The Shadow Payment System.

• Author: Awrey, Dan

1. INTRODUCTION II. THE CORE FUNCTIONS OF MODERN PAYMENT SYSTEMS III. THE HISTORICAL DEVELOPMENT OF BANK-BASED PAYMENT SYSTEMS IV. THE STRUCTURE OF MODERN BANK-BASED PAYMENT SYSTEMS V. THE EMERGENCE AND RISKS OF THE SHADOW PAYMENT SYSTEM A.Crypto-Currency Exchanges B. P2P Payment Systems C. Mobile Money Platforms VI. REGULATING THE SHADOW PAYMENT SYSTEM A. Do Nothing B. Portfolio Restrictions C. Private Third Party Insurance D. Piggy Banking E. Trust in Trusts F. Structural Separation VII. CONCLUSION I. INTRODUCTION

   Banking, derivatives, and structured finance may attract the lion's share of accolades and approbation in global finance--but payment systems are where the money is. Effective payment systems are vital to the smooth and efficient operation of the modern economy. Whenever your employer deposits your salary into your bank account, whenever you use your debit or credit card to purchase goods or services, and whenever you write a cheque to your landlord or to pay a bill, you are invariably relying on one or more payment systems to complete the transaction. Collectively, these payment systems facilitate over $400 trillion in non-cash transactions per year: roughly five times global gross domestic product. (1) Accordingly, while we often take for granted the important functions that payment systems perform within the global financial and economic system, there are few parts of this system that have a more direct impact on our daily lives.

   Historically, payment systems in most jurisdictions have been legally and operationally intertwined with the conventional banking system. Banks accept deposits from households and firms in exchange for a promise to pay back deposited savings, along with any accrued interest, on demand. These deposits are credited to accounts that serve as the backbone of a complex institutional architecture that facilitates non-cash payments among and between households, firms, and governments. This architecture typically includes a network of correspondent accounts that banks hold with one another, along with one or more interbank clearing and settlement systems. Residing at the apex of this architecture is then a central bank such as the Federal Reserve, Bank of England, or European Central Bank that issues the ultimate settlement asset, oversees the functioning of the payment system and, importantly, stands ready to provide liquidity during periods of institutional or systemic stress.

   The defining feature of banks is that they invest deposited savings in loans and other longer term investments. (2) The resulting mismatch between their short-term liquid liabilities (demand deposits) and longer term and potentially illiquid assets (loans) renders banks susceptible to destabilizing runs by depositors and other short-term creditors. (3) In order to minimize the risk of institutional and broader financial instability--and to effectively manage this instability should it arise--bank regulators have developed a range of prudential regulatory strategies. (4) These strategies include emergency liquidity assistance or "lender of last resort" facilities, deposit guarantee schemes, and special bankruptcy or "resolution" regimes for failing banks. Importantly, these strategies often have the practical effect of relaxing the strict application of the general corporate bankruptcy law regimes that apply to virtually all other types of distressed firms; thereby enabling banks--and the payment systems embedded within them--to continue to perform their vital payment, investment, and other functions even under conditions of severe institutional stress. To address the resulting moral hazard problems, bank regulators then subject banks to intensive prudential supervision and impose capital, liquidity, and other regulatory requirements designed to constrain socially excessive risk-taking. (5)

