Why cross-border payments remain expensive

Transferring money from one person to another is relatively easy if you are in physical proximity, in the same time zone or national financial system.

But what if your counterparty is halfway around the world?

We no longer transport gold bullion in ships from one continent to another to settle bills, running the risk of shipwreck or piracy.

But even in the electronic payment era, geographical distance continues to create particular challenges.

The sums at risk when a small German private bank called Herstatt failed in the mid-1970s—the collapse led to losses of around $620m—are dwarfed by the trillion-dollar bailouts that followed later financial crises.

Herstatt had made bad bets on the direction of the US dollar

But the Herstatt case still has particular relevance for anyone involved in cross-border payments.

In June 1974 the global economy was in trouble as a result of a fourfold spike in the price of oil during the previous year, following the 1973 Arab/Israeli conflict.

Currency volatility had soared as a result of the oil crisis and following the US government’s abandonment of the dollar’s link to gold in 1971.

Herstatt had made bad bets on the direction of the US dollar and ran up losses that exceeded its capital by more than ten times, causing local financial regulators to intervene.

The German authorities forced Herstatt to close at the end of the local banking day, 4:30pm in Frankfurt, on 26 June.

This decision made sense from a local perspective, but it caused an international crisis.

The US banks involved in foreign exchange (FX) transactions with Herstatt had already paid deutschemarks to the bank during German business hours, believing they would receive US dollars later the same day in their US bank accounts in New York.

A challenge when FX settlement occurs at different points in time and space

But following the bank’s sudden closure, the six-hour time lag between German and US East coast business hours left Herstatt’s American counterparties unable to collect their payments. The default then led to a cascade of failed payments at banks around the world.

By highlighting the risks involved when the two legs to a financial transaction are settled at different points in time and space, the Herstatt case led to major reforms in the international financial system.

The wish to avoid so-called Herstatt risk was the driving force behind the creation of the Basel Committee on Banking Supervision (BCBS), which sets prudential standards for the global banking system. The BCBS is part of the Bank for International Settlements (BIS).

And the Herstatt case led to the worldwide implementation of real-time gross settlement (RTGS) systems, usually run by national central banks.

RTGS systems ensure that payments between one counterparty and another are simultaneous, executed in real-time and final (in other words, they cannot be revoked).

But there’s no global RTGS system and payments are only certain to be matched against each other in real time at a national (or in the case of the eurozone, regional) level.

There is a system in place to reduce settlement risks between nations and across time zones, however. The safety of the global foreign exchange market depends on a network run by CLS bank, a private sector institution owned by the largest currency-trading banks.

CLS reduces settlement risk by netting individual banks’ payments to each other via its own accounts at individual central banks around the world.

However, CLS still faces some physical constraints in its own ability to net off trades.

Its daily settlement cycle operates only during a five-hour window when the RTGS systems in each settlement currency’s jurisdiction are open and able to make and receive payments.

If CLS failed, the systemic impact would be colossal. CLS settled a mind-boggling $11trn of FX trades on 21 June 2017, its record trading day,

Unsurprisingly, the bank has been designated a systemically important entity by global financial regulators, a label that incurs extra scrutiny by the global financial system’s police force, the G20 Financial Stability Board.

Remittances still cost an average of 7.1 percent of the money sent

But the constraints involved in transferring value through space, which are set by geography and physics, continue to make the global payments market relatively inefficient and, for some users, expensive.

Globally, the World Bank estimates that remittances still cost an average of 7.1 percent of the money sent. This is a direct tax on the hundreds of millions of migrants using the remittance system, whose money flows totalled $575bn in 2016.

These inefficiencies in the global payments system continue to attract a host of new technologies that are attempting to make money transfers faster, cheaper and safer.

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