Our industry’s wholesale financial market post-trade infrastructure is increasingly unfit for purpose.
The mechanism for moving money is dated. While trading can, and does, take place in real time, it takes at least 24 hours for the buyer and seller to agree to settlement criteria and to move funds.
This not only creates enormous settlement risk, but also locks up funds for extended periods of time. Banks’ funding and liquidity profiles are impacted, as are the buffers they need to hold in their accounts.
The extent of the problem
Putting this into context, the Bank for International Settlements (BIS) estimated in 2019 that, of the close to $19 trillion of FX being settled each day, almost $9 trillion is settled without any protection against counterparty default. $9 trillion is nearly twice the annual GDP of Japan.
In the case of conventional bilateral, non-PvP settlement, it is almost impossible for each counterparty to predict when the other is going to meet its obligation. Therefore, to ensure that they always have sufficient liquidity available to meet their cash obligations, banks need to carry large balances in their nostro accounts.
A 2018 report by Oliver Wyman estimated that between 10-30% of a bank’s total liquidity reserves are the result of intraday liquidity requirements, with an approximate negative cost of carry of 100bps. For large banks, the report states, this typically amounts to $100-300m of funding costs annually stemming from intraday liquidity. In the current economic climate this cost is only likely to rise.
The major centralised settlement processes used today are batch-based, limit direct access to the largest financial institutions, limit the number of asset classes which can be settled and rely on legacy technology. Users are constrained by the processes’ inflexibility and lack of configurability. Further constraints exist in terms of restricted coverage by currency and by counterparty.
In short, the problem is getting worse: with market volumes rising, the likelihood of a major systemic glitch occurring is very real.
Implementing new technology
It’s clear the market needs a settlement solution that isn’t specific to one asset class or one line of business (as is often the case currently). The solution needs to solve the problems of today while extending to the asset classes of the future, leveraging the efficiencies of advanced cloud and data analytics.
The entire post-trade process needs to be covered, from matching all the way to settlement, allowing for the efficient and automated netting of transactions as well as for riskless fast settlements or payments.
However, ‘rip and replace’ is not an immediate option for most firms: they need a highly reliable and secure solution which can interoperate with existing legacy systems and business processes.
Addressing current and future challenges
Distributed ledger technology (DLT) brings the speed, transparency, choice, auditability and non-repudiation required by market participants today. It is immutable, resilient and tamper resistant.
Practically, DLT offers a single source of truth to the principles of a transaction. Both parties can be confident that the values derived from the netting calculations are correct, and there is no need to reconcile the outcomes separately. Payments can, and should, be made very effectively immediately thereafter.
DLT also provides the ability to run collaborative, or smart, workflows where each party is running a common process off a common set of data. These workflows not only present opportunities with regards to automation and speed of processing but the technology exists today to allow the delivery of PvP settlement in a fully automated and configurable manner. This eliminates the need for firms to resort to resource-heavy, manual processes which are subject to human error.
By applying 21st century technology to outdated post-trade processes, the instant transfer of funds with full transparency and auditability can be achieved, making the uncertainty of 24-hour settlement cycles a thing of the past.
DLT-based technology can operationalise many of the benefits of blockchain for capital markets, providing a proven and scalable framework for the riskless settlement of assets.
Image and article originally from www.fintechfutures.com. Read the original article here.