It’s not surprising that innovation tends to come from decentralized analogous network solutions, considering that the international correspondent banking ecosystem today is basically a decentralized global network. There has been significant interest in the potential the blockchain technology houses to act as the backbone of a cross-border payments messaging unit. While blockchain transfers won't physically move digital assets, they do record changes in asset ownership, irrevocably. Moreover, certain local exchanges are willing to provide real-time liquidity in local currency in return for ownership of the respective assets, depending on the nature of the asset.
Lately for the wrong reasons, Bitcoin has been capturing many headlines. With it being associated with theft, criminal activity, and a libertarian movement focusing on disintermediating banks, it generally has been deemed too risky for mainstream financial services. Nonetheless, its underlying distributed-ledger technology, the blockchain, is being tested for its ability to deliver various advantages for different forms of payment supervised by financial institutions and regulators. Global banking is currently over a hundred trillion dollar industry. Banks help intermediate payments, make loans, and provide credit. The promise of blockchain as a trustless, disintermediated technology could disrupt all of that. The proliferation of pilot programs using blockchain technology and advances in consumer peer-to-peer payments are pressuring incumbent banks and traditional money-transfer operators to develop and improve their offerings. This promises to soon bring a step-change improvement in associated cost, speed, and transparency.
The traditional network users suffer on three accounts today.
- Taking into account the final mile transfer via a domestic payment network, the average time to complete a cross-border transaction could take anywhere from three to five business days.
- The fees that adds up at each step in the process, like transfers from the sender’s bank to the national correspondent bank, foreign exchange fees and from one correspondent bank to another. Where volumes are high, the fees for cross-border payments generally average 2% to 3% but can exceed 10% when payment values and volumes are low. Also, it isn't always transparent when costs will also be charged to a recipient.
- While the funds are in transit, it’s often difficult for receivers and senders to track their payments, creating uncertainty about both the final payment amount and delivery timing. Especially when problems arise, such as wrong account numbers it can be difficult to trace transactions quickly.
Most high-value transactions are still processed through the correspondent banking network, despite the usual burden these negatives place on users. This is mostly due to security, familiarity, and the ability to transfer bigger sums than other channels presently accept. Another factor is the thorough and more consistent know-your-customer compliance checks incumbent banks practice. Today, several initiatives are underway to alleviate the pain points of cross-border payments in traditional correspondent banking.
Why it’s ripe for disruption?
- Trillions of dollars are traveling around the world through an antiquated system of added fees and slow payments. If you work in New York and want to send a certain amount of money back to your family in Germany, for the wire, you might have to shell out a $25 flat fee and additional fees adding to 8%. The receiving bank gets a slice, your bank receives a cut, along with the unseen exchange rate fees you're charged. To boot, the transaction won't even be registered in your family’s bank until a week later. As you can see these transactions are highly profitable for banks, which incentivizes them less to lower fees.
- A lot of the cross-border payments are even now routed via a network of banks using the SWIFT messaging protocol to execute transactions, known as bilateral correspondent banking relationships. Fees accompany each transaction as each bank performs a function in the value chain. Occasionally, the sum of these fees crosses 10% of a payment’s value.
- Even in extreme cases, bitcoin transactions rarely take more than16 hours to settle. This is still not perfect, but it's still a leg up from the average 3-day processing time for bank transfers.
- Moreover, the creaky infrastructure supporting the payments industry, the world of clearance and settlements, is just as liable to disruption. This is another huge reason behind the future disruption of the payments.
What the future holds
Strong reliance on the existing network and plain inertia have long characterized the payments industry. Even so, the last few years have seen exponential growth in transaction volume for cryptocurrencies like Ethereum and Bitcoin, although much of this was not a function of P2P payments but speculative trading. As consumer, peer-to-peer, instant payments solutions such as Venmo, Xoom, and MobilePay continue to spread, companies will increasingly seek to replicate that speed, convenience, and simplicity in the commercial world. The advancement of new payment technologies is accelerating. This trend reflects the strong potential for profit gains and revenue, and the increasing adoption of mobile digital solutions for everyday tasks, including payments. Regulators are demanding more in equal measure, as users are pressing banks to keep pace with change. As they look for new methods to reduce costs, this additional pressure is pushing banks to review their expansive correspondent banking relations. Increasingly, while tightening their standards to reduce manual interventions and error, they are seeking more efficient network participation.
