Has reform of cross border payments lost its mojo?

A summary of the webinar of June 22 2022 entitled Has reform of cross border payments lost its mojo?

SUMMARY

5.14 Is progress towards cheaper, faster, more accessible and more transparent cross-border payments too slow?

Making cross- border payments faster, cheaper, more accessible and more transparent in terms of cost has support at the highest political level. It is a priority for the Group of 20 (G20), which has charged the Financial Stability Board (FSB) with making change happen.

The reasoning of the G20 is sound. It can, in certain currency pairs, take as long as ten days to transfer money from one country to another and can cost up to 10 per cent of the value of the sum being sent. This is a heavy tax, especially on remittances sent home by migrant workers. But efficient cross-border payment benefits everybody. It is vital to continuing growth in world trade and becoming more important as a higher proportion of trade moves online.

At the behest of the FSB, the Committee on Payments and Market Infrastructures (CPMI) published in July 2020 a list of 19 “building blocks” to enhance cross-border payments. In October 2021, the G20 endorsed a set of four quantitative targets it expects progress towards the 19 building blocks to deliver by 2027. They cover:

– Speed: 75 per cent of payments are to be settled within an hour;

 – Cost: the global average cost of retail payments is to be no more than 1 per cent and the global average cost of sending a US$200 remittance no more than 3 per cent; 

  – Access: all financial institutions and end-users are to have at least one option for sending and receiving cross-border payments; more than 90 per cent of individuals who wish to send or receive a remittance payment are to have access to a means of cross-border electronic remittance payment; and

 – Transparency: all payment service providers are to give a minimum defined list of information to payers and payees (e.g., total transaction costs, expected time to deliver funds) to ensure a floor of transparency across the market.

These four quantitative targets amount to little more than a re-statement of the goals of the G20 programme. Measuring performance against them will be difficult. But they do provide benchmarks against which progress can be measured in some way.

The initial signs appear discouraging. The October 2021 FSB review of the four targets recorded eight surveys, two reviews, two hackathons, one workshop, one proof of concept, one cost-benefit analysis, one promise of technical advice and one deadline extension, but no material, measurable progress. 

An interesting question is whether central banks and other regulators will at some point between today and 2027 lose patience with the relatively slow progress on enhancing cross-border payments. This seems unlikely. 

Regulators recognise that domestic payments systems have to be enhanced before they can be linked across borders. This is especially true of the opening hours of the Real Time Gross Settlement (RTGS) systems operated by central banks.

Regulators also appreciate that apparently slow progress is a classic case of the “last mile” being the hardest, because fresh technical challenges emerge, the scope of the project is widened and the target shifts as the market and the industry change.

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8.56 Are the four quantitative targets for greater speed, lower cost, greater accessibility and enhanced transparency set by the FSB too crude to work?

Quantitative targets necessarily assume that one cross-border payment is much like another. In reality, payments vary widely and travel down different payments “corridors,” as payments aficionados call them. 

Some are retail; some are wholesale. Some are high value; others are low value. Some are in less liquid currency pairs; others in more liquid currency pairs. Some have to settle instantly; some can wait. Performance varies widely by what type of payment is being made. 

While the cost and speed of remittances from major currencies to minor ones clearly need drastic improvement, high value flows between major currencies are not really problematic at all, because services such as SWIFT gpi have solved the problem already.

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12.31 To achieve the four targets, central banks must invest to change their RTGS systems and widen access to them to include non-banks, and private banks must also invest to interact with changed RTGS systems. To what extent are central banks and private banks ready to do that?

The conditions for meeting the four FSB targets by 2027 include longer opening hours for the RTGS systems operated by central banks, and easier access to them by non-banks. And if central banks change an RTGS system, the commercial banks that use it must also adapt their systems.

In the United Kingdom, the Bank of England has pioneered an omnibus account system that allows non-banks to open pre-funded accounts that enable them to finalise payments in central bank money 24/7/365 even though the system itself is only open between 6.00 am and 8.00 pm.

If other central banks adopted a similar policy, cross-border settlements between national RTGS systems, initiated by banks or non-banks, would become possible. 

