1. Board of Governors of the Federal Reserve System
Discussion of Institutions of Foreign Exchange Settlement in a Two-Country Model
David C. Mills, Jr.
Board of Governors of the Federal Reserve System
Disclaimer: Views of author not necessarily views of Federal Reserve Board or System

2. Freeman (AER 1996) Formulates role for central bank lending
Key ingredients
Money used to purchase goods and repay debt
Liquidity problem rationalizes central bank discount window

3. Fujiki (JME 2003) Adds foreign exchange market with liquidity need
Old creditors with taste shock must exchange currencies
Only subsets (of different measure) from each country arrive early to foreign exchange market
Different exchange rates contingent on arrival to foreign exchange market

4. Fujiki (JME 2003) Solution:
One of central banks provides liquidity for early foreign exchange
Liquidity provision restricted by gold standard at optimal exchange rate

5. Today’s Paper Implicitly asks if such a policy is essential Answer: no
Private payment-versus-payment system with central bank liquidity provision
Private Eurodollar accounts
Currency union only under special case

6. Essentiality Definition of essential payment mechanism
Why essentiality test is important
Approach to modeling payments systems: focus on fundamentals

7. Essentiality: A Definition
Achieves desirable outcomes that cannot be achieved by any other payment mechanism
Example of desirable outcomes: public policy objectives
Fed: safety, efficiency, accessibility
Desirable outcomes strike right balance
Today’s paper
Focus on efficiency

8. Why an Essentiality Test?
Strong case must be made for central bank involvement
Careful evaluation of private sector solutions
Example: Monetary Control Act of 1980
Federal Reserve must compete with private sector in provision of payment services
Must review whether provision of some services are essential

9. Why an Essentiality Test?
Determines degree of involvement
Catalyst
Regulation and oversight
Direct provision of payment services
Weigh adequacy of tools that favor less involvement with those that favor more

10. Essentiality Test in Today’s Paper
Equivalent
Central bank liquidity provision under a gold standard
Private payment-versus-payment system with central bank liquidity
Private Eurodollar accounts
Question: How robust is this equivalence?

11. Modeling Payments: Fundamentals
Policy-maker criticism: models seem highly stylized
Risk that conclusions not taken seriously
Solution: focus on relevant fundamentals

12. Lessons from Monetary Theory
Some necessary conditions for money to be essential as means of payment
Imperfect memory about trading histories
Imperfect commitment to (enforcement of) future actions
Recast language of islands, hills and tunnels into language of information, commitment and enforcement
Example: Mills (RED 2004)
Recast Freeman (AER 1996)
Assumptions about enforcement can raise doubts about essentiality of payment mechanism with need for liquidity

13. Conjecture about Today’s Paper
Strong assumptions about commitment of guardians are driving results
Example: Eurodollar accounts
Commitment to negotiable CDs
Commitment to gold standard
Commitment to cooperate
Central bank liquidity provision under gold standard seems to require less commitment

14. Conclusion
Essentiality test is important line of research in theoretical models of payments
Explicit assumptions regarding fundamentals (such as information, commitment, enforcement) add to economist understanding and aid policy-makers