Blockchain, Digital Assets, Crypto, Tokenized Assets, Digital Currencies, Central Bank Digital Currencies (CBDC). I’m sure I forgot many nouns and adjectives that are used to cover this area. In very simple terms, I think of how new technologies have offered alternatives to traditional forms of “currency” and how initiatives in this area will impact financial institutions.
We are starting to see concrete examples where new forms of financial exchange are driving new ways of working, such as companies buying and selling goods using digital currencies to avoid exchange fees and reduce settlement times. I will not attempt to pinpoint exactly which new forms of financial exchange will win out, or identify which business activities and markets will be transformed as a result. Let’s just assume that things will change in many areas and Treasuries will be affected. For simplicity, I need a catch-all reference to use when I say “all of it”, so I’ll use Digital/Crypto Assets.
Impacts on intraday liquidity and on the Treasury function
Many words could be written, with fortunes won and lost, predicting what will happen next in the world of digital assets/crypto. But, unless digital/crypto assets in financial services simply disappear as a concept, treasury functions will have to react to the new world as it evolves. There are two major implications worth considering:
Is the need for intraday liquidity changing?
Should the intraday management process evolve?
The evolution of the need for intraday liquidity in a world of Digital/Crypto Assets
Simplistically, we can think of two different approaches to settling trades in a clearing system with multiple participants. One is to settle transactions as they come in: real-time settlement. The other is to wait until the end of the cycle (usually the end of the day) and then settle all transactions at once: deferred settlement. Each approach has opposing advantages and disadvantages.
Real-time settlement minimizes credit risk – the risk that a participant will default when it owes money to other participants. In a deferred plan, a participant could default at the end of the cycle with large sums owed to others. But delayed regimes are much more efficient in using intra-cycle (usually intraday) liquidity. All credits in this cycle can be used to offset all debits, which means that the outstanding net liquidity needs will be relatively low. In a real-time settlement system, a participant must provide large amounts of intraday liquidity (either through cash pre-funding or as collateral for a line of credit) to be able to continue settling debits even if all of its credit comes much later in the cycle.
Settlement of digital/crypto assets usually occurs in real-time, which means that participants will need to provide enough intraday liquidity to be allowed to participate. Additionally, as we have seen, the current (and anticipated) proliferation of different markets enabled by digital/cryptographic assets will require that this intraday liquidity be distributed across a much wider range of settlement venues, which can be extremely inefficient and costly. A company with a front office that enthusiastically participates in many new digital/crypto asset-enabled markets could see its Treasury back office suffer 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 up-to-date ledger sharing-based marketplaces should be an intraday windfall from heaven. Rather than both parties having to keep their own records separate and hoping/trusting that they are in sync with each other, both can see and use the same shared record. How does this relate to intraday management? The intraday challenge stems from the fact that you don’t know in real time where your money and collateral is in all the accounts you hold. Hence the need for systems to help you understand what is coming in and going out of your accounts as quickly as possible.
In theory, if you had a perfect shared ledger with (all) your account providers, you would have a perfect up-to-the-second view of the exact location of your assets. So, in a utopian world enabled by digital assets/crypto, you would have all the information you need for intraday liquidity processes. There’s a lot more to say about how you turn this information into insights to handle intraday challenges, but we’ll leave that complexity for now.
So where is the problem then? As always, the difficulties come from the transformation of theory into practice. There are four interrelated issues:
1. There might be too many marketplaces. A large bank directly participating in multiple trading venues, combined with the use of hundreds of proxy banks and thousands of nostro accounts in which it participates indirectly, cannot realistically implement a different solution each time. This is where legacy (current!) infrastructures like SWIFT work well; a bank can use SWIFT to connect to virtually all of its required agents as well as many central banks.
2. Inertia to change. There are well-established global infrastructures today, dominated by SWIFT. They work, are reliable, and generally cover all (or almost all) parties involved in day-to-day transactions. It will take a long, long time for risk-averse banks to move away from existing ways of working.
3. There are many different parties (tech companies, banks, new consortia) prototyping in this space, which is great for innovation. But we need a winner or two. Someone needs to emerge to provide the answer so that banks have a clear direction to migrate their current systems, processes and relationships.
4. To manage the intraday challenge, you need to integrate a lot of internal information into a bank’s views (for example, to understand which business units should be charged the costs of providing liquidity). This internal information is much richer but more “messy” than the simplified and consolidated data that is ultimately exchanged with other market players.
A plan for the future
We are heading into a new world enabled by digital assets/crypto and Treasuries should think about when/how they should be ready rather than if. One thing to watch is the evolution of CBDCs. As these become established, the risk/reward profile changes significantly and we are likely to see many more participants willing to these new ways of working.
Typically, it will be the front office of the business 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 accompany new settlement mechanisms and find ways to reallocate these costs to the business lines that generate them. New systems and processes will have to be introduced and companies will have to work hard to minimize the operational risks associated with distributing business across multiple markets. Done wrong, it could look like a company deciding to work with 50 new currencies and having to be a direct clearing participant in all of them with all the cost/processing/risk management that entails.
Three key actions
1 – Optimize intraday liquidity today
While monitoring developments in new markets, the sensible business will get its house in order so that it can manage the current intraday liquidity. The company must take intraday control. Intraday monitoring means you can monitor all of your interest accounts in real time, compare what is actually happening intraday to what you think must have happened at that time (the forecast) and if there is a difference, then manage intraday risks as they crystallize. Intraday monitoring gives you intraday insight and you can use this insight to make the best possible decisions in terms of cash allocation, account funding and settlement settlement.
2 – Ensure the involvement of the Treasury
When the company has the opportunity to participate in a market enabled by digital assets/crypto, the sensitive treasury function will be involved in the process and must ensure:
– The costs of intraday liquidity needed to support new settlement activity are articulated and well understood. They must be part of the costs of any business case.
– It is clear who will pay these intraday costs. Best practice is to allocate costs to the business/customer that generates them.
– The company is prepared to understand and manage volatility in immature markets. Typically, new settlement processes will be automated and real-time, which may challenge existing risk management practices that were designed for more stable and predictable markets.
– Processes are in place to move liquidity between digital and non-traditional assets, both in normal times and in times of crisis. Central banks generally do not operate 24 hours a day, 7 days a week, which can prevent the company from reacting quickly to market movements and force the company to deposit large volumes of collateral in new markets “just in case”. or “.
– The company acknowledges, understands and accepts the impact on capital and liquidity ratios. Haircuts on digital/crypto assets can be extremely high and they are often not eligible to be treated as HQLA. Holding digital/crypto assets rather than more traditional forms can have significant indirect impacts on a company’s financial condition
3 – Find out!
This is a rapidly changing world and it is essential to keep an eye out for developments as they begin to impact your business and the sectors in which it operates.
These are exciting times of change and represent great opportunities for Treasures to enable their businesses to succeed. All of this is perhaps equivalent to when the first industrial revolution accelerated globalization in the 1800s. Global free trade exploded and new markets were created. This required new business models and new ways of working to support new ventures and the financial services industry responded and flourished.