CROSS BORDER PAYMENT: WHAT IS AND WHAT WILL BE
According to a survey published by Phone Pe and Boston Consulting Group, India’s digital payment market is predicted to more than treble to $10 trillion by 2026. UPI volumes have nearly tripled in the last three years, rising to 46 billion transactions in FY22 from 5 billion in FY19. India has been at the forefront of domestic digital payments.
While the domestic payment ecosystem in India has exploded, the same cannot be said for cross-border payments. Sending money from one country to another country is still challenging due to the primary reason that no bank or financial institution is omnipresent and cross-country transactions involve two or more banks in different regions. Banks generally have a strong presence in one or two geographies, and a limited presence elsewhere in the world. For example, Bank of America earns most of its revenue from US & Canada (close to 70%), and only generates 30% of its revenue from the rest of the world. It’s the same with other banks as well. Due to vastly varying regulations in different parts of the world, geopolitical skirmishes, and unfamiliarity with other regions, every bank’s presence is limited. So, to be able to facilitate cross-border transactions, they rely on chains that connect origin and destination banks with several intermediary banks in between possibly in different countries. This is the correspondent banking model. These chains if become long can cause an increase in cost, delays, repeated checks, the potential to lose data, and sometimes transaction failure. The problems are elaborated below:
1. Fragmented and truncated data formats: To make payments, messages are sent from one financial institution to other for updating sender and recipient accounts. These are concise and structured messages in specified formats like ISO 15022 or ISO 20022 to communicate important info such as receiver, sender, currency, date, etc. The problem is that there are too many formats to choose from and every financial institution has its own preference because its legacy systems are built that way. When messages are communicated from one institution to another a conversion delay is observed if banks use different formats for conveying cross-border transaction info, and banks mostly use different formats. Moreover, banks use internal messaging systems to communicate and update accounts. When a message from outside comes in they must convert that message into the format they use internally so their systems can understand it, which ends up taking more time.
2. Complex processing of compliance checks: Since the payment needs to go through multiple countries it needs to comply with the regulations of every country it passes through. Every country checks the transactions for fraudulent activity. So, genuine payments end up getting checked multiple times for the same issue which adds to the delay. Higher the number of intermediaries, the higher the complexity and delay. Sometimes transactions are incorrectly tagged as fraudulent which takes even more time to resolve.
3. Limited operating hours: Transactions mostly happen when the underlying systems are available and, in most countries, these are aligned to that country’s business hours. For a long chain of transactions, the business hours might not overlap for every step. The pending transactions can take place only when the systems are available again. This could take a while before your transaction reaches its destination.
4. Legacy Technology platforms: Many banks still use legacy systems. They haven’t updated their systems from the time they migrated to electronic transactions from paper-based payment processes. These platforms have serious limitations like a lack of real-time monitoring, low data processing capacity, and reliance on batch processing. For many banks, the cost to upgrade their legacy systems does not justify the benefit from this upgradation and hence they choose to remain on legacy platforms. This becomes a barrier to domestic transactions but even a bigger hindrance to cross-border transactions.
5. High funding costs: Many different third-party entities are engaged in every international money transfer. The hefty fees for a cross-border transaction include a charge added up by every entity for each verification and processing stage in the chain. International conversion rates also come into effect. The average cost for cross-border payments, according to the World Bank, is 7.45% which can go up to 15%. Also, to make transactions quicker banks need to make payments in advance and face currency fluctuations which require capital to cover. It becomes part of the fees they charge.
How Cryptocurrency can help!
You see, the idea behind a payment is simple. I give you money in exchange for the goods or services that you provided me. There’s no need for banks or any other party to get involved. Even if the parties are in different countries, it should be a simple peer-to-peer transaction. But as we have seen, it’s not. The good thing is that governments, startups, and other institutions recognize it. They have been working towards making cross-border payments smoother. The G20 identified improving cross-border payments as a top goal for 2020, giving the long-standing and challenging problem significant global impetus. The possible use of cryptocurrencies was highlighted in their findings.
