Fed warns of liquidity threat to settlement utilities

Fed warns of liquidity threat to settlement utilities

The increasing use of 'just-in-time liquidity' provisioning by financial market utilities (FMU) to mitigate against settlement risk poses a growing threat to future financial stability according to a study conducted by the Chicago Federal Reserve.

The authors of the paper - published in the Chicago Fed Letter - suggest that the tight time-frames used by utilities for the settlement of open commitments by user institutions exposes new areas of systemic risk during a domino default scenario.

Market infrastructure platforms referenced in the report include real-time gross settlement systems in payments, CLS bank for FX, and central counterparties in derivatives.

In light of recent liquidity crises, the paper asks: "Can we take it for granted that just-in-time liquidity will be available to FMUs at a time when multiple market participants are in danger of defaulting?"

The document suggests that during periods of extreme market disruption, the presumption that private sources of liquidity will be released into the system does not hold.

"Recent global financial crises have shown that stable and liquid funding may not always be available and that liquidity risk must be taken seriously," the paper contends. "With the increasing dependence of FMUs on just-in-time liquidity, the impact of such liquidity risk on financial markets should be a particular focus of vigilance by market participants and regulators; and it is an important issue to keep in mind as we consider potential changes to the regulatory process."

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