I have been studying Real-Time Gross Settlement systems for the past two months, including questions of liquidity in settlement systems. The question at the heart of the banking system is quite simple, if banks take capital from customers and use it to provide debt to others, then how much money should they keep on hand for their customers' withdrawals and transfers?

This question is hard to answer. As there is a conflict between what the bank does (i.e. provide debt), and how it is supposed to provide it (by taking savings etc.). Everything else, from central banks "offering cheap liquidity" is an add on. They are mechanisms that allow - for example, a bank to easily borrow this money so that they can cancel it out/repay it from transactions coming into their banks.

What makes it all borked is that you can't trust bankers with their grandmas. If there is a flaw, they will exploit it. Every major change has led to an exploit. E.g. In 1918, the American Government introduced the Leased Wire System that used the telegraphs and a network of 12 Reserves to allow banks to transct with each other across CONUS. It reduced the average time for cheques to be cashed in at banks across the country from 5.4 days in 1912 to just 2.4 days. Theoretically, this reduced the risk taken by banks when they transacted with unknown banks across the country, with the Government acting as the escrow. It catalysed innovation and led to an explosion of financial services across the young country.

The system was supposed to be foolproof by reducing the time "credit" was needed to make transactions. Essentially, until one bank sent the money and the other got it, they were operating on a system of credit. And they would "net" the books at the end of the day/week to physically transfer assets. FedWire (Leased Wire System) made everyone feel safe by sending notes of the transactions across great distances. But the netting still took time. All it took was one bank to fall behind on current obligations to other banks for all of the banks to collapse, leading to the Great Depression.

Important people got together and made rule changes to fix the problem. But then they innovated again. The Federal Reserve started making Automatic Clearing Houses (ACHs) and Remote Check Processing Centres (RCPCs) to make settlement faster, starting in the 60s and precipitating in 1972. This made settlement faster therefore safer. And it led to great financial innovation. The magic of computers and innovation meant that people could use these same systems to transact across the world!

Until in 1974, when the German lender Herstatt collapsed due foreign exchange investments based in the Dollar, which caused the bank to fail to meet its settlement obligations...

> That day, a number of banks had released payment of Deutsche Marks (DEM) to Herstatt in Frankfurt in exchange for US dollars (USD) that were to be delivered in New York. The bank was closed at 16:30 German time, which was 10:30 New York time. Because of time zone differences, Herstatt ceased operations between the times of the respective payments. The counterparty banks did not receive their USD payments

This is a simplified history. But the history of banking is the history of doing settlement while managing liquidity and counter-party risk.

No one can predict how this will turn out. But we shouldn't cheer the government cutting out the middleman and going into the business of settlement and direct debt themselves. The Great Collapse of 2034 might be precipitated by it.

https://fraser.stlouisfed.org/blog/2020/09/check-processing-...

https://www.federalreserve.gov/newsevents/speech/bernanke201...

https://en.wikipedia.org/wiki/Settlement_risk