Liquidity bridges have gradually transformed in parallel with the evolution of cross-border payments, mainly due to The G20 commitment to establish a cross-border payment program.
As central banks consider whether to build liquidity bridges, here are some highlights of their benefits and challenges.
Bridges can benefit participants because of how they are able to reduce their need for:
Have multiple collateral buffers in different jurisdictions and/or currencies
· Undertake foreign exchange transactions
Have cash reserves
Therefore, it goes a long way in reducing transaction costs, associated settlement risks, and generally the overall complexity of trades.
Moreover, given the additional flexibility they add, they help banks in managing their intraday liquidity.
Accordingly, it is in the interest of the industry to explore the area of liquidity bridges, as they can certainly offer many benefits to payment service providers and banks in terms of liquidity management while effectively reducing costs. cross-border payment services.
Use liquidity more efficiently
Currently, banks are either required to invest in liquid assets that can be used as collateral or must hold foreign currency in a foreign central bank or in their respective correspondent bank accounts.
And while the need to find that cash can rightly be viewed as a serious credit risk, many miss the opportunity cost it entails.
To compound the problem further, banks typically overfund their payment obligations in order to manage their payment risk.
A liquidity bridge is able to reduce costs while simultaneously releasing participants’ tied up liquidity, which means it will also be easier for banks to better allocate their collateral and manage their intraday needs. By not having bridges, banks that operate in multiple currencies will most likely be required to hold much larger pools in all jurisdictions they operate in, which also comes with higher funding costs and the inevitable pass-through of costs to end-users and rising costs to cross-border payments.
Reduce friction in cross-border payments
Compared to the alternatives, the settlement processes of bridges are much easier and the need for counterparties and/or clearing entities is also less.
Credit and settlement risks can also be reduced or entirely eliminated through liquidity bridges. As such, cross-border payments can be faster, cheaper, and more importantly, less friction.
Help achieve financial stability
Intraday liquidity is highly dependent on the arrangements of central banks towards domestic market participants.
Given intraday settlement obligations, a higher adoption rate of liquidity bridges may be correlated with lower intraday settlement risk internationally.
Additionally, as collateral demands begin to level off, asset volatility will decrease, contributing to overall financial stability.
The risks and challenges of liquidity bridges
Although operational costs are high, central banks that establish and operate liquidity bridges also face other risks.
Risks can be divided into at least four distinct categories:
1. Risks of Entry
2. Operational risks
3. Financial risks
4. Systemic risks
First and foremost, a bridge can only be located where the bank is legally permitted to operate it.
If that jurisdiction does not provide a strong legal framework, the risk is inherently higher.
Additionally, the case becomes increasingly difficult when developing a multilateral bridge as other jurisdictions’ regulatory frameworks, legal agreements, technical implementation costs, operational costs, and even volatility currencies come into play.
Whether it is a bilateral or multilateral bridge, however interdependent the participants become, systemic risk also increases.
Finally, there are also emerging market risks and developing economy risks that need to be considered.
Wrap
Liquidity bridges can allow banks and PSPs to see their costs reduced while reducing the costs associated with cross-border payments.
Risk management should be a top priority for participants as there are still challenges ahead.
However, the upside is undeniably massive and with the G20 pushing for a unified framework, participants can certainly see themselves closer to overall financial stability.
Liquidity bridges have gradually transformed in parallel with the evolution of cross-border payments, mainly due to The G20 commitment to establish a cross-border payment program.
As central banks consider whether to build liquidity bridges, here are some highlights of their benefits and challenges.
Bridges can benefit participants because of how they are able to reduce their need for:
Have multiple collateral buffers in different jurisdictions and/or currencies
· Undertake foreign exchange transactions
Have cash reserves
Therefore, it goes a long way in reducing transaction costs, associated settlement risks, and generally the overall complexity of trades.
Moreover, given the additional flexibility they add, they help banks in managing their intraday liquidity.
Accordingly, it is in the interest of the industry to explore the area of liquidity bridges, as they can certainly offer many benefits to payment service providers and banks in terms of liquidity management while effectively reducing costs. cross-border payment services.
Use liquidity more efficiently
Currently, banks are either required to invest in liquid assets that can be used as collateral or must hold foreign currency in a foreign central bank or in their respective correspondent bank accounts.
And while the need to find that cash can rightly be viewed as a serious credit risk, many miss the opportunity cost it entails.
To compound the problem further, banks typically overfund their payment obligations in order to manage their payment risk.
A liquidity bridge is able to reduce costs while simultaneously releasing participants’ tied up liquidity, which means it will also be easier for banks to better allocate their collateral and manage their intraday needs. By not having bridges, banks that operate in multiple currencies will most likely be required to hold much larger pools in all jurisdictions they operate in, which also comes with higher funding costs and the inevitable pass-through of costs to end-users and rising costs to cross-border payments.
Reduce friction in cross-border payments
Compared to the alternatives, the settlement processes of bridges are much easier and the need for counterparties and/or clearing entities is also less.
Credit and settlement risks can also be reduced or entirely eliminated through liquidity bridges. As such, cross-border payments can be faster, cheaper, and more importantly, less friction.
Help achieve financial stability
Intraday liquidity is highly dependent on the arrangements of central banks towards domestic market participants.
Given intraday settlement obligations, a higher adoption rate of liquidity bridges may be correlated with lower intraday settlement risk internationally.
Additionally, as collateral demands begin to level off, asset volatility will decrease, contributing to overall financial stability.
The risks and challenges of liquidity bridges
Although operational costs are high, central banks that establish and operate liquidity bridges also face other risks.
Risks can be divided into at least four distinct categories:
1. Risks of Entry
2. Operational risks
3. Financial risks
4. Systemic risks
First and foremost, a bridge can only be located where the bank is legally permitted to operate it.
If that jurisdiction does not provide a strong legal framework, the risk is inherently higher.
Additionally, the case becomes increasingly difficult when developing a multilateral bridge as other jurisdictions’ regulatory frameworks, legal agreements, technical implementation costs, operational costs, and even volatility currencies come into play.
Whether it is a bilateral or multilateral bridge, however interdependent the participants become, systemic risk also increases.
Finally, there are also emerging market risks and developing economy risks that need to be considered.
Wrap
Liquidity bridges can allow banks and PSPs to see their costs reduced while reducing the costs associated with cross-border payments.
Risk management should be a top priority for participants as there are still challenges ahead.
However, the upside is undeniably massive and with the G20 pushing for a unified framework, participants can certainly see themselves closer to global financial stability.
