How to Lower the Costs of Cross-Border Payments
The payment experience has evolved remarkably over the past decade. Consumers are spoilt for choice; from multi-currency wallets to buy-now-pay-later (BNPL) services, the number of payment options seem to be endless. Businesses can also make or accept payments with ease using application programming interfaces (APIs).
While the front-end of payments have seen a wave of innovation, the back-end layer underpinning them has stagnated. This is unfortunate, because regardless of the type of payment service, all payments are still eventually settled via traditional, legacy methods.
This stagnation has kept the cost of payment settlements high. It is most evident in cross-border payments due to the fragmentation of global systems; settlements occur across different operational norms, regulatory frameworks, and technological standards.
Issues with the current cross-border settlement system
Currently, the correspondent banking model is the only ubiquitous settlement solution for cross-border payments. When end-users (consumers / businesses) initiate payments through a service provider (perhaps a FinTech), the payment is processed by a commercial bank and eventually settled by the central bank. This would be a straightforward process if the commercial bank is licensed in both of the sender’s and beneficiary’s jurisdictions as the commercial bank can contra against its own accounts.
In most cases, commercial banks do not have presence in the beneficiary’s jurisdiction and must engage the service of another commercial bank. The engaged commercial bank may in turn rely on another commercial bank that has a settlement account with the central bank of the beneficiary’s jurisdiction. Thus, the payment may traverse across a chain of banks and settlement systems before finally reaching the beneficiary. This back-end process is often unknown even to the payment service provider.
Since there is no global centralized system for settlement of cross-border payments, most foreign exchange transactions are settled in this manner. As a system of bilateral relationships, operational processes and liquidity requirements are duplicated across the correspondent banking model, resulting in layers of fees and prolonged delivery.
The other key issue with cross-border payments is presence of settlement risks. In a centralized setting, the operator of the settlement system ensures that the final transfer of a payment in one currency occurs only if the final transfer of a payment in another currency (or currencies) occur. Also known as payment versus payment (PvP), this mechanism eliminates settlement risks for both parties. This is common with most domestic payment systems as the central bank acts as the trusted intermediary. With the absence of a central party in a cross-border setting, settlement risks remain because the second leg of payment may not occur after the first does.
What can be done?
Distributed ledger technology (DLT) presents an opportunity to significantly improve the settlement process for cross-border payments. Decentralization enables distrusting users to reach consensus on their transactions with one another without having to rely on a central party. This is imperative in a cross-border setting because the ownership of data and finality of their domestic currency settlement must remain within their jurisdiction.
In a DLT network, participants run independent nodes that are connected to their own domestic settlement systems with their own rules, yet the nodes communicate with one another with consistent operational protocols, leaving an immutable audit trail of cross-border transactions. Secondly, DLT enables the tokenization of assets, allowing for atomic settlements of transactions, where all relating settlements are executed together, or none are executed at all. The 2019 Triennial Survey conducted by the Bank for International Settlements (BIS) showed that the total FX trades settled globally without PvP has been growing from 50% in 2013 to 60% in 2019. This means that around US$9 trillion of payments remain at risk on any given day.
With tokenization, participants no longer need to trust a central party. Instead, they place their trust in the code executing the settlements. Tokenizing fiat deposits simulates cash-like settlement, enabling PvP transaction finality which eliminates settlement risks.
Decentralization improves cross-border payment settlements
While instant or real-time settlement systems are available in many domestic payment systems, they are rare in cross-border settlements because it requires a country-to-country linkage. Cross-border payments are thus mainly settled on a deferred basis known as bilateral netting, or the offsetting of positions between two parties.
Imagine two banks that make multiple payments to one another. Instead of settling each transaction on a gross basis, they decide to settle the net difference just once a day. This reduces the number of transactions and liquidity needed to settle all payments.
However, the savings from bilateral netting are limited since there are only two parties. To increase the potential of offsetting payments against one another, the number of parties in the netting cycle must be increased. Also known as multilateral netting, it only works if there is a central party to aggregate transactions from all parties to calculate the net values. Again, this does not work in a cross-border setting because apart from competitive objectives, parties cannot share transaction data without breaching privacy laws.
Decentralization enables multilateral netting
Multilateral netting of cross-border payments has been impossible without a centralized system…until the advent of DLT. By combining DLT and confidential computing, it is now possible to aggregate all transactions in a secure enclave for multilateral netting. An enclave is an isolated memory location used to run applications in a trusted execution environment, where not even the owner of the machine doing the computation can see the data being processed.
When privacy is guaranteed, the market is widened to include all potential flows from all potential parties for multilateral netting. This further increases the number of offsetting payments, reducing the number and quantum of settlements, achieving the most efficient FX prices possible.
How does OneHypernet help?
The cost of cross-border payments can only be lowered through efficiency improvements in the settlement process. OneHypernet has created a multilateral, multicurrency settlement system to unlock liquidity trapped in nostro/vostro requirements, perform faster pay-outs, and eliminate cross-border settlement risks. All while guaranteeing data privacy on a cryptographic level.
Depending on the number of participants and transactions in the netting pool, OneHypernet’s solution generally reduces cross-border settlement costs by 70+ to 96%. This solution can be used by banks and payment service providers to lower their cross-border settlement costs, or by enterprises as a treasury solution to improve their cash management with their trading counterparties.
ARTICLE WRITTEN BY: ALSTONE TEE
Alstone Tee is the Co-Founder of OneHypernet.
OneHypernet is part of our Batch 6 Fintech program in Singapore.
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