Optimistic. With 2020 now behind us, that word sums my Bankers’ Plumber’s view of what is ahead of us in wholesale banking in 2021. A longish read, so you might want to save it for chillaxing on Sunday.
This past year I have had the great fortune to work both in the payments arena, with Fnality International, as well as on the asset side, with SIX Digital Exchange, and on top of that, my view of infrastructure has been massively helped by a number of industry experts.
I have distilled my thoughts from those high-quality ingredients. I hope the resulting views offer some inspiration and I hope you will share your views too. Here’s to a very interesting 2021.
My 2019 year-end Blogpost, quoted Liverpool Football Club’s charismatic German coach: “We must turn from doubters to believers” and the importance of the work that has to be done to build the financial market infrastructure for the next 50 years. If that work has some “Blockchain inside”, that may well be no bad thing.
A constant theme this past year has been about “realising benefits from Blockchain / DLT”: are there really any benefits and where exactly are those benefits? My simple answer is yes and that there are two areas, process and the balance sheet, and three key stages in the lifecycle to focus on.
The process view.
Let’s start with things process. My business view is all process driven. The infrastructure that supports wholesale banking is complex and costly. The overall system is one we have let grow, sometimes like weeds, when times were good, and revenues were a lot greater than costs. Banks made super-normal profits, so the focus was on revenue and not on understanding costs.
So, for me, as an infrastructure guy, the value of all the debate around DLT is not about whether it is the global IT panacea for all ills, but rather that it has led us to take a look at our processes.; how we do things. For me, the seminal work is the 2018 Accenture report “Banking on Blockchain”, which suggested an annual savings potential of USD 8 billion plus across the industry from process change. The key value of this work is what it tells us and not whether ultimately, we end up realising that potential with a DLT solution or something else. The key message is: “we can make the processes better, faster, cheaper”.
The balance sheet view.
The next place to look at is the balance sheet. The financial services industry has at its core the role of efficiently moving and allocating money and risk within an economy[1]. If the risk changes, the balance sheet changes and vice versa.
Banks’ balance sheets are generally constrained by two significant factors: capital supply and regulation. Those two dimensions set boundaries on the amount of business banks can engage in given the current processes. As we end 2020, That balance sheet capacity is under attack on two flanks.
On one flank there is a change in regulation in the form of the Basel IV implementation, which means that other things being equal, from 2023, banks’ tier 1 capital ratios will decline by a significant amount[2]. To deal with that rule change, the choices are either to shrink the balance sheet or add new capital. Alongside that, existing business will become less profitable. In simple terms: banks will find themselves forced to offload existing business from the balance sheet and find ways to avoid putting new business on it.
On the other flank is the demand for capital. As the global economy works to recover from the disruption of COVID-19, I sense a broad consensus that there will be a very widespread demand for capital[3]. Quite specifically, the consultancy firm Bain sees private markets as offering great potential for digital assets: “For Digital Assets, Private Markets Offer the Greatest Opportunities.”
In very basic terms, the supply of capital from banks is going to go down and demand will go up. Standard economic theory would suggest that the market will find an equilibrium at higher prices. The practical side of that theory is that lots of businesses would be unable to finance themselves. Not good for economic recovery.
What do the banks need to change?
Banks need to make changes on two dimensions: improve the cost/income ratio and re-shape the balance sheet My way of looking at what might or might not be achieved is to look at ‘internal efficiencies’ vs. ‘external efficiencies’.
Internal is all about what one institution or group can achieve on its own, without explicit cooperation from outside parties. External is about all the processes that involve other parties, either pre- or post-trade.
An inescapable fact about wholesale banking is that in involves extensive collaboration. Banks amongst themselves, or with the buy-side, or with custodians and correspondent banks; there is a huge amount of interaction.
It would be something of an understatement to say that, in financial services, institutions have nowhere near maxed out their potential to reap internal efficiencies.
Both process and balance sheet improvement collaboration.
But, for any one institution there is a cap on internal efficiency; any one business can only be as effective as the external circumstances allow. What are the ways of working and how are the institutions required to collaborate?
If the existing way of organising a syndicated loan involves some extensive back-and-forth and physical documents, with the loans then literally existing “on paper”, then no one institution can change things on its own.
And so, we come back to processes. If we want better, faster, cheaper, we need different processes. If we want to have an impact on the balance sheet, we need different processes. It is all about collaboration. What exactly might change, where are the frictions and what’s it worth to change?
My thinking here can be explained across three stages of the lifecycle: primary markets, secondary markets and the Treasury function.
Primary and process.
In primary, I would include both the capital raising process of debt and equity capital markets and for convenience, the core parts of trade finance and supply chain management. In capital raising, speed is one aspect. All the coordination needed takes time.
In the US, the tech firm Symbiont has been working with an issuer and market participants to create a DLT based proof for issuing Asset Backed Securities. The first dimension of potential benefits comes from process improvement: better tools translates to better, faster, cheaper and give us a slice of that 8bn savings cake Accenture has explained.
