Technology disrupting finance is a narrative that’s existed for a long time.
The dream has always been for Tech to digitise financial services, increase access, reduce concentration risks, and improve customer experience.
Lately, we have heard a lot about how blockchain is going to fix banking… In this article, I’ll tell you how it’s not.

Have you ever made a payment cross border before? Maybe it was to a friend, or maybe you wanted to buy something online that you couldn’t get in your local country.
If you used a credit card, the experience was probably quite pleasant… However I am sure you probably felt like the payment cost a little more than it should have, but it’s fine, you did it anyway because it was worth it to you.
Now have you ever made a bank transfer cross border? I’m willing to bet it wasn’t half as easy as the card payment. I’m willing to bet it took a couple of days to arrive and it also was slightly more expensive than you expected?
That’s the current world of cross border payments!

Now, let’s investigate where do all those extra fees come from and why does it take so long.

Where do all those extra fees come from?
When making a cross border payment, you are charged a fee for the transaction and you are given a slightly worse exchange rate, where the difference between the rate you were given and the real rate goes straight to the forex providers bottom line. 
Why does it take so long?
Simply put, bank settlement is slow… and it’s slightly more complicated than simply sending money from one bank to the next.
I’ll let you in on a little secret… Your funds don’t actually ever leave your bank!

How do the traditional settlement systems really work?

  • Corresponding bank agreements:

Most banks will have accounts with one another.
In the image above, we can see that the blue bank has an account with the purple bank and vice versa. In reality there are a few issues with this, first being that each bank will need to have an account with every other bank otherwise they would need to route this transaction through a number of different banks before it reaches the desired account, adding cost and time delays.

  • Deferred net settlement:

This very similar to corresponding bank agreements, except there is a 3rd party that is included in the middle to keep things honest and make the process work a little smoother.
The biggest problem with this type of arrangement is the word “deferred”. As this indicates transactions don’t happen instantaneously, they are processed as batches overnight and the balances are settled.
The downsides to this are amplified in the case of banks doing forex or cross border transactions between other international banks where the window for risk can be open for a minimum of 2 days, and that’s excluding any local exchange control approval, where each foreign transaction is recorded and analysed to make sure the reason for the transaction is documented and that it’s not a fraudulent transaction.

  • Real-time gross settlement:

These are systems that allow real-time movements of funds between accounts held by banks at their respective central banks. It’s structured very similarly to deferred net settlement, except it makes use of a service to settle funds near instantaneously…
Most banking apps will give you the option for “instant payment” option that costs like $2.10 (£1,60) for instant clearing. That’s prompting your bank to make a RTGS payment instead of a batch payment.

The problems with this system:

As we saw on the image above, this is quite a complex system and it’s almost surprising that it all works together.
A recent excerpt from a CPMI report by the world’s central banks concludes that greater choice and diversity in interbank payment systems may be the key to quicker, cheaper cross-border payments for businesses involved in international trade.
Small and large companies tend to emphasize different problems with cross-border payments.
Indeed, large corporate users, which tend to make high-value international wire transfers, note a lack of transparency, including transparency of forex rates.
While smaller businesses, which usually send smaller payments, also experience transparency problems, but they place a much higher priority on concerns about access to services and the costs of sending cross-border payments.

What are the problems of the traditional settlement system?

In essence, it comes down to a few major things:

  • Cost – Sending individual messages across interbank settlement networks is expensive, so banks opt to batch their transactions in order to save on these costs/ prevent having to pass them onto the customer. This is partly because the majority of these clearing systems are highly monopolised…
  • Transactions are slow – it’s important to note that this is not only a technology problem but a commercial problem. Because it costs so much to use the real-time payment processing, transactions are handled in batches. Batches are dealt with on a daily basis which adds a time delay for local transactions.
  • Trust – There is a level of trust required between counterparties, especially in the case of international transactions to be sure that the transaction has reached finality and can’t be reversed before making funds available to a customer. Utilizing trusted 3rd parties mitigates this, but once again comes at a cost.
  • Transparency – There is little transparency around the fees that the client may pay, there is even less transparency around the specific forex rate you are getting and you also have very little transparency into when your funds will arrive on the other side.

The report also highlights this disconnect between the innovation in payment front-end providers and the traditional methods used for back-end settlement.
For example, if we look at apps like Revolut or Standard Bank’s forex product Shyft, these apps have been a step in the right direction to making cross border payments much easier for users. The process for users is very simple, however, users are still faced with the usual delays and costs that come with the territory of cross border payments.
Correspondent banks have traditionally fared best with a low volume of high-value transactions; today’s growing volume of transactions can bog down traditional correspondent banking networks.

What can be done to solve this?

The CPMI report suggests this problem could be solved if more choices were available for the back end, improving efficiency by “matching different users to providers that focus on their needs.”
More alternatives for back-end settlement are emerging with the potential to improve the overall efficiency of cross-border payments.
These include interconnections between domestic payment infrastructures, expansion of closed-loop proprietary systems across borders, and peer-to-peer payments based on the blockchain, also known as distributed ledger technology (DLT).
While blockchains are not the fastest way to move data, they are a great way to facilitate trustless transactions as they are publicly auditable, global by design and tamperproof.

