Why dealing with a regulated third party that is not really set-up to achieve secure settlement?
We established that the banking business has become a much more capital intensive business, as regulators have declared war on all sorts of hidden forms of leverage (such as the 365-day revolving facilities, amongst others). As a result banks may no longer be the most efficient business partners when it comes to providing security in trade. The next question we should try to answer is whether banks are really needed here. What are banks exactly? Let us go back to basics here.
Banks are intermediaries in capital markets; the latter in the broadest sense of the word. Generally they raise funds by borrowing at the lowest rate possible. They then lend these funds on to clients at a higher rate. It can become complicated when banks raise funds in a form that regulators consider equity (by issuing shares) or otherwise contribute to their capital position (by issuing hybrid debt).
When raising equity the business obtains cash without generating any liabilities. The shareholder has a right to share in the profits, but if there aren’t any he has no further claims. The capital providers to a bank allow the bank to do its business – just as any other business relies on the capital put up by its capital providers. However, the difference is that banks ‘borrow’ from the public. Clients, both businesses and consumers, are owed the monies they have in their accounts at these institutions. It is for that reason banks are regulated.
Regulators determine how banks should be capitalised and this is the unusual aspect of a banking business. Regulators are doing this as banks are seen as essential service providers. Society cannot function without banks. As we established previously regulators hence do not like leverage, as leverage increases risk. The more business (i.e. the lending to clients) is done with 1 unit of capital the higher the chance that if only a small part of this business goes sour this will eradicate this capital and cause the bank to cease to exist.
All of this shows that regulators see banks as brokers that intermediate between people with excess cash and people that will earn cash in the future, but require it now (to build their earnings capacity), and that the people who trust these institutions with their excess cash need to be protected. The goal of this exposé about the role of a bank and the regulatory consequences is hence to make clear that pure risk taking without being an intermediary involving funding is an activity that does not come entirely natural to banks.
Synthetic or unfunded risk-taking is something that is mostly done by insurance companies. As pure risk taking is more difficult to monitor in terms of leverage and hence capital usage, regulators are keen to keep a very close eye on this. Traditionally banks would ‘guarantee’ their clients’ obligations vis-à-vis a third party when the bank was also the custodian of the client’s assets. Recourse would then be easy. However in today’s trading environment banks are not the predominant collateral managers.
These are specialised companies with their operations spread around the world, mostly near important ports, that hold physical assets on behalf of their clients. Knowing that banks’ key added value proposition does not involve the management of physical assets, nor the taking of unfunded risk, why would people then deal with a third party that is heavily regulated and is not really set-up to enhance secure settlement in trade?
At the moment most trade is accompanied by LoCs issued by banks. This drags banks into this arena and slows trade down. In particular when it comes to developing new trade with counterparties that have no relationship with any known banks or SMEs that have insufficient credit capacity to avoid having to post cash collateral. Without even mentioning any compliance, risk management hurdle or operational set-up drawbacks it must be logical that dragging an entity into the fray which has its hands and feet tied is not ideal.
As regulators want banks to focus on their core functions, where they perceive them to be most valuable to society, there is really no reason to involve banks in the settlement process of trade. The world has materially changed since the invention of the bank guarantee in terms of collateral management. Trade should really be settled through an exchange.
Financial transactions have been settled in this manner for many years. The underlying escrow principle of ‘payment versus delivery’ should also be implemented in ‘slower’ markets. With the rise of the fast internet this is now no longer a challenging undertaking.
A platform through which both parties can agree the trading conditions and which subsequently facilitates secure settlement (i.e. payment versus delivery), offers a much better mechanism for buyers and sellers worldwide, in particular when both parties have no previous relationship. It may be superfluous to state that ‘trust’ is one of the main issues holding people back when contemplating the use of a new way to securely settle trade.
If I were to wire a large amount of cash for settlement to the escrow agent (the entity that holds the funds until the goods will have arrived), I must be sure that this party has an excellent reputation and a rock-solid credit standing. Mercurion, a company offering this type of escrow driven digitalised method to settle transactions, works together with the Baltic Exchange as their escrow agent.
Baltic Exchange is part of a group with an Aa2 rating and has extensive experience in the escrow business. Mercurion added to their offering by creating a web-based user-friendly process for ‘flow’ cargo (www.mercuriontrade.com), whereas before Baltic had been mainly involved with the buying and selling of ships and holding deposits in time charter transactions. As with all new processes, change is scary. However, by engaging a conservative institution that itself was founded in 1744, having changed many times itself to remain relevant, people should not be too worried (!)