The 101 aka the basics: How the world of funding might change once we have intraday FX markets.

With things digital assets around the corner and the advent of intraday FX markets, there is a chance to create some fantastic new financial market infrastructure (FMI). I was challenged by a reader of a prior post on the emergence of a new intraday FX marketplace (see here) to share the 101 aka “how it would work”.

This is part five of a five-part series on things cash management. This week’s theme is “How the world of funding might change once we have intra-day FX markets” and I am going to be a little prescriptive, on the role I would like to see regulators play so that tomorrow’s world really is better, faster and cheaper.

The series

1.??? About daily cash management today – click here.

2.??? FX settlement today – things CLS and those not CLS - click here.

3.??? Today’s cross-border payments systems rely on credit – click here.

4.??? How that reliance on credit affects liquidity buffers. Last time – click here.

5.??? How the world of funding might change once we have intraday FX markets.

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Why intraday liquidity really matters

The first four posts in this series explained why I think liquidity is so important. In the first post, I made the case for why daily cash management as we know it today is hard. The second post looked at the world of FX, in particular the risk that goes with all the FX not in CLS, as well as some of the challenges CLS leaves us with. The third post was all about how our daily process of settlement trades and making payments, means there is a huge volume and high value of money movements we have to make, which creates our dependency on intra-day credit from correspondent banks or Nostro. Post #4 translated this dependency on credit and the state of our infrastructure into the cost in dollars and cents which comes from the intraday liquidity buffer requirements which regulators impose. And a very big cost pile it is too.

What does better look like?

In other articles and papers, I have made the case that nirvana would be to have a SpooL, a single pool of liquidity in each currency. For a detailed explanation of that, please see a paper I co-authored with the wonderful Alistair Milne for the Swift Institute: “Payment ‘tokens’: a route to optimizing liquidity management?”.

The basic concept is that any wholesale market participant could have an account with a financial market infrastructure, which could be used for all things P: P for Payments, P as in DvP, Delivery vs. Payment or PvP, Payment vs. Payment. That account would be in central bank money or a synthetic commercial equivalent. This is what Fnality is delivering, initially in GBP.

The technology needs to make each account directly held and directly addressable. That is a necessary characteristic to drive interoperability. Interoperability is the key capability which connects the three parts of the “holy trinity”: marketplaces, asset custody and the means of payment (cf. Figure 1).

Figure 1: The Holy Trinity

Let me illustrate how interoperability might work with new market infrastructure.

Imagine you are the Swiss bank ZKB, the Cantonal Bank of Zurich. You need some USD to settle trades today. You don’t want to store USD, just settle some trades.

ZKB has some collateral, but it is not eligible for repo with the Swiss National Bank (SNB) which is the only central bank ZKB has access to. So, ZKB goes to a new marketplace, HQLAx, where it can do a collateral upgrade trade by borrowing securities vs. other securities as collateral. HQLAx uses interoperability to connect to where ZKB has custody of its digital assets and earmarks or reserves the positions ZKB wants to use. Separately, HQLAx does the same thing with the holder of the collateral which ZKB wants to borrow. When both parts are earmarked, the execution is confirmed, and the earmarked holdings are moved.

ZKB then does a repo with the SNB, for whatever term. The near leg of that is done for immediate settlement, so-called atomic trading and settlement. Again, the marketplace is using interoperability to check that ZKB has securities, earmarking that position and then checking SNB has money. This is how Swiss settlement works today even without blockchain or new digital assets. Importantly though, ZKB needs the resulting CHF in a format which can interoperate with other marketplaces, for example: an intraday FX one.

ZKB now wants to swap what they have and can deliver immediately, Swiss francs, for what they need now, USD, which can be delivered immediately to them by another party. More earmarking.

Once ZKB has those USD, it needs them for securities settlement. For the interoperability process which will drive DvP settlement to work properly, ZKB’s USD balance needs to be directly held and directly addressable. This is true whether it is a marketplace trying to settle a trade instantly or some form of settlement service settling trades done some time back, for example, it is today trying to settle the far leg of a repo done last week. The key point is that when the technical process asks “Does ZKB have USD?”, it wants to know that the USD are in central bank money or its equivalent. If ZKB does not hold those USD directly, but rather via its custodian or Nostro, as we do today, then any balance is commercial bank money. ?

Importantly here, ZKB has variable cost for USD liquidity. Today it has more or less fixed costs; the cost of those intraday liquidity buffers I talked about in Post #4 is fixed in the short to medium term. Reducing the buffers requires a conversation with the regulator, where the institution is going to have to demonstrate reduced reliance on intra-day credit.

My view is that regulators need to allow wider access. Nirvana happens when any wholesale institution can hold an account that is directly held and directly addressable. This is what I have called this a SPooL, a single pool of liquidity.

There is a big obstacle to this set-up: local regulations. As a rule, central banks and regulators only allow institutions which they regulate to have accounts in their local payment systems. Even Fnality, as a new service, is restricted to only being able to offer accounts to those who are part of the Sterling Monetary Framework.

My view is that the world would be better off if we were not forced to use a correspondent bank. Yes, banks make a lot of money from their transaction banking businesses. I say there would be a shift from charging USD 1 or whatever for making a payment to making a market in liquidity.

At this point, I’d expect every regulator to be chanting: “No, impossible, this would be a threat to our ability to execute monetary policy and ensure fiscal stability. Just imagine what would happen if the ZKBs of the world were allowed to hold any amount of GBP overnight! No, no, no.”

This is where we need to separate settling trades & making payments from monetary policy. During the day, all any market participant wants to do is settle trades & make payments as easily, cheaply and with minimal risk as possible. ZKB does not need to be able to hold a “risk-free” asset in the form of balances in central bank money, or its equivalent, overnight. A little awareness of today’s practice will help us out here. Institutions do not want to hold large overnight cash balances with banks, because these are unsecured receivables in the balance sheet. Even today, a standard practice is to sweep long balances to a money market fund.

There is an easy solution close at hand; one where we can use the new and the old. Let’s use Fnality and GBP to illustrate how this can easily work. The Bank of England says to Fnality: “You can allow any wholesale market participant to have an account with your UK entity. That covers banks, FMIs, asset managers, hedge funds and corporates. Any entity we regulate may have a balance overnight. Any entity we don’t regulate must have a zero balance at the close of play. We the Bank want you to establish an automated process that sweeps balances to either a money market fund or a money market counterpart which is designated in advance by those entities we don’t regulate.”

Then to get from where we are today with highly fragmented, costly liquidity to a SPooL, we need a Fnality in each currency, together with marketplaces and settlement services that can leverage the technology with interoperability in order to give us true PvP and DvP settlement.

In conclusion

New technology can really help us. We can only maximise the future benefits if we have a great solution for the means of payment. A SPooL would solve both our fragmentation problem and our reliance on intraday credit. We make the most of new things if there is widespread access for all wholesale market participants to a SPooL in each currency.

That means wider access so we can settle trades and make payments. That necessary feature of daily business in financial services must be separated from how we manage monetary policy & fiscal stability. We can do that simply by being prescriptive about who can hold balances overnight in each currency. To misquote Ronald Reagan: “Mr. Regulator, tear down the wall of the access rules!"

Thanks for reading. I hope you have enjoyed the whole series.

Would you take two minutes and share your thoughts with me? Feedback via the comments would be great.

If you would like to get in touch, please just type: “Can we talk?” into the comments box.

Please feel free to get in contact: https://www.dhirubhai.net/in/bankersplumber/ and [email protected].

#liquidity #spool #intraday #credit