This is the 3rd article of our series of how money move around in the banking system. article1 article 2. Have you ever wondered how do money travel internationally? I think I read somewhere online that physical bills travels on the plane! That is of course false. The basis for international payments / money transfer:
- Money don’t travel across borders for cross border payments.
- The clearing / movement is done through correspondent banking.
I had also asked this question on Quora, and someone answered SWIFT. Although it’s not wrong, it’s certainly not complete. SWIFT is a messaging protocol, hence only takes care of the messaging and figures out how to send the payments. Not the actual clearing and settlement.
So, let’s use an example to show how it works. In our example: John in US wants to send $10 to Adam in England.
If John’s bank is a large US bank, then it will probably have a correspondent bank for handling Pound. Note the correspondent bank should always be an UK bank. For large international bank, the correspondent bank can also be the UK branch of the bank, such as Citi. By UK branch, we mean the bank has license to operate in UK. If the bank is a small US bank, then it might not have a UK correspondent bank, then it will need to find a US bank (intermediary bank) that does. Of cause, the intermediary bank will not offer such service for free.
Let’s keep it simple: John banks with BB&T in US. Adam’s UK bank is RBS.
However, BB&T does not have a UK correspondent bank. Through the SWIFT messaging, it figures out that Bank of America (BoA) can help handle UK currency. BoA has a UK correspondent bank, Lloyds Bank.
- John’s BB&T account debited(-) $10, and BB&T account at Fed credited(+) with $10
- Accounts at the Fed: BB&T -10, BoA +10
- BoA debit $10 from account at Fed, and credit $10 into Lloyds’s account at BoA
- Lloyds’s then moves 7.71 pound ($10 worth) from its account in UK to Adam at RBS
This transaction results in Lloyds bank with $10 extra in its US account, and negative 7.71 pound in its UK account. But, not to worry, Lloyds bank is most likely the bank that handles a large amount of UK payment to the US, and results in netting.
The treasury department of Lloyds bank will also monitor its accounts, if there was a larger than expected deficit in a particular account, then it will go into the FX market to make up the difference.
Now, we haven’t talked about the fees yet. And I think this is the biggest problem with the current cross border payments: high fees. Notice that there are 4 banks involved in our example, every one of the bank will have a fee. The one that will collect the most fee is Lloyds bank. Because it’s doing the currency conversion. The bank usually collect the fee through conversion spread, usually it’s about 2–5 %. As you can see, bank generally net, so it doesn’t really incur the fee it’s charging.
I think the problem here is that we need to have a clearing bank for all the bank in the world. Because as evident above, to reduce costs, one must reduce the connection hubs from sender to receiver. Once again, I believe this is where Visa and Master can benefit. Be the high way for the world.
First principle of thinking
Problem: I think it should be clear above that the reason sending money internationally is so expensive is because all the hops required from the sender’s institution to the receiver’s. This is because there is no international clear bank that all financial institution connects to. Hence, it’s clearly one area in fintech that’s ripe for disruption
Solution: An entity where all participants connects to. Let me clarify by giving some examples that I can think of:
- Incumbent banks form an international clearing bank
- Existing bank network providers (Visa / Master) to offer international money transfer
- Big tech using disruptive technology such as blockchain
- Fintech start-ups doing payments or remittance
1 seems not possible. Forming an international clearing house, and getting all financial institution to participate is so difficult, and I believe that’s why it hasn’t happen yet.
2 is a possibility. Visa, Master, Amex or any other network provider already have connection with the banks. Although processing credit card and payment is different, and will require almost brand new implementation, at least they can leverage their experience working with the bank, expertise in processing payments, their brand, and knowledge in providing technical stack.
3 is also possible, think of Libra. Though the fate of Libra is pessimistic, it seems that China is embracing blockchain. So, a country’s loss may be another country’s gain. Regardless of the political and regulation, I think it’s a great idea. Because if done right, it can offer great benefits to users of international money transfer.
4 is fintech start-ups focused on payments and money transfer. There are money transfer start-ups that offer transparency, reduced cost, and faster speed than existing ways. Some seems to be able to achieve such and still make profit, such as Transferwise. Other start-ups like e-wallet giant Alipay, it already has partnership with Paytm, the e-wallet giant in India. Imagine all the e-wallet are connected.
Sorry that I have digressed here. I will just say a few more words on this. This is not a simple problem to solve. I think it will require everyone (incumbent banks, infrastructure provider, start-ups) working together, complement each other’s area of expertise to come up with a solution. Visa and Master have to partner with banks or other payment provider to bring users to its network. Fintech startups will often need to partner with banks for regulatory compliance and customers…,etc.
- we looked at how money moves in the banking system internationally,
- why there are so many hops, causing the fee to be so high,
- and what are some of the possible solution.
The reason behind it all is that I truly hope one day that transfer money internationally will be free, fast and easy to use. Thank you.