Cross-Border Payments — Part 1: Processes and Arrangements
How do cross-border payments work? What’s SWIFT? Blockchain for cross-border payments? In my latest two-part series on cross-border payments, I discuss the processes and arrangements involved in such transactions and highlight the role of emerging tech in this sector as well!
What are Cross-Border Payments?
As the name suggests, cross-border payments refer to transactions where the transacting parties are in different countries. The transacting entities here could be individuals, businesses, and governments. Depending on who transacts with whom, various types of payments are as follows:
The modes of transaction could include cards, bank transfers, eWallet transfers, and other alternative payment methods (APM).
You might wonder what the deal is with cross-border payments. If you are based in India, and you enter your card details to get a subscription to Wall Street Journal, the process is similar to any other local card transaction, right? Well, you’re not entirely wrong. From your end, the process doesn’t seem different. But what happens behind the scenes is a lot more complex. Cross-border payments are notoriously inefficient, slow, opaque, and costly. Numerous additional considerations such as currency exchange and rate fluctuations, cross-border payment fees, and the presence of multiple intermediaries come into the picture.
Main Entities Involved in a Cross-Border Transaction
Payment Service Providers (PSPs): They offer services at the entry and exit points of a transaction. In some cases, they also handle certain backend tasks. While making a payment, you usually deal with the PSP’s interface and interact with them. They tackle first and last-mile processes and help in directing information flow for cross-border payments.
Backend Providers: There are multiple entities that offer backend services to PSPs. The BIS report on Cross-Border Retail Payments (2018) considers transaction banks, aggregators, payment & market infrastructure operators, ForEx agents, and telecom players under this category. They handle messaging, clearing and settlement, foreign exchange, and liquidity management among other tasks.
A commonly used structure is as follows:
Payer -> Payer PSP -> Backend Arrangements and Processes (Currency exchanges, settlements, etc.) -> Payee PSP -> Payee
Types of Cross-Border Payment Arrangements
Now, the above-mentioned entities operate via different arrangements to ensure that your payment from India reaches the payee in another country. The following are some of them:
- Correspondent Banking: Here, two correspondent banks associated with the payer and the payee respectively interact in the backend to facilitate the transaction.
- Interlinking Model: Here, the payment infrastructures of the two countries (payer country and payee country) can talk to each other. Hence, there’s no need to proceed via correspondent banks.
- Single Platform/In-house Model: Here, the front-end PSPs for the payer and the payee are the same. This PSP offers a single payment infrastructure and there’s no need for two institutions from the two jurisdictions to interact.
- Peer to Peer Model: The payer can directly transact with the payee. Think low-tech solutions such as mailing currency notes to the payee and tech-based solutions such as the transfer of cryptocurrencies.
Correspondent Banking — A Deeper Look
Of these arrangements, correspondent banking is most commonly used for cross-border payments. Now, for two correspondent banks to interact and process transactions, there are two key steps:
1. Messaging and Communication
There are multiple real-time messaging services like Ripple, Fedwire, CHIPS, and SWIFT. However, SWIFT is the most common messenger between correspondent banks, processing over 15 million payments messages each month.
SWIFT = Society for Worldwide Interbank Financial Telecommunications.
According to Investopedia, “SWIFT is a messaging network that financial institutions use to securely transmit information and instructions through a standardized system of codes.”
You might’ve observed SWIFT codes starting with SBININBB for the State Bank of India. Every correspondent bank (you may recall that these are the banks that talk to each other to execute your transaction) has such a code. When a transaction is initiated from Bank A to Bank B, A sends a SWIFT message via the SWIFT network to convey this to Bank B which will then be prepared to clear the payment.
Note that though we say a SWIFT transaction has occurred, SWIFT just facilitates messaging and information dissemination and doesn’t engage in direct fund transfers. It just processes and transmits information, informing institutions that they ought to execute a transaction. In addition to this messaging service, SWIFT also offers business intelligence, compliance and application services.
2. Transfer of Funds
This happens via Nostro and Vostro accounts, terms that are derived from Latin.
Ours <-> Nostrum
Your <-> Vestra
A Nostro account is an account held by a domestic bank in a foreign bank, denominated in foreign currency. This account is referred to by the foreign bank as a Vostro account. Thus, Nostro and Vostro refer to the same account.
Consider two banks A & B based in countries AA and BB respectively. Suppose that Bank A has an account at B where it holds some deposits. Bank A’s account at Bank B is referred to by A as a Nostro account (our account) and by B as a Vostro account (your account). This account held at B is usually denominated in the currency of BB.
Here, since B is taking care of A’s account, it is the facilitator bank. Whenever a payer from BB wants to transfer money to a payee in AA, B deposits the money into the Vostro account from where it moves via a SWIFT transfer to A’s accounts in AA. Following foreign currency exchange in the event of different currencies for the two countries, the payee account gets credited.
Here, let’s also take a quick look at another type of account — the Loro account. If you’ve observed that your bank branch (Say Bank C) doesn’t have a SWIFT ID, it means that it isn’t a correspondent bank. It relies on a partner correspondent bank and utilises the partner’s account at the foreign bank to facilitate foreign transactions. Bank A’s Nostro account at Bank B then becomes the Loro account of Bank C. (That’s indeed a lot of names for one account!)
There are some key challenges that accompany a correspondent banking arrangement for cross-border payments:
- Low accessibility: Unlike for big corporations and MNCs, access is relatively limited to MSMEs and individuals.
- Slow processes: The multitude of processes and intermediaries involved results in high time consumption, thereby enhancing uncertainties and inconvenience. International payments take 2–5 days for completion (SWIFT gpi has, however, reduced this and I’ll be covering that in just a bit), though it can increase or decrease basis factors like the number of intermediate entities and the jurisdictions involved.
- High cost: An amalgamation of fees including transaction costs, compliance costs, foreign exchange fees, and facilitator commissions results in relatively expensive transactions. This also compounds uncertainty on the amount that will be credited or debited.
- Poor transparency: As the payer and the payee interact only with the PSPs, it’s hard to discern progress through the various stages of the backend processes.
- Higher chances of failure: The plethora of entities that must interact with each other for a successful transaction means that an error or misstep anywhere within the complex journey can derail the entire transaction.
- Exchange rate uncertainty: While you might initiate your transaction today, your bank may process it the next working day. In the interim period, any exchange rate fluctuation can result in added uncertainty to your transaction leaving you probing in the dark to make yourself aware of the rate at which the transaction will eventually materialise.
There, now you have a good idea of what cross-border payments are and how it’s done. To alleviate the above-mentioned challenges, innovative methods have come up. SWIFT gpi, blockchain-based networks are some improvements that I shall discuss in Part 2 of this series. Stay tuned!