Chapter 2 - The unseen network powering global transactions

For Treasurers, CFOs and traders orchestrating high-value international payments, understanding the intricacies of the financial infrastructure is critical. This article delves into the world of correspondent banking, its role in global transactions, and the evolving landscape of cross-border payment systems.

In today’s interconnected global economy, moving large sums of money across borders is a fundamental necessity for businesses of all sizes. Whether facilitating acquisitions, managing supply chains, or investing in foreign markets, Treasurers, CFOs and traders rely heavily on a complex network of financial institutions and mechanisms. At the heart of this system lies correspondent banking, a cornerstone of international finance that facilitates cross-border payments.

Correspondent Banking: The Backbone of Global Transactions

Correspondent banking refers to a banking relationship between two financial institute, where one bank (the “Local Bank”) provides banking services to another bank (the “Foreign Bank”), allowing the foreign bank to access financial services.

?How it Works

Let's imagine a scenario where a US-based company wants to pay a supplier in Japan or Germany or even in India. (See the animation file)

Initiation:?The US company instructs its bank (the "originating bank") to send a specific amount to the Japanese supplier's bank account.

1. Correspondent Network:?The originating bank, lacking a direct relationship with the Japanese bank, leverages its network of correspondent banks. It identifies a correspondent bank that has an existing relationship with the beneficiary bank in Japan.
2. Currency Exchange:?Often, a currency exchange is involved. The US dollars are converted to Japanese Yen, Euro or INR, usually at an agreed-upon exchange rate and if currency is volatile then Financial institute exchange the currency against USD.
3. Final Settlement:?The correspondent bank in Japan receives the funds in Yen and facilitates the final credit to the beneficiary supplier's account at the Japanese bank.

As an illustration ( flow 2 in the animation), in the scenario above, Bank of America or their partner Bank will open a Nostro account (a local currency account) with SMBC in JPY. As and when they make payments to a Japanese supplier, they will instruct SMBC (via SWIFT MT103) to credit the beneficiary, allowing SMBC to access the local clearing rail and transfer the JPY to the ultimate beneficiary.

Correspondent banking has an important role in the clearing and settlement of international payments. Clearing is the process of confirming and reconciling the details of a transaction between the sending and receiving banks, whereas settlement is the actual transfer of funds from the originating bank to the beneficiary bank.

Corresponding Banks utilize various messaging system and modes to settle cross-border payments ,which are detailed below.

Society for Worldwide Interbank Financial Telecommunication (SWIFT):?The most widely used system, SWIFT, acts as a messaging system, securely transmitting payment orders and confirmations between banks globally.        

Local Clearing Systems:?Many countries have their domestic clearing systems that are optimized for transactions within their borders, and they generally communicate via MT, MX, or custom messaging.        

Emerging Fintech Solutions:?Fintech companies are disrupting traditional models with blockchain-based solutions and other innovations focused on speed and cost-efficiency.        

API Banking: Application Programming Interface is becoming more popular and can be substituted with the other methods mentioned above for cross border payments.        

Central Bank Digital Currencies (CBDCs): Digital form of a currency is a new norm for settlement for Cross Border Payments and trade transactions.        

In Conclusion

Businesses and Consumers dealing with high-value international payments, navigating the world of correspondent banking, clearing, and settlement is essential for success in the global marketplace. By staying informed about the evolving landscape of financial technology and regulatory frameworks, businesses can optimize their cross-border payment processes, mitigate risks, and seize opportunities in our increasingly interconnected world.

The future of global clearing and settlement is dynamic and full of possibilities. While traditional systems will continue to play a role soon, the emergence of real-time payments, blockchain, CBDCs, and other innovations promises to reshape the landscape significantly. By embracing change, fostering collaboration, and prioritizing security and efficiency, the industry can unlock faster, cheaper, and more accessible cross-border payments for all.

Stay Tuned (teaser for upcoming articles)

• Payment Rails: Mapping the Journey of a Transaction:?Follow the path of a payment from initiation to settlement, uncovering the key players and processes involved.
• Case Studies: Real-World Success Stories:?Discover how businesses can leverage the optimum way to streamline payments, reduce costs, and mitigate risks.
• The Future of Payments: Embracing Innovation:?Explore emerging trends like CBDCs, blockchain, and their potential to reshape the global financial landscape.
• Fintech disruption in Traditional Banking: FinTech has revolutionized banking by introducing solutions that bring value to consumers, Fintech’s agility disrupting the Traditional Bank significance.

PS : All of the captured information, including the names of financial institutes, is for illustration and educational purposes only, and it is my own opinion.