This could be accelerated by adoption of the ISO 20022 messaging standard, including for the standardisation of the Application Programme Interfaces (APIs) that intermediate data exchanges between payment systems – as proposed in “building blocks” 14 and 15. 

One driver of change in RTGS opening hours might be atomic settlement of digital assets, which would require access to settlement systems 24/7/365. And if they get that access, and settlement has to occur instantaneously between pre-funded accounts, counterparties (or at least their service providers) will invest in the technology that eventually enables that to happen in central bank money. 

In other words, what a payment is for can determine its combination of speed, cost, accessibility and transparency – and who will invest in the necessary enhancements.

There are signs of private sector investment in enhanced cross-border payments already, and not just in SWIFT gpi or ISO 20022. The BCB Group, for example, runs a round-the-clock global payments network called BLINC. 

If networks like this continue to emerge, they might bypass the current constraints of RTGS opening hours and admission criteria by creating a parallel system that works and establish themselves securely enough to deny banks and central banks the business they serve permanently. These networks are already the choice of non-bank payments providers that never want to assume the capital and regulatory burdens of a banking licence. 

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20.07 Is there too great a choice of solutions available in cross-border payments for banks to make decisions rather than wait-and-see if a consensus emerges?

A surfeit of choice is a common complaint about capitalism in general, but it is always superior to a lack of choice, and the function of the marketplace is to help consumers choose decisively between competing alternatives over time.

At present, the choice in payments is unusually wide. The industry is undergoing a period of experimentation, driven largely by digital technology.  As in any evolutionary process, the services which best meet the needs of consumers over time will attract investment – which is not unlimited in quantity – and survive.

That assortative process does not guarantee a reduction in complexity; it may even increase it. 

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23.19 Could more efficient cross-border payments services reduce the cost of the liquidity buffers maintained by banks in different jurisdictions? 

One of the 19 “building blocks” enumerated by the CPMI aims to enhance reciprocal liquidity arrangements across national borders. To be specific, building block 11 suggests “analysing the feasibility of bilateral arrangements between large-value payment system operators and central banks to enable collateral posted in one jurisdiction to support liquidity issuance in another.”

A present, banks are holding excess liquidity in markets all over the world to make sure that they can meet their settlement obligations. This has capital as well as interest costs, which are rising as interest rates go up. 

An Oliver Wyman study of 2018 estimated that large banks have an average of US$100 billion in various liquidity “buffers” and that at global systemically important banks (GSIBs) the average rises to US$237 billion. Of these sums,10-30 per cent is required to support intraday movements, imposing a liquidity cost on the 30 GSIBs alone of US$7-21 billion a year.  

The Bank for International Settlements (BIS) has estimated savings of US$8 billion if the top 100 Tier 1 banks were able to reduce their intraday liquidity requirements by 25 per cent.

Reducing these costs is one of the primary incentives for banks to support the HQLAx initiative, which aims to make collateral in one jurisdiction available to secure a liability in another jurisdiction by tokenising assets to a global blockchain network. 

Fnality, the consortium of global banks developing the use of asset-backed digital cash on blockchain technology, has estimated that banks which consolidate their activities on its network of inter-operating domestic payments infrastructures – so effectively creating a single global pool of liquidity – can reduce their intraday liquidity requirements by up to 70 per cent. 

Other global payments network, such as the BLINC network controlled by BCB Group, could generate similar savings in liquidity costs.

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27.38 Why haven’t the 19 FSB building blocks endorsed digital identities as a replacement for the current expensive and ineffective KYC, AML, CFT and sanctions screening checks – and what chance is there of the banks adopting ISO 20022 in the near future? 

The need to conduct Know Your Client (KYC), Anti-Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks on the senders and receivers of payments – to the standards set out in the 40 Recommendations on the subject laid down and regularly updated by the Financial Action Rask Force (FATF) – is a well-recognised obstacle to greater efficiency in cross-border payments.

Yet rather than propose adoption of digital identities – a risk-based, efficiency-enhancing method of ascertaining identities endorsed by the FATF itself – “building block” 5 calls on financial markets to “apply AML/CFT rules consistently and comprehensively.” It adds that this means “ensuring more effective and robust implementation and application of AML/CFT frameworks while continuing to pursue a risk-based approach.”

