COLUMN | Trades settle and payments land as if by magic, but behind the scenes fragmented accounts across market infrastructures lock up billions in idle liquidity. The elixir is not new plumbing but the operating model: disciplined intraday liquidity management, starting with steps firms can take today.
When we flick a switch, we expect the lights to come on. Just like that. We assume it is going to work. The same holds for water from a tap and “money” in wholesale banking. A CEO once told me that in his trading days he just “assumed money”. That meant “buy this, sell this”, and take it for granted that trades will be settled and payments will be made. As if by magic, a hidden hand made it all happen.
Spoiler alert: behind the scenes, getting the right amount of money in the right currency to the right place at the right time is not magic. Money gets where it needs to be because somebody in an operational role is entrusted with cash management, aka intraday liquidity management (ILM). It becomes a decision that makes 24/7 possible.
ILM is a daily job to be done, because settling trades and making payments requires us to make conscious decisions about where we have our money, or in technical terms, our liquidity. Those activities happen in payment systems, in central securities depositories and international central securities depositories, and in CLS where we settle some FX on a payment-versus-payment (PvP) basis.
Today, as a rule, these financial market infrastructures are vertical silos, each requiring participants to operate some form of account. At any moment in time, the balance in any one account is discrete from any other account the participants have in the same currency. It’s called fragmentation. There is, of course, the exception of the Swiss market, which I previously wrote about.
While financial institutions can transfer money between each other like retail account holders, it is not all instant. Certain flavours of friction might get in the way: the use of a correspondent; whether firms have a balance or a bank has granted them intraday credit; the queue in the payment system; and the availability of liquidity. Simply put, just because your euro account at SocGen says +100 million does not mean that the payment you asked for in the TARGET2-Securities pan-European settlement system happens instantly. As chief engineer Scotty in Star Trek would say: “Ye cannae change the laws of physics.”
Then comes the roadblock: opening times. Not all systems are open 24/7; things are a bit better than “bankers’ hours”, but far from “always on”. Weekends are a big deal. It is precisely the operating hours that force members of instant payment systems to keep their accounts full “just in case”.
What difference does this make?
Where there is fragmentation, there are questions such as “How much liquidity do I need?” and “What is the worst case?” The default here is to have a “little extra, just in case”.
Hans Radtke quantified this in his LinkedIn post: €88.8 billion is locked up in TIPS and EUR1, the euro instant payment systems. Radtke points out that the Eurosystem is trying to reduce the pain. That said, regulators focus on effectiveness, not efficiency. I’ll be blunt: they don’t really care about profitability.
Another eye-opening metric is that the top 59 banks in the world have an average of €202 billion in liquidity buffers, of which between 10% and 30% is for intraday liquidity.
Yes, we are effective; trades get settled and payments are made. But we are not efficient. CFOs make businesses pay for that liquidity and those businesses recoup that from clients in higher costs. Ultimately, that affects profits and those profits affect the returns in our pension funds and other investments. Sadly, many regulators and central bankers are immune to this reality because they have final-salary, defined-benefit pensions.
Can you remediate?
Yes. Even if we do not change our infrastructure, there are some basic things you can do to combat fragmentation in the status quo.
One of them is to have as few Nostros as possible. Tight discipline is needed. Close every account you do not really need.
Transaction bankers routinely make one evergreen argument: “reciprocity”. They believe they have to keep an account at Bank X because Bank X has an account with them. I don’t buy this one.
Hard facts
Years back at Credit Suisse, the manager of all our Nostros and cash management told me that his best estimate was that every “Open Nostro”, whether we used it or not, cost about CHF20,000 per year in admin overhead including reconciliation, check activity and a year-end statement for audit.
If one of your transaction bankers takes umbrage at your suggesting an account be closed, just ask them if they are OK with the cost allocation of US$20,000 for the general overhead.
Perhaps the most astounding Nostro story of my career comes from my time at Credit Suisse, where an employee in the Frankfurt office concluded he needed a(nother) Swiss franc account and promptly opened it with Citibank Zurich. The mind truly boggles.
A similar theme is having Nostro accounts for different businesses in the same entity. The main argument I have heard is that it makes it easier to reconcile. While Credit Suisse’s Zurich office had one USD Nostro at BNY, the international business had 26. I call “unnecessary” on the one-per-business approach.
Tight control
Having too many Nostro accounts is an illness that affects every financial institution. Nostros need very tight control. The only recipe I have come across that works on this topic has three ingredients:
- Central control: manage these things globally and only in one place.
- Dictatorship: issue a rule saying that no Nostros should be opened without going through the right process.
- Cost allocation: figure out a “basic fixed cost to operate”. Charge for it internally. Then figure out a variable charge that is activity based such as a small charge per debit or credit.
Effective FX settlement
My second “do-it-now remediation trick” is to make sure that every FX trade you could settle PvP in CLS is settled there. I have completed three full CLS implementations. Every single time we found trades not going to CLS which could go there. And this is not a case of “one and done”. I recommend doing a check every six months on the “leakage”.
My third recommendation is to avoid moving any money in the real world that you don’t need to. That has two dynamics. The first is inter-company trades, which are an evergreen. You can settle every one of these via your CLS infrastructure in any currency pair. Or create a “bank for the bank”, where every subsidiary banks with the main bank in the group. Corporates can do this too. The second dynamic is to net whatever you can. At a minimum this should be applied to every FX trade not in CLS. Ideally you would include every single inter-company payment.
A few years ago I worked with a client who used their CLS infrastructure for netting inter-company FX trades. We looked at what else still moved IRL. On a sample day, we found some 70-odd movements between two entities across nine currencies. About 6.5x the optimal number. At the same time, a third of all the cash moving in those entities’ bank accounts in the real world was inter-company, presenting infinite scope to do better.
The more advanced step is to invest in intraday liquidity management. There are three things to focus on:
- Who does it, who do they report to, and does their function have a seat and a voice at a table that matters?
- What gets measured?
- What tools do they have?
For as long as we have these vertical silos, we will have fragmentation. And as we add tokenisation and digital assets, in the short and medium term it looks like we will have more fragmentation and not less. The word “AND” is our enemy.
As we design for tomorrow around tokenisation, I conclude with the view that the single biggest “infrastructure upgrade” we could build for is one where in each currency wholesale institutions can operate a “single pool of liquidity”, a SPooL, serving all things P: P as in Payments, P as in DvP for securities trades and P as in PvP for FX settlement.
Referring to himself as The Bankers’ Plumber, Olaf Ransome is founder of 3C Advisory LLC – drawing on decades of senior operational experience from large banks. To connect, find his LinkedIn page here.
