The next big thing that will transform the world of finance, we are told, is “Blockchain”, the digital technology behind the much-maligned Bitcoin that could fundamentally change banking and other transactional relationships.
We shall see. It will be interesting to watch how regional financial institutions take to the new technology. Banks in the GCC, especially in the UAE, have traditionally been at the forefront of technological innovation, so you might expect them to welcome Blockchain wholeheartedly.
But just occasionally regional banks and other financial institutions seem to lag behind the rest of the world in adopting innovative financial technologies and techniques. One such example is the attitude towards “netting”, a financial practice common in the international banking community but which has been slow to get approval from the authorities in the UAE and elsewhere.
As one big international bank recently informed me, it is becoming a serious problem for foreign banks looking to do business here. It will make big American and European banks think twice about doing business in the UAE in the first place, especially with local banks, and charge them more for some fairly simple financial transactions.
Not that netting is anything like the sophisticated technology of Blockchain. It is actually a fairly common sense approach to financial transactions, involving setting off credit and debit positions against each other for the sake of settlement, especially, but by no means exclusively, in a situation of actual or potential default.
Bank A owes Bank B $5 million, but also has deposits of $3m in Bank B. So its net obligation to Bank B is $2m. That’s netting, simple abacus accounting, especially if Bank A goes bust and Bank B wants to guarantee it gets at least some of its money back.
As you might imagine, in the modern banking world it gets a bit more complicated. Global financial institutions doing complex transactions with each other use netting to mitigate risk in deals involving derivatives, swaps and stock loans. The total amount of risk is greatly reduced if netting is allowed.
In the case above, if there were no netting in place, the total at risk between Banks A and B would be $8m.
And here is the rub. Banking regulations in the UAE and other parts of the GCC do not allow for enforceable netting. The position of any netting agreement is unclear in law and regulation, which means it cannot be assumed to be in place in extremes, most often in case of default.
There are a couple of notable exceptions: the Dubai International Financial Centre last year enacted a Ruler’s Decree providing for enforceable netting in the case of insolvency. As is often the case, the DIFC seems to be ahead of the curve in its acceptance and application of modern banking techniques.
And Abu Dhabi Global Market, the capital’s new financial hub, has also allowed for enforceable netting decisions, according to its recently enacted rules. Another forward-looking decision.
But the rest of the industry, in the “onshore” sector and therefore subject to Central Bank rules, does not allow for enforceable netting. Banking experts I asked about this could not explain why the industry was so reluctant to take on such an apparently common sense concept, which has been in existence for a long time in the rest of the world.
The issue assumes greater relevance than ever in the era of tighter capital requirements under the Basel regulations. If in the UAE international banks have to provide capital against gross positions, that would constrain their balance sheets in other areas to the tune of many billion dollars.
So international banks looking to do business in the UAE will seek a non-Emirati transaction partner, all other things being equal. An American looking to fund an infrastructure project or trade deal would look to a French, or British or German bank, rather than a local lender.
Or they would charge the local more for the same deal, to reflect the increased risk in the absence of netting.
It looks like one of those administrative oversights that could be put right easily and quickly, making a significant difference to local transaction levels and liquidity requirements.
Then maybe they can start to think about Blockchain.
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