Meanwhile, for cryptocurrencies like Bitcoin and Ethereum, developers are actively working towards uncovering cheaper solutions as transaction fees can be high. Bitcoin Cash, another cryptocurrency, already has low-priced transactions. TenX is tackling the payments issue a tad differently. They have built a wallet attached to a debit card, meaning, everywhere you usually use plastic, you can just use cryptocurrency instead. The company is working on a distributed network to trade between various cryptocurrencies and working to integrate that network with physical cards. Now BitPay is a Bitcoin payment service provider that allows merchants to store and accept Bitcoin payments. BitPay charges 1% per transaction, compared to the 2%-3% fee associated with credit card transactions. With Ripple, in-network banks can initiate payments in Ripple crypto tokens and have them routed via the most efficient foreign exchange pathways. They rely on an open source distributed technology protocol and are currency-agnostic. Then the in-network receiving banks can settle payments once received. Ripple confirms transactions within a minute. Various big financial intuitions already use this technology. These institutions are a part of a growing chain of innovative financial institutions experimenting with blockchain technology. Blockchain holds a promise to give billions of people around the world and especially in developing countries, access to financial services. BitPesa is an example of this. It is a blockchain company focused on facilitating B2B payments in countries like Nigeria, Kenya, and Uganda. BitPesa can slash fees to 3% through the blockchain, compared to a massive 9.2% fee charged on the average cross-border payment to Kenya.
Similarly, the Clearing House’s real-time efforts and the U.S. Federal Reserve’s Faster Payments Task Force point to governmental efforts underway to migrate to faster payments technologies. Such programs are now live in over thirty countries that, combined, account for almost half of all global credit transfers. The need for systems integration and interoperability to allow for real-time cross-border payments will grow as the shift towards faster payment technologies gains momentum. But this will demand increased collaboration and complexity to handle foreign exchange functions.
However, not everyone has been so quick to jump on the bandwagon. Governments in several countries, most notably Russia, China, and Iceland, by passing legislation that makes banks’ use of cryptocurrencies illegal effectively, have taken a more defensive position. Also, using the technology across various jurisdictions makes it hard to offer robust user guarantees, and even harder to make decisions about whom to prosecute in the event of failures. However, several central banks have publicly spoken of their intentions to experiment and investigate with blockchain technology, including those of England, Canada, South Africa, and the Netherlands. All have recently clarified its policies on the issuance of central bank digital currency (CBDC), and many have put together teams to explore the implications of doing so. Adopting this model will take considerable time, although theory suggests that governments should take the lead in issuing such currencies in the future.
What will it take to succeed?
For starters, new solutions will need to be technologically easy to integrate, have relatively low costs, allow banks to remain competitive while removing healthy margins and offer clear advantages such as lower compliance risk. But above all, new systems must deliver a step change in security. Its use of multifactor authentication at crucial transaction stages, thanks to leading-edge encryption is a significant attribute of blockchain technology.
The benefits it offers to both users and issuers is at the heart of the adoption success of any new payments alternative. The ability to track value ownership could be an advantage to governments. However, at the sacrifice of loss of anonymity for consumers will raise privacy concerns. The benefits would be much more balanced from a commercial standpoint. Through low-cost channels, businesses could easily track, execute and prove payments, and be able to automate many business functions, such as auditing and tax preparation.
Efforts to circumvent compliance in the payments industry is promptly brought out and punished, as it is among the most heavily regulated industries. So wider adoption by banks of innovative technologies will have to meet their highest stringent AML and know-your-customer compliance obligations inevitably.
The banking network serving as the sender bank’s local presence in far-flung geographies has served us well for as long as we remember. However, the expectations of today's money receivers and senders are changing, demanding new cross-border payment approaches that are more economical, rapid, transparent, convenient and secure. Whether a transformation in cross-border payments is primarily driven by new solutions like blockchain that deliver compelling advantages to inspire an entirely new network of bilateral peer-to-peer agreements or by network effects, aimed at improving and adopting the technology stack over time remains to be seen.