Regulating liquidity - the impact on clearing and sett lement
The regulatory drive for ‘liquidity pricing’ and the full allocation of related costs is bound to challenge the profitability of current business services. This paper reviews the requirements and potential solutions for clearing and settlement services that will emerge from the new regulatory model for liquidity risk and provisions.

Settlement banks are increasingly concerned about their liquidity risk exposure to client cash flows. While this is partly because of tough economic conditions, it’s also because of the fresh attention paid by regulatory bodies towards client liquidity. Some banks are already withdrawing from settlement service agreements with large and volatile liquidity users such as investment businesses. But the business need for settlement remains; in fact, it’ll only continue to grow. At the same time, direct, self-clearing in multiple currencies is impractical for most banks. So a new solution is required.

Riding the winds of change
The new regulations require analysis and allocation of liquidity, and its risk management, to the lines of business that generate liquidity demand. Liquidity pricing must be built into every part of a company’s business plan including governance, strategy and capital or liquidity management. It must be applied consistently and fairly across business units.

Where a bank is self-clearing and a direct settlement member of clearing and settlement mechanisms [CSM s], it will have established ways to manage liquidity alongside other business risks. But in most banks, there are no equivalent metrics or liquidity cost allocations made with respect to indirect CSM participation and to correspondent banking business services.

Centralisation of a bank group’s cash management is good strategy; especially if it also meant quantification of the liquidity costs with other service costs. That would enable a rational review of business profitability and pricing models, leading to a wholly new basis for banking services or product offerings.

Changing Focus
There is a need for clarity on the risks and risk mitigation options of each type of banking service, and of each type of banking client. Liquidity provision regulations are likely to make ‘indirect settlement services for high value cash flows’ into a specialist market. Banks will look for new models to address the liquidity risk of settlement.

To avoid risk or to manage it?
Despite its clear strengths and value, before and during the crisis, people now see CLS third party services as taking extra liquidity risk on-board. This is based on the fact that CLS settlement members are committed to the settlement cash flows coming in from the matched and mature trades of their third party clients logged in the CLS system.

The new regulations for liquidity management will impact banking in a wide range of business areas.

• liquidity pricing will challenge the profitability of current business services
• scarcity of appropriate collateral will drive moves for liquidity efficiency, especially in commodity payments and settlement services
• liquidity risk will demand premium prices, and new service relationships and pricing models will be required to address high value settlement business.
• clearing and settlement schemes will need to review the impact of potentially larger memberships and smaller scale banks as members.