Market failures in infrastructure provision and single points of failure It is instructive to consider why providers of the market infrastructure and their members might, left to their own devices, invest too little in resilience and risk-mitigation. The answer lies in the microeconomics of infrastructure provision, and, in particular, the presence of market characteristics such as network externalities, increasing returns to scale and coordination failures. By network externality, I refer to the incremental benefit derived by existing owners of a particular good or service when another party purchases that good or service. For instance, the broader the participation in a particular exchange or trading facility, the more extensive the trading opportunities and the deeper the liquidity; as a result, the greater the potential benefits from membership of that exchange. Equally, in the case of post-trade infrastructure – clearing and settlement systems – the greater the volume of transactions cleared or settled, the greater the potential for netting exposures and/or cash-flows (or in gross payment and settlement systems, the more efficiently liquidity can be recycled). BIS Review 77/2007  3  Increasing returns to scale reflect the fact that infrastructure provision is, by and large, a fixed-cost business: once an investment has been made in the information technology supporting the trade, clearing or settlement of a given volume of transactions, the marginal cost of each transaction up to the capacity of the system is very low.

But the market characteristics imply a tendency towards natural monopoly in the provision of infrastructural services and hence dependence on a single, non-substitutable provider: often termed a “single point of failure”. A monopolist provider of infrastructure services may face insufficient incentive to innovate – including in risk-reduction – and, importantly, may not fully internalise the potential effects of a disruption to its services on the financial system as a whole, thereby undervaluing system resilience from a public policy perspective. But couldn’t the users of the infrastructure ensure that the monopoly provider invested more heavily in risk mitigation? And with many infrastructures being user-owned cooperatives, would there not be a natural mechanism for this? Perhaps – and indeed there is evidence of effective risk-mitigation among user-owned providers, for example the throughput guidelines on payment flows to lower liquidity risk in CHAPS, the UK high value RTGS payment system, was led by member initiative. But such risk mitigation may still not be enough to meet social welfare goals fully. First, the effects of a disruption are likely to be felt beyond what may be a narrow group of direct users of the infrastructure. That is, the effects may be systemic; for instance, there may be an interruption to the flow of liquidity via dependent markets or systems, or among participants relying on the system indirectly, for example through a correspondent banking relationship. Second, users may place insufficient value on systemic stability because material operational failures are low-probability events and difficult to anticipate.