Correspondent banking and beyond

Feature | 21 September 2017

Is the current correspondent banking model broken?
Even if not, in an era of derisking and shrinking correspondent networks, it may not be helping trade being financed. Katharine Morton looks at where we are now, where we can go and what the model could look like in 20 years' time

Every generation has its vision of what the future looks like, but when we look back at that vision, it often looks more like a reflection of that generation. Who can forget those communicators in the 1960s Star Trek that became the template for Motorola's iconic cell phone or that DeLorean in Back to the Future? Building for that future often means creating bolt-on visions to the present and visions of the future can soon look dated.

How we got here

How companies that trade reconcile their bought and sold ledgers with the nominal ledger is the core of double entry bookkeeping that was the vision of the future of the 15th century1. Banks work in a paradoxical, upside down way - their assets are really liabilities and their liabilities are really their assets, and unlike a company which is buying and selling many different things in the real world, the bank must have bilateral relationships. That is the core of correspondent banking. There must be some party in the chain who you can trust, or sue when things go wrong.

Not for the first time, there's a big difference between companies who trade and the banks which once used to trade on behalf of their clients and now often trade simply for themselves. And bolted on top of that is the arduous business of complying with the increasingly complex and convoluted world of regulation. If we were starting with a clean sheet of paper to build the future of correspondent banking, we wouldn't be starting from here.

"I wouldn't say that the correspondent banking model is broken", says Huny Garg, head of trade and supply chain at SWIFT. "It continues to play a fundamental role in supporting international trade, finance, commerce and the payments industry (see interview on page 16). However, it is also clear that a number of correspondent banks have chosen to restrict or terminate their relationships with local banks in a number of markets. This is driven by concerns around KYC, financial crime and regulatory compliance. If we can address these issues, we will see this trend reversing."

Christian Westerhaus, head of product and strategy, institutional cash management at Deutsche Bank, says correspondent banking "forms the cornerstone of global trade and has done for centuries. The fact is, there is no existing alternative in place to support trade finance and cash payment flows in addition to the needs of today's digital economy."

The settlement mechanism that underpins the network - nostro-vostro accounts held by correspondent banks, remains much the same as it has been in the past 40 years of operation of SWIFT. For sure, things have got bigger and faster.

Paula da Silva, head of transaction services at SEB says, "It's a comprehensive chain from A to Z and most of the players pride themselves as being at the peak of the chain but the customers themselves have to go to many fragmented parts of the industry in and outside banking to, say, finance invoices, get LCs, customs, ask for bank guarantees, etc. It's cumbersome for companies to trade across borders and we banks haven't facilitated that as an industry."

Da Silva adds, "New players start their business idea from a customer perspective, alleviating customer pain points. Banks have had 400 years starting with something within the bank and moving it out to customers, never end-to-end. SWIFT is an example of between bank-to-bank solutions. It perfects and perfects and perfects within SWIFT.

SWIFT has had a fantastic model between banks - one-to-many and many-to-one, and companies have to find ways to connect to their banks, all segmented. It's a brilliant idea but has never been an end-to-end solution to payments and that's one area it's been losing ground."

Gpi shaking up the model?

Martin Schlageter, head of treasury operations at Roche in Switzerland gained his insights into the world of correspondent banking in his role as one of several corporates invited to join the global payments innovation (gpi) initiative in the background to give feedback. "Initially, banks demanded to have this as a bank-only development, but SWIFT had this idea that this must be something that adds value for the corporate world as well. They wanted to make sure that whatever they developed, together with the banks, was not disconnected from what the end corporates expect."

And that divergence in expectations is becoming ever clearer. Developments in the retail spectrum with instant payments settling through various channels online, anywhere, anytime, contrasts with the correspondent experience. "You have correspondent banking, which is completely not transparent, which is slow, which is costly. Where you still work the same way you worked 20 years ago, where you're trying to figure out by e-mail why a payment has a delay, where it's stuck, where the fee is taken. It is a backwards experience, this is something that has to be changed. Either it has to be completely reorganised, or, like SWIFT is trying to do with gpi, to make improvements, or it will become redundant because other players will come in and some fintechs will develop possibilities to do this differently. Things feel a bit outdated."

