Too much cash. It sounds like a good problem to have.
But for banks, it can be costly to have too much cash sitting around doing nothing. Having too little liquidity can run them afoul with regulators, of course. It’s part of a chief financial officer and treasury department’s job to manage this to a reasonable level.
A technology solution to the liquidity problem is being created by CIBC, Commerzbank, Credit Suisse, ING and UBS, along with the blockchain consortium R3 and the liquidity management software company HQLAX. They are building a distributed ledger specifically for banks to trade highly liquid securities with one another and thus be better able to manage their liquidity ratios.
It’s early days and the bankers’ ambitions are modest so far.
“My hope for this project is that it helps us frame a discussion with custodians, partner banks and regulators that leads us down a pathway to commercialization and to a real platform that allows for a marketplace for real-time transacting,” said Emmanuel Aidoo, head of blockchain and distributed ledger technology strategy at Credit Suisse.
The liquidity problem
In a recent report, the Bank of International Settlements found that financial institutions hold more highly liquid assets to meet short-term obligations than they need to.
“As a result of Basel III regulation, particularly as it relates to the liquidity coverage ratio, banks have done a good job of sourcing liquidity and in many cases now, banks are in a position where they have excess capacity of liquidity,” said Guido Stroemer, CEO of HQLAX.
This puts an onus on the CFO and treasury department of each bank to manage their liquidity ratios to a target, he said.
Liquidity is typically managed through the borrowing and lending of cash and securities.
Stroemer was working in UBS’s treasury department when he perceived a need for a standardized and transparent marketplace for banks and other market participants to transfer liquidity.
“The underlying securities settlement system that we have in place across the globe is quite fragmented, and it’s difficult in this day and age to move securities from one international central securities depository to another,” he said.
Stroemer said he believes that rather than physically transfer cash and securities among one another, banks would be better off keeping all the securities in a secure place, and transferring legal title to them amongst each other.
In the plan for the new ledger, a trusted third party, such as a central securities depository, will use R3’s Corda platform to issue and track receipts (formally called digital collateral receipts) for the securities banks want to trade. The ledger will not store the cash or securities — the trusted third parties will take care of that.
Why a distributed ledger?
Aidoo sees several reasons.
“Firstly, there is no golden source ledger for [high-quality liquid assets], no global central repository,” he said. “The distributed ledger technology allows you to link these all together, which is meaningful.”
The technology allows market participants to settle trades simultaneously, regardless of time zone or geography and promises greater speed of settlement, Aidoo said.
That “ultimately allows for bank and corporate treasurers to be more efficient with respect to how they manage and optimize balance sheet,” he said.
About that 'blockchain inspired' ledger
R3 recently stopped calling its Corda platform a blockchain, instead referring to it as “blockchain inspired.” What does this mean?
According to Charley Cooper, R3 managing director, the group has chosen the attributes of blockchain technology that are most appropriate and readily deployable in a heavily regulated, complex market environment, and rejected others.
One element it’s dropped is the concept of complete transparency.
“In the original blockchain construct, all participants on a network get to see what everyone else is doing,” Cooper said. “In the banking world, where confidentiality between banks and confidentiality of client information is paramount, the idea that we could take that bit of blockchain tech and deploy it into a regulated market was fanciful.”
R3 has also dismissed the notion of a public ledger that anyone with computing power can join.
“One decision we made early on was that regulated institutions couldn’t rely on anonymous or pseudonymous actors out there in the internet to validate or deny transactions that exist between regulated parties,” Cooper said.
On Corda, network participants will decide who to accept in a given ledger, and if needed put them through some kind of vetting similar to know-your-customer compliance.
R3 has partially adopted the idea of consensus, where the majority of participants on a network need to validate a transaction.
In an OTC swap transaction on Corda, for instance, the two counterparties, the clearinghouse, the exchange and the custodian might all have a role in consensus.
“That ensures against fraud or two parties claiming a transaction happened, when ultimately it had not,” Cooper said.
R3 takes a mixed position on another core concept of blockchain technology, immutability — the preservation of a transaction so it can’t be changed.
“Immutability is an incredibly important attribute for blockchain technology and allows auditability and independent verification of different things,” Cooper said. “What it does not do is allow for flexibility in a situation where two counterparties to a trade disagree about that trade.”
The parties may also find themselves both wanting to change the agreement.
Corda will allow a change to be made to a financial arrangement if both parties consent and regulatory approval is granted.
Steve Wilson, vice president and principal analyst at Constellation Research, sees sense in this approach.
“Distributed ledger technology is proving invaluable for coordinating the state of a deal at a point in time, so that in the event a rewind is necessary, everyone has an agreed starting position,” Wilson said. “We don't have that type of coordination or certainty right now in complicated deals.”
The banks, R3 and HQLAX plan to bring a pilot to market in the first quarter of next year.
“R3 is light-years past the first-generation blockchain ideas of trust and decentralization,” Wilson said. “It’s solving problems in very complex settlement situations, improving speed, efficiency, coordination and certainty.”
He cautioned, however, that “big deals will still go wrong occasionally, and we still need to trust the individuals making the deals.”
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