That’s the process part, but what about the balance sheet?
Primary and the balance sheet.
The second dimension of improvement is on the balance sheet. There are two aspects to this. First, the new process would allow the settlement cycle to be reduced from 5 days to same-day. Shorter settlement cycles would have an impact on the balance sheet, because between trade date & settlement date, credit & counterpart risk (CCR) has to be measured and capital is needed to support that. The research work that preceded the launch of Fnality International estimated that the then 15 banks in the USC Project the average value of a 1% change in CCR was worth a USD 300 million reduction in risk weighted assets per bank.
But that still leaves assets on the balance sheet. Back to the impact of Basel IV mentioned earlier; the banks also want to unload assets from the balance sheet and have alternatives to having new business impact the balance sheet. This is where we need new multi-sided markets. To illustrate, Germany has a huge tradition of the “Hausbank” supporting SME businesses. That model was built on a closed, bi-lateral relationship between a company and its main bank. That works until it doesn’t, with Basel IV providing the reason.
So, to reduce and then protect the balance sheet we need a better process; a new platform connecting buyers and sellers.
There is also a third dimension to consider. I mentioned earlier the role of financial services in “moving and allocating money and risk”. Today, primary market processes are expensive, so the result is a big divide. Big deals for big companies which can access the capital markets, while smaller firms and smaller financing needs have to rely on their banks. A report from HSBC & the Sustainable Digital Finance Alliance highlighted the potential in the ESG / Greenbond space:
- The costs associated with the current financial market infrastructure are a barrier to the capital allocation process; there is a demand for sustainable investments, call it ESG or Green bonds.
- DLT offers the prospect of:
- Cheaper & faster, issuance and trading. Meaning capital will be raised that otherwise wouldn’t, investment activity can take place that otherwise wouldn’t. Perhaps even in small enough units that smaller companies can access the capital markets.
- Better, because with the IOT, Internet of Things, the activity financed by that issuance activity will be measurable in a transparent way.
- Making smaller investments more accessible through fractionalisation.
So, in the area of primary markets, we have the potential to change the process, protect the balance sheet and improve capital allocation. The use of Blockchain is not a pre-requisite for any of this, but there is little to be had in the way of benefits without collaboration and Blockchain is a good tool to solve for that particular challenge.
Secondary and process.
Now let us turn to the next important area of wholesale banking activity, secondary markets. Here too, there are potential savings from process changes, as well as balance sheet ones. A recent paper from Oliver Wyman for ISSA, the International Securities Services Association, suggested that some 5 to 10% of post-trade costs could be addressed by outsourcing, twice the current level. If the primary process can be moved to some variant of T+0, then so too can the secondary process, which would provide balance sheet relief. Process improvement in trade finance and supply chain financing offers huge potential: according to a study from Cointelegraph Consulting and Swiss enterprise blockchain firm Insolar, blockchain technology can reduce supply chain-related costs for businesses between 0.4% and 0.8%, which translates to USD 450 billion in costs.
Secondary and the balance sheet.
So, lots of opportunity for better, faster and cheaper, but what about the balance sheet? We come back again to Basel IV and the need to offload existing assets from the balance sheet. We have asset securitisation today; Swiss banks will for example sell their mortgages to the Pfandbriefbank. Importantly though, the solution to the Basel challenge is not going to lie in moving assets from one bank to another. To systematically help all banks offload assets, we need new multi-sided markets, bringing together the supply of & demand for capital easier and more global. That need is no different to what we mentioned earlier in regard to primary markets.
Imagine you can move these things to a new platform so that you improve the whole origination process and then create secondary trading. Now you have achieved a few things: firstly, created the means to use the security as collateral, second the means to transfer risk, even in small quantities, and thirdly, even if you hold some of the risk, there is now a secondary market, so there is a price, which means the asset may no longer be classed as Level 3, reducing the capital needed to support it, which would have a positive impact on the balance sheet for those assets that remain there.
In regard to the use of Blockchain, I would make the same point as with primary markets; collaboration is essential and Blockchain is a good tool for that.
Treasury Matters.
The third stage of the lifecycle to examine is the Treasury function. In day-to-day matters the Treasury has to make sure there is enough cash, in the right currency, in the right place, at the right time. Sounds simple enough. But in practice it is not, and it is a discipline that is closer to art than science. The known unknown is that settlement is not precise; trades fail, collateral does not move on time, monies are not received, unexpected funds are received, and cash is needed in many places. Liquidity, by which I mean both cash and collateral, is fragmented; there are several places we can hold securities and there are multiple settlement locations where cash is needed in any one currency. There is a necessary reliance on intermediaries in the form of correspondent banks and custodians, coupled with an extensive dependency on intra-day credit.
Liquidity, or the lack of it, was certainly a significant factor in the collapse of Lehman Brothers in 2008. Since then, regulators have had a very strong focus on ensuring that banks have adequate liquidity buffers generally and some very specific reserves to support intra-day liquidity specifically. These liquidity reserves are part of Basel Pillar 2; the reserve requirements are subjectively set by a regulator. Any changes need to be negotiated and will require hard evidence of improvement.
