Basel III regulation gives a specific reason for why blockchain will save banks billions in regulatory costs (Premium)

The information is a bit in the weeds, but we recently came across a smoking gun, pile-driving conclusive reason for why blockchain makes dollars and sense for banks looking to reduce their regulatory exposure costs. The argument is unavoidable, courtesy of the Basel Committee. Here’s what we found:

The Basel Committee on Banking Supervision released “Revisions to the Standardised Approach for credit risk, second consultation paper” in December 2015. This is an important document that spells out new winners and losers in financial markets – we are analyzing it in full for a January Finadium research report.

One big piece of evidence for blockchain or any other instantaneous settlement system is in reduced risk for outstanding unsettled transactions and hence the capital that banks must retain for this exposure. Page 39, paragraph 73 of the revised text states (red added by us for emphasis):

Banks are exposed to the risk associated with unsettled securities, commodities, and foreign exchange transactions from trade date. Irrespective of the booking or the accounting of the transaction, unsettled transactions must be taken into account for regulatory capital requirements purposes. Where they do not appear on the balance sheet (ie settlement date accounting), the unsettled exposure amount will receive a 100% [Credit Conversion Factor – CCF]. Banks are encouraged to develop, implement and improve systems for tracking and monitoring the credit risk exposure arising from unsettled transactions as appropriate so that they can produce management information that facilitates timely action. Furthermore, when such transactions are not processed through a delivery-versus-payment (DvP) or payment-versus-payment (PvP) mechanism, banks must calculate a capital charge as set forth in Annex 3 of this framework.

What is this Credit Conversion Factor, you ask? Its a way of converting an exposure into Exposure at Default, which is the basic measurement tool of calculating capital required to hold against an outstanding exposure. We tackled this in some depth on our December research report, “Regulatory Costs of OTC Derivatives vs. Securities Finance Transactions.”

Walking this through, banks must account for all off the balance sheet unsettled transactions at 100% of the Exposure at Default Cost. As of June 2015, selected US broker Statements of Financial Condition show that receivables from brokers, dealers and clearing organizations were:

Goldman Sachs: US$1.34 billion
Morgan Stanley: US$3.3 billion
JPM Securities: US$2 billion (from the notes as unsettled transactions)
Merrill Lynch (Pierce, Fenner and Smith): US$11.5 billion

This sample is already US$18.14 billion in unsettled transactions that need to be accounted for. If they are off balance sheet, that requires 100% of capital to cover Exposure at Default.

Now what if there were a system where all transactions were settled immediately: not T+0 but T+.05 seconds? Leaving aside the technology and politics for a moment, this system would result in US$0 outstanding for brokers in their unsettled transactions, thereby eliminating any charge for outstanding transactions. There should also theoretically be no fails since every transaction would require a valid token of some sort on the other side.

Regulatory costs are a basic reason why banks and brokers will explore blockchain and distributed ledger technology. By reducing credit risk exposure, and hence the regulatory capital charges or credit risk exposure, this is a massive cost reduction play.

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