Layered Money
Figuring out what our financial system actually looks like
From the first post in this series, we’ve so far gone through what a progressive financial ecosystem looks like and why we would want to be part of one. I also started to touch on a very specific approach I’ve been working on along these lines, on the idea of creating a new “challenger bank”.
To fully appreciate how this works though, we would need to have an understanding of how the financial system is currently setup, and where the “hooking in” points are for anyone exploring fintech solutions.
In this second piece, we will look at unraveling the local financial landscape. Understanding this landscape would then help me to explain the reasoning behind some of the approaches I’ve taken so far in implementing the idea.
Redefining what “bank” means
Before we even get started, the first thing we need to do is understand what exactly it is we mean by the word “bank”.
There are official definitions of what a bank is, and the expectedly onerous licensing & regulation that comes with that, but that’s not what we’re referring to… at least not quite yet.
For our purposes, a “bank” would be the thing that gives our users access to basic financial services and a few nice extras, in a way that competes with what traditional banks offer.
This is why we chose to go the route of a “challenger bank” over the other options available to us. As mentioned in the previous post, challenger banks are lighter versions of full banks that choose to tackle some small portion of the entire range of services offered by a full bank. They:
- work under different licensing arrangements
- have different capitalization and compliance requirements, and
- often rely on more established financial institutions to enable access to the financial infrastructure of a given jurisdiction.
This last point is the key element to figuring out what a potential challenger bank looks like.
What access can the planned challenger bank get to the financial system, and how autonomous is that access?
Is the access direct, or does it have to be through an intermediary?
To properly appreciate these questions, we would first need to understand what our local financial infrastructure looks like. If you’ve ever wondered “how does my money actually work?”, the following section is for you!
The T&T Financial Landscape
The financial infrastructure of a place generally refers to the set of networks, institutions and regulations that allow for:
- the pooling of capital, and
- the flow of capital
The best way to understand how these two things interact is to take a layered approach when looking at the whole system.
A Layered Approach
In most financial systems, this infrastructure gets built out via the layered approach mentioned above. What this looks like is, the top-level layers are reserved for high-value & infrequent transactions while the lower levels accommodate scale and are used for more lower-value but frequent transactions. The levels are usually inter-related too, where lower levels build off the higher ones through some form of aggregation.
The design that emerges is that progressively larger numbers of transactions are conducted on lower level layers and then are netted off and settled by some appropriate layer above them.
In T&T, what this ends up looking like is that we have our Central Bank sitting at the top of everything, the commercial banks sitting below this, and then the various payment networks (Linx, Visa, Mastercard etc.) sitting between the banks. Finally as fintechs come online, we will start to see these new entities form a layer below the banks.
Pooling Capital
Capital usually sits at rest in special institutions licensed to operate within our system. These institutions act as store houses where individuals, businesses and larger organization can safely hold their funds and use them in different ways.
For simplicity, we will only be looking at the pooling of liquid capital, or more colloquially, money.
The types of financial institutions we are interested in are:
- The Central Bank
- Commercial Banks, Credit Unions & NBFIs
- E-money Issuers (fintechs)
The Central Bank
Central Bank accounts sit at the top of the liquid capital stack (money supply) in most financial systems. Accounts held at the Central Bank are used as reserves for commercial banks and large institutions. The money held in these accounts is special “high quality” money that is accepted by all institutions in the financial system, since it sits closest to the money creation process.
What this means is that all institutions are willing to accept this Central Bank money for settlement, as opposed to commercial bank money that is usually only useful within a single given bank. For example, money within Scotiabank can be thought of as created by Scotiabank under license from the Central Bank. This is an important point. Commercial bank money is not the same as Central Bank money. If Scotiabank needs to settle a liability with Republic Bank, Republic Bank would much prefer to receive “Central Bank money” than “Scotiabank money”.
Given this, these accounts at the Central Bank are usually used to facilitate high value transfers between large institutions. The Central Bank can literally be considered as the “banker of banks”.
Note: physical cash is also considered as “Central Bank money”, and so withdrawing cash at a Scotiabank ATM for example is really an exchange of “Scotiabank money” for “Central Bank money”.
Commercial Banks and other institutions
These banks are licensed entities that are allowed to take and hold deposits for any individuals and institutions from the general public. Commercial banks facilitate the scaling of “capital pooling” by being able to service a much broader range of lower value customers. For context, this is required because the Central Bank would not have the capacity to manage accounts for individuals and institutions within its own internal systems.
From this perspective, commercial bank accounts are a layer below the reserve accounts that each commercial bank holds at the Central Bank. Their layer facilitates being able to offer deposit accounts to a wider proportion of the public than a Central Bank could directly.
