Are we at another Herstatt risk moment in the global financial system?

In 1974, the Herstatt Bank in Germany collapsed after making a series of wrong moves on the foreign exchange markets, ending up with DM470 million in losses (worth the equivalent of nearly USD 1 billion today). This forced Herstatt into insolvency before it could settle accounts with counterparty banks, putting client funds at risk.

The failure of Herstatt was a major factor in the creation of real-time gross settlement systems and other structures that mitigate against settlement risk. It led to the world’s central banks establishing a centralised clearing facility for foreign exchange – the Continuous Linked Settlement (CLS) Bank in Canary Wharf – to protect against this kind of failure.

With the recent failure of Wirecard, issues at Travelex and regulatory pressure to insure the decentralized global payment chain, we could be at another inflection point where there is a challenge of systemic risk to global payments. Innovative fintech companies will want to understand both the potential impact of this pressure on innovation in the fintech ecosystem and what they can do about it.

Pressure on the payments industry

Regulators in the UK and elsewhere have serious concerns that the coming economic downturn, brought about by Covid-19, is going to cause systemic risk in the decentralised global payment ecosystem by forcing many undercapitalized smaller payments players into insolvency and placing client funds at risk.

Many non-bank fintechs – in the same vein as other internet technology companies such as Airbnb and Uber – are asset-lite businesses. This is part of their attraction to venture investors; start-up capital goes directly into funding growth and is not parked on the balance sheet. Digital payments companies move money around, but they don’t hold substantial liquidity on their balance sheets. However, banks and credit institutions are required to keep risk-weighted capital on their balance sheets, which can be adjusted in times of crisis, like in 2008. The time for something like this could be coming for payments.

There has always been a question about whether the asset-lite model can work in non-bank financial firms in the long term, but the coming downturn and recent business failures are going to put it under increased scrutiny. 

Regulators are, of course, doing the right thing and must protect consumers and business customers. But this needs to be balanced with continuing to bring transparency, inclusion, access and ease of use to a long-protected financial system. 

Innovation at risk

The fintech revolution happens from the bottom up. Investment in small innovative firms, which provide new services to consumers and business, forces more established firms and banks to modernize in response. In the process, a few unicorns are born, many firms fall by the wayside and the pace of innovation across the industry is accelerated. Innovation relies on many diverse firms trying and testing different technologies, business models and solutions for underserved constituencies.

We are likely to see further consolidation in the industry as a result of the economic downturn, with smaller fintechs sadly falling by the wayside as they struggle to secure funding to grow or do not have enough capital to meet the enhanced liquidity requirements likely imposed by regulators. And as the cost of starting an innovative fintech company rises dramatically with a requirement for more balance-sheet capital, these firms may be less attractive as venture investment and affect the flow of funds into innovation.

Towards a solution and the new normal

Now is not the time to speculate on exactly what the future might look like or casually toss ideas around. What is clear, though, is the need to balance reduction of risk with a continued focus on innovation – we simply cannot afford to wipe out the progress that has been made. We must find the workable midpoint between everyone becoming a bank and everyone being unregulated.

To meet increased requirements from the regulators, there will need to be some structure in the non-bank payments market that provides insurance to its customers. Bank accounts in most markets come with insurance (e.g. FDIC, FSCS) and there may be scope for a similar solution for fintech firms.

Whatever happens, it will come at a cost. We can expect to see fewer regulated payments firms in the future, and those that do exist will be larger and better capitalised. To enable innovation to flourish in this environment, banking- and payments-as-a-service firms will become ever more critical.

There will, of course, be winners and losers, but the digital payments industry can only progress if all interested parties within the ecosystem – investors, regulators, fintechs and regulated financial institutions – work together to address the challenges outlined here.

Above all, though, this new structure must be built primarily to preserve the benefits of innovation, and not only centred around reducing risk. Financial inclusion, transparency, low cost, ease of use – these are the features that the new normal must be built around. We can’t afford to let these benefits slip as we rightly work towards better regulation.