Home and away. Internal and external. With the European club football competitions reaching their final stages, a simple analogy may help to explain what a strategy for addressing the liquidity management challenge might look like.
In the Champions League and Europa Cup, teams play twice, once at home and once away. Mastering liquidity has some things in common. Last week’s post dealt with the internal, home leg. All the things that one bank can do under its own steam.
This week’s post is about the away leg; the one where you have to have play with ever other institution in the industry. This is about the collective, the industry infrastructure. Right now, if your bank is trading FX with market participants in USD / CNY and EUR / TRY, or making non-FX payments in GBP, you have to move real money in the real world.
The size of the intraday liquidity buffer is a function of three things:
- The limit your Nostro gives you
- The payments you have to make
- The receipts you get from your counterparts
In an ideal world, you have no limit, wait for receipts and make payments. Theoretically brilliant, practically unworkable. If nobody pays until the other guys do, you have a Mexican standoff. Nostros are also obliged by regulators to execute a certain percentage of payment value by certain times.
So the simple truth is that the Nostros need the clients to either have cash on hand or use intraday overdrafts. Banks have realised this, so there are some collective efforts to look at what might be possible. CLS Bank is looking at this, as is the GFXD of the Global Financial Markets Organisation.
“Netting” is the name of the game. This means looking at “all the movements” in one currency going in one direction and comparing them to those going in the other direction. Then comes the crucial question of how you determine “all the movements”. That might be just the cash flows from FX trades between Bank and Bank B, or all the cash flows between the same Banks. Or, might be all the FX cash flows between many participants in a system or all the cash flows between them?
The industry has some experience of netting and those who work in large banks with multiple legal entities will have some useful experience to add to the debate:
Internal challenges: banks have both many entities and many systems. If you ask the FX Ops folk to net FX cash flows between Group Entity A and Group Entity B, they will be fine. Then say, net those cash flow with the cash associated with OTC derivatives and margin movements between the same entities. Chances are they say “too hard”.
FXNet: this was a predecessor to CLS Bank. It was well used, but not by everybody. The experience of Credit Suisse all those years ago illustrates a key obstacle to adoption. CS’s business was split in to two parts: the Swiss business, which sat on “old iron” mainframes and the London Branch, the high volume international part, which sat on a new platform. The London Branch was a big and happy user of FXNet, the Swiss were not. It was too hard to deal with netting on the mainframe. Many other banks in Europe had a variation on that same “old iron” problem. All of them were though able to use CLS when it became available.
CLS: CLS is not a netting system. It allows for net funding, with gross settlement. Every single trade in that system is settled gross and the members are sent bank statements by CLS showing every debit and credit. That is vital because it eliminates the need for complex processing. The architects of the CLS system, several of whom represented banks who could not use FXNet, learned from the challenge of FXNet and built a mousetrap that all could use. The use of CLS is vastly wider than FXNet ever was.
So simply put, something that can offer net funding and gross settlement has the potential for the widest take-up.
There are also other challenges to consider further upstream from the settlement process. All FS institutions are faced with having to confirm trades on multiple platforms. It is hard work; you have to know where to find the other parties and you are forced to deal with multiple ways to confirm a trade. Then you have to maintain all the settlement instructions, the SSI’s.
Lessons Learned: This is a really important area; think of it like the challenge the EU has with migrants. The EU has no coherent policy and so everybody has a problem, with many countries overwhelmed. The FS industry has to get this right or it will simply drown in the costs.
To really help the industry, we need a new piece of industry infrastructure. Let’s call it a “Cash Flow Optimiser”. To succeed it will need to:
Deal with any cash flows: as alternatives and possibilities are discussed, those addressing this need to be sure the proposed idea will capture any flow.
Net funding / gross settlement: the obstacle to wider use of FXNet needs to be top of mind. Wide use will be far more likely if the result of the magic new netting process is a series of gross entries on a bank statement. This may well need the Nostros to be part of the solution.
Serve the whole value chain: go all the way upstream. Capture the trades, standardise the confirmation process, eliminate the need to worry about SSI’s. There would also be an opportunity to match all cash flows.
This is all as hard as it is necessary. No one piece of industry infrastructure is global panacea for all ills; CLS is unparalleled in its reach and effect. Yet it only covers some 65% of the FX flows in eligible currency pairs. So that leaves 35%, all the other FX pairs that are not it and all the one way cash flows. That is both a lot of money and a lot of activity. If the banks can condense that activity, they can put a serious dent on their liquidity buffers and save real money.
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