Blockchain and DLT. Much hyped and feted as the global panacea for all ills in the banking world. What might happen in 2019? I hope this article offers some useful insights and references.
Why all the fuss around DLT? Easy one. The old banking model is broken and it is proving too hard to make money and at the same time the regulatory costs of being in business are hurting. McKinsey offer some useful insight that makes it very clear that the banks are struggling to earn more than very modest returns:
“In 2016 for the 7th consecutive year, FS return on equity (ROE) is stuck between 8 & 10%; the industry’s cost of equity. At 8.6% ROE was down a full percentage point from 2015. Banks’ shares are trading at low multiples, suggesting that investors have concerns about future profitability.”
The constraints of Basel III are limiting the banks’ ability to make the most of their operational leverage; simply doing more business is limited by balance sheet constraints.
Banks do have some scope for cutting costs. Oliver Wyman recently put out an authoritative report on Intraday Liquidty, or more specifically its cost. I could have told you the numbers myself, but as we all know, big places like to see nice shiny reports from the brand name consultancies. The report puts the pool of intraday liquidity for big banks at $100B and its cost at $100 to $300 million per year. So many banks focus on cutting headcount; this is way more of a big deal.
In midst of this grind, along comes DLT / Blockchain tempting us all with the promise of vast improvements and big, big cost savings. Accenture put out a great piece on this: “Banking on Blockchain, A Value Analysis for Investment Banks” By their reckoning, banks have the potential to save $8billion on a cost base of $30 billion. 26%. Well worth chasing.
The banks themselves seem to have come to some consensus on which areas they expect to be disrupted by DLT. FIServ and Finextra produced a paper: “Payments Transformation: Jostling for Position in the New Digital Landscape.” which captured the industry view of the key verticals the banks expect to be disrupted by DLT: Securities, Asset Management, Cross-Border Payments and Trade Finance.
In 2018, there were plenty of ICOs, i.e. assets going straight to Blockchain. Sometimes, these assets are referred to as native tokenised assets. Meanwhile, existing exchanges have ambitions to tokenise existing assets. SIX Group in Switzerland announced SDX, the Swiss Digital Exchange. A banking consortium is partnering with Deutsche Boerse Group to create HQLAx, which will bring collateral to the Blockchain.
The Central Banks have set out some boundary markers for where they believe a DLT based means of payment, a so called Central Bank Digital Currency, might serve a purpose and even how it might work. The CPMI paper from March 2018 suggested that “settlement” was an area where the use of CBDC would be useful. More recently, the Bank of England, The Monetary Authority of Singapore and the Bank of Canada published a really well researched and presented paper: “Cross-Border Interbank Payments and Settlements”. Importantly, they note that the demand for cross-border payment is going up whilst the availability of Correspondent Banking services is declining. This is an unintended side-effect of the the regulatory environment. The report suggests that W-CBDC might help counteract some of the systemic risk involved in the current model.
In a March 2018 article for The Banker, Gary Gensler, the former CFTC chairman and US Treasury Official, offered the insightful opinion that a peer-to-peer network might offer an alternative to some of the centralised costs of trust implicit in the current model. He was though forthright enough to emphasise the need to comply with public policy.
Where are we now?
Whilst there may well be other approaches to technology which might offer just as much potential as DLT based solutions, the advent and even some of the hype of DLT has pushed the banking industry to come to a view on what might be possible. The Accenture study suggests there are huge potential savings; even 10% of their number is still big. At the same time, there is a drive to tokenise assets. My view is that “the tokenisation train has left the station”; new assets will increasingly go straight to Blockchain and existing ones will be tokenised.
So, Financial Services cannot ignore DLT, it has to do something, but what?
To help me understand what is needed to make DLT work in Financial Services, I divide business activities into three groups:
|Group I||Things you don’t need money or a means of payment for.||For example KYC / Identity|
|Group II||Things you need money for but the rest of the process needs massive improvement, so if you can fix two out of three things, then that ain’t bad.||Trade Finance and Capital Markets are prime examples; the end-to-end process in each is slow and manual. Some Collateral Management.|
|Group III||Things where money / means of payment is an integral part||Securities settlement, cross-border payment, FX, Most Collateral Management. Includes new native tokenised assets such as shares of real-real-estate developments.|
Those business activities in Group II are working hard to implement new end-to-end on-chain processes. They are missing one on-chain piece: payment. They can though make some very worthwhile improvements without on-chain payment.
