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Blockchain, Digital Assets, Crypto, Tokenised Assets, Digitial Currencies, Central Bank Digital Currencies (CBDCs). I’m sure that I’ve missed out many nouns and adjectives that are used to cover this area. In really simple terms I am thinking about how new(ish) technologies have offered up alternatives to traditional forms of ‘money’ and how initiatives in this space will have an impact on Financial Institutions.
We are starting to see real-life examples where new forms of financial exchange are bringing about new ways of working, such as corporates buying and selling goods using digital currencies to avoid FX fees and reduce settlement times. I am neither going to attempt to work out exactly which new forms of financial exchange will win out, nor will I identify which business activities and markets will be transformed as a result. Let’s just assume things will change in many areas and Treasuries will be impacted as a result. For simplicity I need a catch-all reference to use when talking of ‘all this’ so I will use Digital/Crypto Assets.
The impacts on intraday liquidity and on the Treasury function
Plenty of words could be written, with fortunes won and lost, predicting what happens next in the world of Digital/Crypto Assets. But, unless Digital/Crypto Assets in financial services simply disappears as a concept, Treasury functions will have to react to the new world as it evolves. There are two broad implications worth considering:
Does the need for intraday liquidity change?
Does the process for managing intraday need to change?
The changing need for intraday liquidity in a Digital/Crypto Assets world
Simplistically we can think of two different approaches to settling transactions in a clearing system with multiple participants. One is to settle transactions as they arrive: real-time settlement. The other is to wait until the end of the cycle (typically the close of the day) and then settle all transactions in one fell swoop: deferred settlement. Each approach has opposite pros and cons.
Real-time settlement minimises credit risk - the risk of a participant defaulting when owing the other participants money. In a deferred scheme a participant could default at the end of the cycle with significant monies owing to others. But deferred schemes are much more efficient in the use of intra-cycle (typically intraday) liquidity. All of the credits in that cycle can be used to offset all the debits, meaning the outstanding net liquidity requirement will be relatively small. In a real-time settlement scheme a participant must provide large amounts of intraday liquidity (either by prefunding with cash or in the form of collateralising a credit line) to be able to keep settling debits even if all their credit arrive much later in the cycle.
Digital/Crypto Assets settlement is typically real-time, which means participants will need to provide sufficient intraday liquidity to be allowed to participate. Also, as we have seen, the current (and anticipated) proliferation of different digital/crypto assets-enabled marketplaces will require such intraday liquidity to be distributed across a much wider range of settlement venues, which can be extremely inefficient and expensive. A firm with a front-office that enthusiastically participates in many new digital/crypto assets-enabled marketplaces might see its Treasury back-office suffering from having to fragment its liquidity pool across a much wider range of venues.
The impact on intraday liquidity management
At first glance the introduction of marketplaces based up upon sharing an up-to-date ledger should be intraday manna from heaven. Rather than both parties having to maintain their own separate records and hoping/trusting they are in sync with each other, both can see and use the same shared record. How does this link to intraday management? The intraday challenge stems from not knowing in real-time where your cash and collateral is across all the accounts you hold. Hence, the need for systems to help you understand as quickly as possible what is moving in and out of your accounts.
In theory, if you had a perfect shared ledger with (all of) your account providers, then you would have a perfect up-to-the-second view on exactly where your assets are. So, in a utopian digital/crypto assets-enabled world, you would have all the information that you need for intraday liquidity processes. There is a lot more to be said on how you turn that information into insight to manage the intraday challenges, but we’ll leave that complexity for now.
So where is the problem then? As always the difficulties come from turning theory into practice. There are four interrelated issues:
1. There could be too many marketplaces. A major bank participating directly in multiple trading venues, combined with using 100s of agent banks and 1000s of nostro accounts where it participates indirectly, can’t realistically implement a different solution each time. That’s where legacy (current!) infrastructures like SWIFT work well; a bank can use SWIFT to connect with pretty much all its required agents and many central banks too.
2. Inertia to change. There are well-established global infrastructures today, dominated by SWIFT. They work, are reliable and typically cover all (or almost all) the parties involved in current trading. It will take a long, long time for risk‑averse banks to migrate away from existing ways of working.
3. There are many different parties (technology companies, banks, new consortia) that are prototyping in this space, which is great for innovation. But we need a winner or two. Someone needs to emerge as providing the answer so banks have a clear direction for migrating their current systems, processes and relationships.
4. To manage the intraday challenge, you need to bring in a lot of internal information into a bank’s views (e.g. to understand which business units should be allocated the costs of providing liquidity). This internal information is much richer but ‘messier’ than the simplified and consolidated data that ultimately is exchanged with the other parties in the marketplace.
A plan for the future
We are moving to a new digital/crypto assets-enabled world and Treasuries should be thinking about when/how they need to be ready rather than if. One thing to monitor is the evolution of CBDCs . As these become established the risk/reward profile changes significantly and we are likely to see many more willing participants for these new ways of working.
Typically, it will be the front-office of the firm that will see the immediate benefits of the new world and Treasury/Operations will face new challenges. The Treasury function will need to consider the increased intraday liquidity costs that come with the new settlement mechanisms and find ways of allocating such costs back to the business lines generating them. New systems and processes will need to be introduced and firms will have to work hard to minimise the operational risks that come with distributing activity over multiple marketplaces. Done badly, this could be like a firm deciding to work with 50 new currencies and having to be a direct clearing participant in each of them with all the costs/processing/risk management that this entails.
Three key actions
1 - Optimise intraday liquidity today
While monitoring evolutions in the new marketplaces the sensible firm will get its house in order so it can manage current intraday liquidity. The firm must gain intraday control. Intraday control means you can monitor all your accounts of interest in real time, compare what is actually happening intraday to what you think should have been happening at this moment (the forecast) and if there is a difference then manage the intraday risks as they crystallise. Intraday control gives you intraday insight and you can use this insight to make the best decisions possible in terms of allocating liquidity, funding accounts and supporting settlements.
2 - Ensure Treasury involvement
When the firm gets the opportunity to participate in a digital/crypto assets-enabled marketplace the sensible treasury function will be involved in the process and must ensure:
- The costs of intraday liquidity required to underpin the new settlement activities are articulated and well understood. They must form part of the cost side of any business case.
- It is clear who will pay these intraday costs. Best practice is to allocate the costs to the business line/customer that generates them.
- The firm is prepared to understand and manage the volatility in immature markets. Typically the new settlement processes will be automated and real time, which can give challenges to existing risk management practices that have been built for more stable and predictable markets.
- Processes are in place to move liquidity between digital and non-traditional assets, both in normal and in stressed times. Central banks do not typically operate 24*7 which can limit the firm in reacting quickly to market movements and require the firm to post large volumes of collateral into the new marketplaces ‘just-in-case’.
- The firm recognises, understands and accepts the impact on capital and liquidity ratios. Haircuts on Digital/Crypto Assets can be eye-wateringly high and they are often ineligible to be treated as HQLA. Holding Digital/Crypto Assets rather than in more traditional forms may have significant indirect impacts on the firm’s financial position
3 - Educate yourself!
This is a fast-changing world and it is essential to keep an eye out for developments as they start to impact your firm and the sectors it is active in.
These are exciting times of change and represent great opportunities for Treasuries to enable their firms to succeed. This is all perhaps equivalent to when the first industrial revolution accelerated globalisation in the 1800s. Global free trade boomed and new markets were created. This required new business models and ways of working to support the new ventures and the financial services industry responded and flourished.