Whether it’s a manufacturer expanding their supply chain, international trade or an individual sending money abroad, cross-border payments are an essential part of the global economy. This activity has only been increasing and with that increase, several challenges have come to light that are worth discussing.
Before getting to the challenges, it’s worth breaking down the cross-border payment ecosystem – particularly the players and how transactions go from initiated to settled. Cross-border payments have a number of players, well imagined by the Bank for International Settlements (BIS) in their report on Cross-border retail payments in 2018.
The BIS saw that there are differences in the “front end” and “back end” players – that is, what the user sees and what they don’t see. Payment service providers or PSPs arrange the payment with the users and then with each other and their banks, they arrange the terms of the payment (such as the foreign exchange).
PSPs may be banks, post offices or money transfer operators (MTOs). Various payment instruments can be used in an online transaction. One popular method is a payment card. Provided both Payer and Payee banks subscribe to the same set of rules and procedures, an exchange between a banks cardholder with another banks merchant can be made. These transactions still require foreign exchange conversions.
If we take a closer look at back-end services using another image provided by the BIS report, we can see that many of these services happen without the awareness of the payer or payee. PSPs provide these services using agreements or outsourcing arrangements. Examples listed in the report are:
All of these exchanges are taking place electronically and therefore need a standard format and validation when travelling around the world from server to server. SWIFT is by far the largest network provider with responsibility for, amongst other things, identifying the payer and payees account information and the payment amount.
After payment messages are exchanged, the transaction must be cleared. Domestic transactions are more likely to be standardised in format, date/time, currency and timing (e.g., peak times are likely to follow a predictable pattern) and are therefore easier to clear. Additional PSPs, varied timing and different currencies cause a slow down in clearing cross-border transactions.
Finally, settlement is the issue of the funds in accordance with fulfilling the obligations of the payment contract. In some transactions, this may involve multiple payments and multiple intermediaries. In cross-border payments, for example, funds may be transferred from one PSP to another in a different jurisdiction. This is also where the foreign exchange is calculated and if one of the currencies being used is non-standard, there may need to be a third-currency to facilitate the exchange.
Of course, in reality all of this is more nuanced and varies with each transaction but knowing all the players and parts of the process helps us when dissecting the challenges. It is important to see how cross-border transactions differ from domestic ones and how electronic transactions require computer readable formats to decipher and process a settlement.
The first challenge with cross-border payments is a people challenge. In a multi-dimensional world, customers from different jurisdictions have different ideas of what constitutes the best experience of a cross-border payment transaction. What’s more important to someone in the UK may be low priority to someone in Japan. The importance of these qualities may also vary by the size of the transactions or by who is conducting the transaction. For example, a business to business (B2B) transaction may have different qualities than a Person to Business (P2B) or a Government to Person (G2P) transaction.
Luckily for PSPs, one thing is clear – customer experience is a priority! As domestic transactions become faster, cheaper and more convenient, expectations on cross-border payments are also high. Today’s cross-border transactions are difficult to trace and therefore difficult to predict settlement times. Same day payments are rare in cross-border transactions and in comparison, extremely regular in domestic payment environments. Costs are always higher in cross-border transactions and transparency around the cost is often non-existence. Payers want to know how much their fees will cost before making the transaction.
When I talk about financial inclusion here, I mean, access to the financial system by people and businesses. I have already written a little about access to financial services for SMEs here. Cross-border payments are not always hugely inclusive to individuals either. In countries where access to a bank account is low, for example, not everyone will be able to make cross-border transactions.
Fortunately, there has already been some progress in this area with mobile payments, e-wallets, digital currencies and advanced KYC and AML compliance.
Compliance is a challenge for PSPs. Cross-border payments, involving different jurisdictions, makes keeping up with the regulatory environment very time consuming and costly. There may also be uncertainty when interpreting regulation that could lead to non-compliance. This may lead to some PSPs choosing not to offer cross-border transactions and those that do will increase restrictions on customers in a cross-border transaction in order to decrease risk. These restrictions are more likely to hit SMEs and individuals not on the financial system.
Issues arise when the payer’s PSP provides information that does not correspond or is in a format not understood by the payees PSP. Manual processes (and therefore increased costs) are left to pick up the slack that would easily be fixed by a common standard format.
Because there is still difficulty in creating a cross-border payment messaging standard, this means information needs to be translated from machine to machine. ISO 20022 is an international payment messaging standard which has aimed to create cross-border message standards and increase the efficiency of cross-border payments. At present, ISO 20022 has been adopted by 70 countries so there is still much work to be done. Central banks and governments have a role to play in encouraging this adoption through regulation.
Front and back-end providers are set up to accept funds in one currency and make payments in another but this function is dependent on the arrangements in place. The back-end arrangements determine how funds received are converted, how they’re held, where conversion occurs (i.e. by service provider or by intermediary) and how risks are managed. For example, exchange rates could change unfavourably from the moment the pay is initiated to the moment it is settled.
Banks often offer additional Know Your Customer (KYC) and Customer Due Diligence (CDD) checks in accordance with the local regulation but there is still so much fraud in the financial system, it’s clear that these processes are not working that well – more on that here. Banks struggle with getting the balance right between over-checking a customer’s credentials and not checking enough. The customer experience is important and parties in the transaction are only willing to give up so much data and convenience to the process. We know that the more the transaction is worth, the more due diligence is required and accepted by the parties but there is still a way to go in understanding the best path forward. Regulations like AML5 in the EU are helping to prevent fraud and terrorist financing in the EU but do not solve global problems.
Individuals are getting accustom to the faster and cheaper payment transactions of their domestic region; they now expect these same conveniences when it comes to cross-border transactions. While there are some technological innovations being made to improve the speed, efficiency and cost, there is still some way to go before user experience is really as improved as it is for domestic payments. One of those, will be global adoption of the ISO 20022 standard and a global standard for identification.
SMEs and those without a bank account in developing nations are not fully benefiting from the cross-border payment ecosystem. SME customers face higher fees and longer transactions times while those without bank accounts lack access to the front-end service providers. Better services and mobile payment technology may hold solutions to both of these issues.
While I did not attempt to provide any real solutions to the challenges facing our cross-border payment ecosystem, I feel obliged to highlight the important role that Legal Entity Identifiers will play. The recent news about vLEIs has encouraged me to think about a missing element to cross-border payments so far, the digital identity. As electronic payment transfers go from bank to PSP to foreign exchange to PSP and back to the bank, all players will need to be trusted to accept and send payment messages. Legal Entity Identifiers would be required for all entities involved in the transactions (banks, PSPs etc) but vLEIs can also be issued to individuals by their bank or government and used to create transaction records on a distributed ledger. This would enhance traceability and transparency of the financial system.
In addition, the LEI is in itself, a standard for identity (ISO 17442) and has been incorporated into the ISO 20022 standard for payment messaging. Using the LEI can help reduce the cost associated with manual fixing of inconsistent messaging formats across borders and help to speed up time to settlement.
If you’d like to learn more about Legal Entity Identifiers, visit our guide here.
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