There Is No Such Thing As "Dormant Funds" In Banking
(Source: forbes.com)

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(Original link: forbes.com)

One of the principal claims made by Ripple for XRP is that it would free up $5tn that is “sitting dormant” in bank nostro/vostro accounts around the world. In a blogpost , Ripple says that this “ties up capital that could be used in more productive ways.” Using a digital asset such as XRP as a bridging currency for foreign payments could, according to Ripple, enable banks and payment providers to “free up the assets that would normally be committed to funding nostro accounts around the world.” There’s only one problem with this. It’s not true.
Brad Garlinghouse, chief executive officer of Ripple Labs Inc., speaks during a Bloomberg Television interview at the Goldman Sachs Technology and Internet Conference in San Francisco, California, U.S., on Tuesday, Feb. 13, 2018. Garlinghouse said XRP and others should be referred to as "digital assets" rather than cryptocurrencies during an event last week. Photographer: David Paul Morris/Bloomberg © 2018 Bloomberg Finance LP
First, here is a primer on nostro/vostro accounts. They are transaction accounts – what you and I know as “checking” accounts – that banks hold with each other. “Nostro” means “my account with you”: “vostro” means “your account with me”. For every nostro at one bank, there is an equivalent vostro at another bank. Remember this as you read the next few paragraphs.
Consider an American bank that needs to make payments in Euros to a European bank. It opens a Euro account at the European bank – this is its “vostro” account. That vostro account is a Euro deposit account in a European bank. In this respect it is just like a retail deposit account in a European bank. It is debt, not capital. It is also “on call,” since the American bank can withdraw funds at any time. And it doesn’t have to contain a large amount of money. It only needs to hold enough money to meet forthcoming payment obligations.
Like other deposit accounts, vostro accounts are interest-bearing. A 2016 study by McKinsey , cited by Ripple, says banks used to make quite a lot of money from interest payments on vostro accounts, so they had an incentive to keep large balances. But now that interest rates are near zero, this source of income has dried up. Banks don’t have to maintain large balances in vostro accounts, and increasingly, they don’t want to.
For its own records, the American bank also creates a mirror image of its Euro vostro account on its own balance sheet – this is the “nostro” account. Any positive balance in that Euro nostro account is a cash asset on its balance sheet, just as U.S. dollar cash balances are. Just like checking accounts, nostro accounts can go overdrawn: if they do, then the nostro balance becomes a liability (debt).
Most payments out of nostro accounts can be predicted in advance, either individually (for large payments) or as an average daily movement (for smaller payments, for example credit cards used abroad.) Under Basel III rules, banks must have, or be able to easily obtain, sufficient liquid funds to meet anticipated payment obligations over the next 30 days. In practice this means that they keep highly liquid securities which they can loan out (repo) for cash in the wholesale funding markets. To fund a nostro account, they could combine repos with spot FX deals, or they might use FX derivatives to set up a future funding stream. Provided there are liquid markets in the settlement currency, funding nostros can be done on the day of payment, or even later if the correspondent bank doesn't mind the vostro going overdrawn.
Although the amount of interest banks pay each other for vostro balances has fallen dramatically since the advent of near-zero interest rates, balances in nostro/vostro accounts are higher than ever. McKinsey says that at the end of 2015, nostro balances worldwide exceeded $27 trillion. (It’s worth remembering at this point that for each nostro there is a vostro which is its mirror image. Together, nostros and vostros worldwide total to zero.) According to McKinsey, the reason why nostro balances are so high is rapidly growing international transactions. Cross-border payments have risen dramatically.
Ripple’s argument is that nostro/vostro balances “lock up” funds that could be put to better use. So, that $27tn contains a large element that is not doing anything – Ripple estimates $5tn, though it doesn’t say where it gets this figure from.
I’m afraid this is a major misunderstanding of the status of those funds. They are indeed “locked up" (encumbered), so they can't form part of the bank's liquidity reserve. But that is because they are already committed to making payments that are coming due. Money that is due to be paid to someone else is not yours to use . That is true of banks just as much as you and me. In no way is money in nostro accounts “dormant.” Like the money in my checking account, it is briefly present and soon gone. Nostro account balances are moving balances.
Nonetheless, nostro/vostro balances are on average very ...

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