Cross-border payments part 1: how foreign exchange (FX) works: clearing and settlements

Intro

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.

FX settlement: what are the players

Nostro and Vostro accounts

Well at the high level, through Nostro and Vostro accounts:

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.

Netting

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.

FX settlement solution options
  1. reduces settlement, credit, and counterparty risks,
  2. reduce cost as there is less operation, and
  3. increase speed.
  1. direct bilateral relationship: like the BofA and BBVA example.
  2. Use netting network: networks developed for FX netting, such as FXNET, SWIFT Accord,
  1. CLS

SWIFT

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.

  1. Identify counterparties that offer the best opportunity for netting and negotiate and sign appropriate documents,
  2. Agree with counterparties on the currencies to be netted, netting cutoff time and standard instructions for settlements,
  3. Ensure that each deal has been individually confirmed,
  4. At the netting cut-off time, identify all transactions to be netted for settlement,
  5. Compute net amounts by currency, or by currency pair based on the contractual arrangement with the counterparty,
  6. Confirm net amounts to be settled with the counterparty (by phone, fax, or S.W.I.F.T. ),
  7. Confirm any gross amounts to be settled (for example, for transactions done after the netting cutoff time),
  8. Generate payment and receipt (payment advice) messages for net amounts,
  9. 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
  10. 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:

  1. Costly
  2. Slow
  3. And process not very transparent
  1. Cost. There is cost associated with maintaining many different accounts (nostros)
  2. 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.

The solution

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.

Visa B2B connect

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Ming-Chieh Lee

Ming-Chieh Lee

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passion for #fintech #payments #RTP real time payment #Banking as a Service #digital strategy #blockchain