Demystifying cross-border payments – Part Two
How cross-border payments work: sending and receiving money
In Part One of our series on demystifying cross-border payments, we gave an overview of the landscape. Today we will dive deeper into the mechanics and some of the economics of moving money across borders.
Traditional ways of making cross-border payments
Moving money around the world has come a long way. Originally, people transferred money to another country in one of three ways:
- Carried physical cash across borders
- Used acquaintances or couriers to move the money on their behalf
- Used informal trust-based broker networks (such as hawala) to transfer the money without physical money movement.
All of these methods, however, posed problems – they were inefficient, unreliable, risky, and often costly. It took 100 years before major advances enabled effective cross-border payments on a global scale.
Let’s now look at how international payments developed in the modern era.
The development of communication network and messaging standards
In the early 1930s, the German postal service developed the first major Telex network of teleprinters, which enabled the electronic transfer of written messages. Banks could use it to communicate with their counterparts overseas to settle transactions. As a result, Telex became the primary tool to facilitate international money transfers in the developed world until the 1970s.
In 1973, 239 banks from 15 countries came together to develop an even better medium – the Society for Worldwide Interbank Financial Telecommunication (SWIFT). Based in Belgium, SWIFT established a common language and model for payments data across the globe, which, since then, has served as the default network for communication related to cross-border transactions. Today, SWIFT is used by more than 11,000 financial institutions across over 200 countries and territories globally.
The emergence of correspondent banking relationships
However, communication networks alone did not solve the other prerequisite for making reliable cross-border payments – a way to transfer funds between disconnected systems.
Currencies are closed-loop systems, so banks had no way to move money from a domestic payment system in one country to another. As a result, financial institutions developed a new funding mechanism to solve this challenge – correspondent banking.
If Bank A in one country wants to transfer money to Bank B in another country, each needs to hold an account at their counterpart. During an international transaction, there is no physical movement of funds – instead, bankers credit accounts in one jurisdiction and debit the corresponding amount in the other.
Source: Bank of England
A problem arises when banks want to make international payments to all countries and all banks globally. For this to succeed, they would either need to set up their own branches everywhere, or have thousands of direct relationships and hundreds of accounts to manage. Only a tiny handful of the world’s largest international banks come close to achieving this, and even they constantly struggle with the multitude of challenges of local requirements from a technology, infrastructure and regulatory perspective.
Faced with painful impracticalities, banks often need to transact with intermediaries, also known as correspondent banks. In some cases, more than one correspondent bank can be involved in the process – especially when moving money to and from emerging markets. But as the number of correspondents in the chain increases, the transaction time and transaction costs rise too.
Source: Bank of England
This combination of the SWIFT communication network and correspondent banking relationships has been the go-to method for moving money across borders over the last 40 years. This is the reason why more than 80-90% of cross-border payments revenue is still captured by banks (see graph below). While it remains practical for the majority of corporate transactions, the model is not economical, especially for lower value transactions. As such, there is an influx of non-bank providers who are increasingly focusing on making bigger inroads to address the growing SME and consumer markets.
As you can see from the chart above, banks still capture the vast majority of the market for cross-border payments even when it comes to lower-value consumer and SME transactions. This presents an opportunity for non-bank providers by addressing the significant challenges that SMEs and customers still face when moving money internationally.
Why we need to envision a future with an enhanced solution for lower value transactions
There are six major challenges for lower value transactions with the correspondent banking model.
- Speed. Cross-border payments can take up to two to three days if multiple intermediaries are involved, and even longer for some less-developed markets. Since peer-to-peer (P2P) payment systems have introduced domestic real-time payments, customers want cross-border transactions to take place in real time. But real-time payments for low value transactions can’t happen because you need sufficient volume to move money economically – banks are unlikely to get an FX quote for 20 rupees, for example.
- Limited transparency and dependability. Even more important than speed is transparency – where the payment is in the chain and when it will arrive, confirmation of payment into a recipient’s account and upfront transparency on speed, cost and time of arrival. With the standard operating model, there’s little transparency. That’s because the different intermediaries in each transaction chain all do things differently, and that affects cost, speed and arrival confirmations. For example, banks don’t have full visibility over the different fee sharing agreements between third-party correspondent banks. They only know the exact cost of the transaction after it has been processed, rather than in advance.
- High cost. Costs can be quite high. There are three cost components per transaction – SWIFT messaging fees, transaction fees, and spread on foreign exchange (FX). With multiple intermediaries, all these costs can often add up to US$25-35 per transaction (even higher in some markets) excluding FX, as each correspondent bank will need to be reimbursed for their service, with fees ranging widely dependent on individual commercial agreements. That might not seem much for very high value transactions (more than US$100,000+ for instance), but it can be extremely costly when it involves processing many transactions under US$5,000.
