Sorry for the lack of updates. I have a whole bunch of material of material I need to publish on MarketSkeptics.com.
Anyhow, for now, here is an explanation for the Fedwire Funds Transfer System from the Federal Reserve. It is very helpful for understanding the financial system if you understand the payment system holding it up.
(emphasis mine) [my comment]
Effective financial systems depend on safe and efficient payment systems, particularly systemically important payment systems. Systemically important payment systems can transmit economic shocks across markets and international borders. Poorly designed or operated payment systems can exacerbate economic disturbances, while well-managed systems help minimize these disturbances.
As a real-time gross settlement (RTGS) system for the United States and the U.S. dollar, the Federal Reserve Banks' Fedwire® Funds Service (Fedwire) plays a critical role in the implementation of United States monetary policy through the settlement of domestic money market transactions. Fedwire is also an important vehicle for time-critical payments, such as the settlement of commercial payments and financial market transactions.
Fedwire is a RTGS system owned and operated by the Reserve Banks that enables participants to make final payments in central bank money. Fedwire consists of a set of computer applications that route and settle payment orders. In addition, Fedwire and related applications review payment orders for syntax errors, query and update account balances, and notify participants of related credits and debits to their accounts. Fedwire is supported by a national communications network.
An institution that maintains an account with a Reserve Bank generally can become a Fedwire participant. Participants use Fedwire to instruct a Reserve Bank to debit funds from the participant's own Reserve Bank account and credit the Reserve Bank account of another participant. Fedwire processes and settles payment orders individually throughout the operating day. Payment to the receiving participant over Fedwire is final and irrevocable when the amount of the payment order is credited to the receiving participant's account or when the payment order is sent to the receiving participant, whichever is earlier. Fedwire participants send payment orders to a Reserve Bank on line, by initiating an electronic message, or offline, via telephone. Payment orders must be in the proper syntax and meet the relevant security controls. An institution sending payment orders to a Reserve Bank is required to have sufficient funds, either in the form of account balances or overdraft capacity, or a payment order may be rejected.
The Reserve Banks developed Fedwire to improve the safety and efficiency of the interbank settlement process. In the early 1900s, settlement of interbank payment obligations often involved the physical delivery of cash or gold to counterparties, which was both risky and costly. To mitigate these risks, in 1918, the Reserve Banks introduced its first dedicated funds transfer network, featuring a Morse code system that connected the twelve Reserve Banks, the Board, and the United States Department of the Treasury. The key feature of this arrangement was the ability to transfer balances held at the Reserve Banks using a secure communications network. The elements of this feature remain the foundation of Fedwire operations.
As communications technology improved throughout the century, the Reserve Banks also improved Fedwire, striving to increase its levels of security and automation. From the 1920s to the 1960s, Fedwire migrated from leased-line public telegraph circuits to telex to computer operations and proprietary telecommunications networks. These operations were organized and executed on a decentralized basis among the twelve Reserve Banks. This organization matched the localized structure of the domestic banking system at the time and allowed each Reserve Bank to serve the specific needs of institutions in its Federal Reserve District.
During the 1980s, however, the consistency of services across Districts became increasingly important as interstate banking emerged in the United States. More bank holding companies owned depository institutions in multiple Districts and sought greater standardization of Reserve Bank services. The Reserve Banks addressed this demand by deploying standard software in each Reserve Bank.
In the 1990s the Reserve Banks consolidated most mainframe computer operations, centralized certain payment applications, and consolidated Fedwire management at specific Reserve Banks. Section 10 of this assessment provides greater detail about these organizations and the roles they play.
Recently, the Reserve Banks have started to take advantage of the flexibility and efficiency that Internet protocol (IP) and distributed processing technologies offer. The Reserve Banks are using these technologies to enhance the functionality and operational reliability of Fedwire and other Reserve Bank services.
An institution that maintains an account at a Reserve Bank generally is allowed to be a Fedwire participant. These institutions include Federal Reserve member banks, nonmember depository institutions, and certain other institutions, such as U.S. branches and agencies of foreign banks ["institution" refers to Federal Reserve member banks, nonmember depository institutions as defined in Section 19 of the Federal Reserve Act, U.S. branches and agencies of foreign banks, and Edge and agreement corporations]. ...
Vehicles for Access
Fedwire funds transfers can be initiated online or offline. ...
