Correspondent Banking reinvented with blockchain technology
It’s 2020 and when you make global payments via your bank the experience is, by and large, the same as 20 or 30 years ago: takes days, total cost is unclear but always high. The alternatives with a money transfer operator, the new or not-so-new players, come with speed, but also with fees and limitations.
Recent efforts to enhance speed and transparency, i.e. efficiency of global correspondent banking, are falling short, the underlying ineffective setup remains: disjunct accounts in every bank’s books across the world. Enter Blockchain, a new paradigm for transaction processing in distributed ledgers – and Bitcoin as a revolutionary approach for money altogether.
This mini-series of three short white papers is setting out to draw a path to a substantially better solution which is very feasible in the short to mid-term. This implies to stick with the principles of fiat money, all existing requirements and sound principles of regulation. More fundamental changes based on “true” crypto currencies with their wider economic implications will at the very least need much more time to be universally understood and implemented, let alone accepted.
In the first part we will be addressing the current correspondent banking setup, in contrast with the Blockchain approach, first implemented for Bitcoin. But even in the light of this contrast, the fundamental requirements for global payments have not changed – and are worthwhile to be reiterated and summarized.
In the second part we will compile in some depth the key prerequisites for Blockchain in global payments, for them to support economic activity: finality, transparency and trust, liquidity both locally and for universal settlement.
The third and final paper will put things together and describe how banks or licensed payment operators can execute payments globally, all in fiat currency, within seconds at low cost and with full access to local liquidity. A distributed ledger replacing the separated disjunct legacy correspondent accounts is the key to the solution – enabling a much more effective setup with a whole new level of efficiencies.
In summary, we will show that re-inventing global payments around a distributed ledger represents the quantum leap which would elevate the system of correspondent banking to a better, more evolved form. Banks or licensed payments operators as payment start and end points, plus two additional roles for potential intermediaries is all it takes. Rethinking the system in the realm of a new paradigm will enable institutions to stay relevant to their customers while delivering on the evolving needs of the global economy.
The end user will ultimately neither know nor care if a Blockchain has been involved at the center. What counts for them has not changed at all: cost, speed, transparency and instant availability for the recipient – it is up to the current players to organize against these requirements or let altogether new players step in and deliver.
Global payments are needed, correspondent banking is not
One of the most disrupting innovations of mankind accelerating the very development of our civilization is, in short, money. With it people are able to exchange different goods with a single measure and store value for future purchases. Access to a simple common currency facilitates the development of any economy. Another factor is globalization which on one hand allows trading far beyond the borders of a community, region or nation and on the other hand enables collaboration and innovation on a global scale, supporting growth in emerging as well as established markets. To simplify, we will define cross-border cross-currency payments as “global payments”.
With platforms such as eBay or Alibaba scaling around the globe, payment flows have started shifting from wholesale to retail. Globalization also brings talent and workforce from emerging to more developed countries and vice versa. Expatriates often support their families in their home countries, so called remittance payments show sustained growth in value and transactions, at over 700 billion US-Dollars in 2019 .
The most constraining factor for the global exchange of money is the channel, or so called “rail”, on which money is being transferred. Channels are used to execute payments across countries and settle the transaction in the designated currency.
The current system of multiple parties facilitating global payments in their local schemes is unlikely to fit the demand for inexpensive and quick payment processing. For the EU, payments are processed within one banking day if they stay within the member states. Processing times of a couple of days are still more realistic for payments between Europe, the Americas, Africa and Asia.
Banks in many countries have identified the need for more timely payments and introduced instant payments in their respective local markets. But these instant payment schemes have not yet developed to cover global payment settlement. For now, global payments are still routed across countries in comparably slow schemes and agreements. Depending on the national infrastructure, it is possible that at least the “last mile” of the payment is executed within seconds.
All are employing the traditional rails of local currency accounts, held in the books of banks across the globe, with stop of processing at their local cut-off end of business time. Cross-currency liquidity is settled mostly at T+2, so the day after tomorrow is when liquidity replenishment will finally arrive in a destination country.
Slow speed combined with high cost promoted the rise of Money Transfer Operators (MTO) like Western Union, Ria or Transferwise focusing on global payments by leveraging liquidity in their network of operating countries, some in specific focus corridors.
Blockchain technology is often assumed to aim to replace “real-world” fiat money, Bitcoin being the most prominent example. The question beyond this discussion is how it can possibly help to leave the world of local correspondent accounts shutting down each evening – after all, it is always 6pm in some part of the world.
Blockchain, a new hope
The thought of using modern computer technology to solve the problem of payments is not new. And while there were concepts following this ideology like Wei Dais “b-money”  in 1998 or Nick Szabos “bit gold”  in 2008, the breakthrough for this ideology was more recently.
On November 1st, 2008, in the midst of the financial crisis, a new concept was put forward in the paper “Bitcoin: A Peer-to-Peer Electronic Cash System” . This concept explains how a peer-to-peer network allows funds to be transferred from one party to another without using a financial institution or any predefined intermediary. Bitcoin is by design a permissionless and public Blockchain, which means that anyone can join the network. The transaction data is available to the public and participants can join without prior identification, which makes it possible to operate anonymously. Although the idea of using Blockchain to solve global payment inefficiencies is a feasible approach, the implementation offered by Bitcoin is not sufficient for professional use cases in the world of business. Financial institutions and most if not all companies and other entities are bound by regulations around bookkeeping and taxation. They require a Blockchain-based solution which is permissioned and, in many cases also private, which means that participants can only join after identifying themselves and undergoing a rigorous vetting process. As a result, access to and visibility of transactions is limited to a selected and perfectly identifiable group.