A recent survey released by IBM states:
“69 percent of banks admitted that they have issues with the existing cross-border financial infrastructure. 54 percent of them believed Central Bank Digital Currency could improve the cost, speed, and resiliency of cross-border payments once deployed.
Among the respondents, 38 percent of the central banks were already researching a CBDC solution, while the others were not active in the space.”

It’s all about universal value

Central banks continue to maintain their distance from Bitcoin but have shown interests in issuing their private digital currencies.
For example, the South African Reserve Bank (SARB) ran a POC to assess the viability and use case of blockchain inside the Reserve Bank as a RTGS solution.
They communicated that “the results show that the typical daily volume of the South African payments system could be processed in less than two hours (70,000) with full confidentiality of transactions and settlement finality. Transactions were processed within two seconds, across a network of geographically distributed nodes, with distributed consensus providing the requisite resilience. The SARB was able to view the details of all the transactions to allow for regulatory oversight.” The SARB are continuing to pursue active development in this space.

Another example of banks exploring blockchain is JP Morgan recently announcing their very own stable coin called JPM coin.
JP morgan believe that JPM Coin can yield significant benefits for blockchain banking applications by reducing clients’ counterparty and settlement risk, decreasing capital requirements and enabling instant value transfer.
There has been great discussion around whether a central bank digital currency should be pegged to a single sovereign currency or a basket of assets.
Responses indicated a central bank-issued fiat-pegged digital token as the likeliest outcome, which would have no significant implication on existing monetary policies and still keep the door open to integrate with traditional payment and settlement systems.
If we look at blockchains outside of the constraints of a central bank settlement solution, we can see that this technology has really thrived in 3rd world countries whose national financial system is in turmoil.

In Venezuela, cryptocurrencies are enabling local businesses to own, transact and store something of value that isn’t at the whim of an unstable government, which devalued the bolivar by 95% on Aug. 20.

In Africa, cryptocurrencies are aiding cross-border payments, helping businesses expand across the fastest-growing continent by population.

On the BTCGhana platform, users can make Bitcoin purchases through established exchange platforms and can, within minutes, send the payment to local remittance platforms, including TigoCash, Airtel Money and MTN Mobile Money. This service allows African users to pick up cash at local remittance outlets with ease, without having to deal with complex withdrawal and deposit methods involving bank accounts and credit cards, which are difficult and time-consuming to obtain.

US based cryptocurrency exchange Paxful recently built its second school in Rwanda which is funded entirely by donated Bitcoins through the #BuiltWithBitcoin campaign.

Buying and selling cryptocurrencies anywhere in the world has universal value. It’s digital, it’s p2p [peer-to-peer], and it doesn’t rely on a banking system or government. You can argue that, in a place like Venezuela, in many ways, it’s more valuable and more portable.
With the bolivar plunging, Venezuela has been called a “perfect storm” for cryptocurrency adoption.

16% percent of global remittances are now conducted using cryptocurrency, almost double the previous year.

When money is sent to countries within Africa using traditional financial methods, “super-taxes” are often incurred – especially when sending money within the continent. A remittance going from South Africa to Malawi could see fees upwards of 20 percent, for example.

But what does this mean for the banking ecosystem?

With the rise of smartphone penetration and the internet, cryptocurrency has made it easier than ever for the unbanked to move their funds across borders without the need of a 3rd party, there are services that allow people to barter cryptocurrencies for cash, gift cards, paypal, skrill, Alipay, M-pesa, airtel money etc.

Binance, one of the world’s largest cryptocurrency exchanges launched in Uganda in November last year. Within the first week, they had over 40,000 people sign up to buy cryptocurrencies. Binance partnered with the local mobile network operators to allow users to buy cryptocurrencies with their funds in the MNO’s payment system. These users didn’t even have bank accounts.

Where will banks exist in this ecosystem?

In the short term, I believe many banks might benefit from experimenting with blockchain technology, not by using it to optimise their existing processes, but by building complementary products that leverage the technology in new ways.
Banking are offerings most likely going to need to become quite compelling in order to persuade users to continue using them after cryptocurrency adoption has become more widespread and mainstream as holders of crypto are already able to access financial services without ever touching a bank. Some real-life examples are:

Stablecoins: a consumer can self-access a stable value index collateralized by fiat or other digital forms of value. Depending on the country this person lives in, this can be a significant upgrade over the local currency.

Lending: a consumer can self- access loans by pledging digital collateral.

Asset management: a customer can self-access funds/portfolios tracking a variety of new and traditional underliers (e.g. utility tokens, tokenised securities, wrapped Bitcoin, etc).

Derivatives: a consumer can self-access derivative markets to create long/short positions on various outcomes. These can be for risk management or leveraged trades.

Banks can leverage their reputations to offer cryptocurrency services to their customer bases, whether they supply crypto or securely hold their clients crypto, there are a few banks that have already gone this route such as VPE bank in Germany and Bank Frick in Liechtenstein.

Stablecoins will play a big role in interbank settlement in the near future as well as de-risking day to day crypto payments from fluctuations.

In the mid to longer term – I don’t believe that blockchain will slot into existing banking and cross border settlement processes to make them work better, I think it would fundamentally shift the way that people transact with each other, everything in the world is becoming simpler and easier for people thanks to technology.
At the end of the day, the consumer will be the winner.