This week there is twice as much at stake as there was in last week’s post; $2B vs. just $1B. Every year. The focus for this post is on the external; why is it so expensive for our industry to support the daily process payments processes which make the wheels go round every day?
What is it worth, why bother?
Let’s start by making sure we understand the size of the prize. Last week, I made the case that the financial services industry has some $400B in reserves to support its intraday commitments. My view was that some 33% of those assets are supporting internal activity that is simply the result of institutions’ inefficient structures which sees them exchange funds between their many legal entities, aka the many left hands, in the real world.
My best guess was that 25% out of this 33% was unnecessary, which leads to my hypothesis that our industry can save itself at least $1B by simply being smarter about inter-company transactions. Feedback on the post suggested some agreement; at least with the principals, if not with the exact numbers.
My view is that the same logic can be applied to the 67% of the assets supporting external activity.
The working hypothesis for this post is that the savings potential is another $2B, i.e. 2/3 * 75% * $4B cost of the overall 400B in assets. Every year.
The current process is under threat
Today, financial institutions send instructions to their Nostros simply with a value date; “Please make this payment on Tuesday”. The timing is left to the Nostro. What happens next is a function of three elements: the local payment system rules on volume & value throughput, the cost of making a payment through those systems and the credit appetite that a Nostro has for its clients.
The latter is all about intraday; the Nostros know that clients will be flat or close to it at the end of the day, but they don’t know too many details about their clients’ receipts. So the standard process is to allow a substantial intraday overdraft limit in order to facilitate the payment process. (See prior post for more)
The Transaction Banks’ business model has been a simple one: Nostros have traditionally charged per ticket fees for their payment services. On the cost side they have paid the external payment system fees and their internal operational costs. This made them a bit of money and then they made a lot of money charging interest on overnight overdrafts and paying little on any credit balances. Now these businesses are having to pay the internal charges for the use of the liquidity buffers. That is hurting. A lot.
Those intraday overdrafts are now having two unintended consequences. First, the FI’s which have them are now measuring this as credit taken and have to have liquidity buffer assets to support them and secondly, the Nostros have to have liquidity buffer assets to support the credit given. Some optimisation is possible, but:
If the Nostros reduce the limits: they have to manage more “in flight payments, they may miss targets from the payment system and they increase operational risk. So this helps, but it does not solve the problem generally.
If the banks throttle payments: one or two banks can make this work. If all the banks link release of payments to actually having funds available, we have the same problem as above and all the extra operational risk of a more complex process. So this helps the first few players to do this, but it does not solve the problem generally and may make things far worse.
Bi-lateral netting: this is an effective risk reduction tool. In fact, the BCBS acknowledge its value in their guidance for managing FX settlement risk (BCBS 241). But, it is normally manual; from experience in FX operations, it takes about 10 minutes per day per counterpart. Then there is the challenge of which payments and receipts can be netted; cross-product is always a challenge. Banks have silos and many cannot net an FX related movement with an interest rate swap related movement and a stock loan one. As it is manual, including same day flows is somewhere between difficult and impossible. Internally, netting processes are often awkward and likely to go wrong. Deutsche Bank, for example, will say: “We can net FX and collateral, but not stock loan or OTC derivatives. This is because the products reside in separate silos”. Then there will be others who simply do not have the functionality to net at all”. So this helps, but it does not solve the problem generally.
CLSNet: this is a new service from CLS Bank. It’s version 1.0 is for netting FX flows only, Albeit in more currencies than the 18 in the core CLS service. It is bi-lateral. The increased automation will make it easier to user, and likely capture some day flows. When they work out how to co-mingle other payments, the utility will increase. But, they will suffer the same challenges mentioned above. So this helps, but it does not solve the problem generally.
Lessons Learned: We are still missing the key piece of Financial Market Infrastructure (FMI). With what is available today, I do not believe that the Financial Services industry has the means to substantially decrease those liquidity costs. I believe that we need two things:
- A central utility that allows participants to agree payment flows, share information with their Nostros and then calculate net funds at a Nostro level. The matching and calculation part of that work needs to be outside a payment system, simply in order to make the process easily manageable.
- A multi-currency system that allows FI’s to operate accounts in any currency they want to. This is a big step and a big enabler. If such a thing existed, then we would have separated the transaction service from liquidity. Each member would source the liquidity it needed to make payments. Included in this would be securities settlement so that somebody needing liquidity could for example repo out securities in one currency and then execute an overnight FX swap in the same system. This would create a global pool of liquidity.
This is where the Blockchain might come in. The first of these has some aspects of “smart contracts”, the second would be a Blockchain powered payments & securities settlement system.
More on both of these in the next post.
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