For every activity in Group III it’s money that matters. Or rather “payment and settlement”. Without a means of on-chain payment, any development will be limited. One possible answer is to use CBDC, Central Bank Digital Currency; there has been a lot of talk about this, maybe too much talk. There are many public and monetary policy issues coupled with CBDC; too many to resolve in a short time.
Christine Lagarde, the head of the IMF, honed in on the possible solution in a recent address at the Singapore Fintech Festival, suggesting the need for a public-private cooperation. I agree with her on the approach, though would respectfully disagree with her statement that a central bank has a comparative advantage at “back-end settlement”; I think the CBs are better at policy and framework rather than operational and coordination matters.
Anyway, waiting for CBDC to be the solution for on-chain payment and settlement does not seem to be a great answer for the challenges we have today and tomorrow. What else is there? Stable Coins perhaps? No, no and no again. I have written previously on why this is a bad solution in Wholesale Markets. However, for as long as there is no better alternative, these things will proliferate and also increase in size.
Trading venues could solve for this by having their own in-house account based settlement system. “Send me your money first and then we will settle the trade”. That will work, but it will be a horrid situation to manage; pots of cash all over the place and no inter-operability between the platforms.
What is missing?
Advancing the use of DLT in Wholesale Markets needs two things:
Firstly, a means of payment on-chain that has enough standing in law to deal with the demands of the Wholesale Markets.
Secondly, the coordination effort to connect this means of payment to the new business applications which are being developed; both those in Group III and Group II (see above). To illustrate: a new digital exchange is going to need several complementary tools to help it function effectively. Over and above the price discovery market place, it will need inventory management: be that liquidity management in the form of Money Market loans and FX, or collateral management in the form of repo or Securities Borrowing & Lending. Coordination includes ensuring there is inter-operability between the payment asset and each business application; we do not want to create a new world where everything has to be on the same platform.
Central Banks could do the first of those things; delivering the means of payment. But even that is not so simple; it needs a global effort, not just a local one. Co-ordinating across multiple business activities to encourage the use of a new “payment thing” is not in the DNA of Central Banks. The former UK Prime Minister, Tony Blair, hit the nail on the head in a recent article in Wired magazine: “The biggest problem with government is that bureaucracies are good at self-preservation and are bad change-makers”.
So that gets us to the public private cooperation idea which Christine Lagarde suggested. Central Banks need to support the creation of the settlement and payment asset. The private sector needs to then do the work to make the most of what public policy will permit.
When do we get there?
Establishing the payment asset is less of a technical challenge than it is a legal and regulatory one. The USC Project is hard at work in this area; there is plenty of work still to do both on creating the asset in each currency and co-ordinating with all the potential business applications.
There will be many cases of “chicken and egg” to solve for: “When will your new trading platform be ready?” “When will your means of payment be ready?”. Will USC deliver an answer in 2019? Unlikely. Early 2020 is more realistic.
DLT clearly offers huge potential. Without a means of payment that potential will go untapped. As an industry we have a one time chance to create one payment standard; a single pot of liquidity serving every business application. That is the holy grail; the potential savings from DLT based processes and lower costs for intraday liquidity.
Will it be the banks that lead the charge for change? Things money and payment have very much been the preserve of the banks. But, they need to act. Senior JP Morgan exec and forward thinker David Hudson had the right thought in a 2017 Bloomberg interview “It’s the incumbent’s job to find the innovation before the innovators find distribution.”
The next obstacle on the USC road is funding; are the banks ready to back the innovation? Carpe diem.
To finish as I started, some words from the Bard of Barking, Billy Bragg, well almost anyway:
“Here comes the future and you can’t run from it, If you’ve got a blacklist Blockchain I want to be on it. The Revolution is just a USC currency away. Waiting for the Great Leap Forwards”
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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