It’s Faster to Fly Money than Make Cross-Border Payments – This Needs to Change
Marcus Treacher, our Executive Chair, writes for Finance Derivative about the economic challenges and opportunities in transforming the two-stage legacy model of cross-border payments.
In the digital age, making payments – whether in country or internationally – should be simple, immediate and extremely reliable. And it is, for domestic purposes. Thanks to national payment platforms facilitating fast, immediate payments (such as banking apps), making domestic financial transactions has never been simpler.
However, the same cannot be said for cross-border payments.
Moving money involves two things: moving the ‘information’ about the money and shifting the actual ‘value’ between one person and another. This process is cumbersome for cross-border payments: the bank making the payment first needs to buy a pool of foreign currency and place it with another bank in the receiving country. Instead of the two elements of money transfer working as one smooth transaction, they actually separate and become a two-stage model. This causes friction and opens the original bank up to greater settlement risk.
The challenges of the current cross-border payment model can be broken down into three fundamental flaws.
1. A Fear of History Repeating itself
Banks have to work hard to be sure the foreign currency money they’ve bought is held with banks that are in good shape, and who won’t lose their money. This is very expensive to do and fraught with risk, as the current raft of bank failures painfully shows.
If a bank does fail, today’s two-step cross-border payment model exposes other banks to what’s known as Herstatt Risk – or in other words, cross-currency settlement risk. Its name is derived from the German Herstatt bank, which became insolvent in 1974, trapping a number of high value cross-border payments for US-based banks in the process.
Herstatt Risk exists because all FX transactions must be settled in the home country of a currency, regardless of where the parties trading this currency are located. Because of time zone differences between different parts of the world, there can be several hours’ delay between the time a bank makes a transfer in one currency and the time it receives a transfer in an alternative currency. One party in a transaction can lose a huge sum of money, due to nothing more than a time difference – as demonstrated in 1974 in the case of Herstatt.
2. Retreat from the Emerging Markets
Heightened awareness of how weaknesses of legacy payment methods expose banks to money laundering and sanctions breach risk has led to considerably stricter demands on the movement of money internationally, driving up the cost and overheads associated with cross-border payments. This has caused banks to pull back from less wealthy countries because they can no longer afford the overheads, controls and risk of allowing their banking network to pay money into a range of developing countries around the world.
But many of these countries are rapidly maturing and, in the future, will have much bigger economies (Nigeria is a great example, predicted to be the first trillion dollar economy in Africa by 2030) and will be the engines of economic growth for large parts of the world. Banks are choosing to get out of these countries at the same time as they are rapidly developing and growing, demanding the cross-border payment connectivity the developed world benefits from as they expand.
Until the two-stage model is fixed, the cost of securing truly global cross-border payments will prevent banks from answering the call and getting back into the fast-emerging markets of the world.
3. Limited Currency Options
At the moment, most cross-border payments need to pass through a small number of systemic currencies: the US dollar, the Euro, the Yen are three key examples. This creates enormous concentration problems across a small number of currencies and clearing networks, increases complexity and cost, and forces the global economy into a legacy hub and spoke payment model at a time when every other aspect of international activity (for example, trade and information) is becoming very decentralised.
Again, the risks of the two-stage model are at the heart of this problem. This keeps banks and businesses worldwide tied into the world’s top ‘super currencies’, when most small exporters and importers just need to use the two local currencies that their goods or services are being sold and bought with. This hurts millions of small companies in smaller, emerging countries that are compelled to need access to super currencies where logically local currencies should suffice – making it harder for them to participate in the same way as larger corporations can.
By reconnecting and replumbing the financial networks that support cross-border payments, it’s possible to completely change the model on which the banking system works globally. While it is harder to replace the foundations (the network beneath the surface) than it is to replace the windows (bringing innovation to legacy infrastructure), addressing the foundations on which the banking system operates is the only way to properly tackle these three problems, and have a huge long-term positive impact.
While attacking and fixing the underlying fabric of the banking system is a bigger lift than what most fintechs are doing today, and is certainly not a quick fix, it has the potential to create an entirely new system for how money moves around the world and open up possibilities for new innovations that aren’t even being spoken about today.
A Fresh Approach to Cross-Border Payments
Ultimately, we need to find a way of moving value with the same ease that information is moved around the world today – consigning the two-stage model to the history books.
Our vision is to create a new one-stage model for cross-border payments by directly connecting together the clearing services of individual countries into a global web, so that banks in any country can connect directly to banks in any other country to exchange value across different currencies, and at the same moment send and receive payments instantly for their customers.
Our goal is to make the movement of value between any two currencies immediate, with no delay, and minimal risk – Herstatt or other – and with full transparency. This will drive down the cost of providing safe, compliant cross-border payments and enable banks to get back into all countries worldwide: is the ultimate goal for enhanced cross-border payments.
This one-stage model alleviates Herstatt Risk, meaning something so simple as a time difference will no longer have grave consequences because both sides of the transaction arrive in each country’s respective bank accounts at the exact same moment in time, regardless of the time of day. At its heart is a concept called “atomic settlement”, where both sides of the transaction “lock together” their ledgers for an instant of time, updating their records together.
With this approach, you remove all risk from moving money around the globe, and the world begins to feel like a single country for businesses and communities. This has major benefits for financial inclusion, especially for those in emerging markets or challenging parts of the world, such as Africa.
In an age of such digital prowess, it’s absurd that the fastest way to get money to many parts of the world is to fly it across international borders. A widely available way to move money cross-border immediately and safely is long overdue, and is the key to unlocking the full potential of our digital age.
It’s a deep-rooted issue that stems from the very foundations that the system has been built upon. Fixing it requires a complete rethink of how we move money around the world.