Working Paper No. 07-22: a Dynamic Model of the Payment System

We study the design of e¢ cient intertemporal payment arrangements when the ability of agents to perform certain welfare-improving transactions is subject to random and unobservable shocks. E¢ ciency is achieved via a payment system that assigns balances to participants, adjusts them based on the histories of transactions, and periodically resets them through settlement. Our analysis addresses two key issues in the design of actual payment systems. First, e¢ cient use of information requires that agents participating in transactions that do not involve monitoring frictions subsidize those that are subject to such frictions. Second, the payment system should explore the trade-o¤ between higher liquidity costs from settlement and the need to provide intertemporal incentives. In order to counter a higher exposure to default, an increase in settlement costs implies that the volume of transactions must decrease, but also that the frequency of settlement must increase.