Settlement – The Core of Banking – Part 1 

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Given that 80% of my payments thoughts over the last month have been on identity it is time to move on to settlement. Understanding the process of settlement is key to understanding both payments and banking. 

Today’s blog hopes to address 4 questions

  • What are the fundamental innovations in settlement?
  • How will innovations change competitive dynamics?
  • How will innovations change political dynamics?
  • What flows will be impacted?

Nobel economists Coase/Williamson demonstrated how transaction costs shaped the Nature of the Firm. Settlement systems define the transaction costs of finance. Thus settlement system design shapes the organization of financial services. Settlement is in the midst of a revolution as many parties seek to remake settlement as the “base” platform capable of unbundling financial services.

Settlement provides the legal structures and operating rules required to clear $USD Trillions per day are 95% across multiple parties. Banking is a connected business, if the world was in a single account there would be no settlement issues as everyone would be on the same ledger. 

As with all networks increasing scale results in increased network rigidity and existing participants consider how changes impact the value they receive and their unique competitive dynamics. For example, many of the proposed changes to settlement will impact correspondent banking. While some see opportunities to reduce the “cost” of correspondent banking, others providing the correspondent services see change as a reduction in revenue.  While the tech of settlement is fascinating, at the end of the day one counterparty has to trust the netting process to permit funds to flow from their account. 

While there is no near-term cliff, settlement innovations may result in a dramatic shift of payment volume. Today V, MA, SWIFT, EFT, … ALL run on the same settlement process. As most of you know, there is over $4T of market cap driven by networks residing on TOP OF settlement.  For example, card networks do not move funds, but rather are messaging networks. While the legal and operational structure of settlement may not change, a change in technology can have significant implications for how messages operate between trusted parties and the DIRECT ACCESS of non-banks (ex PSPs, non-banks, …etc.).  

This is a HIGHLY POLITICAL undertaking, with many change advocates working to reduce the power of US/EU banks and sanctions controls. Changes in settlement have the potential to unbundle banking, payments drive changes to central bank power and FCY reserves. Where open banking breaks open the FRONT END, settlement remakes the back end. For example, if risk in settlement can be managed by specialists commercial/retail banking (and payments) could move toward a model which resembles modern financial markets (clearing process is a commodity).

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Update – Views on CBDCs – Free Content

I thought I’d put together my latest thoughts on Central Bank Digital Currency (CBDC). This blog is an update to my June 2022 Post – CBDCs: Growth Opportunity for US Banks. 

Challenge – Explain a CBDC to a 10 yr old and describe why it is “better” than using cash or a card. While you can never lose your money. The government has the ability to know the source and destination of every transaction.

Continue reading

Case for CBDC – Market Efficiency

Sorry for typos here.  

As most of you know I love to read the arcane (ex favorite book is Weak Linksrelated blog) and I love economists. Today I’m reading some of Thomas Phillippon’s research (NYU’s economist and author of The Great Reversal: How America Gave Up on Free Markets). Many of you will recall I covered Dr. Phillppon’s work in my 2015 blog Changing Economics of Payments. My summary of Phillippon’s work:

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Digital Dollar – Biggest Threat to V/MA (and USD Hegemony)

I doubt if this blog will be beneficial for the crypto and CDBC experts. But for my friends, I’ve linked several very detailed articles and reports… which I’ve tried to summarize.

With respect to payments, let me start with the quote of the week

“Tom look at the pace of change in China as a model. 15 yrs ago they were cash. 7 yrs ago they were China Union Pay, Now they are Alipay/WeChat Pay.. 3 tremendous changes in 10 yrs.  I believe change will happen much faster than anyone could imagine.”

– Top 5 US Retailer

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