The combination of the SWIFT communication network and correspondent banking (CB) relationships has facilitated the movement of money across borders over the last 40 years. This is why banks still capture most of the cross-border payment revenue.
The contemporary global economy works in a coordinated manner for the constituent countries to mutually benefit from cross-border trade and commerce. International payments are a crucial part of the process that ensures the transactions are settled per the contractual agreements. Cross-border commerce has existed for over 2,000 years since the Silk Route was operational. The modes and means of payment have varied from bullion to cash to alternative remittance channels like hawala over the years as the concept of currency came into being. But the need to bypass the physical movement of money has existed ever since accounting replaced the barter system thousands of years ago.
Only in the 1970s were the Clearing House Interbank Payments System (CHIPS) and Society for Worldwide Interbank Financial Telecommunications (SWIFT) introduced to facilitate a rule-based bank settlement system in the US and worldwide, respectively. These systems have fundamentally transformed settlements due to the standardization of industry practices that have helped streamline transactional information sharing. The birth of the internet further called for simplifying invoicing and data exchange by employing digitization, which enabled electronic data interchange (EDI). While these were some major prerequisites for a more connected world of payments, the new millennium came with the promise of an integrated payment infrastructure.
But the hurdles to seamless international payments were yet to be overcome. To counter the same, SWIFT continuously tries to innovate ways for the industry to function better. The global payment innovation (GPI) has been initiated to improve end-to-end payment visibility for a more controlled payment settlement experience for banks as well as users. The sociotechnical infrastructure of the collaborative CB network is why cross-border commerce has been possible, and the intermediaries (correspondent banks) ensure the geographical expansion of the financial sector. The conglomeration of CBs with the architectural specialization for relaying information across the network in the form of FIN messages underpinned by SWIFT forms the plumbing of international payments.
The international payments market is expanding at a 5% CAGR, as shown by the transaction breakdown below:
- Business-to-Business (B2B) transactions are expected to account for US$150 trillion, comprising the largest share.
- Consumer-to-Business (C2B) transactions, such as global eCommerce, are forecast to reach US$2.8 trillion.
- Business-to-Consumer (B2C) transactions, including salaries of international employees, are poised to cross US$1.6T.
- Consumer-to-Consumer (C2C) transactions, like personal remittances, are expected to cross US$0.8T by 2023, being the least contributor.
Although the standard banking route remains practical for the majority of corporate transactions, the model is not yet too economical for low-value transactions. Many non-bank providers are increasingly focusing on making more significant inroads to address the growing SME and consumer markets.
Incumbent Challenges in the Cross-Border Payment Industry
Operational barriers/ Regulatory compliance
The conventional CB mechanism fails to operate without a standardized messaging channel because it is a closed-loop system. Liquid currency pairs offer ease of exchange through direct banking relations among the transacting countries by way of the net payment flow. But in the absence of local acquisitions, as in emerging countries, certain central bank capital restrictions prevent banks from operating freely. The CB networks also face high decline rates for multiple reasons.
Due to a lack of interoperability between all the banks, the reliance on digitally-enabled payment operators on the back-end network for a seamless transaction process is inevitable. This challenge has led many traditional banks to turn to specialists who have partnerships with various banks and wallet service providers to execute A2A transfers. This tendency has driven many front-end payment operators away from the banking rails and toward the alternate networks, which lack proper supervision and auditability.
Scalability and Interoperability
Since the on-premise infrastructural prerequisites for a scalable system are often not fulfilled instantaneously, the prospect of on-demand expansion of services like processing high-volume transactions is a challenge. As the number of CB intermediaries in a transaction increases for transacting an illiquid currency pair, the transaction settlement feasibility decreases with hampered scalability. Then there is the interoperability problem between various payment modes due to the system being designed for banks and not modern digital wallets.
Slower and Costlier
The more agents in a transaction, the longer it takes to reach the intended account and the costlier it is for all parties involved. This reduces banks’ profit margins, dubbing the cross-border payment process dull and non-lucrative.
Solutions to Improve Cross-Border Payments
Global Payments Initiative
The ISO 20022 messaging standard has changed the one-way messaging mechanism. It has incorporated cost-effective two-way messaging for core banking applications and account reconciliations, equipping domestic payment networks for international payment processing. The payments are typically faster under the easy-to-adopt latest norm, but in case of a discrepancy or delay, the inquiry costs are slashed by up to 50%. Increased banking efficiency in the international RTP ecosystem can be attributed to cloud-based tools offered by a unified SWIFT interface. The relationship management application (RMA) and two-factor authentication (2FA) techniques of SWIFT help minimize operational risks by barring unwanted traffic.
Proprietary payment networks
Private companies establish these reliable networks to build direct relationships with their members, providing a secure, fast, and highly transparent payment network, although the scalability is low. Research has shown the potential to reduce international payment costs significantly when processed through proprietary networks.
Payment network aggregators
As discussed in the dependency challenge above, the back-end network operators facilitate cross-border payments flowing through informal channels. They act as a bridge between various payment networks and partners to offer a simple and faster mode of low-ticket payments across geographies using APIs. Their third-party relationships make them scalable but expose them to risks and offer low fund flow visibility.
Banking Business Models through the Lens of Modern Cross-Border Payments
For today’s cross-border leaders and potential entrants, we see several imperatives for success:
Understand future revenue models
Focusing on high-revenue models will help mitigate the unmanageable costs of FX with a service-based approach. Alternate pricing models are the answer to cheaper cross-border payments.
Revisit client propositions
The payment options must be structured according to the customer’s preferences to reap the benefits of high usability. Payments with greater versatility will be an obvious choice for embedded services.
Upgrade the engine room
Increased serviceability will be crucial for reducing international payment costs and financial crime investigation costs to curb AML. Agile operating models need to be developed and adopted to complement the concurrent nostro-vostro system of accounting maintained across cross-border banks for the balance of payments.
Establish a clear role in the value chain
The monolithic architecture of the banking system has reached its natural demise to make way for micro-institutions, which are specialized in one aspect of the value chain for efficient operations. These include customer-facing front-end providers, service aggregators, and infrastructure providers.
Establish a partnership ecosystem
The SME space requires meaningful partnerships among FinTech and neobanks to bundle a portfolio of services with the help of open banking for a connected experience.
The future of cross-border payments is undoubtedly frictionless, with various innovations and collaborations around the corner. Stay on top of the latest developments in the industry to improve your customers’ journeys beyond borders. Contact us now.