08 Nov2nd of 3 Financial Service things that could be better with real money in Blockchain

Last week’s post looked at Payments. This week, Payment vs. Payment or PvP. This is when one currency can be exchanged for another; this is an essential ingredient for the settlement of FX trades.

Delivery vs. Payment for securities will be next week’s topic.

#2 Payment vs. Payment (PvP)

FX is the biggest global market in Financial Services. Historically, the settlement of any FX trade involved risk; paying what you sold was totally independent of receiving what you bought. This is so called Settlement Risk, aka Herstatt Risk. CLS Bank came along to fix that, with the result that there is PvP for much of the world’s FX activity. A large share, but not all; just 17 currencies right now, with an eighteenth, the HUF, about to join.

There is no pressing need to re-invent CLS; just maybe, if the underlying technology was on a Blockchain platform, the systems might be cheaper to operate. Given the daily volume, at 1.5 million trades and the values, with some USD 2.5 billion of trades, a switch to some other platform would be a tall order.

Those 17 currencies all have one thing in common; finality. A payment is considered final and cannot be rolled back. That standard and the need to comply with it is one of the factors that stops PvP being used for all FX.

For the 45% or so of world FX activity that does not fit CLS, there are two settlement options; net or gross.

Netting is a bi-lateral process and one that does not scale well; the two parties have to make contact, agree numbers and then move the net amount from loser to winner.

Gross means that each party pays the full value of what they have sold to the buyer. That is where Settlement Risk comes in; in fact as recently as 2008 during the Lehman bankruptcy, one bank, KfW, was foolish enough both not to use CLS when they could and then dumb enough to pay EUR 319 million away even when the world and its wife knew Lehman had gone under (Click here for the horror story).

Since Lehman, regulators have been both expansive and extensive in their efforts to impose new controls on bankers. Quite rightly, they do not like gross settlement because of the risk involved and one of their latest directives, BCBS 241 sets out new guidance for the management of Settlement Risk.

Elsewhere, banks from countries in crisis and those with poor credit ratings have been faced with restrictions in the FX markets. As Greece has tottered many counterparts demanded that Greek banks make payment first; so called ‘safe settlement'”. The same phenomenon exists in Africa too. That restriction is a hindrance to commercial activity and once BCBS 241 is widely enforced, large banks are going to be even less willing to to settle gross, so the demand for upfront payment might well increase, restricting activity even more.

Now, if there was a single multi-currency Blockchain platform, there would be tremendous potential for the kind of processes that would add value across the industry:

Where so called safe settlement is required, a smart contract could be linked to both a payment request and evidence of payment, immediately triggering the release of what is owed. To illustrate: say EFG Eurobank in Greece wants to sell GBP, buy USD with Nomura. Latter says “pay me first”. Imagine both parties instruct on a Blockchain platform; that could then trigger the payment instruction. That might involve the use of a Nostro or Correspondent, or it may use balances that each bak holds on the Blockchain platform.

The next derivative or degree of sophistication would be to offer netting driven by the central Blockchain platform.

For all the users of a new central platform, communication ought to become much easier too. Access to the platform could come with obligations, such as communicating in some fixed way, so that the two parties would not have to find each other.

For FX at least and quite possibly for any payment, forcing both parties to match in a central place would also a simple pricing mechanism to help encourage adherence to standards. Match an instruction within two hours of the first instruction going in and it is USD 1.00 each, but if the second inout is more than two hours of the first it is USD 10.00 for the “late party” and zero for the timely one, since the latter will no doubt have had to chase the former.

Lessons Learned: So, the regulators would like to see less settlement risk. Well, if they were to help their payments systems create links to a Blockchain platform, then there is more than a sporting chance that great things could be done.

Readers will be able to think of other opportunities and benefits from one central platform beyond those mentioned above; the purpose here is not to be exhaustive, but rather to point out the huge potential, both for risk reduction and better access for all to the world’s financial services infrastructure.

Great infrastructure enables more business and reduces costs. Both of those help the economy. To borrow from former Treasury Secretary Bob Rubin, in a phrase often quoted by his boss, President Bill Clinton: “… the best social policy is a strong economy”. Better infrastructure that makes it easier, less risky and cheaper to do business is certainly something that the Blockchain can enable.

But, and it is a big one, doing that really effectively means adding money to Blockchain. The regulators need to enable that.

More next week on the prospects for delivery vs. payment in the securities business.

Understanding Bitcoin and Blockchain

My own epiphany in matters Bitcoin and distributed ledger technology is the result of three independent sources: I am indebted to Emmanuel Mogenet at Google for his inspiring gift of a Bitcoin, to Richard Brown at R3 CEV for so readily sharing views and educating the latecomer and finally to Silicon Valley legend and LinkedIn CEO, Reid Hoffman for his seminal article in the May 2015 edition of Wired UK: “Reid Hoffman: Why the Blockchain matters.”

I also highly recommend reading an Oct 31st 2015 article in the Economist: “The great chain of being sure about things”. A key thought is around “certainty”; how the Blockchain can improve record keeping.

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