The world today is as globalized as it was inconceivable to exist a couple of decades ago. Businesses across continents, freelancers collaborate with foreign clients, and families send money back to their homelands to support their near and dear ones. Despite the innovation that technology has brought to communication and business for speed, cross-border money movement has not. Cross-border payments remain slow, expensive, and cumbersome. To find out why, one must take a close examination of how exactly these kinds of payments really work and why the system is still charged despite the progress of digital finance.
The Mechanics of Traditional Cross-Border Payments
When a person initiates an international money transfer, the transaction seems straightforward: one person in one nation is sending money to another person in another. But the path that money actually travels isn't quite so direct. Traditional payments are using a massive correspondent bank network of intermediaries between sender bank and receiver bank.
For instance, when the Indian bank is required to pay a Brazilian bank, the two banks may not have to deal directly with one another. The Indian bank simply pays via one or more correspondent banks, which are often based in financial centers such as New York or London. Correspondent banks maintain "nostro" and "vostro" accounts—specialized accounts that enable them to clear foreign transactions on behalf of other banks.
This procedure, under the control of the SWIFT (Society for Worldwide Interbank Financial Telecommunication) message system, is a multi-step process involving verification, settlement, and reconciliation. Along the process, each institution in the chain checks the sender information, adheres to anti-money laundering (AML) and counter-terrorist financing (CTF) rules and regulations, and charges its own fee for processing the payment.
While this network is safe and trustworthy, it is complex and therefore causes delay and extra expense. A transaction which could look to be seconds to complete takes days to complete.
The Cost Drivers in Cross-Border Payments
Cross-border money transfer is expensive not because of any single factor but because there are many layers of expense.
Secondly, correspondent banks also charge service fees at each point of the payment transaction. Every intermediary charges a handling fee, and the charges are cumulated before the remittance is given to the recipient. For low-value payments, these charges can amount to an enormous percentage of the overall transaction.
Secondly, foreign exchange (FX) spreads have another implicit cost accompanying them. Banks never employ the true interbank exchange rate for exchanging currencies. What they do is place their own premium on the exchange rate and thus both the receiver and sender end up both in deficit during exchange.
Third, compliance and regulatory requirements have overheads. The banks have to adhere to international standards of fraud prevention, sanctions checking, and AML checking. Though these are essential to keep the financial system stable, they increase the pace and cost of processing every payment.
Lastly, there are infrastructure constraints. There are inefficient or fragmented banking systems in some areas, so transactions cannot flow smoothly. This makes payments flow through additional intermediaries, and costs and settlement times are both raised.
The Friction of Time
Perhaps the most infuriating part of conventional cross-border transactions is the delay in settlement. Whereas domestic payments might settle in an instant or in a matter of hours, cross-border payments can take up to five business days. This is partly due to time differences between banks, the possibility of manual checks at times, and the role of several intermediaries taking their own time to check and forward the payment.
For users, such delays are annoying during times of high demand for immediate remittances. For companies, delayed payments harm cash flow, complicate supply chain management, and undermine confidence among foreign counterparts.
Limited Transparency for Users
There is also the issue of transparency within the older systems. When one sends money internationally, the person sending the money might not know very much about where the money is at any given time. Unlike tracking packages that give minute-by-minute updates, money transfers will be marked as "in process" for several days with no other comment.
Furthermore, the actual amount of money received by the recipient is sometimes not evident until the process is finalized. As a variety of banks may deduct fees and use varying rates of exchange, senders are not necessarily informed of precisely how much money will be transferred. This type of uncertainty is one big reason why individuals and businesses alike are looking for alternatives to the conventional system.
The Increasing Quest for Alternatives
As the world grows more interconnected, the need for quicker, cheaper, and more transparent ways of sending payments has grown even larger. Remittance corridors, say between migrant workers and their relatives, gather billions of dollars every year, but excessive fees keep taking away from the take-home pay of beneficiaries. Likewise, small and medium-sized enterprises (SMEs) engaged in cross-border commerce often find that conventional payments take away from their already narrow profit margins.
It is against the backdrop of such a strategy that financial innovators and policymakers have been exploring newer systems and technologies that are able to avoid or transcend the correspondent banking system. Digital wallets, mobile money systems, and fintech platforms have already facilitated cross-border payments in some regions. And of the new solutions, the most widely debated solution is probably crypto for cross border payments, and it has raised questions as to whether blockchain-based systems could settle cheaper and faster. As much as the new industry is still in its development stages, its promise is a testament to how imperative there is to replace the legacy payments infrastructure that currently exists.
Why Old Systems Remain So Firmly Embedded
All the irritants aside, older cross-border payments continue to prevail because they are steady and well-established in international finance. Correspondent bank networks, as ungainly as they are, give some degree of regulatory compliance and risk management that newer systems have yet to replicate. Banks are not eager to resort to untested alternatives in a financial system where noncompliance exacts its steep price.
And in addition, the scale of international finance is so vast that any replacement system will have to be compatible with dozens of nations, currencies, and regulatory systems. That is no trivial feat, and why cross-border payment innovation, thrilling as it has been, up to now has been relatively glacial to overthrow traditional models.
Conclusion
Physical cross-border payments are still the foundation of international finance, but they are burdened with inefficiency, high expense, and low transparency. Based on correspondent banks, untransparent fees in the shape of exchange rate markups, harsh regulatory supervision, and outdated infrastructure all work together to make these transactions costly and slow.
With globalization, such inefficiencies are now unacceptable to businesses and consumers who desire faster and more balanced financial services. Alternatives such as digital wallets and blockchain-based systems are attracting attention, but traditional models predominate through their fit within a regulatory framework and trust.
Ultimately, the future of cross-border payments may be one in which the operating security of current systems gets balanced with the fast delivery and cost savings of new technology. Meanwhile, knowing how the current system operates—and why it is still expensive—makes for good background reading for anyone who works in the international financial system.
