Liquidity bridges have gradually morphed in tandem to the evolution of cross-border
payments, mainly due to G20’s
commitment to establishing a cross-border payment program.
As central banks ponder
on whether to establish liquidity bridges, here are some highlights on their
benefits and their challenges.
Bridges can
benefit participants due to how they are able to reduce their need of:
· Having multiple
collateral buffers in different jurisdictions and/or currencies
· Undertaking FX
transactions
· Having cash buffers
Consequently, this goes
a long way in reducing transaction costs, associated settlement risks, and, in
general terms, the overall complexity or operations.
Moreover, given the
added flexibility they add, they help banks in terms of managing their intraday
liquidity.
Accordingly, it is
within the industry’s best interest to explore the realm of liquidity bridges
as they can certainly provide many benefits for payment service providers and
banks in terms of liquidity management while effectively lower costs of
cross-border payment services.
Using Liquidity More
Efficiently
Right now, banks are
either forced to invest in liquid assets which can be used as collateral or
must hold foreign currency in either a foreign central bank or in their
respective correspondent banks accounts.
And while the need to
source this liquidity might be rightfully seen as a serious credit risk, many
miss the opportunity cost it entails.
To further aggravate the problem, banks usually overfund their payment obligations as a way of
managing their risk towards payments.
A liquidity bridge is
able to take down costs while simultaneously releasing the participants’
tied-up liquidity, meaning it will also be easier for banks to better allocate
their collateral and manage their intraday needs.By not having
bridges, banks which operate in multiple different currencies will most likely
be required to hold a substantially larger pools throughout the
jurisdictions they are operating in, something which also comes with higher
funding costs and the inevitable passing of costs to the end users and cost
hike on cross-border payments.
Reducing Friction in
Cross-Border Payments
When compared to the
alternatives, bridges’ settlement processes are much easier and the
need to counterparties and/or clearing entities is also lower.
Credit and settlement
risks can also be reduced or fully eliminated via liquidity bridges. As such, cross-border
payments can be faster, cheaper, and, more importantly, see less friction.
Helping Achieve
Financial Stability
Intraday liquidity
relies heavily on central banks provisions to domestic market participants.
With intraday payment
obligations in mind, a higher adoption rate for liquidity bridges can correlate
with a lower intraday settlement risk internationally.
Moreover, since
collateral demands begin to stabilize so will asset volatility lower, adding to
the overall financial stability.
The Risks and Challenges
of Liquidity Bridges
While there are high
operational costs, central banks which establish and operate liquidity bridges
must also face other risks.
Risks can be divided
into at least four distinct categories:
1.
Entry
risks
2.
Operational
risks
3.
Financial
risks
4.
Systemic
risks
First and foremost, a
bridge can only be established in a place in which the bank is legally
authorized to operate it.
If that jurisdiction
does not provide a sound legal framework, the risk is inherently higher.
Moreover, the case
becomes increasingly harder when crafting a multilateral bridge as other
jurisdictions regulatory frameworks, legal agreements, technical costs of
implementation, operational costs, and even currency volatility come into play.
Whether it’s a
bilateral or multilateral bridge, as interdependent as participants become, so
does the systemic risk become higher.
Lastly, there are also
emerging market risks and developing economy risks which should be accounted
for.
Wrapping up
Liquidity bridges can
make banks and PSPs see their costs alleviated while driving down costs
surrounding cross-border payments.
Risk management should
be a top priority for participants as there are still some challenges which
need to be addressed.
However, the upside is
undeniably massive and with G20 pushing for a unified framework, participants
can certainly see themselves closer to overall financial stability.
Liquidity bridges have gradually morphed in tandem to the evolution of cross-border
payments, mainly due to G20’s
commitment to establishing a cross-border payment program.
As central banks ponder
on whether to establish liquidity bridges, here are some highlights on their
benefits and their challenges.
Bridges can
benefit participants due to how they are able to reduce their need of:
· Having multiple
collateral buffers in different jurisdictions and/or currencies
· Undertaking FX
transactions
· Having cash buffers
Consequently, this goes
a long way in reducing transaction costs, associated settlement risks, and, in
general terms, the overall complexity or operations.
Moreover, given the
added flexibility they add, they help banks in terms of managing their intraday
liquidity.
Accordingly, it is
within the industry’s best interest to explore the realm of liquidity bridges
as they can certainly provide many benefits for payment service providers and
banks in terms of liquidity management while effectively lower costs of
cross-border payment services.
Using Liquidity More
Efficiently
Right now, banks are
either forced to invest in liquid assets which can be used as collateral or
must hold foreign currency in either a foreign central bank or in their
respective correspondent banks accounts.
And while the need to
source this liquidity might be rightfully seen as a serious credit risk, many
miss the opportunity cost it entails.
To further aggravate the problem, banks usually overfund their payment obligations as a way of
managing their risk towards payments.
A liquidity bridge is
able to take down costs while simultaneously releasing the participants’
tied-up liquidity, meaning it will also be easier for banks to better allocate
their collateral and manage their intraday needs.By not having
bridges, banks which operate in multiple different currencies will most likely
be required to hold a substantially larger pools throughout the
jurisdictions they are operating in, something which also comes with higher
funding costs and the inevitable passing of costs to the end users and cost
hike on cross-border payments.
Reducing Friction in
Cross-Border Payments
When compared to the
alternatives, bridges’ settlement processes are much easier and the
need to counterparties and/or clearing entities is also lower.
Credit and settlement
risks can also be reduced or fully eliminated via liquidity bridges. As such, cross-border
payments can be faster, cheaper, and, more importantly, see less friction.
Helping Achieve
Financial Stability
Intraday liquidity
relies heavily on central banks provisions to domestic market participants.
With intraday payment
obligations in mind, a higher adoption rate for liquidity bridges can correlate
with a lower intraday settlement risk internationally.
Moreover, since
collateral demands begin to stabilize so will asset volatility lower, adding to
the overall financial stability.
The Risks and Challenges
of Liquidity Bridges
While there are high
operational costs, central banks which establish and operate liquidity bridges
must also face other risks.
Risks can be divided
into at least four distinct categories:
1.
Entry
risks
2.
Operational
risks
3.
Financial
risks
4.
Systemic
risks
First and foremost, a
bridge can only be established in a place in which the bank is legally
authorized to operate it.
If that jurisdiction
does not provide a sound legal framework, the risk is inherently higher.
Moreover, the case
becomes increasingly harder when crafting a multilateral bridge as other
jurisdictions regulatory frameworks, legal agreements, technical costs of
implementation, operational costs, and even currency volatility come into play.
Whether it’s a
bilateral or multilateral bridge, as interdependent as participants become, so
does the systemic risk become higher.
Lastly, there are also
emerging market risks and developing economy risks which should be accounted
for.
Wrapping up
Liquidity bridges can
make banks and PSPs see their costs alleviated while driving down costs
surrounding cross-border payments.
Risk management should
be a top priority for participants as there are still some challenges which
need to be addressed.
However, the upside is
undeniably massive and with G20 pushing for a unified framework, participants
can certainly see themselves closer to overall financial stability.