Blockchain based rails, with permission and privacy features, can subsequently be identified as a solution for cross border payments.
Transferring money with very limited – if any – intermediaries will result in lower fees and faster execution. Furthermore, transmitting value at the moment it is needed means less cash management at “T+2”, i.e. two days in advance and freeing up money which today is tied up in correspondent accounts. Thus, payments processed using Blockchain technology promise to be very cost-efficient.
Blockchain enables settling transactions in near real-time on a global scale. Near immediate settlement reduces risks for all parties in the economy which can embrace the move to global real time commerce.
Blockchain provides an immutable and verifiable record of all transactions, distributed to all authorized parties, making the whole system transparent. Due to the shared distributed ledger, there are no discrepancies in record keeping with everyone having an identical copy of the ledger. This ledger is maintained and updated communally.
Data is secured on the Blockchain by using cryptography, tying transactions to previous ones and distributing the ledger among participants. Having to alter all previous transactions on the ledger, makes tampering with data harder – near impossible – with an increasing number of subsequent transactions.
So, payments based on Blockchain promise to be cost-effective, almost immediate, transparent and secure. Peer-to-peer payments with Blockchain can bring down transaction costs by 40 – 80% , some estimate even 90 – 95%  and enhance the velocity of transactions to 4 – 6 seconds on average.
Beyond these fundamentals, Blockchain enables banks to reinvent their relationships among each other. Correspondent accounts can be replaced by fiat money on Blockchain to dramatically improve transparency and efficiency. It gives the ability to manage transactions across all of a bank’s assets, formerly in correspondent accounts, through a single interface. There is also greater visibility of transaction status, current balance, and tracking over time, independently of banks business hours across different time zones.
Blockchain has the potential to resolve inefficiencies and provide a faster, cheaper and more secure alternative to the current system. Still, the existing requirements and rules for global payments, which have evolved over decades are holding and will not change with the advent of a new technology, Blockchain or not. Ultimately, we will need Blockchain systems to fulfill all of them, and then some.
Key requirements in global payments, Blockchain or not
In order to successfully process global payments, there are some challenges to overcome, mainly the four described here: finality, transparency, liquidity and global settlement assets.
Finality: In any payments system, it has to be evident at any single point in time which payment transactions are settled, and which are not; there has to be well defined, up to the minute or second finality. Settled payments are called final if they are unconditional and irrevocable . As a last resort, risking downtime is preferable to losing the finality of the system. Many business transactions in the world’s economy need to rely on the certainty that a monetary value has been transferred with finality.
Also, the status quo has been established with Real Time Gross Settlement systems to settle on a continuous basis, meaning to settle in “real time”. As a result, payment transactions are not subject to any waiting period, with transactions being settled as soon as all processing requirements are fulfilled. This substantially reduces the duration of credit and liquidity exposures and helps to minimise or even eliminate risks in the settlement process and credit risks which arise from settlement lag .
Transparency: It is essential for financial institutions to meet their regulatory obligations e.g. Anti-Money Laundering and Know Your Customer Knowing who is ultimately receiving and sending funds forms an essential part of dealing with money laundering and terrorist financing. The shorter and less complex the payment chain, the easier it is to keep an eye on the data. These requirements for transparency underpinned the EU Funds Transfer Regulations 2015, detailing the information around payers and payees which must accompany all such transactions.
Another dimension is cost transparency, easier to achieve in short and simple payment chains. Furthermore, it enables customers to make better decisions which services to use, from a time and price standpoint, if the information is available ex ante.
Liquidity: In order for a global payment system to work, liquidity can be a constraint, therefore access needs to be ensured at all times. The participants on the network have to be assured of high liquidity 24/7 throughout the process, in order to enable a pay out in the target country and currency. Ideally the liquidity will not be trapped in an isolated system or settlement asset for settling cross border payments but can be easily withdrawn or exchanged to other forms of liquidity – or instantly stocked up as needed.
Global settlement assets: Payments are settled in currency, globally between two different currencies, therefore volatility looms large when they are exchanged against each other. When this currency pair is not highly frequented in global trade, settlement via a third, more universally traded asset is the most viable option. Being too volatile can render any asset unfit as a dependable global settlement asset. Volatility will be priced into any exchange transaction, thus ultimately raising costs for payment processing.
Besides being stable, a global settlement asset needs to be ubiquitous, universally accepted at best. Therefore, such assets need to be treated uniformly or near identically at least in a number of countries.
Access to liquidity is also required for a global settlement asset to ensure availability, meaning a wide range of market participants offering exchange into and out of the settlement asset. Among the fiat currencies the US Dollar has held the #1 position for decades and any replacement will need to be at least up to par regarding volatility, universal acceptance and liquidity.
How to fulfill these essential requirements for global payments with Blockchain systems will be elaborated in part 2 of this series.
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