This paper surveys the growing literature on payments. We begin by presenting a simple model that illustrates the essential function of payments and how this may be implemented through various arrangements. We show how the basic models of payments have been used to address a variety of microeconomic and macroeconomic policy issues. We then discuss the links between payments economics and other fields, including monetary theory, corporate finance, and industrial organization. We conclude with an overview of the empirical literature and directions for future research.

Increased awareness of the importance of non-bank financial infrastructures has brought increased concern about the potential for bailouts and the resultant moral hazard problem. This paper examines the question with regard to derivatives central counterparties. We consider the layers of protection that derivatives central clearing parties (CCPs) have established in the absence of an expectation of regulatory rescue. We then provide a model of the tension between the desire for ex post rescue of a systemically important financial infrastructure and the desire to maintain ex ante discipline on the infrastructure. The model illustrates the factors that should lead to relaxation or tightening of the financial regulator's discretion for rescue. We consider examples of failures of derivatives CCPs in order to highlight the importance of these considerations.

In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The "put option" value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.

[In this article, we consider the relative merits of net versus gross settlement of interbank payments. Net settlement economizes on the costs of holding non-interest-bearing reserves, but increases moral hazard problems. The "put option" value of default under net settlement can also distort banks' investment incentives. Absent these distortions, net settlement dominates gross, although the optimal net settlement scheme may involve a positive probability of default.]

We develop a model of liquidity shortages that incorporates a general equilibrium feature of liquidity: when banks hold more liquidity, other agents in the economy hold less of it and will supply less in times of crisis. We show that the private holdings of liquidity at banks are inefficient, with the direction of the bias being determined by the characteristics of the suppliers of liquidity to banks. Minimum liquidity requirements for banks may reduce welfare; in such cases interest rate policies that stimulate the ex-post supply of liquidity can restore efficiency. Overall, our results show that optimal liquidity policies critically depend on a financial institution’s (marginal) source of liquidity and will hence differ across institutions of different types.

This paper studies rehypothecation, a practice in which financial institutions re-pledge collateral pledged to them by their clients. Rehypothecation enhances provision of funding liquidity to the economy, but it also incurs deadweight cost by misallocating the asset among the agents when counterparties fail. We examine the possibility of a conflict between the intermediary and its borrower on rehypothecation arrangements. The direction of this conflict depends on haircuts of the contract between them: if the contract involves over-collateralization, there tends to be an excessive use of rehypothecation, and if the contract involves under-collateralization, there tends to be an insufficient use of rehypothecation. This offers an empirical prediction of a link between the size of haircut in collateralized financial contracts, borrower information, and the likelihood of rehypothecation.

We propose a theory of corporate liquidity management in which signaling through illiquidity is cheaper than signaling through “skin in the game.” This causes ex post liquidation of worthy projects even when there are enough aggregate resources available for their continuation. We examine the policy remedies for this distortion and consider their consequences for the supply of liquidity, interest rate policy, and subsidies.

Demandable-debt finance by banks warrants explanation because it entails costs of bank suspension, liquidation, and idle reserve holdings. An explanation is developed in which demandable debt provides incentive-compatible intermediation where the banker has comparative advantage in allocating investment funds but may act against the interests of uniformed depositors. Demandable debt attracts funds by giving depositors an option to force liquidation. Its usefulness in transacting follows from information-sharing between monitors and nonmonitors.