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A process that is ripe for digitization and automation is financial netting, a way of consolidating or reconciling multiple payments between two or more parties to create a single amount due to each participant. It simplifies doing business and reduces risk.
Banks do it. Securities, currency and other markets do it. Service providers, central exchanges and clearinghouses do it on behalf of these organizations. Netting can also be used in virtually any kind of inter-company transaction, from reconciling AP/AR between two companies to resolving bankruptcy claims.
First, the 101 on netting, which is most easily explained with an example. Party A is due to receive $75,000 from Party B. At the same time, Party B is due to receive $30,000 from Party A. Instead of Party B paying $75,000 to Party A and Party A paying $30,000 to Party B in two separate transactions (called gross settlement), the payments can be netted. That way Party A owes nothing, and Party B pays Party A $45,000.
Within an organization, standard business software can typically handle netting for things like transfers between business units or divisions. But between two businesses, banks, or traders, for example, and especially between multiple parties, the netting process is more complex.
Proven benefits of a blockchain-based financial netting solution
Working with existing clients, we have proven that using blockchain to streamline netting can:
- Lower costs for all parties
- Reduce manual data entry and file uploads
- Automate and speed processing of matching and netting transactions
- Increase security through encryption and tamper-evident distributed ledger technology
- Provide transparency and enhance trust with permissioned access to transaction data
Blockchain and financial netting: How it works
We have a replicable solution built on the IBM Blockchain Platform that transforms and simplifies netting between two or more parties. The heart of the solution is a blockchain network that serves as a single source of truth and a permanent audit trail through immutable storage of transaction data. The engine that drives the solution is automation, enabled by smart contracts and agreed-upon business rules.
Here’s how it works. Participants send transaction data to the blockchain in real time from their in-house applications, granting visibility to selected participants and to no one else, preserving privacy in an environment where multiple parties are participating. This approach avoids errors that come from manual data entry processes and makes transactions available for netting faster — actual processing is based on the timing agreement between participating parties.
Blockchain smart contracts encode and automate these agreements and can include other business rules governing the transactions and relationships between parties, and even governance rules from regulatory bodies. Smart contracts can also include the mathematical instructions for the netting itself, calculating who owes what to whom.
Netting in foreign exchange markets: Revolutionizing post-trade processing
CLS, a financial market infrastructure delivering settlement, processing and data solutions, worked with IBM Blockchain to develop its CLSNet solution for the foreign exchange (FX) market. In production for more than two years, CLSNet is a standardized, automated bilateral payment netting calculation service for approximately 120 currencies not covered by the CLS FX settlement service.
Without CLSNet, companies trading in the FX market that want to net with each other use processes that are largely manual and not fully standardized or scalable. Alternatively, with gross settlement, participants need to settle transaction by transaction, which requires more intra-day capital liquidity and incurs higher costs due to more frequent payments using the Swift network.
With CLSNet, which is considered the first global FX market application running on blockchain in production, buy-side and sell-side participants send their trade instructions to the platform. CLSNet matches instructions and sends a match notification to each counterparty that serves as the legal confirmation of the underlying FX trade. Participants then assign a cut-off time for each currency, and when that time is reached, they receive a report of their net payment amounts. Delivery of payments is handled outside of CLSNet via instructions sent over the SWIFT network.
Using blockchain as an immutable, auditable record of all transactions, plus smart contracts to standardize and automate netting, CLSNet helps buyers and sellers drive operational process efficiencies, such as optimizing intraday liquidity, enabling real-time awareness of currency and counterparty exposures, and reducing risk.
Using blockchain for netting interbank cash transactions
It is not uncommon for banks to find themselves flush with cash in one city and low on cash needed to fill ATM machines in another city. Physically moving cash from one city to another is expensive, requiring armored car transport, possibly air transport, and insurance, among other costs. Another option is to ask the central bank to absorb the excess money in one city and provide cash in the other city, but this is also a costly alternative.
A third option is now available from IBM Blockchain working with TecBan (Tecnologia Bancária S.A.), Brazil’s largest ATM network operator and a leading specialist in managing the money cycle through self-service solutions and bank sharing. The company offers a blockchain-based service that enables banks to optimize the availability of money at their branches spread across several cities through interbank money transfers.
The TecBan solution, built on IBM Blockchain Platform and IBM Cloud, provides an automated application that matches cash requirements and cash availability between banks. Netting of interbank transactions is also handled in the blockchain network, without manual processes. All that is required is a transfer of custody, and the cash is “moved” from one bank to another within a shared TecBan vault in or near the city closest to the ATM that requires cash.
The primary benefit for the banks is reducing the cost of cash logistics. For TecBan, blockchain technology has made it possible for the company to offer a new, more efficient and cost-saving service to member banks.
Financial netting and blockchain in your industry: Build on our experience and assets
These financial netting solutions are replicable. By that I mean we have built it already for existing clients and can recreate the solution quickly for other companies and their partners. Assets such as rules for matching and logic for calculations, templates for user interfaces, and APIs for connecting trading systems or systems of record can be customized for application in any industry requiring transaction netting.
By taking advantage of an existing customizable solution and the expertise of IBM Blockchain Services, companies can progress from design to working pilot in as little as three months. After applying learning from the pilot to hardening the infrastructure, you can begin to scale by adding new participants to the network.
The solution itself is built on the IBM Blockchain Platform, which is a value-added commercial distribution of The Linux Foundation’s open source Hyperledger Fabric. The IBM Blockchain Platform is cloud agnostic, so it can run in the cloud of your choice or on-premises. Each party in the blockchain network can maintain their data on the IT infrastructure or 3rd party cloud vendor of their choice. The platform is GDPR compliant, so it is ready to support global business relationships.
Our customers are finding that once they have a blockchain network built for one business application, such as financial netting, it provides a platform for automating other business processes or offering new services to their customers.
If you are in a business that is looking for a better way to manage netting between companies, consider blockchain. It addresses privacy and compliance, can scale to handle very high-volume workflows, and provides an immutable audit trail. IBM Blockchain Services can help you join either the CLSNet or TechBahn solutions discussed in this article, or you can talk to us about how we can replicate a similar a blockchain-based netting solution for your organization.
This use case telling the story of Financial Netting will be followed up by more examples of how blockchain services are being used in various industries to help solve real world problems. Be sure to read our recent articles on Invoice Reconciliation and Digital Ticketing and upcoming articles, or schedule a free one-on-one consultation to find out how you can benefit from this solution.