I believe that there is a need for an alternative mechanism to conserve liquidity. It is not possible to do better than CLS for FX flows; CLS is the gold standard. That should not mean that a complementary Financial Market Utility (FMU) would not be a valuable tool for the industry. This post describes what that alternative might look like.
This is the seventeenth in a series of posts on how banks and FI’s might adapt to new BCBS guidelines on intraday liquidity and FX settlement risk. The previous posts are available on the 3C Advisory website, click here.
The idea is this; a service for members to submit and match any transaction involving a payment—all their FX trades, any wholesale loan trades, bilateral margin, derivatives payments. Any “one-way” payment. Those payments are then settled on value date on a multi-lateral basis, by netting at the Nostro level.
Let’s assume this is a club with membership rules; rules that allow a wide participation, on a par with SWIFT rather than CLS. Think of the service as a three part offering:
Matching: same type of thing we know today, but aided by a few club rules; SSIs, or standard settlement instructions, are stored centrally. No need to track these anymore. An instant message service is included, and its use is mandatory, making it easy to communicate with the other party when things do not match. Some rules are added on cost. For example, if the second party does not confirm within, say, two hours of the time at which the first party has submitted, then the late party pays a meaningfully expensive ticket fee of, say, 100x the usual cost. Trade submission would be available in a wide variety of formats: SWIFT, file or even a simple log in and ticking of the trades that are accepted. The service would be a central one, “in the cloud”. This means that FIs could eliminate the plethora of platforms and internal software that they typically have to support for confirmations.
Control: the settlement process is also aided by the club rules. All matched CLS trades are passed on 1:1 to CLS, reducing the number of inputs CLS has to manage. All the remaining matched trades are broken down by currency, and the net results are tracked. Each member has to designate one, and only one, Nostro provider per currency. That Nostro must acknowledge its appointment and must also provide a limit for the client. That limit would only be visible to the Nostro, and it would allow the Nostro to see where the client is, relative to that limit.
Netting: then takes place by currency, by value date, at the level of the Nostro—that is, all the EUR being paid by the many Citibank clients to Unicredit, and all the EUR being paid by the many Unicredit clients to Citibank—but this is done within the limits that each of those Nostros has set for its clients. Actually, what this does is a direct replica of what actually happens in real life; when all of today’s many payments are made and the dust settles, that net amount is actually all that needs to move. The new service would then send the two banks a “net account settlement statement” and file. The Nostro would process the underlying debits and credits to the client account. As a club, the rules can enforce a join-the-club netting agreement under one acceptable legal jurisdiction, for example, the laws of England and Wales, saving the members the very tedious task of entering into and maintaining many bilateral contracts. At a stroke this would meet one of the requirements set out in the BCBS guidelines on FX settlement that is not PvP.
Using the capped credit limits would offer immediate benefit to the Nostros and the underlying FIs and even to corporate clients. Whilst it uses the same idea of the Nostros reducing or capping limits mentioned a prior post, it is both significantly different and superior. The netting mechanism has sight of all the cash flows. There is certainty of both payments and receipts. There is also all-round visibility; the FIs know exactly where they are, the Nostros know where their many clients are and at any time, if needed, the regulators can see what is going on. This is an increasingly valuable ability in light of one of the other bits of regulation being imposed on FIs: recovery and resolution planning. This applies to SIFIs, significantly important financial institutions, and it requires them to have a plan for what would be done so that if there is a bankruptcy event, it can be managed in an orderly way without spreading out to other institutions.
Part II on this idea next week.
Lessons to be Learned: Cash management is a major challenge for banks. It is about to get a lot harder once all the BCBS guidance finds its way into national regulations. Access to smarter common infrastructure is needed in order to help the banks simplify their processing.
An alternative, as a wise long term friend, Bob Blower, has pointed out, is to use CFD’s in FX. That would need a new product and several new processes. Possible, and indeed is an idea that has been around for the best part of 20 years. That would still leave a lot of cash flows that need organising.
I am indebted to Mike Zehetmayr at IBM for his cooperation, thoughtfulness and indulgence on the ideas expressed in this post. The ideas here are the product of many hours of thought and deliberation, and the ideas would not be at all ripe without his contribution to the thinking and the support of IBM on the research.
A personal request: Finally. I have ventured into self-publishing. The not so creatively titled, but practical guide: “Cash & Liquidity Management: Mastering the Challenges of New Regulations and a Changing Marketplace” is now available in print and on Kindle. All the bits form the Blog are there, together with a lot of detail on current challenges. Many of those challenges will take effect on Jan 1 2015. Time to be well informed! As too is the book on more general operations issues.
Book #1: The Bankers’ Plumber’s Handbook
How to do Operations in an Investment Bank, or Not! Includes all the Blog Posts, with the benefit of context and detailed explanations of the issues. True stories about where things go wrong in the world of banking. Available in hard copy only.
Book #2: Cash & Liquidity Management
An up to date view of the latest issues and how BCBS guidance that comes into force from Jan 1 2015 will affect this area of banking. Kindle and hard copy.
Hard Copy via Create Space: Click here
Amazon UK: Click here
Amazon US: Click Here
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