Cross-border payments part 1: how foreign exchange (FX) works: clearing and settlements
Explains how FX works, how FX settles, and root cause of the pain points in cross-border payments
Key takeaway: Start with simple concept what is foreign exchange (FX), then introduce different parts of FX, and we will see how it all comes together to explain the pain points in cross-border payments.
There is a joke that while you can receive an email instantly, but the fastest way to receive cross-border payment is to get on an airplane, and delivered that money. With so much going on in fintech, sadly this is still true today. Cross-border payments still remain one of the area ripe for disruption. To get a deeper understanding of what’s causing the current pain points and what an ideal solution can look like, let’s dig into the basics: how foreign exchange (FX) works and settles.
What is Foreign Exchange
Foreign exchange is exchanging one currency ($) to another currency (Euro) at the agreed upon exchange rate and date. Note, that there are physical and cash settlement. For this article, we will keep the discussion on the physical settlement side.
Let’s start with a simple example: John in US wants to pay 100 Euro to his supplier Bob in Germany. John has US dollar bank account with Bank of America (BofA), while Bob has Euro bank account at BBVA. So we want to exchange $ to Euro. Assuming the exchange rate is $1.2 to 1 Euro. So for settlement, $120 from John’s account at BoA will be debited and Bob’s account at BBVA will be credited with 100 Euro. But how is this done?
FX settlement: what are the players
Nostro and Vostro accounts
Well at the high level, through Nostro and Vostro accounts:
Nostro: A Nostro account is a reference that Bank A (local) uses to refer to its account that is on deposit in Bank B (Foreign), in the local currency of the country where Bank B is located. In our example above would be in Euro.
Vostro: A Vostro account is just the opposite. Vostro account is a reference used by bank B (foreign), accounts held by bank B in bank A, denominated in our local currency. In our example above would be in dollars.
Using our example above, Bank of America would be bank A and BBVA would be bank B. A Nostro account from BofA’s perspective would be an account BofA has at BBVA denominated in Euro. The term used to describe these banks is “correspondent bank”. Bank of America would be a correspondent bank for the US dollar to Euro trade.
FX settlement risk:
With these Nostro and Vostro accounts connecting the banks, FX settlement risk is one of the biggest concern in the international banking community. From the bank’s perspective, if one of the bank that I have Nostro account at defaults, what happens to my fund? Especially a lot of the times, amounts in FX trade are quite large.
With Nostro and Vostro accounts come settlement risk, to reduce the settlement risk and dive a bit deeper in FX settlement, we will need to understand netting.
Netting refers to the practice of consolidating multiple trade / settlement into single value. For example, if Bank of America wants to sell $120 for 100 Euro, and BBVA wants to sell 100 Euro for $120 dollars, then BofA and BBVA would match their trade and net to 0. So, no actual movement of money will occur across the 2 banks. BBVA would just move 100 Euro to BofA’s Nostro account at BBVA. BofA would move $120 to BBVA’s Vostro account at BofA.
There are great benefits with netting such as:
- reduces settlement, credit, and counterparty risks,
- reduce cost as there is less operation, and
- increase speed.
The rule of thumb is net whenever possible. Net first, then go through physical settlement on consolidated trade. For netting, there is bilateral netting and multi-lateral netting. The example above is a simple bilateral netting.
For bilateral netting, banks have the following options:
- direct bilateral relationship: like the BofA and BBVA example.
- Use netting network: networks developed for FX netting, such as FXNET, SWIFT Accord,
For multi-lateral netting:
Note that CLS merged with ECHO and Multinet to create a bigger network, which is essential to get the effects of netting.
After exhausting all netting options, banks will need to physically settle on the consolidated FX trade. Currently, that’s mostly done through SWIFT. SWIFT stands for The Society for Worldwide Interbank Financial Telecommunication. Yes, it’s basically a messaging network. Each bank is assigned an IBAN number, a unique identifying number. SWIFT uses wire transfer to settle money movement. For how wire transfer works, check my article on How payments are cleared and settled, and look for Fedwire and CHIP.
The SWIFT’s messaging system also provides routing capability. It works similar to the airline system. Imagine going to Hawaii, and there is no direct flight. The airline system is usually able to get you to Hawaii through transfer flights. SWIFT’s routing is able to help banks find the correspondent bank who can trade in the desired currency in the FX trade.
SWIFT’s messaging system is used to help confirm the details in FX trade as show in step 6 & 7 below.
The following list describes the steps of the netting process, either manual or automated:
- Identify counterparties that offer the best opportunity for netting and negotiate and sign appropriate documents,
- Agree with counterparties on the currencies to be netted, netting cutoff time and standard instructions for settlements,
- Ensure that each deal has been individually confirmed,
- At the netting cut-off time, identify all transactions to be netted for settlement,
- Compute net amounts by currency, or by currency pair based on the contractual arrangement with the counterparty,
- Confirm net amounts to be settled with the counterparty (by phone, fax, or S.W.I.F.T. ),
- Confirm any gross amounts to be settled (for example, for transactions done after the netting cutoff time),
- Generate payment and receipt (payment advice) messages for net amounts,
- Monitor net (and gross) payments and receipts and reconcile Nostro accounts. (This step could involve matching gross information from the FX system and net information generated manually.), and
- Generate accounting entries as needed.
Understand the pain points in cross-border payments
Now with most the roles and players identified in FX, let’s understand the pain points in cross border payments:
- And process not very transparent
It’s because banks have limited correspondent banking relationship. In order for a FX to go through, there are hops to find the bank that can execute the trade. These hops are causing speed and lack of transparency since each bank may not have system in place for real time messaging or real time handling. As we have seen, the best way to save cost in FX is effective netting. Limited banking relationship makes netting more costly than it has to be. Because more hops increase fees as there are more parties involved.
Why do banks have limited correspondent banking relationship?
- Cost. There is cost associated with maintaining many different accounts (nostros)
- Reduce the risk exposure. With so many bank accounts, bank increase its exposure to risks (default, credit, counterparty) by any of the banks it has nostros account with.
With our understanding, it’s not hard to see solution where all financial institution should be directly connected to a master network, that maximize netting. And with direct connection, would also resolve the slow problem as well.
The good news is that there are a number of promising solutions in the market, and I believe we will see more advancements or applications in this area to come. Promising solutions include SWIFT’s GPI, Visa B2B connect, and Ripple. I will go into detail on Visa’s B2B connect in the next article.