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Using Blockchain in Banking to Improve FX Payment Efficiency

By Frances Coppola

Many companies are evaluating blockchain technology to improve efficiency in international trade and foreign currency exchange management. Banks appear to be taking the lead in adopting blockchain for FX transactions, but the efficiency gains they realize may also trickle down to their business customers.

One area which looks particularly promising is FX “payment netting” (more on that below), where blockchain is already delivering significant savings to financial institutions through improved cash flow efficiency and reduced manual intervention.

 

FX Payment Netting, and How Banks Can Use Blockchain to Improve It

 

When two parties enter into an FX contract, whether spot or forward, they agree to exchange two currencies on an agreed date. The quantity of each currency that will be exchanged is determined by the exchange rate. For example, a U.S. business that needs £10,000 to pay its British suppliers in three months might enter into a three-month forward FX contract to exchange U.S. dollars for British pounds at 1.32. When the contract matures, the business is obliged to pay $13,200 to the counterparty, and the counterparty is obliged to pay £10,000 to the business. A simple bilateral FX trade like this is likely to be settled gross, meaning that both parties will pay the full amount.

 

However, two parties that trade frequently—for example, banks involved in FX market-making—could have many USD-GBP FX contracts maturing on the same day, and the contracts could be in both directions, offsetting each other. If a spot FX contract to exchange £10,000 for USD at 0.75 and a three-month FX forward contract to exchange $15,000 for GBP at 1.32 were due for settlement on the same day, the banks’ net liability would be, respectively, $1,666.67 (rounded down) and £1,363.54 (rounded up). Clearly, settling these contracts gross would mean the banks making very large payments to each other to no purpose. So instead, the banks total up the contracts due for settlement each day and pay each other the net amount in each currency. This process is known as “FX payment netting.”

 

Putting FX contracts on to a blockchain—a database consensually shared by participants across a business network—creates a permanent, immutable record of each transaction. The transaction can be tracked by all participants from start to settlement. The blockchain’s permanent record can be used as the basis for software applications that manage positions, automate payment netting, and reconcile net payments to their underlying contracts.

 

The Global Settlement System Using Blockchain for FX Netting

 

The global FX settlement system CLS supports FX payment netting in 18 currencies. Member banks can use CLS’s main application, CLSSettlement, to net down and settle FX transactions involving only those 18 currencies. However, CLS member banks trade many other currencies. Payment netting in currencies not supported by CLS can be a manual and time-consuming process; many contracts are still settled gross.

 

As a result, CLS has introduced a new blockchain-based application, CLSNet, to enable its member banks to net FX trades involving 120 currencies not currently supported by CLSSettlement. Banks can notify trades to the blockchain using SWIFT, the global provider of secure financial messaging services. Payments are then automatically netted and reconciled to the underlying contracts. Banks settle the net amounts either via CLS itself (if the net amount is in a supported currency) or between themselves using SWIFT.1

 

Two large U.S. banks have already signed up for CLS’ new blockchain application, as have several Chinese banks.2 However, CLS says that banks’ internal IT systems can be a barrier to adopting blockchain, and banks may also have concerns about relying on the security of an external blockchain node. In the future, CLS says, major banks might adopt its blockchain technology to run their own nodes.3

 

How a Major Bank Uses Blockchain to Manage FX Netting

 

Global banks and corporations typically work in multiple currencies and may have operationally independent business units that manage their own FX positions. That operational independence can enable the units to respond quickly and effectively to customer needs by accessing local markets, but it can also result in a considerable reconciliation headache for central treasury functions trying to manage cash flows across the company. It can also mean high working capital costs, since many FX trades may have to be settled gross, meaning the company must obtain the full contract amounts in order to settle.

 

For more than a year now, one of the world’s largest banks has been using blockchain internally, to manage FX netting across its business units. The bank says that using blockchain technology has enabled it to net an estimated 3 million FX transactions down to about 150,000, “drastically” improving cash flow efficiency and reducing its reliance on external technology providers.4

 

Now the bank plans to roll out its blockchain netting application to its corporate clients, so that they too can save money by settling internal FX trades net instead of gross, reducing settlement costs and minimizing manual reconciliation.5

 

The

Takeaway:

It’s still early days for blockchain technology in FX. But indications are that using blockchain to increase cash flow efficiency by automatically netting intra-company and external FX payments could deliver considerable cost savings to banks and, eventually, to businesses.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “CLS’s DLT payment netting service goes live with Goldman Sachs and Morgan Stanley,” CLS; https://www.cls-group.com/news/cls-s-dlt-payment-netting-service-goes-live-with-goldman-sachs-and-morgan-stanley/
2. Ibid.
3. “Banks Don’t Really Want to Use Blockchain for FX Settlement After All,” Bitcoin News; https://news.bitcoin.com/banks-dont-really-want-to-use-blockchain-for-fx-settlement-after-all/
4. “HSBC banks on blockchain to finesse FX trades,” Financial Times; https://www.ft.com/content/60d5a48c-17fa-11e9-9e64-d150b3105d21
5. “HSBC Readies Blockchain FX Tool for Corporates,” PYMNTS.com; https://www.pymnts.com/news/b2b-payments/2019/hsbc-blockchain-fx-trading-cryptocurrency/

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