Voice of the Industry

Demystifying cross-border payments – history, challenges, and the road ahead

Thursday 29 July 2021 07:43 CET | Editor: Raluca Constantinescu | Voice of the industry

Dawei Wang, Head of Strategy at Thunes, lifts the hood on international payments and dives deep into the mechanics and the economics of moving money across borders

Traditional ways of making cross-border payments 

Originally, people transferred money to another country in one of three ways: by carrying physical cash across borders, by using acquaintances or couriers to move the money on their behalf, or by using informal trust-based broker networks (such as hawala) to transfer the money without physical money movement. However, these methods posed problems – they were inefficient, unreliable, risky, and often costly. It took 100 years before major advances enabled effective cross-border payments on a global scale. 

Let’s see how international payments developed in the modern era. 

The development of communication network and messaging standards 

In the early 1930s, the German postal service developed the first major Telex network of teleprinters, which enabled the electronic transfer of written messages. Banks could use it to communicate with their counterparts overseas to settle transactions. As a result, Telex became the primary tool to facilitate international money transfers in the developed world until the 1970s. 

In 1973, 239 banks from 15 countries came together to develop an even better medium – the Society for Worldwide Interbank Financial Telecommunication (SWIFT). Based in Belgium, SWIFT established a common language and model for payments data across the globe, which, since then, has served as the default network for communication related to cross-border transactions. Today, SWIFT is used by more than 11,000 financial institutions across over 200 countries and territories globally. 

The emergence of correspondent banking relationships 

However, communication networks alone did not solve the other prerequisite for making reliable cross-border payments – a way to transfer funds between disconnected systems. As currencies are closed-loop systems, banks had no way to move money from a domestic payment system in one country to another. As a result, financial institutions developed a new funding mechanism to solve this challenge: correspondent banking

If Bank A in one country wants to transfer money to Bank B in another country, each needs to hold an account at their counterpart. During an international transaction, there is no physical movement of funds. Instead, bankers credit accounts in one jurisdiction and debit the corresponding amount in the other. A problem arises when banks want to make international payments to all countries and all banks globally. For this to succeed, they would either need to set up their own branches everywhere or have thousands of direct relationships and hundreds of accounts to manage. Yet, only a few of the world’s largest international banks come close to achieving this, and even they constantly struggle with the multitude of challenges of local requirements from a technology, infrastructure, and regulatory perspective. 

Faced with painful impracticalities, banks often need to transact with intermediaries, also known as correspondent banks. In some cases, more than one correspondent bank can be involved in the process – especially when moving money to and from emerging markets. But as the number of correspondents in the chain increases, the transaction time and costs rise too. 

This combination of the SWIFT communication network and correspondent banking relationships has been the go-to method for moving money across borders over the last 40 years. This is the reason why more than 80-90% of cross-border payments revenue is still captured by banks. Although it remains practical for the majority of corporate transactions, the model is not economical, especially for lower value transactions. As such, there is an influx of non-bank providers who are increasingly focusing on making bigger inroads to address the growing SME and consumer markets. 

Why we need to envision a future with an enhanced solution for lower value transactions 

There are six major challenges for lower value transactions with the correspondent banking model. 

  1. Speed – cross-border payments can take up to three days if multiple intermediaries are involved, and even longer for some less-developed markets. 

  2. Limited transparency and dependability – with the standard operating model, there’s little transparency because all the intermediaries of each transaction chain do things differently, and that affects cost, speed, and arrival confirmations. 

  3. High cost – there are three cost components per transaction – SWIFT messaging fees, transaction fees, and spread on foreign exchange (FX). With multiple intermediaries, all these costs can often add up to USD 25-35 per transaction (even higher in some markets) excluding FX, as each correspondent bank will need to be reimbursed for their service, with fees ranging widely dependent on individual commercial agreements. 

  4. Lack of interoperability – in its nature, the correspondent banking model only involves banks, and SWIFT is owned by banks and designed to serve them. In today’s increasingly diverse financial ecosystem, however, customers need to be able to move money across multiple payment methods in addition to bank accounts – but the current model does not offer the ability to easily move money from bank accounts to e-wallets and vice versa. 

  5. Limited coverage – despite SWIFT offering connectivity to over 200 markets, each individual bank’s coverage is limited to the size of their own correspondent banking network. Interestingly, the number of active correspondent banking relationships globally declined by 20% between 2011 and 2018, while the number of active corridors dropped by 10% (BIS).  

  6. Limited accessibility – in some markets, bank account penetration is very low (below 30% across the population), and most people don’t even have access to cross-border payments. Additionally, as banks continue to abandon corridors, certain customers (such as those in emerging markets) are being left with less formal options to receive or send money internationally, which results in the few choices available being very expensive. 

Regulators, governments, and businesses must address the challenges above to make cross-border payments faster, cheaper, more transparent, and more accessible, especially for those that have been traditionally underserved by large financial institutions. 

The future of cross-border payments 

SWIFT gpi – SWIFT has recently enhanced its service by implementing its global payments initiative (gpi), which enables banks to provide details of deductions, payment status, and confirmations to a tracker hosted on the gpi cloud that banks and end users can access to get payment status and other information. Settlement speeds and transparency for correspondent banks have improved, but these changes have only impacted the large payment flows. Also, for most banks, using the SWIFT gpi is expensive and they do not have the resources to implement this solution. 

Payment network aggregators – they operate payment networks that primarily rely on indirect network connections. Similar to correspondent banks, they leverage third-party relationships to reach markets where they don’t want to establish their own connections. This makes it easier for them to scale and offer broad coverage as they essentially aggregate the individual connections of multiple partners. But indirect connections charge ongoing fees, expose payment network aggregators to varying levels of risk associated with each partner, and offer limited visibility of fund flows. For cross-border payment providers, these types of partners offer a quick and easy way to reach many markets, but this can mean having to compromise on transparency, costs, and security. 

Proprietary payment networks (such as Thunes) – these build individual, direct connections with each of their network members, as opposed to using (and paying for) the connections built by others. In other words, they have built an infrastructure that allows money to change hands easily. However, companies just need to be part of the network. As a result, these networks have complete visibility over the fund flow and greater control over transaction costs and risks, which translates into higher transparency, higher security, and lower costs for customers using them. A research from McKinsey shows that the costs associated with cross-border payments can be reduced by up to 90-95%, which is what some operators of proprietary payment networks are already achieving. 

About Dawei Wang 

Dawei Wang is Thunes’ Head of Strategy. Dawei possesses a strong knowledge of the payments sector as well as expertise in growth and M&A strategy. He was previously a Strategy Consultant and banker with EY-Parthenon and JPMorgan respectively, where he regularly advised the CXOs of some of the largest global financial institutions, PE/VC investors, and fintechs on their most pressing strategic and capital-related agenda. He holds an M.A. in Economics and Strategy from Imperial College London. 

About Thunes 

Thunes is a B2B company that powers payments for the world’s fastest-growing businesses. Thanks to a single API connection, customers reach new markets and multiple payment options in over 100 countries without the need for countless integrations to multiple systems. Today, more than 100 banks, payment service providers (PSPs), money transfer operators (MTOs), mobile wallet operators, platforms, and fintech companies around the world use us to process cross-border payments in a cheaper, faster, more transparent, and more secure way.

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Keywords: Thunes, cross-border payments, SWIFT, banking, FX
Categories: Payments & Commerce
Countries: World
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