Nonlinear Pricing with Competition: The Market for Settling Payments
August 25, 2015
The payments settlement system in the U.S. has multiple players, one of them is Fedwire which offers immediate and final settlement; it charges high fees for urgent payments and low fees for less urgent ones.
A study from the Federal Reserve Bank of New York has found this has led to the creation of a two-tiered system of payments settlement with the following outcomes:
- A bank with insufficiently high urgency for immediate settlement will tend to settle all or none of its payments with Fedwire depending on whether the average cost of settlement on Fedwire is greater than or less than the average cost of settlement on a competing system.
- A bank with flexible payments with high enough urgency for immediate settlement will settle the most urgent payments on Fedwire and the rest on a competing system.
- The study shows that typically banks will respond to average price. As a result, small changes in average price may induce large changes in volume of payments.
Also, pricing in this system has some social welfare implications:
- Costs of delay are introduced when payments are moved to a competing system. These costs are deadweight losses and are inefficient.
- Because there is duplication in running separate settlement systems, migrating all payments to only one would free up resources to be used elsewhere.
The study concludes that it is feasible to migrate all payment volumes to Fedwire but for this to happen the total cost of settling payments on competing systems must be higher than the incremental cost to the bank of settling that volume on Fedwire.
Source: Adam Copeland and Rodney Garratt, "Nonlinear Pricing with Competition: The Market for Settling Payments," Federal Reserve Bank of New York, August 2015.
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