Lack of adoption of digital identities is one reason progress on making low value retail payments more efficient is much slower than in high value wholesale payments. Market participants need stronger incentives to encourage them to share the data that makes digital identities possible.

Market participants also need to see a set of incremental steps towards the adoption of digital identities, which will gradually capture the network effects that are the best guarantor of rapidly accelerating adoption.

The adoption of ISO 20022, which could accelerate inter-operability between different networks, is hampered by misaligned incentives. Multiple versions now exist. Adoption is patchy and driven mainly by regulatory insistence that financial market infrastructures (FMIs) use it. 

Even in the payments industry, which is ostensibly undergoing a compulsory move to ISO 20022, nobody expects the entire industry to adopt it. Like Legal Entity Identifiers (LEIs), another good idea struggling to gain adoption, ISO 20022 promotion needs a greater emphasis on the commercial opportunities it might create.

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33.17 Is there a risk of damaging fragmentation in cross-border payments networks?

Cross-border payments are fragmented already, and yet payments are completed successfully. The future is unlikely to be as fragmented, despite the current surfeit of experiments. But any durable and effective eco-system must preserve choice for consumers, which is not synonymous with fragmentation. 

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34.58 Do the regulators want to displace correspondent banking from the cross-border payments business?

“Building blocks” 13 (`Pursue interlinking of payment systems’) and 17 (‘Consider the feasibility of new multilateral platforms and arrangements for cross-border payments’) both imply regulators are comfortable reducing the reliance of cross-border payments on correspondent banks.

After all, correspondent banks are in large part responsible for the slowness, opacity, inaccessibility and especially the costs of cross-border, cross-currency payments. They have high capital costs, inefficient processes for establishing identities, funding costs inflated by liquidity buffers and they enjoy generous spreads on FX transactions. 

All this is especially true of the performance of the banks in the less liquid currency pairs, which affect the remittance markets in particular, because the solutions available in the more liquid currency pairs (such as SWIFT gpi) are not being used. 

Even large banks now self-clear in their own currency only and rely on a small coterie of around 15 international banks for all the other currencies, partly because they lack liquidity in the major reserve currencies but mainly because of reciprocity: the willingness of banks to trade the loss of revenues in one area for gain of revenues in another. So even in liquid currency pairs, high value flows are highly concentrated between a small class of correspondent banks. 

Central banks will be reluctant to tinker with this model, for fear of losing their oversight of it and its potential impact on the stability of the global financial system. The way the Bank of England has restricted and controlled the use of its omnibus account service is a clear indicator that central banks like business to go through banks they supervise and control.  Even the introduction of central bank digital currencies (CBDCs) and tokenisation of money (initially through Stablecoins) will not dilute that basic concern to retain control.

However, correspondent banking services are not well-adapted to meeting some of the operational challenges counterparties face even in liquid currency pairs, such as reducing liquidity costs, tightening settlement timetables and servicing cross-currency swaps on an intra-day basis.

On the other hand, central banks have expressed concern about the shrinkage in the number of correspondent banking relationships. A recent Bank for International Settlements paper, entitled On the global retreat of correspondent banks, showed how correspondent banking relationships and flows – both by number and value – are decreasing.

Ironically, the shrinkage is driven chiefly by the determination of the regulators in another guise (the FATF) to lay on banks a potentially expensive KYC, AML, CFT and sanctions screening risk for the customers of their correspondent banks, whose credentials it is too difficult and costly to check. 

Banks are de-risking their correspondent banking networks for sound commercial reasons. Indeed one of the dilemmas central banks must confront is the fact that the structure of a service crucial to world trade and global financial stability is in hock to normal commercial incentives.

In retail FX, business is increasingly intermediated not by traditional correspondent banking networks but by FinTechs (such as Wise and Western Union) using their own accounts in multiple jurisdictions. Something similar is evident in developing economies, where services such as Mpesa (east Africa) and UPay (India) are providing money transmission services to the unbanked. 

