Traditional ways of making cross-border payments
Originally, people transferred money to another country in one of three ways: by carrying physical cash across borders, by using acquaintances or couriers to move the money on their behalf, or by using informal trust-based broker networks (such as hawala) to transfer the money without physical money movement. However, these methods posed problems – they were inefficient, unreliable, risky, and often costly. It took 100 years before major advances enabled effective cross-border payments on a global scale.
Let’s see how international payments developed in the modern era.
The development of communication network and messaging standards
In the early 1930s, the German postal service developed the first major Telex network of teleprinters, which enabled the electronic transfer of written messages. Banks could use it to communicate with their counterparts overseas to settle transactions. As a result, Telex became the primary tool to facilitate international money transfers in the developed world until the 1970s.
In 1973, 239 banks from 15 countries came together to develop an even better medium – the Society for Worldwide Interbank Financial Telecommunication (SWIFT). Based in Belgium, SWIFT established a common language and model for payments data across the globe, which, since then, has served as the default network for communication related to cross-border transactions. Today, SWIFT is used by more than 11,000 financial institutions across over 200 countries and territories globally.
The emergence of correspondent banking relationships
However, communication networks alone did not solve the other prerequisite for making reliable cross-border payments – a way to transfer funds between disconnected systems. As currencies are closed-loop systems, banks had no way to move money from a domestic payment system in one country to another. As a result, financial institutions developed a new funding mechanism to solve this challenge: correspondent banking.
If Bank A in one country wants to transfer money to Bank B in another country, each needs to hold an account at their counterpart. During an international transaction, there is no physical movement of funds. Instead, bankers credit accounts in one jurisdiction and debit the corresponding amount in the other. A problem arises when banks want to make international payments to all countries and all banks globally. For this to succeed, they would either need to set up their own branches everywhere or have thousands of direct relationships and hundreds of accounts to manage. Yet, only a few of the world’s largest international banks come close to achieving this, and even they constantly struggle with the multitude of challenges of local requirements from a technology, infrastructure, and regulatory perspective.
Faced with painful impracticalities, banks often need to transact with intermediaries, also known as correspondent banks. In some cases, more than one correspondent bank can be involved in the process – especially when moving money to and from emerging markets. But as the number of correspondents in the chain increases, the transaction time and costs rise too.
This combination of the SWIFT communication network and correspondent banking relationships has been the go-to method for moving money across borders over the last 40 years. This is the reason why more than 80-90% of cross-border payments revenue is still captured by banks. Although it remains practical for the majority of corporate transactions, the model is not economical, especially for lower value transactions. As such, there is an influx of non-bank providers who are increasingly focusing on making bigger inroads to address the growing SME and consumer…