Fedwire operating hours for each business day begin at 9:00 p.m. eastern time (ET) on the preceding< /i> calendar day and end at 6:30 p.m. ET, Monday through Friday, excluding designated holidays. ...
Intraday central bank credit in the form of daylight overdrafts is generally available to Fedwire participants. Additional information on the provision of daylight credit to Fedwire participants is provided in section 3 of this assessment.
Many Fedwire participants use daylight credit to make payments throughout the operating day. Overall, aggregate average daylight overdrafts averaged $62 billion per day in 2008, with aggregate peak daylight overdrafts averaging $169 billion each day. In 2008, ten institutions accounted for about 78 percent of total average overdrafts.
In 2008, Fedwire processed an average daily volume of approximately 521,000 payments, with an average daily value of approximately $2.7 trillion. The distribution of these payments is highly skewed, with a median value of approximately $24,000 and an average value of approximately $5.8 million. Roughly 11 percent of Fedwire payments are for more than $1 million. Approximately 7,300 depository institutions are eligible to initiate or receive funds transfers over Fedwire. Use of Fedwire, however, is also highly skewed. Sixty-seven participants account for 80 percent of the volume of payments, and twenty-three participants account for 80 percent of the value of payments.
1.1.1 Federal Reserve Act
Several sections of the Federal Reserve Act (FRA) provide the legal basis for operating Fedwire. The FRA permits a Reserve Bank to receive deposits from any of its member banks or other depository institutions and to receive deposits from other Reserve Banks for purposes of exchange or collection. In addition, balances maintained at the Reserve Banks can be checked against and withdrawn from for the purpose of meeting existing liabilities. ...
1.3 Other Applicable Laws
U.S. depository institutions and U.S. branches and agencies of foreign banks are subject to the liquidation provisions of applicable federal and state banking laws. The liquidation provisions of U.S. banking laws do not contain a zero-hour rule that would have the general effect of voiding a settled funds transfer over Fedwire involving an insolvent participant [TRANSLATIONS: Do not be afraid to do business with institutions you know to be insolvent (The US financial system wouldn't work without this)]. The payment from the originator to the beneficiary should not be affected by the insolvency of an institution unless the institution is the originator and a court finds the payment void as a fraudulent conveyance, unlawful preference, or some similar inequitable conduct.
2.2 Financial Risks in Fedwire
As with other RTGS systems, Fedwire processes transfers individually, as soon as they are received. Continuous real-time processing and the immediate settlement finality provided by Regulation J insulate receiving Fedwire participants from credit risk.
To effect the smooth and efficient operation of Fedwire, the Reserve Banks provide daylight credit, in the form of daylight overdrafts, to most Fedwire participants. The provision of daylight credit converts the liquidity risk otherwise borne by participating institutions to credit risk borne by the Reserve Banks. Although Reserve Bank daylight credit eliminates almost all liquidity risk on Fedwire, the daylight credit limits prescribed by the Board's PSR policy can constrain some Fedwire participants' payment operations. Each participant is aware of these constraints and is responsible for managing its account throughout the day.
3.1 Management of Credit Risk
3.1.1 Credit Risk to Participants
Funds transfers over Fedwire settle in central bank money with immediate finality and, as a result, credit risk to the receiving institutions is eliminated. Sending institutions, however, may face the operational risk of erroneous funds transfers because of these characteristics.
3.1.2 Credit Risk to the Central Bank
To the extent a Reserve Bank provides daylight credit to a Fedwire participant, it exposes itself to direct credit risk from that participant. If that participant were to fail and be closed before it extinguished its daylight overdraft, its Reserve Bank could face a financial loss. The PSR policy attempts to control and mitigate these exposures while providing sufficient liquidity to account holders for making payments.
Part II of the PSR policy, adopted in 1985 and modified subsequently, sets out the Federal Reserve's rules regarding the use of Reserve Bank intraday credit or daylight overdrafts. The policy requires all institutions incurring daylight overdrafts in their Reserve Bank accounts to establish a maximum limit on uncollateralized daylight overdrafts ("net debit cap"), based on a multiple of the institution's risk-based capital. Only those institutions eligible to use the discount window, the Reserve Bank's overnight credit facility, may incur daylight overdrafts. All net debit caps are granted at the discretion of the Reserve Banks.