   Technological innovation is rapidly changing the way we make payments. To see how, you need only go to a grocery store, use public transit, or sell your old sofa on eBay. Perhaps most importantly, while banks and bank-based payment systems still dominate the financial landscape in most jurisdictions, recent years have witnessed the emergence of a vibrant, diverse, and rapidly growing shadow payment system. This shadow payment system includes peer-to-peer (P2P) payment systems such as PayPal, mobile money platforms such as Kenya's M-Pesa, and crypto-currency exchanges such as Mt. Gox. (6) Despite this diversity, the financial institutions that populate the shadow payment system share two core features. First, these institutions perform the same core payment functions as conventional deposit-taking banks: combining the acceptance of funds (7) (storage) with the promise to transfer (8) or convert these funds on demand (liquidity). (9) Second, these institutions reside outside the perimeter of the regulated banking system. (10) As a result, these institutions do not directly benefit from the prudential regulatory strategies that ensure that bank-based payment systems can continue to function during periods of institutional stress. Accordingly, while these institutions may seem like potentially promising substitutes for bank-based payment systems, the conditions under which they can credibly commit to simultaneously provide their customers with both storage and liquidity are often limited by the strict application of general corporate bankruptcy law.

   The rapid changes in the way we make payments have significantly outpaced our understanding of the potential risks stemming from the emergence and growth of the shadow payment system. This Article seeks to make up this lost ground by identifying and examining the risks that the shadow payment system poses to customers, along with those it may in the future pose to financial and economic stability. As we shall see, these risks are a product of the fundamental disconnect between the shadow payment system's core storage and liquidity functions (which generally resemble the payment functions of conventional deposit-taking banks outside periods of institutional stress) and its current legal and regulatory treatment in many jurisdictions (which in a great many cases does not). Just because we don't call something a "duck" doesn't mean we should eliminate the possibility that it might quack.

   The risks that the shadow payment system poses to customers flow principally from the prospect of delayed conversion or transfer of funds (illiquidity) and the potential write down of these funds where they are characterized as unsecured liabilities in the context of any bankruptcy proceeding (loss of value). These risks were vividly illustrated by the failure of the crypto-currency exchange Mt. Gox, which filed for bankruptcy protection in the United States and Japan in early 2014 with over $USD470 million in missing assets. (11) While some of these assets have reportedly since been located, customers will still likely be required to wait until the conclusion of the bankruptcy process before receiving repayment--a process that has already taken several years and at this stage remains ongoing. It is also highly likely that customers will ultimately receive only a small fraction of the funds they originally entrusted to Mt. Gox.

   While perhaps not an immediate threat, the emergence of the shadow payment system also poses potentially significant risks to financial and economic stability. These risks flow from three principal sources. First, as an increasing number of micro and small enterprises--from online merchants to Kenyan coffee growers--come to rely on the shadow payment system as their primary means of making and receiving payments, there is a corresponding risk that the failure of institutions within this system could jeopardize the liquidity and, ultimately, solvency of an important cross-section of firms within the real economy. (12) Through this channel, institutional instability within the shadow payment system could have an adverse impact on economic growth and employment. Second, as the shadow payment system continues to grow and evolve, the pressure to generate profits may drive institutions to bundle payment functions with more conventional forms of financial intermediation: combining their promise of storage and liquidity to customers with investments in longer-term and potentially illiquid assets. (13) The resulting maturity and liquidity mismatches would raise the prospect of destabilizing runs by customers and other short-term creditors. Through this channel, correlated runs within the shadow payment system could lead to a contraction in the money supply, thereby driving a contraction in investment and economic growth. Finally, as an increasing proportion of funds become held by institutions outside the conventional banking system, this may undercut the ability of central banks to use existing monetary policy tools to manage the money supply in pursuit of price stability, financial stability, and other policy objectives. (14) At present, each of these potential systemic risks is somewhat speculative: the shadow payment system has simply not achieved sufficient scale to pose a clear and present danger to financial or economic stability. Nevertheless, identifying potential risks at this early stage can enhance our understanding of how best to approach the design and regulation of this increasingly important component of the financial system.

   Having identified the risks stemming from the emergence of the shadow payment system, this Article goes on to examine a range of strategies for minimizing their harmful effects. Given the functional parallels, it might seem tempting to subject institutions within the shadow payment system to the same prudential regulatory strategies that are currently imposed on conventional deposit-taking banks. Ultimately, however, the diversity of business models within the shadow payment system--combined with the absence of meaningful levels...