FX and Blockchain (aka, the solution for everything)
The few inevitabilities in life are death, taxes, and someone telling you that blockchain will revolutionize your industry. Well, sometimes that someone is right, as is the case for the foreign exchange market. The “revolution” will benefit market makers, price takers, and potentially open new opportunities to investors. This article will focus on the benefits for market makers, or more specifically the banks that operate in the FX arena. It will be the first in a series highlighting how blockchain will create widespread benefits.
T+2 and the Problems of Procrastination
“Why put off until tomorrow what you can put off until the day after?” This adaptation of Mark Twain’s quirky quote is apt for today’s foreign exchange market. Like all financial markets, FX is a trade-today, and quite literally “pay the day after tomorrow” market. In other words, if a company requires Euros, it agrees upon the rate today and will only receive and pay for the Euros in two days. Anything settled sooner is an exception.
This lag in all financial transactions is the result of time required to verify payments, collect signatures on actual paper, or physically record and transfer ownership. But this lag creates risks and inefficiencies. If a company trades with a bank today and fails to meet its end of the bargain in two days, that creates settlement risk, a form of credit risk. Even if the failure was simply an operational delay, there can still be funding and reconciliation issues.
In addition to settlement risk and operational funding errors, the trade-to-settlement delay also creates a more subtle problem for banks. The process by which banks fund FX transactions creates an inefficient use of capital. The degree of inefficiency can vary, but banks effectively have to pre-fund various accounts (called Nostro accounts) to make payment. For example, an American bank will hold British Pounds (GBP) with a bank in the UK to settle its GBP FX trades. Typically, the American bank must hold a cushion, or excess funds, as the exact amount at any given moment is unknown. Think of this requirement as the way an individual or corporation might hold excess cash as the exact future cash needs cannot be perfectly forecast.
Fortunately, as Bob Dylan said, “the times they are a-changin’.”In an ideal world, there will be no lag between trade-date and settlement-date.
Blockchain brings T+0 to FX
A deep dive into the technology behind blockchain is beyond the scope of this article. However, it is important to note that transacting FX on blockchain will allow for an immediate and secure exchange of currencies. From the perspective of a bank offering FX trading to its clients, this value proposition is a promising one. Take the example of settlement risk. A blockchain solution using smart contracts eliminates the two-day lag. Trade execution and settlement will be nearly simultaneous, and with the proper platform, settlement risk from the bank’s perspective disappears entirely.
At the same time, funding costs shrink. Here again, the execution platform is important as it has to allow banks to more efficiently fund transactions, thereby greatly reducing the overnight balances held in Nostro accounts. Blockchain can offset the rising cost of capital and increased regulatory capital requirements faced by banks.
The blockchain solution with its distributed ledger technology will also provide other less immediately apparent benefits. For example, this solution reduces breaks, reconciliation errors and corrections thus decreasing burdens on the back-office function. The technology also offers a more secure approach to trading and settlements, as well as an improved regulatory function.
If blockchain is so effective at reducing costs and increasing efficiency, why is it not already used for all FX trading?
The industry will move to blockchain. And it is probably closer than you think. However, banks, particularly large banks, may find it challenging and expensive to work through all the technological and operational issues independently. The easier first step is to begin a dialogue with a firm who is already working towards this goal. 9th Gear Technologies, Inc. is delivering on the shift to T+0.