One of the projects hosted by the BIS Innovation Hub is Project Nexus, whose goal is to link domestic instant payments systems run by central banks (such as Faster Payments in the United Kingdom) with each other across national borders. 

Likewise, the euro area has operated the cross-border TARGET Instant Payment Settlement (TIPS) for retail payments since November 2018. 

Scaling such projects takes time as well as ingenuity, and they operate as messaging layers, leaving banks and the domestic clearing house and RTGS systems they use to handle the actual netting and settlement of the payments. 

Nevertheless, banks will have to respond to the competitive pressure exerted by developments of this kind, even before they take account of the many new services being developed by incumbent and challenger FinTechs and the threat implicit in “building block” 17: an entirely new, cross-border payments infrastructure.

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47.08 What role do CBDCs and Stablecoins have to play in making cross-border payments faster, cheaper, more transparent and more accessible?

Only one of the 19 “building blocks” (19, which urges the market to “factor an international dimension into CBDC designs”) even refers to CBDCs. Yet a series of projects run by central banks and financial market infrastructures have proved that CBDCs can be used to settlement financial transactions across national borders:

• Project Dunbar (the Reserve Bank of Australia, Bank Negara Malaysia, the Monetary Authority of Singapore, the South African Reserve Bank and the BIS Innovation Hub) developed prototypes for a shared platform that allows banks to settle cross-currency transactions using CBDCs without correspondent banks while solving three obstacles: non-resident banks’ access to CBDCs; the need to adhere to local regulations; and the need to find a single governance regime for a multi-jurisidictional service;
• Phase 1 of Project Helvetia (the Swiss National Bank (SNB), the Swiss stock exchange SIX and the BIS Innovation Hub) showed a wholesale CBDC can be used to settle tokenised securities in central bank money in one country (Switzerland) and currency (CHF) while phase 2 proved a wholesale CBDC can be integrated with existing bank and central bank systems; 
• Project Jura (Banque de France, the Swiss National Bank (SNB), a private sector consortium and the BIS Innovation Hub) showed it is possible to settle tokenised securities atomically cross-border and cross-currency (euros and CHF) in central bank money using CBDCs within existing regulatory frameworks and without linking multiple platforms or using intermediaries and without central banks losing control of their national currency;
• Euroclear and Banque de France showed it is possible to settle tokenised French treasury bonds (OATs) against CBDC on a permissioned tokenisation network at high volume in both the primary and the secondary markets; that bonds can be posted as collateral against CBDC in repo transactions; that interest can be paid in CBDC; and that costs are reduced via fewer reconciliations as banks move tokens not data between digital wallets, shorter settlement timetables, and continuing use of legacy systems to inter-operate; and
• Project mBridge (the Hong Kong Monetary Authority, the Bank of Thailand, the Bank of China, the Central Bank of the United Arab Emirates and the BIS Innovation Hub) has proved that cross-border payments can settle in seconds rather than days, operate 24/7 and cut the cost by up to half, by linking national payments infrastructures rather than relying on correspondent banking networks. 

mBridge is in some ways the most significant. “Building block” 19 looks forward to inter-operating domestic payments markets infrastructures as a key contributor to more efficient cross-border payments. It expects those “providing domestic CBDC implementations” to be plied with “the necessary guidance to enable cross-border transactions via access by non-residents and/or interlinking with international infrastructure.” 

This idea was initially floated in a BIS paper of March 2021. It advanced three possible options: increased compatibility of national CBDC systems; linking of multiple CBDC systems; and the integration of multiple CBDC systems into a single “mCBDC” system.

The last of these options seems least likely to be adopted because of the implied loss of control by national central banks and the reduction in the resilience of the system as a whole if it rests on a single platform (it becomes the storied “single point of failure”). 

The investments being made by central banks such as the Bank of England and the European Central Bank (ECB) in enhancing their RTGS systems ahead of the introduction of a CBDC suggests linking compatible systems is a more likely outcome. The success of the Fnality approach of working with national payment systems suggests central banks are more open to the idea of inter-operating than integration.

mBridge suggests that, provided linked national payments systems can provide a settlement layer on their own platform – SWIFT, the current correspondent banking network for cross-border payments is purely a messaging layer, not a settlement layer, that role being fulfilled by CLS – it is possible to achieve speed and cost savings at scale in cross-border payments by infrastructural means.  