A cryptocurrency is a type of digital money that is stored on a digital wallet and operates as a means of exchange through a computer network. It is not backed or upheld by any one central organization, such as a bank or government. You could send/receive cryptocurrency from your wallet to/from someone else’s wallet without intermediaries. Cryptocurrency is built on blockchain technology. Blockchain (a chain of blocks) technology is the backbone of cryptocurrencies through which they maintain a decentralized, publicly available, secure ledger (record of transactions). In a blockchain, the previous records in the ledger act as an input to secure later transaction records. So, if you were to change something in a former transaction, it would effectively change all the latter transactions and consequently the ledger. Now, this copy of the ledger would not match other copies on the network and all the records after the changed one will be considered invalid. So, transactions once undertaken are unerasable in the blockchain which is an important security feature. This way blockchain creates a secure chain of transactions. The novelty of a blockchain is that it fosters confidence without the necessity for a reliable third party by ensuring the integrity and security of a record of data. These networks are decentralized (no central or controlling authority), permissionless (anyone can make a transaction), provide short settlement times, and have no intermediaries involved in a P2P transaction, unlike the conventional banking system. Consumer-oriented startups are using well-known blockchain cryptocurrencies, such as Bitcoin (BTC) or Ethereum (ETH), to make sending payments internationally easier. The procedure for cross-border cryptocurrency payments is pretty simple. Suppose you are living in France and want to send money to your friend in Australia. You would first need to find an “on-ramp” service provider. An “on-ramp” service provider lets you exchange your fiat money for an equivalent quantity of cryptocurrency via a bank transfer or a credit card. Then, this cryptocurrency may be kept in a safe digital wallet. Once more, there are several different wallets to pick from, and creating an account is really simple. Once your money is in the digital wallet, it could be transferred instantaneously to your Australian friend’s cryptocurrency wallet. Your friends could transfer the received cryptocurrency back to their bank account using the “off-ramp” service provided by the same service providers or keep it there for future transactions. You could do all of this in a matter of minutes and at a fraction of the cost. No need to wait days for a simple transaction to come through or pay hefty fees for a simple transaction. Now there’s a lot happening behind the scenes like mining, hashing, recording on a ledger, and establishing consensus between users which effectively makes cryptocurrencies very reliable, secure, and publicly available to everyone thereby making cryptocurrencies ideal for cross-border or even domestic transactions.
But why hasn’t this picked up? Many people use cryptocurrencies for regular transactions. There are trading platforms where you could trade in these cryptocurrencies, and many brick-and-mortar stores, and online retailers have started accepting crypto. Some popular ones are Newegg, Overstock, Starbucks, and Twitch. Many cryptocurrencies have become big enough to compete with government-backed currencies. But this practice has been limited to tech-savvy customers only who can use cryptocurrencies on their own. It is still a niche market. There are several other reasons why Cryptocurrencies are still a long way from widespread adoption.
A major one is the lack of support cryptocurrencies receive from the government. Government backing was the pillar that made UPI such a successful initiative in India, but they have not extended their support to cryptocurrencies. Why is that so?
Why have governments shied away from Cryptocurrencies?
You see, traditional currencies like the dollar, the rupee, the euro, the yuan, etc. are subject to the control of governments. To manage the economy, the government uses the monetary policy as a lever. They keep tabs on how money is moving throughout the economy and levies taxes accordingly. They can track illegal or fraudulent activity involving fiat money. The government steers the economy, establishes monetary policy, encourages financial transactions, and influences import-export, by controlling the currency. But since the cryptocurrencies like Bitcoin are of decentralized nature, the government no longer has influence over the monetary system. Because the fundamental technology of bitcoin forbids the use of a central authority for any transaction, the government is powerless to control the flow of money. Cryptocurrencies can circumvent government-imposed capital controls. The governments don’t want this to happen, and they are correct to do so. Cryptocurrencies are very volatile. Since there is no regulating authority in cryptocurrencies, their value is driven only by supply and demand which causes enormous volatility. There have been days when Bitcoin has seen a drop in its value of more than 30%. This type of volatility is undesirable for every stakeholder. As a result, several economies are against bitcoin and other cryptocurrencies.
So, what do we do? Should we abandon the concept of transactions in cryptocurrencies? Blockchain technology has too much potential to be abandoned. Governments understand this and want to ensure that blockchain can be used in the best possible way to ease cross-border payments. So, the issue is how to use the blockchain so that governments can maintain monetary oversight and still allow cryptocurrency-like transactions. The answer is CBDC.
Government’s answer to Cryptocurrencies
CBDCs (Central Bank Digital Currencies) are digital tokens that are issued by a central bank very similar to cryptocurrencies. It’s like real currency sitting in a digital wallet on your phone (not in your bank account). They will be treated as legal tender and can be exchanged one-to-one with the existing currency. They are linked to the value of the fiat money used in that nation to maintain monetary oversight and avoid volatility. Unlike Cryptocurrencies, CBDCs could be designed on a centralized blockchain where only central banks will have the power to issue new currency. CBDCs could also be designed on a digital ledger that is not based on blockchain. Nonblockchain CBDCs have their own benefits like greater scalability. What is best for a country must be decided on a case-to-case basis. There is no one shoe fits all approach. Irrespective of what the CBDC design is, they have several other benefits when it comes to cross-border transactions.
1. For CBDCs, banks will have to start with a clean slate. Every central bank will have to go through the design and development stage. Banks will have the opportunity to consider both international and domestic aspects while designing their CBDCs. For instance, CBDC infrastructures might be made available around the clock, enabling rapid cross-border settlement, and resolving inconsistencies in the operation hours of various countries.
2. They could also make sure that they consider the existing legal and regulatory framework which needs compliance for cross-border transactions.
3. Also, many countries are currently looking towards CBDCs as a solution for solving cross-border transaction issues at the same time. It gives them the opportunity to coordinate their efforts and achieve interoperability between their CBDCs right from the start. It might be more challenging to achieve interoperability once systems have been completely developed and put into use.
