1. Mapping the Shadow Payment System
(January 2019)
Dan Awrey and Kristin van Zwieten

2. Overview Unbundling payments from banking The core legal challenge
How shadow payment systems are responding to this challenge
Some wildly premature macro observations

3. Unbundling payments and banking
Over the past several hundred years, payment systems have evolved primarily within the cozy confines of the regulated banking system.
Deposit liabilities are the source of most of the money within the economy
Most of this money sits in bank accounts, or banks’ accounts with a central bank
Money is transmitted from bank to bank (and depositor to depositor) through these accounts, often with the help of a clearinghouse or other payment and settlement system that is itself made up of member banks

4. Unbundling payments and banking
Within this system, banks can be understood as performing three core payment functions.
custodial storage
transactional storage
liquidity

5. Unbundling payments and banking
Increasingly, these core payment functions are being performed outside the regulated banking system.
Bank-based P2P payment systems
Proprietary P2P payment systems
Mobile money platforms
Cryptocurrency exchanges

6. The core legal challenge
The fragility of bank balance sheets provides a compelling rationale for prudential regulation and supervision.
Capital requirements
Liquidity requirements
Deposit guarantee schemes
Emergency liquidity assistance
Special resolution regimes

7. The core legal challenge
Importantly, this regulation has the practical effect of insulating bank depositors from the application of general corporate insolvency law.
Thus protecting them from any delay in withdrawing or transferring funds due to the application of an automatic stay (illiquidity).
And the pooling of depositor claims with those of other creditors pursuant to the pari passu principle (loss of value).

8. The core legal challenge
Importantly, this regulation has the practical effect of insulating bank depositors from the application of general corporate insolvency law.
Thus protecting them from any delay in withdrawing or transferring funds due to the application of an automatic stay (illiquidity).
And the pooling of depositor claims with those of other creditors pursuant to the pari passu principle (loss of value).
The practical effect of bank regulation is therefore to significantly enhance the credibility of a bank’s promise to perform its core payment functions during periods of institutional distress.

9. The core legal challenge
The upshot, of course, is that firms performing core payment functions outside the regulated banking system are subject to general corporate insolvency law.
This poses the very real risk that customers will face illiquidity and/or loss of value during periods of institutional distress, confounding their expectations as ‘depositors’.
An example: the Mt Gox bankruptcy.

10. Responding to this challenge
The key question animating our research is how these firms attempt to insulate ‘depositors’ from these risks.
Examining ‘depositor’ contracts and public filings.
Currently focusing on private law strategies, but eventually expanding to encompass regulatory regimes that may play a functionally equivalent role.
And whether firms are permitted to intermediate ‘depositor’ funds.
Beginning with firms in the EU and NA, but with the intention of expanding globally.
- Thus are firms in the shadow payment system effective substitutes for banks?

11. Responding to this challenge
The key question animating our research is how these firms attempt to insulate ‘depositors’ from these risks.
Do nothing
Portfolio restrictions
Third party insurance
Trust arrangements
Piggy banking
Structural separation

12. Responding to this challenge
The key question animating our research is how these firms attempt to insulate ‘depositors’ from these risks.
Do nothing
Portfolio restrictions
Third party insurance
Trust arrangements
Piggy banking*
Structural separation
Individually, none of these strategies* completely insulates ‘depositors’ from the risks of illiquidity or loss of value.

13. Responding to this challenge
The key question animating our research is how these firms attempt to insulate ‘depositors’ from these risks.
Do nothing
Portfolio restrictions
Third party insurance
Trust arrangements
Piggy banking
Structural separation
Collectively, however, these strategies can be combined in ways that mimic the protections enjoyed by bank depositors.

14. Responding to this challenge
Despite the relatively low initial costs of doing so, our research has yet to identify a single firm that has combined these strategies in a way that serves as an effective substitute for the protections enjoyed by bank depositors.
There are at least two potential explanations for this observation.
Current regulatory regimes (e.g. PSD2) do not require it.
The combination of structural separation, portfolio restrictions, and trust arrangements effectively prevents firms from engaging in meaningful intermediation of deposited funds.

15. Responding to this challenge
Our preliminary results suggest that firms within the shadow payment system are at a comparative disadvantage to banks in terms of being able to credibly commit to perform core payment functions.
Insofar as these firms are permitted to intermediate customer funds, they may also be replicating the fragility of bank balance sheets – thus potentially necessitating more stringent prudential regulation.
This will especially be the case where these firms are able to attract ‘depositors’ with higher rates of interest, but without affording them similar levels of protection.

16. Macro observations
Looking (very, very far) into the future, the continued growth of the shadow payment system could pose a number of macro risks.
Interference with the mechanics of money creation.
Fragmentation of monetary policy transmission channels.
Highly correlated operational (IT) risks.
Potential disruption to SME working capital.
Destabilizing ‘depositor’ flows.

17. Macro observations
Looking (very, very far) into the future, the continued growth of the shadow payment system could pose a number of macro risks.
Interference with the mechanics of money creation.
Fragmentation of monetary policy transmission channels.
Highly correlated operational (IT) risks.
Potential disruption to SME working capital.
Destabilizing ‘depositor’ flows.
However, given the comparative advantage enjoyed by the regulated banking system, the shadow payment system may ultimately prove to be a transitory phenomenon.

18. Thank you.