increased affordability and a decreased appetite to retain this risk have led to a growing appetite for schemes to transact in one go, rather than perform staged buy-ins spread over several years[5]. So called ‘jumbo’ schemes may also present exciting opportunities for the insurers. This all points to a material increase in pension schemes’ demand for BPA in 2023. But I’d note that this is an acceleration of the existing demand for BPA in a large but finite market in run-off (see chart 2 and 3).
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Secondly, the disruption in the UK gilt market last autumn resulted in some pension schemes being overweight in illiquid assets[7] as gilt values fell significantly, and schemes sought to reduce their leverage under liability driven investment strategies[8]. We see insurers increasingly developing solutions to accept illiquid assets as part of the BPA premium, as pension schemes may be reluctant to dispose of these assets in the open market, potentially at a large discount. This requires significant due diligence, and we are seeing insurers seeking more advice from third party specialists such as property valuation experts both for illiquid asset valuation and to calibrate adequate market value haircuts. Alternatively, we have seen deferrals of premiums incorporated in deals giving pension schemes time to dispose of such assets in an orderly fashion[9]. These premium arrangements can be complex and potentially capital intensive due to the increased uncertainty they can create.
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Related to that point, the third area I would like to touch on is a key aspect of the changing pensions and insurance landscape. One industry estimate, suggests that the UK life insurance industry could onboard more than £500bn of pension liabilities – and associated assets – over the coming decade[13] [14]. This is a big structural change in the control of long-term investments in the UK, and the decisions that insurers make now will have long term consequences for the performance and development of the broader economy.

This entry was posted on Thursday, May 4th, 2023 at 7:16 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.