The Shadow Payment System

Abstract

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. Historically, payment systems in most jurisdictions have been legally and operationally intertwined with the conventional banking system. The stability of these payment systems has thus benefited from the unique prudential regulatory strategies governing deposit-taking banks. These strategies include emergency liquidity assistance, deposit guarantee schemes, and special resolution regimes. Importantly, these strategies have the practical effect of relaxing the strict application of corporate insolvency law, thereby enabling banks – and the payment systems embedded within them – to continue to perform payment and other functions even under severe institutional stress.Recent years have witnessed the emergence of a vibrant shadow payment system. This system includes peer-to-peer payment systems such as PayPal, mobile money platforms such as M-Pesa, and crypto-currency exchanges such as Mt. Gox. The defining feature of these shadow payment systems is that they perform many of the same payment functions as conventional banks, but without benefiting from the prudential regulatory strategies that ensure that bank-based payment systems can continue to function during periods of institutional stress. This paper examines the potential risks to shadow payment system customers generated by this functional gap, along with the likely effectiveness of various strategies that these systems currently – or might in future – employ to address these risks.