It’s finally time to move on from a $2.2 trillion problem by burying Bankhaus Herstatt — a half-century after its collapse.
On June 26, 1974, before the New York money market opened, liquidators swooped in. They closed down the Cologne-based midsized lender before it could release the dollars for all the currency trades in which it had already received Deutsche marks. The ensuing chaos on both sides of the Atlantic led to the creation of the Basel Committee on Banking Supervision. But the so-called Herstatt risk, in which one party is left holding a claim after it has discharged its obligations, has lived on.
In 2020, Barclays Plc sent a $130 million payment to the foreign exchange business of Bavaguthu Raghuram Shetty, an Indian tycoon in the United Arab Emirates, but the money never reached the counterparties.
While that was a minor accident, the potential for more significant mishaps exists. On any given day, nearly a third of the $7 trillion deliverable foreign exchange turnover is exposed to settlement failure. A big chunk of the risk resides in emerging markets, whose currencies are increasingly on one side of the trade against the dollar, euro, yen, or pound. Only 18 coins enjoy the payment-versus-payment protection accorded by CLS Group Holdings AG, a crucial market infrastructure owned by the world’s largest banks.
Now, another joint initiative is taking on the challenge. Partior — Latin for “to distribute and share” — attacks Herstatt’s risk with distributed ledger technology. The 24×7, always-on platform facilitates liquidity by making trades “atomic” — either both legs of a transaction occur in sync, or neither does. That cuts counterparty risks, especially for offshore Chinese yuan, Indian rupee, Indonesian rupiah, and other emerging-market currencies.
Founded in 2021 by JPMorgan Chase & Co., DBS Group Holdings Ltd., and the Singapore state investment firm Temasek Holdings, Partior brought in Standard Chartered Plc as a fourth founding member and its first euro settlement bank last year.
However, the goal of the venture goes beyond reducing settlement risk. Smart contracts, or self-executing computer code, allow programmability, enabling institutions to offer new instruments such as intraday FX swaps. As Stella Lim, the Singapore-based chief operating officer of Partior, explained to me, instead of sitting on excess funds to clear anticipated payments later in the day, banks can enter into “intraday FX Swaps to access liquidity for hours or even minutes,” helping them save on the cost of cash buffers.
An industry group of 25 large banks concluded recently that the wholesale foreign exchange market is at an inflection point as “participants are now faced with more options on how to execute and when to settle their FX transactions.” Completing timed settlements in the existing architecture is fraught with friction. Central banks and correspondent banks in other countries would have different operating hours. Currency restrictions in some local markets might also get in the way. Besides, banks need to run additional internal controls on large payments. Whether those and regular anti-money-laundering checks can be concluded in time remains an open question.
Rather than trying to speed up the existing rails, it may be time to add new ones. Cost is the most significant pain point of international transactions for a bank’s retail clients. For corporate customers, it’s speed. For asset managers, the main worry is failed trades as regulation halves the time taken to complete a US securities trade to one day from May. Now that smartphone-based payments are instantaneous within national borders, nobody wants to wait too long for funds to transfer to another country. As Citigroup Inc. says, the retail experience with fast domestic payments drives the “consumerization” of corporate expectations in more complex situations involving multiple currencies.
A consensus is beginning to emerge in the financial industry: If clients are to be given what they have come to expect, money has to stop moving in the form of messages. Instructing institutions to debit and credit accounts and then reconciling those changes in multiple ledgers to ensure nobody comes up short is unnecessary in the 21st century. Modern initiatives will be built around a unified catalog, which the Bank for International Settlements promotes as a complete makeover of “how we think about money.”
Imagine the unified ledger as a giant scoreboard. It will track changes as financial institutions swap digital tokens with one another according to pre-programmed logic. Some tickets will represent securities; others will stand in for bank deposits. A third type will consist of different countries’ central bank digital currencies or CBDCs. No token will leave any wallet if the payment doesn’t come from another. Participants will monitor the game by sending messages and looking at the scoreboard. As Partior says, the unified ledger will record the value exchange as “a global real-time source of truth.”
We aren’t there yet. For one thing, CBDCs aren’t ready. For another, the legal and regulatory tower will need a significant update. Although a unified ledger would be strictly institutional and highly secure, some technological challenges might be similar to those plaguing conventional accounts-based finance and cryptocurrencies on a public blockchain. For instance, all smart contracts must be rigorously audited for integrity. A single node getting hacked — like in the recent ransomware attack against Industrial & Commercial Bank of China Ltd. — wouldn’t alter the truth recorded by the unified ledger. But then, it never pays to underestimate criminal ingenuity.
Nor is it prudent to overlook minor stumbles. Nobody in June 1974 could have predicted that a small German bank’s failure, resulting from its misadventures in the currency market, would spook the New York Clearing House members that they would insist on recalling payments they had authorized the previous business day. London bankers were furious. Trust would eventually return, though the episode lingers as a cautionary tale. The world of money and banking still has a few steps ahead before it can let Herstatt rest in eternal peace. Luckily, it won’t be another 50-year wait.