CHIPS Liquidity Algorithm Frees Up Billions From Bank Balance Sheets

All companies strive for liquidity — the ability to turn assets into the cash needed to fund short-term liabilities. Liquidity is especially important to financial institutions (FIs) so that they can settle payments and meet their own obligations to other banks, as billions of dollars’ worth of payments cross the globe.

Real-time gross settlement systems (such as Fedwire, run by the Federal Reserve), post accounting entries for each payment on the central banks’ books — where each payment sent or received impacts the balances held by the banks.

Alternatively, there’s The Clearing House Interbank Payments System (CHIPS), which uses multilateral netting of transactions. As banks send funds to each other, they typically have to maintain (and prefund) higher balances on the books to keep the funds flowing.

In an interview with PYMNTS, Michael Knorr, senior vice president and lead product manager for CHIPS, said the private sector high-value clearing and settlement system’s liquidity algorithm has been unlocking FIs’ liquidity, which in turn improves operations and frees up capital to be deployed “downstream” to end customers, giving rise to positive ripple effects that extend for beyond the FIs’ own balance sheets.

Delving Into the Mechanics

In describing the algorithm, he said that “as payments come in on its queues, it looks for efficient ways to combine payments before settling them and posting entries.” The payments offset one another before dipping into liquidity, Knorr said, who said banks’ focus on liquidity is increasing in the face of Basel 3, which raised minimum capital requirements.

“The better you can utilize and manage your intraday payments liquidity,” he told PYMNTS, “that frees up the balances that you can use to meet your other short-term liquidity obligations — and regulatory requirements.”

The algorithm is generating benefits for CHIPS’ participating banks. Earlier this month, CHIPS announced that its liquidity algorithm drove over $5.1 billion in annualized economic savings and an average of $321 billion in daily liquidity savings last year, as billions of dollars flowed through the global economy and payments flow through CHIPS from outside the U.S. and enter the proverbial dollar “leg” of their journey 23 hours a day.

Priming the Pump

“We ask our participants to ‘prime the pump’ … for the next business day when the system opens,” said Knorr, who added, “They put a small amount [of money], in relative terms, into the system … and that creates a positive balance throughout the day that is being used to net payments and settle against that prefunded balance while providing intraday finality for the participants.”

There’s also the option to put additional liquidity into the system — a form of supplemental funding — to provide even faster settlement of the transactions and the payments that the banks have submitted. This in turn, reduces the balances that are needed in the central bank account — and each dollar that’s used from a funding perspective can be “turned” 29 times — and can be used, to say, purchase Treasurys or fund other short-term funding to support the banks’ operations.

Asked by PYMNTS how the algorithm performs in times of stress to the financial system, Knorr said that back testing has proved that the settlement mechanisms are efficient.

As for benefits for end customers, Knorr said that the speedier payment cycle times mean that banks (and by extension their clients) get money in hand more quickly — to deployed into lending and other activities. “And” he added, “better information is available on the status of the payments — and that they are settled.”

Looking ahead, CHIPS’ outreach to new banks beyond the roughly 50 FIs currently participating will continue. “Banks are interested beyond the liquidity savings mechanism,” he observed, “and will consider participating in CHIPS so that they can route transactions by Fedwire or CHIPS and can dynamically switch between them to make sure they have a more resilient payment infrastructure in place.”