[Banking on Blockchain: Part 1] The Pre-funding Paradox

In this entry to my short series on the key institutional challenges to blockchain adoption, we shall be exploring why the much-celebrated “instant settlement” benefit of the technology is actually a liquidity tax for treasuries.

The Hidden Cost of Instant Payments

On blockchain rails, every single transaction is settled individually and immediately. This means that if Bank A sends $10M to Bank B, and Bank B sends $9M back one minute later, the total liquidity required to facilitate those two moves is $19M. Both banks must have their respective amounts ready to go at the exact second of the trade.

By contrast, in traditional correspondent banking, transactions are bundled over a period (usually a day). Using the same example: At the end of the day, the system calculates that Bank A owes Bank B a "net" total of $1M. Only $1M of actual cash moves. Here, the delay acts as a natural netting window, allowing banks to only move the difference, not every single dollar.

The loss of that netting under blockchain payments has significant repercussions for a bank’s liquidity management and how it earns revenue. By moving to the blockchain rails, the banks are required to hold $19M in pre-funded accounts rather than $1M. The extra $18M now “trapped” is money that is now earning zero or low interested instead of being deployed in higher-yielding assets.

The Continuous Linked Settlement, a primary infrastructure for FX settlement, highlights that their multilateral netting process reduces the funding requirements of banks by 96% to 99% on average. Remove this netting efficiency, and banks could need 10x more liquid capital on hand to facilitate the same volume of payments, per the Bank for International Settlements.

The “Dual-Stack” Tax

The challenge explained above from banks’ blockchain adoption is further exacerbated by the transition phase we find ourselves in where banks are supporting parallel infrastructures (Legacy and Blockchain).

If banks operated fully on blockchain infrastructure, then this pre-funding issue may not occur. Money, securities and all assets would seamlessly convert and settle on demand when needed, making holding money in advance of payments unnecessary.

However, moving banks by their thousands to these new ledgers will take years, even decades. In the meantime, leveraging blockchain technology for some cross-border payments means banks need to:

1. continue to hold liquidity buffers for traditional SWIFT/Correspondent world; and
2. ring-fence additional pre-funded cash in specific 24/7 on-chain wallets to support atomic settlement.

In the end the “efficient technology” is making the bank’s balance sheet less efficient. Instead of one pool of liquidity, you have fragmented pockets of cash.

Conclusion

The pre-funding paradox isn't a terminal flaw of blockchain, but it is an operational wall that many current fintech solutions fail to climb. To move beyond the PoC stage, we must find ways to reconcile the speed of atomic settlement with the capital efficiency of netting.

Financial institutions are already exploring solutions, such as implementing on-chain "queuing" algorithms that wait for offsetting payments to arrive before triggering an atomic settlement or wholesale Central Bank Digital Currencies, but my advice first and foremost is for industry players to add nuance to the “instant payment” benefit of blockchain.

To Fintech vendors in particular, I recommend front-loading your responses to these challenges. Don’t just pitch a faster rail but pitch a rail that understands the bank’s intraday liquidity constraints. The ultimate product would be one that integrates with legacy treasury stack without doubling capital requirements.

Next week in Banking on Blockchain: Part 2, I will discuss the "Ghost Town Effect”, where the industry seems stuck with building "Grade A" infrastructure for users who never come.