We know from work by Oliver Wyman on intraday liquidity, that big banks have an average of USD 100 billion in liquidity buffers, with GSIBs at some 237 billion. 10 to 30% of that is to support intraday, i.e., the complexity of fragmenting liquidity and relying on intermediaries. So, that is at least 100 million in costs which are pretty much fixed on Jan 1 every year; like house contents or car insurance.
To put those numbers in perspective, the intra-day liquidity costs for the 30 GSIBs are pretty much the same order of magnitude as the potential cost savings for the entire industry from process improvement that Accenture suggested might be available from using Blockchain.
There are two major drivers of the size of those liquidity buffers. The first is the requirement to use correspondent banks and custodians. Local regulations restrict access to payment systems to local entities, forcing foreign entities to access those payment facilities via the local commercial banks. Providing that support involves the widespread use of intra-day overdrafts, which actually drive up the intraday liquidity buffer needs for both credit givers and credit takers.
The other driver is that liquidity is fragmented; the settlement processes we have built up over time force the financial institutions to keep and manage cash in many locations: Euroclear, Clearstream, CCPs, domestic CSDs, custodians, nostros. Because settlement is closer to art than science, balances are hard to predict really accurately so there is a lot of slack in the process. Switzerland, with its Swiss value chain, is a rare exception where both securities settlement and payments share a single pool of liquidity.
Treasury and process.
We talked earlier about the potential to improve processes for both primary and secondary settlement. As we design those new processes, we have the opportunity to simplify the Treasury part of the lifecycle; changing the rules to allow all banks to have direct access to the RTGS systems or other payment systems in each currency and making new settlement processes point to that facility as a single pool of liquidity.
Conclusion
Drawing all of the observations above together, my summary view is that any prospect of better, faster, cheaper lies in having better processes and in constructing those processes in ways that make the collaboration that is essential to wholesale markets more effective and efficient.
Business process is something that makes the difference between profit and loss; in times past, banks made what the economists call ‘super-normal profits’; revenues greatly exceeded costs and life was good, even very good. Today’s environment looks more like one of ‘normal profit’; everybody makes a dollar. Who wins is a function of who keeps the biggest share of that dollar. He with the best process will win.
How efficient & effective the financial services sector is makes a difference to the ordinary man in the street. The majority of people have pensions, which need their underlying investments to prosper. SME businesses are an engine of employment in most countries, so their access to financing matters.
Private markets will be very important in the coming years; banks can serve those markets very efficiently in balance sheet terms if we can work together to create new multi-sided markets, improving both primary and secondary processes. In parallel, as we architect new infrastructure for the world of tomorrow, we need to pay particular attention to how the money or payment side is organised.
Real success will require us to create a single pool of liquidity that is open for more direct, wider access than today’s RTGS systems and to use that widely for many settlement needs and to then connect that liquidity pool to securities markets for instant DvP, delivery vs. payment, settlement of securities trade. Together those two ingredients will bring us to a global collateral pool, which is a holy grail for the industry.
Blockchain is not a priori required for any of this change; it just happens to have been a catalyst to make us explore what is possible. It is though, a great tool to aid collaboration. As a technology, DLT offers two important qualities that are important when we have shared infrastructure: resilience and improved cyber security. Resilience comes from the D part of DLT; distributing the processing around a number of participants eliminates the risk of a single point of failure. As our world becomes more technology dependent, DLT based processes make cyber-attacks harder to orchestrate. In financial market infrastructure, both these things are worth having.
To misquote Bill Gates; “Process change in banking is essential, Blockchain is not.”
And there’s one more thing.
Reconciliation. As Bono might put it about Blockchain: “There’s been a lot of talk about this Blockchain thing and reconciliation. Maybe too much talk. ..”
I’ll offer that the two favourite words for an accountant are: “It reconciles”, or perhaps “It balances”. Same difference.
In banking, there has been a lot of chatter around Blockchain and how it will do away with reconciliations, which are of course the staple diet of operations in banks. Well, I am here to tell you that rumours of the death of reconciliations are greatly exaggerated. A firm’s internal books & records are not about to be substituted by external ones; the discipline of reconciling the internal ledger to an external statement will be as essential tomorrow as it is today. Good control is not going away.
Now maybe, the nature of our processes means there will be fewer breaks and differences. CLS settlement for FX is a textbook case of this effect. Discipline still there, differences zero. Amen to that.
Note:
I am indebted to Daniel Lemcke for his help in shaping some of the thinking. Daniel is a partner at the challenger consultancy Elixirr; shared adventures have taken us to London, Moscow and Johannesburg in recent years.
[1] Source: “When the Tide Goes Out: Big Questions for Crypto in 2019”, Gensler, Coindesk, Dec 17th, 2018.
[2] See: “Basel “IV”: What’s next for banks?”, McKinsey, April 2017.
[3] For more insight, see Global Digital Finance (GDF), Private Markets Digitisation Steering Group
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