Speed of pay

Cash management

Speed of pay

September 2019

Under fire for rising costs and lengthy processing times, the global correspondent banking model has frustrated corporate clients and prompted market entrants to develop alternative solutions. flow’s Graham Buck assesses whether the model is fit for future purpose

The global payment system has long relied upon correspondent banking to execute cross-border payments from a respondent bank to a beneficiary bank.1 The model has preserved trust and security for years, but is becoming outmoded as corporates seek real-time or near-real-time services, and emerging and maturing new technologies – such as distributed ledger technology – make them possible.

The Federal Reserve is now entering the arena with plans to launch FedNow, a service that will enable US banks to offer 24/7 real-time payment services by 2024.

Meanwhile, market entrants are responding to demands by utilising technology and alternative payment routing. Often providing cheaper and faster execution, these services might appear to offer the antidote to long-held issues with traditional cross-border payments. One area where they cannot compete, however, is security.

With around US$7bn lost to fraud by corporates worldwide between January 2016 and October 20172 and a median loss of US$104,000 per incident for larger companies (nearly doubling for small businesses), the checks and balances designed to rein this in need reassessing.

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The traditional model

According to a 2018 McKinsey/SWIFT report, cross-border flows represent one-sixth of total transaction values, but international payment revenues total up to US$200bn globally, divided evenly between transaction fees and FX revenues. The report puts this at 27% of global transaction revenues, increasing by 6% each year.3

An outline of the correspondent banking model is useful in understanding the issues. The Bank for International Settlements defines it as: “An arrangement under which one bank (correspondent) holds deposits owned by other banks (respondents) and provides payment and other services to those respondent banks.”4

Take as an example a French company ready to pay for a shipment of oil from its Malaysian supplier. It issues a payment order to its bank (the respondent bank) to initiate payment. With no clearing system between these two countries, the respondent bank begins the process by sending the funds to an intermediary or correspondent bank.

This correspondent bank acts on behalf of the respondent bank, either passing the transaction on to the supplier’s bank in Malaysia (the beneficiary bank) or, where there is no direct relationship with the beneficiary bank, to another correspondent bank closer to the beneficiary bank. This process continues until the beneficiary bank is reached, at which point it makes the funds available to the Malaysian supplier.

Stefan Fruschki, Head of Regulatory Management, Institutional Cash Management, Deutsche Bank, explains: “By requiring that, at each step, the funds are passed between banks that are familiar with one another – which includes conducting the necessary regulatory and due diligence checks – this process ensures security along the entire transaction chain.”

 

Safety and soundness

The downside is that the checks involved are rigorous and typically require considerable resources and time. Tightened regulations, such as the fourth Anti-Money Laundering Directive and the EU’s Funds Transfer Regulation (FTR) 2015,5 require additional checks to secure against fraud, terrorist financing and other risks.

These mandatory checks, while retaining security, also make it increasingly costly to maintain broad correspondent banking networks. In order to fully comply with these regulations, notes Fruschki, “banks have implemented state-of-the-art know your customer solutions, sanctions screening, embargo filtering and transaction monitoring controls. Each process requires significant IT investment and must be overseen by a team of employees, further inflating our costs.”

The end goal of fast, efficient and secure cross-border payments is within sight
Stefan Fruschki, Head of Regulatory Management, Institutional Cash Management, Deutsche Bank

Such checks also add to the time taken to process a transaction as they must be conducted by each bank along the chain – often including different types of checks for different jurisdictions.

The FTR also mandates that banks along the transaction chain must ensure that full information on the party issuing the payment order and the beneficiary party has been received and is passed on to the next bank in the chain. To mitigate the cost of these checks, banks will typically deduct their fee from the payment itself, meaning the beneficiary often receives less money than expected.

These fees are determined and deducted after the respondent bank has begun the transaction process. As the respondent bank cannot predict the path that the payment will take along the chain, transparency over the cost of cross-border payments is often impossible. This is frustrating for the customer, who is left in the dark as to how much of the original payment will be credited to the beneficiary account.

