Rewriting the Rule Book For How Money Moves Around the World
Is it possible to completely change the way money moves around the world by directly connecting the clearing services of individual countries into a global web?
Cross-border payments can be a complex and costly process, as they involve the exchange of different currencies and the use of different clearing systems. Although challengers have revolutionised how payment instructions transfer money cross-border, many still rely on outdated methods.
Here, our very own Marcus Treacher discusses paving the way for a more efficient and inclusive global economy, and new innovations in cross-border payments.
When you move money in any situation, you are doing two things: 1) moving the ‘data’ and ‘information’ about the money, and 2) shifting the actual ‘value’ between one person and another.
Domestically, this all happens at the same time because the movement of money happens in the same currency and goes through the same clearing system. This allows for faster, immediate payments (through banking apps, for example), and countries around the world have implemented immediate low and high value payment services for domestic use.
Cross-border payments simply don’t happen in the same way. When making a payment across two countries, the process becomes ‘clunky’. This is because the sending bank needs to first buy a pool of foreign currency and place it with another bank in the country it’s paying to.
This forces the two steps apart, creating a two-stage model which in turn creates considerable ‘friction’: 1) the shuffling, buying and selling of money long before the actual transaction needs to be completed, and 2) sending an instruction to exchange ownership of that money.
In recent years, new challengers such as Wise, Nium and PayPal have revolutionised how payment instructions transfer money cross-border, making them instant, safe, and less expensive for their customers. But these companies still rely on using outdated methods to first buy and fund the many pools of currency that will be used for their customers’ payments. This creates cost, risk, and restrictions for them and the banks that support them.
These problems are caused by three fundamental flaws in the current cross-border model:
1: Lack of Trust
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: A retreat from emerging markets
Following the 2008 financial crisis, heightened awareness of the weaknesses of legacy payment methods, and money laundering and sanctions breaches, has led to considerably stricter demands on the movement of money internationally. This, in turn, has caused banks (who are using old methods today) to pull back from less wealthy countries because they cannot afford the overheads, controls and risk of allowing their banking network to pay money into a range of less developed countries around the world.
In the future however, these countries will become much bigger (Nigeria is a great example, which very soon will be a large population centre) 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. These countries need the know-how and connectivity the developed world benefits from.
3: Currency concentration for global payments
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) are becoming very decentralised.
We need to open up the world’s payment networks; businesses trading with each other in any two countries should be able to do so in their respective local currencies, point to point, immediately and with much lower counterparty risk.
A solution to this problem is a system whereby millions of small companies in smaller, emerging countries are able to participate in the same way as larger ones 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 rip up 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 will have a huge long-term impact.
I liken this revolution to the advent of the internet, which only really came into play once the Internet Protocol (IP) was adopted worldwide. This basic reconfiguration of how information is moved and shared to drive and underpin everything else, is incredibly powerful.
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.
The ultimate goal for cross border payments
A fresh approach is needed to modernise the way money moves cross-border, that fully utilises the power of current digital technologies to move value with the same ease that information is moved around the world today.
Our vision is to directly connect together the clearing services of individual countries into a global web, so that banks in any country can connect to banks in any other country to exchange value across different currencies, and then send and receive payments instantly across these currency pools.
For example, the movement of value between a pot of money in one currency (e.g. Sterling) and a pot of money in another currency (e.g. Thai Baht) can be made to be immediate, with full trust between the banks in the UK and Thailand, with no delay, and minimal risk – Herstatt or other – and with full transparency.
This would mean two things: 1) a smooth execution of the payment itself, with the companies making the payment happen faced with virtually no risk, and 2) the movement of money internationally would become instant, removing the potential for one half of the transaction to moved when the other hasn’t – this is the ultimate goal for enhanced cross-border payments.
This model alleviates the aforementioned 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. This is known as ‘atomic settlement’, or in other words, both sides of the transaction are ‘locked together’. With this approach, you remove all risk from moving money around the world, and the world begins to feel like a single country. This has additional benefits for financial inclusion, especially for those in emerging markets or challenging parts of the world, such as Africa.
To solve the underlying problems currently preventing payments from moving efficiently around the world – the holding and moving of liquidity – it’s imperative we fundamentally re-wire the foundations upon which money moves.
A system which coordinates the ledgers that record who has what money and where, across different parts of the world, is a stark contrast to a banking system that today still manages its money through messaging.
Immediate payments, with full transparency, without any concern that money won’t arrive at its destination in time for a payment to happen, will serve a global community of banks, companies, governments and people who are crying out for a system to power today’s rapidly moving global digital economy.