Liquidity bridges have gradually morphed in tandem with the evolution of cross-border payments, mainly due to G20’s commitment to establishing a cross-border payment program.

As central banks ponder on whether to establish liquidity bridges, here are some highlights of their benefits and their challenges.

The Benefits of Liquidity Bridges

Bridges can benefit participants due to how they are able to reduce their need of:

• Having multiple collateral buffers in different jurisdictions and/or currencies
• Undertaking FX transactions
• Having cash buffers

Consequently, this goes a long way to reducing transaction costs, associated settlement risks, and, in general terms, the overall complexity of operations.

Moreover, given the added flexibility they add, they help banks in terms of managing their intraday liquidity.

Accordingly, it is within the industry’s best interest to explore the realm of liquidity bridges as they can certainly provide many benefits for payment service providers and banks in terms of liquidity management while effectively lowering the costs of cross-border payment services.

Using Liquidity More Efficiently

Right now, banks are either forced to invest in liquid assets that can be used as collateral or must hold foreign currency in either a foreign central bank or in their respective correspondent bank accounts.

And, while the need to source this liquidity might be rightfully seen as a serious credit risk, many miss the opportunity cost it entails.

To further aggravate the problem, banks usually overfund their payment obligations as a way of managing their risk towards payments.

A liquidity bridge is able to take down costs while simultaneously releasing the participants’ tied-up liquidity, meaning it will be easier for banks to better allocate their collateral and manage their intraday needs. By not having bridges, banks which operate in multiple different currencies will most likely be required to hold a substantially larger pool throughout the jurisdictions they are operating in, something which also comes with higher funding costs and the inevitable passing of costs to the end users and cost hike on cross-border payments.

Reducing Friction in Cross-Border Payments

When compared to the alternatives, bridges’ settlement processes are much easier and the need for counterparties and/or clearing entities is also lower.

Credit and settlement risks can also be reduced or fully eliminated via liquidity bridges. As such, cross-border payments can be faster, cheaper, and, more importantly, see less friction.

Helping Achieve Financial Stability

Intraday liquidity relies heavily on central banks' provisions to domestic market participants.

With intraday payment obligations in mind, a higher adoption rate for liquidity bridges can correlate with a lower intraday settlement risk internationally.

Moreover, since collateral demands begin to stabilize so will asset volatility lower, adding to the overall financial stability.

The Risks and Challenges of Liquidity Bridges

While there are high operational costs, central banks which establish and operate liquidity bridges must also face other risks.

Risks can be divided into at least four distinct categories:

1. Entry risks
2. Operational risks
3. Financial risks
4. Systemic risks

First and foremost, a bridge can only be established in a place in which the bank is legally authorized to operate it.

If that jurisdiction does not provide a sound legal framework, the risk is inherently higher.

Moreover, the case becomes increasingly harder when crafting a multilateral bridge as other jurisdictions' regulatory frameworks, legal agreements, technical costs of implementation, operational costs, and even currency volatility come into play.

Whether it’s a bilateral or multilateral bridge, as interdependent as participants become, so does the systemic risk become higher.

Lastly, there are emerging market risks and developing economy risks which should be accounted for.

Wrapping Up

Liquidity bridges can make banks and PSPs see their costs alleviated while driving down costs surrounding cross-border payments.

Risk management should be a top priority for participants as there are still some challenges which need to be addressed.

However, the upside is undeniably massive and with G20 pushing for a unified framework, participants can certainly see themselves closer to overall financial stability.