In this blog we find out what everyone is talking about when we say payment rails. We look at how value actually moves, and what are the differences between low-value and high-value payment rails.
How does money move?
We pay and get paid on a daily basis but few people understand how money – or value – is actually moved around. Looked at simply, value moves through accounts and account relationships.
Let’s take a straightforward example: Paul needs to transfer 100 euros from his account with Bank A to Sarah’s account with Bank B.
But why would Bank B credit Sarah’s account with 100 euros just because Bank A instructs it to do so.?
For this money transfer to work, Bank A must have an account with Bank B that is holding more money than it wants to transfer. Now, Bank A can tell Bank B: “Please debit my account by 100 euros and credit Sarah’s account with 100 euros.” At the same time, Bank A debits 100 euros from Paul’s account, to recoup the funds it has released to Sarah’s account at Bank B on Paul’s behalf.
What are payment rails?
Obviously, it is not possible for banks to have accounts with every other bank, therefore, there are institutions which act as aggregators or intermediaries and connect multiple parties to each other.
At a domestic level, the central bank typically acts as a national intermediary. Every domestic bank has an account with the central bank and through this account and its link to the domestic payment system – called a real time gross settlement system (RTGS) – local banks are able to pay all other local banks.
For cross-border payments, the intermediary role is played by ‘correspondent banks’. As we saw with the example of Paul and Sarah, banks have accounts with other banks in other countries (called nostro and vostro accounts) and use them to facilitate transactions in multiple currencies. In this way, they can leverage the connections of correspondent banks with hundreds of other banks and payment systems worldwide.
To describe this network of connections and technologies linking financial institutions, the term ‘payment rails’ is commonly used. The analogy with railways is a good one. If you look at a railway map, there isn’t always a direct connection between every single city, but all cities can be connected via railway switches and transport hubs, which act as connectors. Similarly with payment rails, financial institutions and intermediaries.
Are the payment rails outdated?
Historically, for cross-border payments, correspondent banks have been the most used payment rails, particularly for high-value payments. These institutions are underpinned by SWIFT as a technology and network provider. In the retail and SME sectors, networks such as credit card providers MasterCard and Visa have built global franchises through worldwide merchant relationships and card technologies. More recently, non-bank financial institutions have turned their sights to the cross-border market, including players such as Currencycloud, Thunes, Wise, Rapyd and Niumetc, first targeting smaller, retail and remittance payments and now moving up the value chain with a focus on SME- and even higher-value payments.
All of them are competing for a piece of the large and growing cross-border payments business. According to the Boston Consulting Group, the value of cross-border payments is expected to increase from almost $150 trillion in 2017 to more than $250 trillion by 2027. This equates to a rise of more than $100 trillion in only 10 years.
As technological and business innovations help to move money more efficiently, some argue that new developments such as cryptocurrencies or wallet schemes mean there is no longer a need for money to be moved using the same network of relationships between correspondent banks or intermediaries.
This may be true within a closed-loop environment. Imagine if we were ALL customers of Bank A, then there would be no need for Bank A to have accounts or relationships with other banks to facilitate our transactions. But as soon as we want to do business with a customer of Bank B, or a customer of Bank C in another country, then the closed-loop breaks. So, unless every bank or business belongs to the same payment system, or use the same currency, databases and technology, we will have to interoperate with other environments (countries, currencies, systems, etc) and we will need those connectors and intermediaries to facilitate our transactions.
Cross-border payment rails essentials
When selecting the right payment rails to use, five essential dimensions must be considered:
- Counterparty risk: am I comfortable to entrust this provider with my money and data?
- Compliance obligations: does this provider enable me to meet my compliance obligations? An essential point is to be able to identify and screen counterparties to a transaction – i.e. the customers sending and receiving the funds.
- Service level: what can I expect from this provider?
o How many currencies/corridors are covered?
o What is the level of reporting and transparency that I receive?
o How fast does it process payments, and what is the level of certainty on the outcome?
o What is the arrangement in terms of liquidity – pre-funded, credit line, etc.?
- Operational excellence: the integration with the provider must be light and easy, but also resilient and reliable. Issues always arise in cross-border payments and there must be strong exception and investigation processes.
- Pricing: How competitive, transparent and predictable is the pricing?
It is somewhere within or across these five dimensions that new entrants look to disrupt the existing payment rails and players.
High-value payment rails across borders
Cross-border payment rails were originally designed and used only for high-value payments. Historically, those transactions have largely been payments in US dollars because the bulk of global trade and investments are denominated in US dollar. Slowly, global trade is diversifying away from the dollar and usage of other currencies, including the euro and the renminbi, are growing for high-value transactions.
