By Indranil Bhattacharya, Senior Payments Architect, Icon Solutions
As global trade, investment and commerce have boomed over recent decades, cross-border payments have become foundational to the world economy. The Economist reports that some $140 trillion moved across borders in the past year and, according to the Bank of England, this is estimated to reach $270 trillion by 2027 as globalisation marches on. Traditionally, financial institutions have used correspondent banking capabilities to facilitate cross-border transactions. The correspondent banking model emerged in the late 19th century and comprises intermediary ‘correspondent’ banks that facilitate the exchange between banks in different jurisdictions. Payments are then settled using central-bank operated domestic or regional payment systems (such as RTGS for high-value payments and ACH for low value payments). The result is a worldwide network where customers can make a payment in any currency, anywhere in the world.
Yet, despite the ongoing growth in cross-border payments, correspondent banking is in retreat. The World Bank reports that 75% of banks have significantly declined their correspondent relationships. In its place, alternative payment ‘rails’ – the underlying digital infrastructure that enables money to be transferred from one account to another – are emerging as financial institutions look to realise the potential of truly frictionless cross-border payments.
Understanding the limitations of correspondent banking
Over recent years, the development and rollout of real-time domestic and zonal payment systems (such as SEPA) have transformed customer expectations for payments. This has only served to highlight three significant issues with cross-border payments, in that they are expensive, slow and lack transparency.
This is primarily due to the inherent complexity of the cross-border payment and settlement process. The nature of the correspondent banking model means there are multiple entities involved in the execution of a single cross-border transaction. This is coupled with an alphabet soup of compliance headaches, including anti-money laundering (AML), counter-terrorist financing (CTF) and know your customer (KYC) requirements, alongside a patchwork of divergent technical, operational and regulatory standards across different jurisdictions.
The results are predictably bad. Consumers don’t know when a payment will complete or what fee will be imposed. Commercial banks lack visibility and must rely on cumbersome manual operations to process transactions. Central banks are inadvertently creating barriers as only the largest commercial banks have the capacity to join multiple local schemes (such as domestic RTGS) given the differing membership and technical requirements. This creates the need for a number of intermediaries to complete cross-border payments, compounding complexity.
Enhancing legacy infrastructure with ISO 20022
However, attempts to address these challenges are constrained by the outdated legacy infrastructure that underpin the correspondent banking model. In the search for a safe, efficient and inclusive international system for cross-border payments, attention has turned to enhancing the underlying payment rails to support increasing volumes and resolve the complexity associated with correspondent banking.
One significant step forward is the ongoing migration to the ISO 20022 messaging standard. ISO 20022 enables standardised, relevant and enriched datasets that are directly associated with the payment message, supporting the delivery of accurate and complete payments data
This will simplify end-to-end payment flows, and make it easier for banks to port a domestic or geographical zone payment to the most suitable and cheapest cross-border payments rail. More complete and accurate data will also support automation and ease compliance, making cross-border payments faster and more transparent
Alternative rails for cross-border payments
But in parallel to enhancements to these bank owned rails, the emergence of alternative rails that lie outside of the traditional banking infrastructure are facilitating the movement of richer, more integrated transaction data between parties.
For example, products from OFX, PayPal, Remitly and Wise already allow for easier, cheaper and faster transfers than legacy rails. And Visa Debit leverages Visa’s vast networks to connect directly into the ACH systems of the 100-plus countries and territories in which it operates, generating significant cost-savings that can ultimately passed on to end-users.
Elsewhere, Ripple has demonstrated the use of a distributed ledger as a payment rail. This provides a system for the direct transfer of funds that settle in almost real-time, and is cheaper, more transparent and more secure when compared to the current system.
Given the ability of these emerging alternative rails to reduce costs and increase speed and transparency, we anticipate wide adoption from payment service providers and, eventually, that the correspondent banking model for cross-border payments will be replaced. Instead, most cross-border payments will be achieved through a combination of rails including connected central infrastructure like RTGS, card-brand and non-bank solutions, and blockchain-based exchange mechanisms.
But for customers, the actual mechanism used is unimportant. What matters is that banks can provide a range of cross-border payment solutions that allow customers to pick and choose based on specific requirements or demands. They can then, for example, opt for low-cost rails or providers that offer specific services such as real-time FX, with the bank or payment provider using the most appropriate mechanism to fulfil the request. Although this model may fragment the value-chain in the backend, the actual customer experience will be seamless.
Preparing for the next-generation of cross-border payments
With cross-border payments primed for transformation, banks should move quickly to identify the requirements and strategy needed to move to next-generation cross-border payment workflows.
In the immediate short-term, this involves prioritising strategic ISO 20022 migration to reap the benefits of enriched, standardised datasets.
Looking further ahead, the focus must be on building the flexibility and agility to support the rapid and concurrent adoption of multiple alternative payment technologies. Banks should look to increase technology reach by striking partnerships with Payments as a Service (PaaS) providers to deliver a range of value-added options for cross-border payments, meaning that enabling easy connectivity with third-party providers via APIs will be integral. More broadly, the onus will be on developing a flexible, open, data-focused, cloud-based architecture and supporting business operating model.
By taking these steps, banks will be ready to seize the opportunities presented by truly frictionless global commerce.