Note: Interestingly, with the advent of Central Bank Digital Currencies (CBDCs), the broader public is effectively being given access to direct reserve accounts at the Central Bank. CBDCs are a scaling solution for Central Bank reserve accounts, which has interesting implications for the future role of commercial banks as these systems develop past their early implementations.
E-money Issuers
These are entities specially licensed to take customer deposits via a commercial bank. There are many variations of this license in different jurisdictions, but the essence of it is that institutions can be licensed to do some subset of what a bank does. The benefit of this more restricted license is that the requirements (capitalization, compliance etc.) are usually less onerous than those for becoming a full bank.
In Trinidad & Tobago, e-money issuers (EMIs) are allowed to hold deposits on behalf of customers, but these deposits must be backed by funds held at one or more commercial banks. The intention is that these EMIs can then turn around and offer deposit/transfer services in even more scalable ways by leveraging internet/mobile technologies to reach end users.
From our “layered” perspective, what this ends up looking like is that “EMI Money” is backed by reserves in “commercial bank money” which in turn are backed by reserves in “Central Bank money”, with each successive layer being able to reach a broader audience in more flexible and scalable ways.
Flow of capital
With pooling capital now covered, we will now look at the flow of capital.
The flow of capital speaks to how money can move through the different pools among individuals, businesses, organisations and government. There are a series of pipes and tubes of different shapes and sizes that facilitate this movement.
You can think of these as much like the plumbing you would come across in a home or building that facilitates the flow of water.
Clearance and settlement
To understand how money flows through the system we would first quickly need to understand the concepts of “clearance” and “settlement”. In a very simple way, clearance is the process by which an institution checks whether funds are available for transfer, and it also sometimes involves the pre-emptive updating of balances before funds have actually moved. Settlement on the other hand, is the process by which funds actually move from one place to another.
Money transfer networks
The major networks/systems we are interested in are:
Local
- RTGS
- ACH
- Linx
International
- Visa/Mastercard
- Forex
Local Flows
RTGS
Layer 1 network
This is the “big player” of the clearance and settlement game. The RTGS system refers to the set of accounts held at the Central Bank. This system is optimised for fast settlement (hence the name Real Time Gross Settlement) and it is usually reserved for very large transfers that need to both clear and settle very quickly. RTGS transfers are usually reserved for amounts above $500,000 and transfers settle with almost immediate finality. The money held in these accounts is “Central Bank money” and RTGS only deals with the transfer of this type of money internally within the Central Bank.
This quick settlement is unique to RTGS where there is, in theory, no clearance process for transfers. For every other type of transfer though, there is a much wider gap between clearance and settlement, with clearance happening pretty quickly but settlement taking many days, weeks, and in some cases months!
ACH
Layer 2 network
This system runs one level down from the RTGS system and is the mechanism by which banks handle smaller transaction between user accounts both internally and across banks.
ACH, or Automated Clearing House, is the messaging layer banks use to pass clearance messages around. These messages are collected and netted off against each other, and various account balances are updated to reflect these changes.
Note: funds between different banks usually haven’t settled yet at this point.
Then at a later time, banks would take their buckets of net transactions and compare them with the other banks to reconcile who owes whom. The RTGS is then used to do these large reconciliation transactions and at this point all balances can usually be considered confirmed.
Transactions within the same bank usually happen fairly quickly (within 24 hours), but transactions across banks are apparently trickier and can sometimes take days to reflect in the receiving party’s account, likely when all ACH checks/balances and the actual settlement process via RTGS have been completed and been reconciled.
For more technical folks, this was a great series on how ACH works from a developer perspective.
Linx
Layer 2 network
This system also runs one level down from the RTGS system and is the mechanism by which users may make payments (generate payment messages) from Point-of-Sale terminals.
A transaction in this case consists of a user inputting their card at a terminal and authenticating it with their PIN number. At this point, a payment message which consists of the PIN and the transaction amount are sent along to the bank for confirmation over the Linx network. Once all looks well, the bank sends back a message to the merchant’s terminal and the transaction is approved. Clearance is completed at this point.
The rest of the transaction after this then looks similar to how it would look after clearance happens with an ACH transaction. Batches of transactions are collected and netted off, and then after some time balances across banks are reconciled (likely via the RTGS) at which point the transaction would be considered settled. There are apparently varying experiences on when transactions actually get reflected on sending and receiving ends from hours to days, as with ACH as well.
International Flows
With these systems, we start to get to the point where we will be departing from the local RTGS system and instead will be switching to the international correspondent banking system.
Within this system, our local banks have a direct relationship with banks in the US and instead of holding “Central Bank TTD Money” in reserve accounts at the Central Bank, they now hold “USD Money” in nostro accounts at a foreign bank.
Visa/Mastercard
Layer 2 network (international)
A transaction in this system can happen either at a point of sale terminal or through an online payment portal. As with the Linx system, there is an authorisation step when the customer inputs their payment details where the card details and account balances must be checked. This messaging usually happens through an international payment processor via the respective card networks (Visa/Mastercard networks).