Net Debit Caps
One way that the Reserve Banks manage their credit risk is through periodic and ongoing assessments of institutions' financial condition. Institutions that have access to the highest levels of daylight credit must assess annually their financial condition and operating environment. Net debit caps for these institutions generally are based on creditworthiness, as determined by the institutions' capital adequacy and most recent supervisory rating. Moreover, these institutions must monitor and control their customers' use of daylight credit. Institutions with unsatisfactory creditw orthiness may not use Reserve Bank intraday credit.
In addition, the Reserve Banks have developed extensive guidelines to monitor internally the condition of institutions that have access to Reserve Bank intraday credit. These guidelines, known as the "condition monitoring" guidelines, establish standard criteria and practices used by the Reserve Banks for account risk management. These criteria help identify institutions that present high potential risk to the Reserve Banks and that, as a result, require special controls and monitoring. The Reserve Banks may decrease or reduce to zero an institution's net debit cap. Reserve Banks may also choose to monitor an institution's payment activity in such a way that if an outgoing Fedwire funds transfer exceeds the institution's available funds, the transfer will not be processed and may be immediately rejected back to that institution.
The PSR policy generally does not require institutions to pledge collateral to the Reserve Bank to secure daylight overdrafts. The PSR policy allows certain institutions to pledge collateral for the specific purpose of gaining additional daylight credit beyond a net debit cap. In addition, the Reserve Bank may require institutions that pose exceptional risk, such as those in weakened financial condition or in imminent danger of failure, to pledge collateral to secure any daylight overdrafts.
Even though the PSR policy does not require the explicit collateralization of most daylight overdrafts, a significant amount of the Reserve Banks' intraday credit exposure is secured by collateral. Regulation J provides that, to secure any overdraft, as well as any other obligation due or to become due to its Reserve Bank, each sender, by sending a payment order over Fedwire, grants the Reserve Bank a security interest in all of the sender's assets in the possession of, or held for the account of, the Reserve Bank. The security interest attaches when an overdraft or other obligation becomes due and payable. Thus, any of the sender's assets that are in the possession of, or held for the account of, a Reserve Bank secure the sender's daylight overdrafts, up to the value of those assets.
Daylight Overdraft Fees
Since 1994 the PSR policy has included a fee on daylight overdrafts. The intent of this fee is to moderate the use of daylight credit. The fee is set as an annual percentage rate. Initially, this rate was set at 24 basis points and was increased to its current level of 36 basis points on April 13, 1995. The overdraft fee is applied to a measure of average daily overdrafts for each institution less a deductible amount related to the institution's capital.
3.2 Management of Liquidity Risk
3.2.1 Liquidity Risk to Participants
An institution's account balance, which includes both reserve and clearing balances, is available for settlement purposes throughout the Fedwire business day. In addition, most Fedwire participants have access to Reserve Bank daylight credit. Although this intraday credit eliminates almost all liquidity risk in originating Fedwire payments, certain participants can be constrained from making payments by controls and monitoring that may be imposed by the Reserve Banks.
Daylight overdrafts must be extinguished by the end of the operating day. Daylight overdrafts can be extinguished by incoming payments to an institution's Reserve Bank account, including payments from financing obtained in the money markets, or borrowed funds from the Reserve Banks' discount window. To obtain a discount window loan, institutions must have executed the appropriate legal agreements with and pledged adequate collateral to its Reserve Bank. Daylight overdrafts are not automatically converted into discount window loans. An institution must contact its Reserve Bank and explicitly request the discount window loan. A discount window loan is made at the discretion of a Reserve Bank.
3.2.2 Liquidity Risk to Central Bank
Because the Reserve Banks have access to unlimited liquidity [ie: ability to print money], the Reserve Banks do not face liquidity risk from Fedwire operations or the provision of intraday credit.
3.3 Tools for Managing Credit and Liquidity Risks
The Reserve Banks maintain a series of tools to manage the financial risk posed by Fedwire participants. These tools include an account balance monitor, a daylight overdraft reporting and pricing system, a collateral management system, and a database that aggregates supervisory, financial, and other information to assess risk and creditworthiness.
