Journal of Financial Market Infrastructures

Welcome to the spring 2013 issue of The Journal of Financial Market Infrastructures. It is roughly a year since the Principles for Financial Market Infrastructures were published. Recently, in December 2012, an accompanying document called "Principles for financial market infrastructure: disclosure framework and assessment methodology" was published. The aim of the disclosure framework is to enhance the consistency of the information that the different financial market infrastructures (FMIs) are required to publish as part of the principles on transparency. The assessment methodology serves as a reference manual for those - such as the IMF, the World Bank, central banks (in their role as overseers) and securities regulators - examining an FMI's compliance. Last but not least, FMIs can also use the methodology when drawing up self-assessments.

Taking the principles, disclosure framework and assessment methodology together should enable the relevant authorities around the globe to assess the compliance of FMIs in their jurisdiction with the relevant subset of the twenty-four principles. Worldwide, central banks and securities regulators have begun implementing these principles in their legislative frameworks and oversight policies as a first step. Subsequently, a lot of assessments will have to be carried out in order to see whether the FMIs do indeed meet the new, more stringent principles. In the jargon of the rating framework used in the methodology, if a principle is met, we would say it had been "observed". In the coming years we will therefore hopefully see (full) observance of the transparency principles so that it becomes clear which infrastructures (payment systems, central counterparties, central securities depositories, securities settlement systems) are deemed systemically important. Let us call this set of infrastructures "SI": the set of all FMIs identified by authorities globally as systemically important.

It would be nice to now conduct the following thought experiment. Suppose that we annually consider SI and that information about the level of principle-by-principle compliance also becomes public. To start with we would surely see only partial compliance, but after sufficient time (this may be a long time, though) let us suppose that SI fully observes all individual principles. Is the systemic risk of FMIs then fully mitigated? Can we rest assured that the chance of that systemic risk manifesting itself has been eliminated? The answer is no. Full compliance of an FMI with all principles is not a guarantee that nothing can go wrong. There is no such thing as 100% safety. Full compliance gives us an assurance that the likelihood of malfunction and the propagation of systemic risk is low and hence the residual risk is small enough.

Accepting that the residual risk is nonzero, could we then relax knowing that full compliance of SI implies that residual risk has been minimized? The answer is, in my opinion, still no. FMI-by-FMI compliance does not necessarily mean that, at the holistic level of the warehouse (as introduced in my previous editor's letter), residual systemic risk is minimal. For an assessment of that risk, the structure of the whole FMI sector should be taken into account. To be clear, full compliance of all FMIs is a necessary but not sufficient condition for minimal residual systemic risk of SI. To stay in the language of the principles, we could define yet another principle, not for FMIs, but addressed at FMI researchers.

Principle 25: systemic risk of SI. An FMI researcher should analyze the interdependencies in SI of the FMI under study and should take them into account if they would alter their research conclusions compared with the situation of the FMI in isolation.

A principle on systemic risk cannot be addressed at a single FMI, but FMI researchers could take the bigger picture of interdependencies into account. As the warehouse interpretation clearly shows, infrastructural systemic risk can manifest itself along many different paths and in many different forms. It is therefore necessary to study systemic risk by taking multiple systems into account. Doing so is a daunting task for the future that can only be performed after we have gained sufficient knowledge at the level of individual infrastructures.

I am very happy to now introduce the four papers of this third issue of The Journal of Financial Market Infrastructures.

The first paper, "Network dynamics of TOP payments" by Marc Pröpper, Iman van Lelyveld and Ronald Heijmans, applies network theory to the Dutch real-time gross settlement system called TOP. They find that the network characteristics become clear within one hour of its daily formation. The network also exhibits a few nodes with a large number of connections, and a large number of nodes with only a few connections. The network properties changed considerably following the migration to TARGET2.

Our second paper, "Measuring free riding in large-value payment systems: the case of TARGET2" by Martin Diehl, addresses the topic of free riding in large-value payment systems. Free riding is here taken as paying in relatively late during the day. Using an axiomatic approach the author develops several measures for free riding including, among others, a cost and risk perspective.

The issue's third paper, "Making the over-the-counter derivatives markets safe: a fresh look" by Manmohan Singh, studies the issue of mandatory central clearing for over-the-counter derivatives following the call from the G20 summit in Pittsburgh in 2009. The author considers the risks involved in moving from the decentralized structure of today, with a small number of very large banks, to another decentralized structured with a number of central counterparties. More central counterparties would increase overall risk compared with the present situation. It is argued that as the preferred solution of a centralized structure with only one central counterparty is not likely to materialize, a tax on derivative payables could then be envisaged.

The fourth paper in the issue, "Pricing, competition and innovation in retail payment systems: a brief overview" by Wilko Bolt, provides a clear overview of fundamental economic issues in the retail payments sphere: competition in a two-sided market and the optimal pricing structure including the infamous interchange fee problem. This forum contribution also provides the reader with insights into the role of innovation and ways to regulate this market.

I hope this third issue of The Journal of Financial Market Infrastructures provides readers with sufficient food for thought.