24 Mar3 ways Central Bank Digital Money will help banks. Stuff worth knowing from The Bankers’ Plumber

“Help for banks”. That hardly sounds like a noble cause worthy of anybody’s support. But bear with me for this two minute read and I’ll explain.

If I have any of this wrong, please let me know your views. In any case, please share widely. For the plumbers of the banking world this is important stuff; individually we can help FS shops be efficient and effective, but only to the extent the market mechanisms are any good.

The wholesale banking markets are condemned to do one thing that other industries are not; settlement, the exchange of assets and money. Today Ford & General Motors may be interested in what the other is doing, but they are not forced to constantly interact. Well at least not until we have autonomous self-driving cars sharing a common road.

Banks however are forced into multiple interactions every day; if I want to pay a UK supplier for a service to my Swiss consultancy, Credit Suisse, the firm’s local banker needs help from a UK clearer. As soon as the banks trade with one other, for example in the foreign exchange markets, they need to settle their trades. Of course, banks have done plenty to deserve the public’s disdain, distrust and lack of sympathy. That said, these interactions need to function both efficiently and effectively in order for the banking system to work.

Right now, e-money, digital currency, Central Bank Digital Money (CBDM) or Currency (CBDC) together with DLT, Distributed Ledger Technology, are being heavily touted as a global panacea for many, if not all, ills.

Money is a very fundamental thing, so understandably as a hype around Crypto and ICOs has developed, it has made the Central Bankers nervous and made them sit up and take notice. Central Banks have the mandate to ensure that monetary systems function properly; understandably and rightly, they are wary of new things.

Recently, the Central Bankers have tried to draw the lines to show where they see a role for new technology and where they don’t. See my recent post: “BIS warns central banks on digital currency issuance”. That has been followed up with a formal paper from the CPMI, the Committee on Payments and Market Infrastructures.

For things settlement, this committee really matters. Think of it as the Central Bank Plumbing Policy & Rule Making Club. Under the auspices of the BIS, the Bank for International Settlements, the world’s Central Bankers come together to set policy. That policy is then enacted as laws, guidance, ordinance in each country. Not every country does the same thing, but it would be quite fair to say that actual national rules are mean reverting. These folk are gatekeepers and key-masters of the rules of national banking plumbing.

So, here is my summary of what this latest white paper is suggesting:

  1. CBDC in retail or consumer markets would create more problems that it would solve
  2. There might be a place for CBDC in wholesale markets, albeit there are inevitable concerns about Operational Risk and Cyber Security. The authors also expressed some concern as to whether the new technology might really be so much more efficient
  3. CBDC may offer a way for institutional investors to access Central Bank money in a helpful way

Both what is said and what is not need some interpretation. I agree that for retail payments at a national level, any significant upside from CBDC, and with it DLT, is not obvious. I would also agree that any efficiency gains may be modest.

The third point, together with what is not said about regulatory costs are IMO where the juice is in matters CBDC / CBDM. Insitutional business is not always good for banks and increasingly, many aspects of so called transaction banking are as welcome at banks as the proverbial pork-chop at a Bar Mitzvah.

Going back to the plumbing and settlement, imagine that at the end of business this last Friday, Credit Suisse had a balance of $500mm in its USD account at BNY Mellon, its US Nostro. If it did, it was a function of operations rather than intent. But, all the regulatory rules still come to pass; the LRD (BIS Basel III Leverage Ratio Denominator) is the key driver here and it will require that 500mm to be backed by the same amount of HQLA, High Quality Liquid Assets and capital of 5%. For CS too there are consequences; that operational balance ends up as “Cash at Banks” in the balance sheet and impacts its Risk Weighted Assets.

If CS could hold that balance in something that was treated like Central Bank money and risk, then BNY Mellon would be as happy as Credit Suisse.

Another side effect of the role the banks play in settlement is liquidity. Since the 2008 events around the collapse of Lehman Brothers, the regulators have focussed on matters liquidity. LCR the Liquidity Coverage Ratio is one outcome of this focus. LCR looks at cash flows in the next 30 days and requires HQLA to cover them. Cash flow is outflows less inflows by currency by counterpart, with the latter discounted by 25%.

Broadly, a decent metric. Well at least until you get into the plumbing of matters settlement. Imagine on day 1 Bank A does a forward value trade selling GBP 100 to Bank B vs. USD 150, for value Day 30. Later the same day, as markets move, Bank A buys GBP 100 from B for USD 151. There is a USD 1 profit.

When the LCR machinery kicks into gear, Bank A will have outflow of GBP 100 less 75% of 100 inflow from B, and will need 25 in HQLA in GBP and then in USD, it will need 150 less 75% of 151. And B too will need HQLA. And it does not stop there. LCR is two pronged. First, so called Pillar 1, is the calculated value as per the rules. Then comes the add-on of Pillar 2; this is a subjective amount determined by the regulator based on how well the bank in question is perceived to be in control of its business.

How banks manage things intraday is a big part of this Pillar 2. For more insight see this recent well presented article from Pete McIntyre: “The Regulators restart the intraday liquidity race – 12 talking points“. Intraday is all related to settlement, the must do bit of plumbing the banks have to do. Exact numbers aren’t published, but I’d put good money on the number for intra-day alone being between USD 20B and 30B for each Tier 1 bank / GSIB. Every 1B is about USD 10 million per annum in costs. Intraday is certainly the lion’s share of this subjective Pillar 2 add-on.

Lessons to be Learned

The folks from the CPMI have made some correct observations regarding the potential for CBDC to be helpful in wholesale banking.

Given financial services companies have to deal with plumbing of the settlement processes, it is appropriate for the Central Banks to offer help to ensure the plumbing is as effective & efficient as possible.

The upside for the FS institutions from CDBC is not so much about operational efficiency per se; saving a few heads, be they on-shore, near-shore or off-shore, will not noticeably move the meter. But, right now, people cost is the default lever for banks to all on in order to increase profitability. That has its limits. In fact, the more they cut heads, the worse their process control, the larger the potential Pillar 2 add-on can be.

CDBC with some help from DLT offers the possibility to reduce the really significant regulatory costs associated with the settlement end of our industry.  On that front, the banks do deserve some help from our regulators and Central Banks.

In summary, CDBC might help in three ways:

  1. Operational Efficiency: a little
  2. Liquidity: potentially a lot
  3. Regulatory Capital and Assets: potentially a whole hell of a lot

Now what the banks would do with the increased profitability and lower capital needs that such plumbing changes might bring is entirely another matter. How much should flow to the 1% in dividends, share buy-backs, carried interest and exec compensation schemes is best left to those in other professions. I am but a humble plumber.

About the Author: The Bankers’ Plumber. I help banks and FinTechs master their processing; optimising control, capacity and cost.

If it exists and is not working, I analyse it, design optimised processes and guide the work to get to optimal. If there is a new product or business, I work to identify the target operating model and design the business architecture to deliver those optimal processes and the customer experience.

I am an expert-generalist in FS matters. I understand the full front-to-back and end-to-end impact of what we do in banks. That allows me to build the best processes for my clients; ones that deliver on the three key dimensions of Operations: control, capacity and cost.

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