‘Split’ transactions

Given these challenges, some businesses – particularly fintechs – have sought alternative methods of executing a payment, with the aim of making the process faster and cheaper. The most prominent example of this involves ‘splitting’ the transaction into two parts.

The first step is for the ordering party to make a payment directly to its payment provider. The payment provider then approaches its own bank and initiates a second transaction, requesting that the funds be transferred to a bank in the payer’s target destination. Through this method, the payment provider’s bank acts as the payer, enabling the bank in the target destination to pay via the domestic clearing system, as a local payment.

Separating transactions in this way enables alternative providers to limit the number of banks included in the transaction chain, which speeds up the payment by avoiding clearing cycles and reducing the fees incurred.

 

Faster, cheaper – but better?

The two-step approach appeals from the customer’s perspective in terms of offering cheap, fast and reliable payments. Even regulatory bodies welcome the resulting competition; most recently, Poland introduced the split mechanism in 2018 in a bid to combat VAT fraud.

However, it also opens up payments to a significantly greater risk of fraud. Splitting the transaction typically results in the receiving bank in the target destination lacking visibility over the ordering party, while the bank that provides the account to the payment provider lacks information on the beneficiary. With so little data provided on both payer and payee, the risk of fraud and money laundering is greatly increased.

While it remains legal to split transactions in this way in certain jurisdictions, safety concerns have led European regulatory bodies to make the practice illegal. As a result, intra-European payments must now be run through local clearing systems but, in the absence of a standardised, global payments regulation, outbound cross-border payments to non-EU jurisdictions can continue to be moved using the split-transaction model.

Splitting the transaction where jurisdictions allow therefore remains an attractive option for corporates. The choice of whether to use a regulated bank process or an unregulated payment service provider (PSP) for cross-border transactions often hinges on speed and cost, which are two strengths of the split-transaction model.

Yet split transactions are not sustainable for cross-border payments going forward. Instead, Fruschki argues: “Corporates should introduce a third factor – responsibility – into their considerations when assessing options for cross-border payments.” He adds that “while cut-price alternatives are tempting, they often impose a strain on the financial system that upholds them.”

 

An improved model

Corporates cannot be expected to choose between efficiency and responsibility indefinitely, so the onus is on the financial services industry – including banks, fintechs and PSPs – to collaborate in devising a better solution.

Progress is being made here, with SWIFT’s standard in global payment innovation since 2017 – SWIFT gpi – helping to improve the transparency and speed of cross-border payments run through the correspondent banking system.6 In July 2019, a trial payment from Australia to Singapore’s Fast and Secure Transfers domestic instant payment service, integrating SWIFT gpi, was settled in just 13 seconds.

Each of SWIFT’s cross-border messages comprises several data fields that provide detailed information on the payer and the payee in a transaction. These must be completed and passed on by each stakeholder in the payment chain, ensuring continuous transparency. There is even scope for SWIFT gpi payments to be connected to domestic instant payments systems – such as Europe’s fledgling TARGET Instant Payment Settlement – thus avoiding end-of-day cut-off times and ensuring that funds are credited on the same day they reach the beneficiary bank.

27%

of global transaction payments are cross-border

(McKinsey)

Fee-based frustrations are also being addressed. Deutsche Bank and its peers are developing a solution to ensure that recipients always receive the full amount due, with all fees charged directly to the ordering party.

“The end goal of fast, efficient and secure cross-border payments is within sight,” concludes Fruschki. “As we approach the finish line, corporates must decide whether the short-term gains in terms of speed and security outweigh the less pressing but ever-important need for a safe, efficient and secure global payments system.”

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Sources

1 See ‘Pollinating payments’ by Ruth Wandhöfer and Barbara Casu at https://bit.ly/2TJ9P7b, db.com/flow
2 See
https://bit.ly/2HvziNC at s3-us-west-2.amazonaws.com
3 See
https://mck.co/2PBUYfH at mckinsey.com
4 See
https://bit.ly/31BJvyc at bis.org
5 See Deutsche Bank white paper, EU Funds Transfer Regulation 2015, at
https://bit.ly/31EYJm7, db.com/flow
6 See
https://bit.ly/2Z0ACAV at swift.com

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