Liquidity and Optimal Incentives for Settling Financial Trades∗

Payment and settlement systems support financial transactions through credit, keep records of transactions by adjusting credit balances and require such balances to be periodically reset through settlement. We study the efficient design of financial trades when the payment system can monitor some transactions better than others and when liquidity provision in the form of settlement is costly. Efficient use of information requires the payment system to subsidize transactions that cannot be monitored by using some of the surplus from transactions that can be monitored. The cost of credit then optimally declines with the degree of information. As credit involves the possibility of default, an optimal payment system needs to provide intertemporal incentives to ensure settlement. An increase in liquidity costs worsens the incentives to default. Hence, we find that if the payment system is concerned about default in short-term trading, it is optimal to tighten liquidity provision in response to an increase in the costs of financing liquidity.