Settlement within these systems looks a lot different though since they happen in some foreign currency like the USD instead of via TTD and local systems. When it comes time for settlement, SWIFT payments denominated in foreign currencies are usually sent by the local banks to some intermediary bank where Visa/Mastercard would then manage the netting via the correspondent banking network. Again this system carries its own nuances for clearance and settlement that are outside the scope of this post, but suffice it to say that settlement is then considered to be complete at this point via a foreign currency transaction.
Note: there is a local-only International Debit option that looks a lot like the Linx system, except messages are handled by the Visa/Mastercard networks instead of the Linx network. This also applies to local-to-local credit card transactions.
Forex
Bridge layer
When it comes to considering international transactions, foreign exchange currencies become a vital tool in bridging our local networks to international ones, with the most prevalent currency being the US Dollar.
TT Dollars only have money-ness within Trinidad & Tobago and are virtually worthless outside our borders. This extends to the various payment networks we have locally that run only on TT Dollars. What this means is that to access foreign payment networks and engage in international commerce, local entities must first be able to exchange their TT Dollars for US Dollars via some form of a local currency market.
The liquidity & depth of these local markets then represent the effective capacity of our bridges to foreign payment networks and international commerce.
If the bridge is too small, or if it heavily favours only one direction then this introduces significant friction to our being able to interact with the outside world financially. The efficient operation of markets for TTD-USD exchange, while not a formal payment network or institution in itself, is a vital element of our national payments landscape when we consider the extent to which we interact with foreign institutions and services in today’s world.
Foreign exchange availability is a critical infrastructure element.
Interfacing with the T&T landscape
With the entire landscape now properly laid out, our next challenge now would be to figure out how best to attack the problem of getting robust access to it for my potential solutions. Some key considerations for this would be looking at the level of licensing & due diligence required for each approach, how robust/risky the approach is, and how reliant I would be on forming partnerships that are outside the current core business functions of potential partners.
My requirements for an ideal access strategy would be:
- access to foreign payments
- some mechanism for on/off-ramping to my chosen system from TTD held at a commercial bank
Non-viable routes
The following are options I ruled out when thinking though this access problem:
- Commercial banking license
Local ACH, Linx | Int’l Visa/Mastercard access
This point is stating the obvious, but a commercial banking license is far too demanding to pursue for our planned approach. - Commercial banking partnership
Local ACH, Linx | Int’l Visa/Mastercard access
While a viable option in theory, in practice we decided that there would likely be significant friction with this approach.
Firstly, the banks have showed a slowness in being able to successfully adopt/integrate tech-based solutions.
Also, in our experience, a conversation with them that involves working with a potential competitor will likely be a tricky one even though there could be strong synergies, as we have seen from similar partnerships in other places. - Credit Union license/partnership
Local ACH, Linx | Local Visa/Mastercard access
While less onerous than a banking license/partnership, this would still require significant legwork and co-ordination with a large number of persons to setup. This also likely only gives us access to the local financial system which wouldn’t be ideal for our intended strategy. There could also be complications around how we would work with “users” since this setup likely means they would need to become members of the Credit Union.
Interestingly on this point, there was once an initiative by the folks at Paywise to form an “e-commerce co-operative” as a way to get access to the local financial system in a similar way. For various reasons that approach never panned out.
The Visa/Mastercard route
Based on everything so far, it becomes apparent why I decided that trying to secure a Visa/Mastercard prepaid card program would be ideal to bootstrap our intended service. It gives us the required international access, it gives us ready-made systems for iterating quickly with, and it likely is a much lighter route regulations-wise than any of the other available options so far.
Working with a Visa/Mastercard program denominated in USD is tricky though as it would require us to consider how TTD deposits can be converted to USD or vice versa and sent to/from the card.
We would also need to consider whether the infrastructure that a Visa/Mastercard program provides is self-contained enough that we would be able to work off of their licenses, or whether we would need to pursue an E-Money Issuer license locally to be able to implement some of the custody & transfer mechanisms that we’re thinking about.
Diving deeper into exploring these options gets more into the territory of understanding how Visa/Mastercard programs work and all the things they offer, which I plan to explore in the next post in this series.
The Series:
Useful links & references
- T&T Banking Legal Framework: https://www.central-bank.org.tt/about/legal-framework
- Directory of licensed institutions in T&T: https://www.central-bank.org.tt/core-functions/supervision/banking-sector (also documented by TTIFC)
- T&T Payments System Overview: https://www.central-bank.org.tt/sites/default/files/page-file-uploads/The Payments System In Trinidad %26 Tobago.pdf
- A presentation for the new Draft Payment Systems Bill: https://www.central-bank.org.tt/sites/default/files/latest-news/presentation-payment-system-webinar.pdf
