By Alex Knight – EMEA Head, Baton Systems

Financial markets and their participants are experiencing an extended period of unprecedented stress – volumes and volatility are sky-high, while liquidity and confidence are in short supply. 

In times of extreme volatility, it is vital that markets continue to operate and function smoothly. Unfortunately, like a small hole in a dam, any weakness in systems and processes will be exposed over time – especially during these periods of increased market activity and stress.  As a result, it is absolutely critical that comprehensive risk management be prioritised for firms to not only succeed but, simply, to survive.

The core areas of risk management – liquidity and funding risk; settlement risk; operational risk; and data security and resiliency – are indeed the linchpins of financial services firms. Take settlement risk and liquidity risk, which of course are highly intertwined. Following the dramatic flight to USD cash in the second half of March, central banks are announcing bold measures to ensure continued access to liquidity. Nevertheless, market participants still have an acute need to accurately monitor, plan and source funding. 

At the same time, settlement processes need to be monitored and optimised, and settlement failures (actual or potential) must be flagged and acted upon in real-time. And all of this has to be managed efficiently and effectively in the context of an increasingly challenging funding and risk environment.  

Settlement challenges

Even a slight delay in settlements and payments increases risk and cost, much less a full settlement failure. Settlement problems can arise due to a number of factors, including:

  • Siloed banking systems and processes
  • Inconsistent (and generally manual) workflows
  • Restrictions imposed by central bank payments windows
  • No established tool for the settlement of non-CLS eligible transactions
  • Lack of visibility into intraday payment and funding information

Even if an institution is able to address each of these issues on its own, it faces the challenge of interoperability – requiring the settlement solutions it implements to be compatible with the wider ecosystem. Anything that causes delay or friction is costing money.

It is worth noting that while CLS has been a tremendous tool in specifically eliminating settlement risk related to FX transactions, the BIS Quarterly Review* (December 2019) revealed that total settlement risk has actually risen since 2013. 

Source: BIS Quarterly Review (December 2019)

But how can firms with limited resources – and no appetite to enter into a multi-year implementation – solve this problem? 

One flexible approach is to adopt the best elements of distributed ledger design and overlay these seamlessly on top of existing platforms and ledgers. These advantages include using a shared, permissioned, replicated ledger to connect counterparties’ disparate ledgers, while maintaining all the transparency and security required. This can reduce settlement times from days to minutes, enabling speed, efficiency and accuracy while ensuring settlement finality, providing full visibility and confidence to all parties, and freeing up capital. 

Any settlement and payments engine should also be integrated with a comprehensive view of obligations and exposures across business or product siloes, along with a global “longbox” to access a complete inventory of funding sources, and a rulebook to confirm the agreed parameters. It does not require radically re-engineering and harmonising existing processes and workflows, or changing any payment rails.  

Reducing settlement risk

An effective settlement risk solution overcomes the barriers posed by legacy technology systems, and offers improved data security and resilience. It facilitates visibility and optimisation of intraday funding, delivering real-time updates on settlement exposure across business siloes, with centralised controls to throttle (where appropriate) or sequence. Distributed workflows that eliminate manual intervention significantly reduce errors. Crucially, such a solution provides an opportunity to reduce or even eliminate settlement risk – even for non-CLS transactions.

Banks’ ability to monitor settlements and outstanding obligations, alongside available funding, on an intraday basis, is a prerequisite for effective management and control of settlement risk and liquidity. 

While headlines around the world are understandably focused on the fallout from COVID-19 and the extreme volatility of financial markets, we shouldn’t underestimate how the rather more mundane requirements of risk management will determine how well we, as a society, pull through this crisis.

Baton Systems is helping banks and other financial institutions synchronise and orchestrate the movement of financial assets, using existing payment rails.

*Article was originally featured in the European Risk Management Council’s Risk Landscape Review, March 2020