In other words, the long-term outlook is for decentralised networks of payments infrastructure networks, with CBDCs used not just to settle transactions but to supply the FX component too – in a fashion that cannot be decided till CBDCs are issued in the major currencies and have proved their usefulness in their domestic markets.  

One challenge for this model is to decide where liability falls if a counterparty to a cross-border payment fails to deliver. Any losses could be mutualised by the central banks that operate the various national payments infrastructures that make up the network but that would deter many central banks from joining. The network of networks is more likely to operate in the same way as CLS, which was set up to eliminate that form of counterparty risk known as Herstatt Risk by adopting a payment-versus-payment model: the collective network would not be a counterparty to the transactions. 

So a network of payments infrastructures is a plausible vision of the future. However, the ability of central banks to collaborate on cross-border payments initiatives is increasingly limited by geopolitical tensions. 

The United States and China, to take an obvious example, have differing views on the value of the US dollar as the premier reserve currency and on the purpose of issuing a CBDC. It would be difficult for the two countries to agree on inter-operating payments infrastructures.

In the meantime, Stablecoins pegged to a currency or a basket of currencies have emerged as an alternative to CBDCs for completing cross-border payments. Indeed, there is a view that, if CBDCs take much longer to be issued in major currencies, Stablecoins will have cornered the market in cross-border payments by the time that they do.

However, although Stablecoins exist in minor as well as major currencies such as the US dollar and the euro, it is not yet clear how many currency pairs Stablecoins can cover. Nor is it clear how a Stablecoin issued in one currency can be exchanged for a Stablecoin in another currency without using digital wallets on a cryptocurrency exchange – a service which tends to deter institutional money.

Central banks are also cautious about Stablecoins because they could lose control of local monetary conditions if consumers and businesses preferred to be paid in and hold a Stablecoin denominated in another currency (something they can currently prevent by denying regulated banks the right to offer foreign currency accounts and clearing and settlement of foreign currencies).

Even before the collapse of the Terra/Luan algorithmic Stablecoin, it was clear from policy announcements in the United States and the United Kingdom that Stablecoins are going to be regulated. 

Their issuers are also likely to be made subject to the Principles for Financial Market Infrastructures (PFMIs) published Issued by the Committee on Payments and Market Infrastructures (CPMI)  and the International Organisation of Securities Commissions (IOSCO) in April 2012 to govern the resilience of payments systems.

The lesson to existing and would-be innovators in cross-border payments is clear: seek regulatory status before launching a new product or service.

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1.04.14 Assuming the four quantitative targets set by the FSB are met, what will the future of cross-border payments actually look like?

The future promised by the four quantitative targets of the FSB – 75 per cent of payments settled within an hour at a fully disclosed cost no greater than 1 per cent on systems open to 90 per cent of the population – is neat, measurable and homogeneous. The global reality is likely to be messier.

Different services will be offered and bought for different types and sizes of cross-border payment. Entirely new products and services will continue to emerge, and some will succeed. Over time, service providers will consolidate and technologies – especially blockchain-based platforms and the orthodox digital systems used by incumbents – will converge.

But the most important determinant of the shape of the future will be regulation. Regulators – and especially the determination of the central banks to retain control of monetary policy and maintain financial stability – will constrain experimentation. 

They are already increasing regulation of Stablecoins and cryptocurrencies. As they do so, however, it is likely that the involvement of traditional financial institutions in novel markets will actually increase. That is essential, because public sector policymakers need private sector actors to make innovation and investment in cross-border payments actually happen. 

Central banks and banks and FinTechs need to work together, informally as well as formally, to build the future of cross-border payments. And it will be obvious when that future has arrived because nobody will be talking any more about the need to make cross-border payments faster, cheaper, more accessible and more transparent.

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If you would like more information or we can assist in any way or you would like to join future discussions please email Wendy Gallagher on wendy.gallagher@futureoffinance.biz