For high-value payments, the payment rails generally consist of two or more correspondent banks depending on the currency, jurisdictions and other requirements, transacted via global messaging network SWIFT. The cross-border market is necessarily more complex than the domestic. Payments may cross time-zones, be subject to local currency controls and compliance checks, or come up against legacy domestic banking infrastructure such as batch processing. These factors can add friction to the payment process and may lead to delay or the need for repairs. Nonetheless, this model continues to work well for the bulk of payments. Initiatives such as SWIFT gpi have brought valuable enhancements to the cross-border market making payments faster, more transparent and fully traceable for payers and beneficiaries.
Using a unique end-to-end identifier in each gpi payment (the UETR), SWIFT gpi has been able to provide greater granularity on the performance of cross-border payments, which reveals that they are generally faster than most people think and that the biggest impediments to speed are regulatory barriers and currency controls.
• 92% of gpi cross-border payments are credited to the beneficiary’s account within 24 hours;
• The number of intermediaries plays no significant role in the payment speed;
• The main culprit for slower payments is local currency controls. When countries with regulatory barriers and capital controls are excluded, then almost 50% of gpi payments arrive in less than 30 minutes.
But even while there are many initiatives to improve the efficiency of high-value transactions, the biggest disruptive forces in cross-border payments are being felt in the low-value space.
Small is beautiful
Low-value or micro-payments experience different pressures than high-value, and these are shaping patterns of innovation and competition.
First, low-value payments are made more in local currencies than high-value transactions (which are concentrated in the currencies of commodities and trading, largely the dollar, euro and the renminbi). Think of an expense claim, the reimbursement for someone’s gift, the payment for a purchase on an e-commerce platform, or a worker’s remittance. These kinds of smaller payments are made in the local currency of the recipient.
Second, the low-value payment market is much more price sensitive. Given that costs represent a much higher proportion of a low-value payment, payers need to be certain in advance what the charges will be, exactly how much will be debited from their account and how much will be credited at the other end.
Perhaps the most important driver is the fact that cross-border payments are seeing the biggest growth. A recent report from MasterCard shows that this growth in cross-border flows is driven by remittances, e-commerce, SMEs and the service economy.
It’s therefore understandable that most new entrants are focusing their firepower on low-value transactions in the consumer-to-consumer (C2C), business-to-consumer (B2C) and business-to-business (B2B) segments, believing this space is currently underserved by banks and traditional payment providers. According to a report from EY, it is particularly low-value transactions from, to, and between emerging markets that offer the highest potential for disruption, driven by changing consumer behaviour, increased trade with emerging markets and rising financial inclusion.
Micro-payments via Correspondent Banking
We’ve seen that correspondent banking works well for high-value payments, but does it work as well for micro-payments?
Some banks have found ways to tailor their correspondent banking execution model. For example, SWIFT Go, is a new service from SWIFT and a group of correspondent banks that builds on the success of SWIFT gpi. The service promises to enable banks to offer their SME and retail customers predictable, fast, secure and competitively priced low-value payments anywhere in the world and is seen as the international banks fight back against fintechs and other PSPs in this low-value space.
But there are limitations to how such models may work. To come back to our railway analogy, new high-speed and high-performance rail tracks are taking shape for cross-border micro-payments, however, such investment only makes commercial sense for routes with high traffic. In Japan, for example, the famous Shinkansen was only built between big cities. For the rest, travellers must revert to the regular trains.
Similarly, it may be economically viable for large banks to re-design their network of correspondent banks to support micro-payments in their top 5-10 corridors but may not be so for the rest. The 80/20 rule usually applies: 20% of the payment corridors (eg, dollar-sterling; dollar-euro etc) generate 80% of the volumes (or profit). Servicing the remaining 80% of the corridors that only generate 20% of the volumes may not be straightforward.
The challenge of scaling low-value payment offerings economically is even more pronounced for smaller institutions, of which there are many globally.
Who will take up this business opportunity?
This means there is a real opportunity for aggregators that can help financial institutions and payment providers to reach the range of markets and currencies that meet the needs of low-value payment customers.
Some correspondent banks might find it an attractive niche. Fintechs, large and small, have already moved in that space. The acquisition of Currencycloud by Visa for £700 million, and Thunes total funding of $130 million demonstrate that the industry sees value in this payment vertical.
The other future trend is the interlinking of real-time payment systems, as proposed by the Nexus project from the BIS. This set-up also has the potential to transform cross-border low-value payments.
In conclusion, cross-border payments are following a similar trajectory with payment rails providers racing to deliver instant cross-border payments.
One thing is certain, disruption is taking place in that space and customers will feel the benefit.