- Lack of interoperability. In its nature, the correspondent banking model only involves banks and SWIFT is owned by and designed to serve banks. In today’s increasingly diverse financial ecosystem, however, customers need to be able to seamlessly move money across multiple payment methods in addition to bank accounts. Mobile and eWallets, for example, are being used by more than two billion people globally, but the current model does not offer the ability to easily move money from bank accounts to eWallets and vice versa – it lacks interoperability across payment methods.
- Limited coverage. Despite SWIFT offering connectivity to over 200 markets, each individual bank’s coverage is limited to the size of their own correspondent banking network. Interestingly, the number of active correspondent banking relationships globally declined by 20% between 2011 and 2018, while the number of active corridors dropped by 10% (BIS). Key drivers for this include high regulatory burden, decreasing risk appetite of banks, and low profitability associated with certain payment corridors.
- Limited accessibility. In some markets, bank account penetration is very low (below 30% across the population), so most people don’t even have access to cross-border payments. Additionally, as banks continue to abandon corridors, certain customers (such as those in emerging markets) are being left with less formal options to receive or send money internationally, which results in the few choices available being very expensive. In such cases, underserved individuals and businesses often opt to use informal channels that pose additional risks.
Regulators, governments, and businesses must address the challenges above to make cross-border payments faster, cheaper, more transparent, and more accessible, especially for those that have been traditionally underserved by large financial institutions. An increasingly globalised world and ever-more complex financial ecosystems make this issue more urgent. In fact, in 2020, the G20 made enhancing cross-border payments a priority in order to support economic growth, international trade, global development, and financial inclusion.
The future of cross-border payments
- SWIFT gpi
SWIFT has recently enhanced its service by implementing its global payments initiative (gpi) and it’s nothing like its predecessor. This technology enables banks to provide details of deductions, payment status and confirmations to a tracker hosted on the gpi cloud, which banks and end users can access to get payment status and other information. Settlement speeds and transparency for correspondent banks have improved, but these changes have only impacted the large payment flows. Also, for most banks, using the SWIFT gpi is expensive and they do not have the resources to implement this solution. Additionally, with this model, higher transaction costs are sometimes passed on to the senders, which is in conflict with the goal of making cross-border payments cheaper.
- Payment network aggregators
Payment network aggregators operate payment networks that primarily rely on indirect network connections. Similar to correspondent banks, they leverage third-party relationships to reach markets where they don’t want to establish their own connections. This makes it easier for them to scale and offer broad coverage as they essentially aggregate the individual connections of multiple partners. But indirect connections charge ongoing fees, expose payment network aggregators to varying levels of risk associated with each partner, and offer limited visibility of fund flows.
For cross-border payment providers, these types of partners offer a quick and easy way to reach many markets, but this can mean having to compromise on transparency, costs, and security.
The types of networks offered by these players can vary based on their ability to move funds between different payment types. Some are specific (only allowing transfers from bank accounts to bank accounts, for instance), while others are interoperable (such as allowing transfers from mobile wallets to bank accounts).
- Proprietary payment networks
Proprietary payment networks, such as Thunes, build individual direct connections with each of their network members, as opposed to using (and paying for) the connections built by others. In other words, they have built an infrastructure that allows money to change hands easily. Companies just need to be part of the network. As a result, these networks have complete visibility over the fund flow and greater control over transaction costs and risks, which translates into higher transparency, higher security, and lower costs for customers using them.
Research from McKinsey shows that the costs associated with cross-border payments can be reduced by up to 90-95%, which is what some operators of proprietary payment networks are already achieving.
The geographical coverage of proprietary payment networks can vary significantly. Building their own networks, instead of using existing third-party connections, is a slow process. As a result, only a handful of players offer multi-regional or global coverage, while the rest are usually focused on a single region (Europe, North America or Asia-Pacific, for example).
Similar to payment network aggregators, some of these players provide networks for a specific payment type (bank accounts only, for instance), while others offer interoperable networks (such as allowing transfers from mobile wallets to bank accounts).
How Thunes can help
Thunes’ proprietary interoperable global payment network enables seamless movement of funds across borders. Thanks to a single API connection, customers reach new markets and multiple payment options in over 100 countries without the need for countless integrations to multiple systems. Today, more than 100 banks, payment service providers (PSPs), money transfer operators (MTOs), mobile wallet operators, platforms and fintech companies around the world use us to process cross-border payments in a cheaper, faster, more transparent, and more secure way.