Central Bank Money (CeBM), as distinct from commercial bank money, is used for settlement between banking institutions and their central banks. The differences between the two are important as central banks can protect themselves from retail exposure while commercial banks do the work of determining credit risk across a broad borrower audience. For dealers and clearing firms, the more business they can conduct in CeBM including settling and netting trades, the more effective they can be in balance sheet management.
All developed economies have two payments infrastructures: one supported by central bank money and the other by commercial bank money. Central bank payment systems are meant for large banks to settle transactions with one another and on behalf of underlying clients, and CeBM is considered risk-free as there is no insolvency risk. Central banks open accounts for large banks, governments and selected non-government entities like the International Monetary Fund, but these accounts are not meant for the public. Central bank money takes two forms, banknotes and deposit money.
Commercial bank money on the other hand is meant to provide capital liquidity to private markets through the issuance of liabilities; central banks control how much issuance can occur through fiscal and monetary policy including interest rates, which helps dictate consumer demand. Commercial bank money is denominated in the same currency that bank notes represent. Banks can open accounts with one another to settle transactions in commercial bank money, or a small bank can use the correspondent clearing services of a larger bank to access similar services as CeBM but without an account. If both banks are central bank members, they typically use central bank money to settle their accounts. Non-banks can only access CeBM indirectly through their commercial bank accounts. There is some also credit risk as commercial banks could potential fail, which has implications for risk capital calculations.
A new introduction by Clearstream and Eurex provides an opportunity for banks to settle and net their securities transactions in CeBM. This is a market first. Technically, Clearstream has connected to the European Union’s TARGET2 real-time gross settlement platform, enabling settlement in CeBM for triparty repo. The next phase is extending settlement for both specific ISIN and GC Pooling repo to coincide with the introduction of the European Collateral Management System (ECMS) in November 2024. The combination of Clearstream’s triparty and settlement connectivity to both TARGET2 and ECMS will enable Eurex Clearing market participants to settle the largest Euro specific ISIN and TriParty repo in CeBM and at a single settlement system.
The basics of balance sheet netting
Regulated banks must adhere to several simple rules for netting down their balance sheet exposure in Europe. Trades must have the same counterparty, same settlement date, there must be a netting agreement in place, there must be settlement on a net basis and there must be intraday credit facilities in place (see Exhibit 1). Central counterparties (CCPs) have become attractive in recent years due to novation: by becoming the buyer to every seller and seller to every buyer, they fulfill the criteria of being the same counterparty to every trade. Settlement on a net basis can occur on a CCP; otherwise, repo is reported on a gross basis, which creates capacity limitations. At Deutsche Boerse, the remaining criteria are met by a combination of Eurex’s overnight transactions, legal agreements and Clearstream’s settlement and credit mechanisms.
Expanding netting to Central Bank Money
The opportunity to settle in CeBM comes from the client’s account at Clearstream (the T2S-DCA account). Banks and brokers that have both a Clearstream account and a dedicated account at their central bank can instruct an exchange of securities and cash on T2S with an integrated settlement model. Eurex Clearing sends the settlement instructions to Clearstream on behalf of Eurex Repo trading participants in both GC Pooling and Special market segments.
The combination of the CCP plus CeBM layers on two balance sheet efficiencies for banks with central bank accounts. First, the CCP delivers netting benefits on its own; in a 2022 case study, Eurex found that a broker-dealer client could reduce its capital exposure by €3.8bn on a €25bn notional matched book. Second, a shift to CeBM from commercial bank money settlement can improve liquidity, eliminate settlement credit lines and reduce risk. While no study yet exists that demonstrates the financial savings of settling in CeBM, a move from commercial to central bank money is an immediate risk reduction that can show up in capital and leverage ratios.
Anecdotally, market participants are positive on the new netting opportunity. Michael Cyrus, head of short-term products, equity finance & FX at Dekabank noted that “given that there is some perception in the market that intraday liquidity management will become more important, central bank money on Eurex Repo for balance sheet netting seems to be a great idea. And in this case, the netting would also reflect a reduction in capital and risk, I would think.”
According to Raul Schwab, Senior Associate Vice President – Product & Business Development at Eurex, settlement in CeBM adds additional efficiencies for clearing clients at Eurex. Schwab notes four main areas:
- Clearstream Banking Frankfurt is the settlement system for Eurex cleared specific ISIN and GC Pooling (TriParty) repo
- Single central bank money cash account (T2S-DCA) for specific ISIN and GC Pooling repo
- Consolidate and mobilize T2S eligible collateral incl. ECMS
- Single legal framework
- Capital efficiency that leads to reduced cash balance and associated capital requirements.
- Risk reduction by settling with central banks in place of cash correspondent banks
- Account consolidation that reduces operational complexity and reduces the still-outstanding problem of fragmented market infrastructure and legal frameworks across all the EU countries.
The ability to net in CeBM has client benefits as well. Michel Semaan, global head of securities financing at BBVA, said that “there should be a benefit in terms of the ability to extend a larger share of the activity to clients following the additional netting impact. Beyond pricing, I think that it will especially allow dealers to offer better liquidity and increase volumes traded with certain clients (where a two-way business and enhanced netting are present).” CeBM netting could then become a competitive differentiator between dealers in delivering client solutions.
Although an ideal outcome would be that all banks with central bank accounts choose to settle their repo trades in CeBM, that is unlikely to occur. Commercial bank money remains a vital part of capital and financial markets including for mobilizing collateral efficiently. According to Schwab, the new initiative by Eurex and Clearstream aims to “improve the efficiency of commercial bank money settlement processes and enable better integration with CeBM settlement, such as through initiatives like T2S. This enhances collateral management efficiency and risk mitigation for Eurosystem credit operations and supports the harmonization of European capital markets.” Not everyone may turn to CeBM as their entire solution however.
Where DLT fits in
A future next step for balance sheet netting in CeBM is on distributed ledger technology platforms. This provides an opportunity settle in digitized CeBM or even in Central Bank Digital Currencies (CBDC). While still speculative, the ECB is investigating the idea of CeBM settlement in a DLT pilot project. This would substantially speed up settlement times, providing another layer of balance sheet efficiency to Eurex and Clearstream clients with central bank accounts.
This article was commissioned by Eurex.