Previous comparative analyses of gross and net settlement have focused on the credit risk of the central counterparty in net settlement arrangements and on the incentives for participants to alter the risk of the portfolio under net settlement. By modeling the trading economy that generates the demand for payment services, we are able to show some largely unexplored advantages of net settlement. We find that net settlement can prevent certain gridlock situations, which may arise in gross settlement in the absence of delivery versus payment requirements. In addition, we show that net settlement can economize on collateral requirements and avoid trading delays.
JEL classification: E58, G21, G28
Key words: clearing, settlement, settlement risk
The authors are grateful to Scott Freeman and Larry White for comments on earlier drafts. This paper was written while Roberds was a visiting scholar at the Institute for Monetary and Economic Studies at the Bank of Japan. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, or the Bank of Japan. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Charles M. Kahn, Department of Finance, University of Illinois, 217 David Kinley Hall, 1407 West Gregory Drive, Urbana, Illinois 61801, 217/333-2813, firstname.lastname@example.org; James McAndrews, Research Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, New York 10045-0001, 212/720-5063, email@example.com; or William Roberds, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia, 30303-2713, 404/498-8970, firstname.lastname@example.org.
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