4. Furthermore, as payments are made using a direct liability of the central bank, the safest and most liquid settlement asset, this would increase the security of cross-border payments.
5. CBDCs should be and probably would be designed to coexist with and supplement currently available cross-border payment methods. In this scenario, CBDCs would broaden the range of payment options, fostering cross-border resilience, competitiveness, and efficiency.
6. CBDC, if built on blockchain could be augmented with smart contracts that could make conditional payments even easier. In a smart contract, the conditions of the agreement between the buyer and seller are directly encoded into lines of code, making it a self-executing contract. The agreements and underlying code are spread throughout the blockchain network in this case the CBDC network. For example, suppose you stay in India, and you have bought a painting from a vendor in France via Amazon. The agreement between you and the vendor is that you will pay for the painting right away once you have received it. This agreement will be encoded in form of a smart contract when you are placing the order. So, when the painting is delivered by the agent and it has been verified by Amazon that you have received the painting when you sign for it, your account gets debited, the vendor’s account in France gets credited, and Amazon gets its fee for the right amount. All of this happens instantaneously if there is proper interoperability between India’s and France’s CBDCs without involving any intermediaries.
7. Smart contracts embedded into CBDC can also be used as anomaly detection tools for monitoring illegal financing, money laundering, and fraud. CBDCs will always leave a money trail. This will help the government track wrongdoings because they can follow where and how you use the money, but this will give rise to privacy concerns.
In the union budget for 2022–23, Indian Finance minister, Nirmala Sitharaman talked about the launch of Indian CBDC, i.e., Digital Rupee in the financial year 2022–23. Although very little has been disclosed about it, we hope it will disrupt the Indian payment system just like UPI did. You can expect to see new payment firms coming up and offering a digital rupee wallet or existing payments firms adding a digital rupee option in their apps in the next few years.
What can be done to make CBDC successful?
Governments have the most important role to play. First and foremost, they will have to educate people about the benefits of using CBDC. Governments will have to incentivize current and new players to offer CBDC services. Governments will have to figure out the master CBDC in domestic transactions and learn from them to improve cross-border transactions. They will have to ensure that CBDCs are interoperable with the other new CBDCs as well as current payment systems. Privacy concerns will also be needed to be addressed for acceptance and adoption of CBDC. For governments, it could be a chance to offer digital payment services to the unbanked section of society.
Payments are a two-sided market. For it to be successful it needs to be embraced by both consumers as well as merchants. In money matters, most people care about primarily three things — Security, Cost to use, and ease to use.
Security: Individual customers will probably use apps or cards to access their CBDC. Apps must be protected against tampering and manipulation by using cutting-edge security features. There must be solutions like deactivating CBDC wallets temporarily if the need arises. Biometrics and other strong customer authentication (like PSD2 standards in Europe) will have to be deployed to prevent unauthorized access. Features like receiver authentication (like two-factor authentication but better and quicker) need to be ideated so that users don’t feel hesitant sending money using CBDC.
Cost: CBDCs are well sorted on the cost front. Since they are specifically designed to avoid intermediaries and enable P2P transactions, the cost to use CBDC is bound to remain low. We just need to ensure that there are enough players in the market to keep the competition high, and the cost to use the service will fall in line automatically. We will also need to make sure that CBDC is compatible with current devices like mobile phones, POS machines, cards, etc. Customers especially small merchants cannot be expected to buy additional devices to use CBDC. CBDC needs to be designed to be used under currently available infrastructure.
Easy to use: Have you wondered that when you buy something from a Kirana store and transfer the payment from your ICICI Bank account to the shop owner’s SBI Bank account, you are most likely using services like Google Pay, PhonePe, or Paytm which do not hold either of your money rather than UPI apps from ICICI or SBI. That is the beauty of customer experience. Likes of Google Pay, PhonePe, and Paytm have offered a swifter payment experience than retail banks and customers have embraced them by awarding them a giant market share in the Payments industry. Customers tend to gravitate towards services that are easy to use. They’ll even use costlier services in search of a better customer experience. So, to instigate the adoption of CBDC we will have to ensure that CBDC platforms have an excellent customer experience. With CBDC we can also explore transferring payments offline. It could be a game-changer for places with limited or no internet connectivity.
References
1. https://www.phonepe.com/pulse-static-api/v1/static/docs/PhonePe_Pulse_BCG_report.pdf
4. https://ethereum.org/en/developers/docs/smart-contracts/
6. https://www.bankofengland.co.uk/payment-and-settlement/cross-border-payments
7. https://www.cnbctv18.com/cryptocurrency/how-do-crypto-cross-border-payments-work-12922362.htm
8. https://calbizjournal.com/five-reasons-why-the-government-does-not-like-bitcoin/
9. https://www.ibm.com/blogs/internet-of-things/why-central-banks-dislike-cryptocurrencies/