Westerhaus at Deutsche sees gpi improving the customer experience in cross-border payments by same-day availability of funds, end-to-end payments tracking in the cloud and transparency of fee structures. "There will be full transparency of the fee structure via updates from each involved bank to the SWIFT gpi cloud. The amount transferred to the seller's account will be known and can be reconciled immediately," he notes.

"If you look at the model from today's perspective, when a cross border payment is effected, the corporate treasurer has not always had a full view on when that payment finally hits the beneficiary, or the final costs associated with that payment. The introduction of SWIFT gpi together with this cloud based solution affords corporates greater transparency and also offers the opportunity to digitise their processes, for example, through tracking services. This initiative will also help to minimise issues with suppliers and reduce financial risks as a result of payment delays."

Schlageter at Roche is concerned that some banks will hesitate to adopt gpi. To that end, he was party to a letter publicising the initiative with SWIFT2. Total transparency is a double-edged sword for banks. While back office processes will help banks find where payments end up and where fees are taken, visibility has its challenges.

"Once you have this transparency, you can see which bank is faster in executing payments, and which bank takes less fees, then you can, of course, start rerouting your payments. You have a basis to improve your payment flow, and I think this is exactly what corporates are looking for."

Not all banks are enthusiasts. "Some are quite hesitant to open this up because they see - first of all, gpi is an investment, maybe they have some payback through their own usage, but once they open this up to the customers, they will definitely be faced with the changing behaviour of corporate customers because they may bypass that particular bank, because they think that they have higher correspondent fees than others."

Bringing on the revolution

Clearly, part of the customer experience from a trade finance perspective is getting access to funds at all (witness the much-quoted US$1.5trn trade finance gap). Does technology have a role in mitigating that?

"The necessity of correspondent banking to facilitate trade is currently the only option we have," says SEB's da Silva. "But for the future, it's too stale and outdated and will not prevail as it is. For banks, it won't be necessary to have 5,000 banking relationships to serve customers around the world. If you have a potential feed with the blockchain, you will need a settlement account with every currency, but that's it. It's currently highly complex and costly for no reason."

Will blockchain and distributed ledger technology (DLT) be the answer (see Rebecca Brace's article on page 36)? "If the 'answer' means replacing the correspondent banking model with blockchain/DLT, then that is somewhat unrealistic, certainly not in the immediate future," says Deutsche's Westerhaus. "Two issues need to be considered here - reach and applicability. In cross-border payments the most important aspect is reach. Even the best technology is limited without it."

"One should not forget the current model has a proven track record certainly in terms of stability, trust and reach. But it can be optimised. This is the beauty of gpi; it combines the network and innovative technology to provide a better cross-border payments experience to the industry as a whole."

Schlageter is glad that SWIFT hasn't waited for blockchain before making its move with gpi. "I couldn't care less if it's blockchain or not as long as I get instant information, updates on where my payments sit. A lot of people are lying back and waiting for blockchain thinking this will revolutionise everything but there's already a bit of a revolution with gpi because you go from lengthy daily, if not weekly, process to get clarification of certain payments, you move to instant information at your fingertips."

What kind of blockchain?

Westerhaus argues that DLT can, however, play an important role in the future in terms of further optimisation of correspondent banking. "Indeed, a number of banks have taken part in the recently launched a proof of concept (PoC) for nostro reconciliation utilising a private permissioned blockchain in a closed user group environment. Deutsche Bank is part of the validation group." However, it is still in the early stages and there remain issues that need clarification in terms of governance and legal framework.

Will we see the end of nostro-vostro with DLT? "That ultimately depends on if DLT establishes itself in the payments space and, if yes, which type of DLT model is used. If an open permission-less system were to be the established model (difficult to imagine at this stage due to potential lack of clear, transparent and predictable governance) then it is possible we would see an end of nostro-vostro as we currently know it," says Westerhaus.

If, however, a private permissioned blockchain in a closed user group environment were to be used such as SWIFT's nostro reconciliation (currently in PoC), then nostro-vostro would still exist, but DLT offers the potential for it to become far more efficient and cheaper. "Again, the advantage of using such a model is that it builds on the existing gpi foundation," Westerhaus says. The SWIFT nostro reconciliation PoC aims to help banks overcome challenges in monitoring and managing their international nostro accounts, which are crucial to the facilitation of cross-border payments.

