Digital cash can prevent accidents on the $19 trillion FX highway

On any given day, you’ll find $19 trillion of payment obligations dotting the busy highway of global finance, waiting to be settled.

These claims, all of which result from foreign-exchange trades, mostly reach their destinations without a glitch. But, blockchain evangelists claim, that is more luck than planning: Almost half of this amount remains just as exposed to accidents as it did on a day half-a-century ago when liquidators showed up unannounced at a midsize German bank.

By the time authorities closed down Cologne-based Bankhaus Herstatt on the afternoon of June 26, 1974, it had collected all the deutsche marks it was going to receive that day from currency trades. But since it was still early morning in the US, the lender hadn’t paid out the corresponding dollars. The default brought the New York interbank market to a standstill and became a historic event, leading to the creation of the Basel Committee on Banking Supervision.

A new institution, known as the CLS Group Holdings AG, was created in 2002 to eliminate what came to be described as the Herstatt risk. Jointly owned by over 70 of the world’s largest banks, CLS lines up payments so that neither party in a trade is left holding a claim after it has discharged its obligations. The payment-versus-payment discipline served the foreign-exchange market well during the 2008 financial crisis. It proved its utility again in 2020 when currency prices turned highly volatile in the early days of the pandemic.

CLS is good at preventing mishaps in the foreign-exchange market. The trouble is, it handles only 18 major currencies. That means it misses big chunks of trades where emerging-market currencies are swapped against the dollar or the euro. Overall, the protection offered by payment-versus-payment has begun to fray: from 50 per cent in 2013, coverage fell to 40 per cent in 2019, according to the Bank for International Settlements. After removing claims that institutions net bilaterally, $9 trillion of daily obligations are at higher risk of accidents and mistakes. Therein lies a big opportunity for blockchain tokens to prove their utility.

Mainstream interest is fixated on cryptocurrencies like Bitcoin and Ether, and to a smaller extent on their less volatile stablecoin cousins such as Tether and USD Coin. Sovereign states are also adding to the buzz by preparing to circulate retail central bank digital currencies, or CBDCs, with China stepping up issuance of the e-CNY perhaps as early as next month’s Winter Olympics.

But away from public glare, a different kind of blockchain experimentation is under way. Hong Kong’s mBridge, Singapore’s Dunbar and Switzerland’s Jura don’t come up for dinnertime discussions. And that’s just fine because they’re meant to be workhorse projects, not show ponies competing for attention with Dogecoin or the Sandbox. Through these pilot programmes, important money centres are trying to speed up and secure cross-border finance. They’re doing it by exploring the use of multiple wholesale CBDCs, which will be available only to financial institutions — and not the general public — over a common platform.

Take Jura, which recently passed a crucial test in a near-real setting.

Over three days in November, Natixis SA in France sold tokenised commercial paper worth euros 200,000 ($226,520) to UBS Group AG. The note was then bought by Credit Suisse Group AG, and finally returned to Natixis. All payments took place in two wholesale CBDCs — the euro and the Swiss franc. The use of distributed ledger technology made all transactions “atomic," meaning that the security and money changed hands — in tokenised forms — without exposing any of the counterparties to a Herstatt limbo where they had parted with something of value without receiving the agreed consideration.

The main point of the Jura experiment was to show that, given the right safeguards, multiple central banks could be persuaded to issue tokenised versions of their money on a third-party blockchain platform where foreign institutions could easily access them.

This isn’t something that comes naturally to monetary authorities, which prefer to work with a small group of resident banks. Broadening access to overseas institutions, as the Jura project’s authors note, is “currently the exception rather than the rule”.

In the digital world, however, this exception can become a valuable advantage. If cross-country trades can be settled without an elaborate network of local correspondent banks acting on behalf of foreign institutions, transaction costs can go down substantially. Some of those benefits will ultimately flow to consumers and businesses.

The trick will be to get monetary authorities to pick one or several third-party platforms where they’ll allow unfettered intraday use of their official money by foreigners, albeit in a digitised form. Coordination could be in everyone’s benefit if the end result is to make international finance cheaper and safer — without lingering doubts about a prickly Herstatt needle hidden somewhere in a $9 trillion haystack.