This article was first published in the Americas Securities Finance Guide 2021 (p.25).
3. Efficiency gains from Distributed ledger technology (DLT): HQLAᵡ
Elsewhere, DLT is being used to take a bite out of up to €3.65bn in unnecessary compliance costs banks are paying to manage Liquidity Coverage Ratios (LCR). According to a recent report from Basel Committee on Banking Supervision, the average Liquidity Coverage Ratio of Group 1 banks is 138%. This corresponds to €13.4trn of HQLA, or €3.65trn more than they need to hold according to the 100% LCR required by regulations. Oliver Wyman estimates the opportunity cost of holding €3.65trn back for the LCR that could more profitably be used elsewhere is roughly €3.65bn. The main reason the buffer is so much larger than it could be, is because collateral management is slow and clunky. Specifically, banks must build in capacity for the delays from slow operational processes and settlement fails. HQLAᵡ, a securities lending platform that has been live since the end of 2019, harnesses the blockchain to eliminate many of these inefficiencies. It does so by allowing two parties to transfer the ownership of securities between them without an equivalent transfer between their chosen custodians.
HQLAᵡ operates a digital collateral registry: a blockchain-encoded set of ownership records. Below it sits the existing custody and settlement infrastructure – namely Clearstream, Euroclear and JP Morgan. BNY Mellon, BNP Paribas and Citi will connect later this year, meaning the lion’s share of European collateral is covered. Above it sits the market place on which execution occurs. With each of the six tri-party agents and custodians plugged into HQLAᵡ, a transfer of ownership is recorded in real time on the blockchain record, without any need to change the settlement location of the securities. That means no settlement process. And no delay. Exactly what the delay might be depends on which of the 40-or-so CSDs in Europe is housing the securities. In this cat’s cradle of infrastructures, a legacy of the national silos that traditionally controlled the settlement process, moving a security from one CSD can easily take one or two days. The ownership transfer is both immediate and simultaneous. So it removes the intraday credit exposure inherent in Free of Payment deliveries – where the party who goes first has a credit exposure until the second party completes – and the balance intraday liquidity requirement inherent in Delivery versus Payment – where intra-day cash positions consume liquidity.
Without the need for settlement, the instantaneous transfer of ownership allows banks to cut back the buffers used to protect against delays. “This gives users the ability to move [securities] around more freely, meaning they don’t have to build in the scenarios in which it is delayed,” says Nick Short, HQLAx’s chief operating officer.
As well as reducing credit exposures and liquidity requirements intraday, HQLAᵡ also reduces the operational risk from fails. Because as long as the basket is pre-collateralised, a fail is impossible. In future, this digital ownership record will be good for onward trades: the basket of securities provided by bank A to bank B can be employed in a subsequent trade between bank B and bank C with the same guarantee against failure. HQLAᵡ is reluctant to attach a number to the cash it can save its initial set of clients as it establishes its platform in Europe. But Oliver Wyman estimates that 10% - 30% of bank’s HQLA buffer requirements are driven by intraday liquidity needs, and that proactive management of intraday liquidity can lead to sizeable reductions in a bank’s intraday liquidity requirements of up to 25%. It estimates that every €1bn of HQLA costs banks roughly €10m in lost opportunity costs per year to hold. There is clearly a decent chunk of change to be saved.