The key issue with a distributed ledger is that by its definition it is not 'your' ledger - the very nature of a distributed ledger is that there isn't any of the 'ours/yours' of the nostro- vostro reconciliation account3.

Block to the future?

Blockchain has its enthusiasts. Da Silva at SEB is certainly one. "SEB is very active in the blockchain space with payments in production with Ripple. Is correspondent banking needed for that? There will still be an account needed in real money, not in cryptocurrencies, and the nostro-vostro relationship will be needed at some point for that, but it will diminish maybe by tenfold the need for having all kinds of bilateral relationships in, say, the dollar, as you will only need one. There will be a 'landing' account at the end."

Can you put the finger in the chain when it breaks down, that you can know where and who to sue? What does blockchain bring to that? "Let me disagree," says da Silva. "Banks already have huge investigation departments only for payments that go astray. We don't know who to sue now. Even though it should be pretty clear, it's not always. If anything, it's becoming more cumbersome, particularly across borders."

In terms of blockchain, da Silva says, "by itself it's a contract between two parties. Once it's entered [in the blockchain ledger] you can immediately see what payment is expected and if that's wrong, it can be addressed immediately. When its corrected, that's another block in the chain and you can track from a control and audit perspective much more easily.

"It's much better in the blockchain than in ordinary banking, there's no complexity and there's immediate transfer, so there's no people to reconcile. Transfer of title happens in the frame agreement of the blockchain, not in the transaction," Da Silva explains. "Distributed ledger is nobody's property - it's an immediate transfer of information. That means we agree at the get go that I share all the information with you so it goes through the AML, sanctions screening, etc processes before that stage, so there is no settlement or reconciling as such, it's a joint ownership of that data."

"It's a fantastic customer experience for receivers. A dream come true about real time cross border transfer of funds some people say, 'ah, but blockchain isn't regulated', we say 'no, the rules of engagement and expectation between the participants are regulated upfront also it is important to separate payments through blockchain and cryptocurrencies. The most important thing right now is to move funds fast not to use new currencies.

The blockchain in the future will be fantastic and useful in many areas, in the sweet spot between the bank and customer. The contract is in place - not easy - but once it's done, it's done."

Twenty years' time

What is the vision for correspondent banking two decades from now? "I've been in banking a long time and now is the most exciting time. We weren't expecting to be able to send data using phones, costing nothing, videos, etc. And in 20 years' time, it will be totally transparent and many, many times more efficient for customers, with data easily accessible," says da Silva at SEB.

"It won't be the four-corner correspondent banking model of two banks around the world, no transparency, two days to make a payment, 90 days to settle a trade finance deal. It will be more fragmented with more players, crowdfunding, etc, agile processes and a few larger institutions guaranteeing, putting trust into the equation, giving advisory and a lot of non-banks complimenting the banks. It will be different, much more exciting than now."

"Although the correspondent banking model has existed for centuries, change has accelerated quite visibly in the past couple of years, as we have seen by moving to the SWIFT cloud-based solution," notes Westerhaus at Deutsche Bank. "We expect this evolution to continue based on the SWIFT gpi foundation already in place, incorporating where possible potential benefits of technologies such as DLT to optimise efficiency even further." He cautions that no one party can do it all alone. "The fact that we operate with different currencies, regulators in varying jurisdictions and governance rules means it will have to remain a collaborative effort going forward."

Will documented trust still be at the basis of trade in 20 years? Da Silva says, "Trust digitally probably, but absolutely, people will buy trust and advisory, but they won't buy payments processing because that will be built into your purchasing habits, you choose a product and you won't have to pay actively."

Martin Schlageter at Roche sees change within a decade, not 20 years. "In a nutshell," he says, "This correspondent banking world is still a bit of a closed shop between the banks as costly as it is today, I don't think it's sustainable. The correspondent banking model will be completely different, will be much more transparent, and faster, and less costly in 10 years' time than today."

Katharine Morton is editor-in-chief of TFR

  1. Double-entry bookkeeping was either invented by Benedikt Kotruljević in his 1458 in his work: Book on the Art of Trade or by Luca Pacioli in Milan in 1495.

  2. See TFR article, 'Swift's gpi receives backing from six Swiss corporates':

  3. See Irene Mermigidis' blog blockchain's compatibility with modern reporting standards:

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