The Reserve Banks monitor, in real time, the payment activity and intraday account balances of certain institutions, including those deemed to pose heightened risk to the Reserve Banks, such as institutions in deteriorating financial condition or with a history of excessive overdrafts. If an institution that is being monitored sends any outgoing Fedwire funds transfer that exceeds the institution's available funds, the transfer is immediately rejected and sent back to that institution. The institution can initiate the transfer again when sufficient funds became available in its account. Because only a small number of institutions are monitored in this way, it is mechanically possible, although not permitted under the policy, for most institutions to send payments in excess of their available funds, exposing the Reserve Banks to credit risk beyond institutions' net debit caps.
In addition, the Reserve Banks support a collateral-management system, which is an automated collateral inventory and transaction-processing application used to monitor collateral held primarily for discount window, PSR, a nd Treasury programs. The system supports the valuation of collateral pledged to the Reserve Banks. Fedwire participants do not have access to this system, but periodically receive reports regarding their collateral holdings from the Reserve Banks.
3.4 Incentives to Manage Credit and Liquidity Risks
Daylight Overdraft Fees
The daylight overdraft fee is a critical component of the Board's PSR policy. The Board believes that the fee encourages institutions to reduce and manage daylight overdrafts, thereby reducing overall credit risk to the Reserve Banks. From its inception, the fee was intended to create economic incentives for institutions that incur large daylight overdrafts to reduce and allocate more efficiently their use of daylight credit.
Institutions that do not extinguish their daylight overdraft position by the end of the Fedwire operating day may be charged for an overnight overdraft. The rate charged on overnight overdrafts is generally four percentage points more than the effective federal funds rate on the date the overdraft occurred. In addition, the institution must make up reserve balance deficiencies subsequently by holding extra reserves.
Institutions in sound financial condition that incur daylight overdrafts in excess of their net debit caps are contacted by the Reserve Banks and counseled to keep future overdrafts within the appropriate limits. Institutions that frequently exceed their net debit caps [ie: Institutions in unhealthy financial condition] may be required to apply for a higher cap, if eligible, to increase their clearing balances, to pledge collateral, or to have payments monitored in real time.
9.1 Access to Fedwire
An institution with an account at a Reserve Bank may access Fedwire subject to the conditions detailed in OC 6, Operating Circular 5 (Electronic Access), and the PSR policy.
9.2 Access to an Account at the Federal Reserve
Any depository institution, Federal Reserve member institution, or otherwise eligible institution, including a U.S. branch or agency of a foreign bank, may maintain an account with a Reserve Bank. Each separately chartered or licensed eligible institution may hold a single "master account," with the possibility of creating multiple subaccounts. To obtain an account, an institution must execute an account agreement pursuant to OC 1, which outlines the terms and conditions for a master account.
9.3 Termination of Access
Reserve Banks retain the right to limit their risk exposure. If an institution presents undue risk to a Reserve Bank [and it is not TBTF], the Reserve Bank will generally follow a series of escalating steps to reduce its exposure to that institution. The PSR policy outlines these steps with respect to daylight credit and Fedwire. Reserve Banks may counsel the institution, discussing ways to reduce its excessive use of intraday credit. The Reserve Banks also retain the right to reduce unilaterally net debit caps, impose collateralization or clearing balance requirements, hold or reject Fedwire transfers, or in extreme cases limit the institution to originating only offline payment orders or prohibit it from using Fedwire altogether.
4. An institution generally only holds one "master account" with a single Reserve Bank. This account contains all balances, including those held to meet reserve requirements or clearing balance requirements. Additional information on reserve requirements and clearing balances can be found in the Reserve Maintenance Manual (1.6 MB PDF). Return to text.
5. Additional information on the history of Fedwire can be found in Fedwire: The Federal Reserve Wire Transfer Service, Federal Reserve Bank of New York, March 1995, and "Creating an Integrated Payment System: The Evolution of Fedwire," Adam Gilbert, Dara Hunt, and Kenneth C. Winch, Federal Reserve Bank of New York Economic Policy Review, July 1997. Return to text.
9. Average and peak overdraft figures do not include overdrafts by GSEs and certain international organizations. PSR policy changes that went into effect in 2006 aligned the treatment of GSEs and certain international organizations with the treatment of other account holders that do not have regular access to the discount window and are not eligible for intraday credit. See Policy Statement on Payment System Risk (212 KB PDF).
My reaction: I will add something later.