A correspondent bank is a financial institution that provides banking services on behalf of another financial institution. Correspondent banking is essential for cross-border transactions in the legacy banking system and is a critical component of the existing global payment system. Through correspondent banking relationships, banks can provide cross-border payment services to their customers and access financial services in different jurisdictions.
The MT103 is a SWIFT message format used for making payments.
“Banks have traditionally maintained broad networks of correspondent banking relationships, but there are growing indications that this situation might be changing. In particular, some banks providing these services are reducing the number of relationships they maintain and are establishing few new ones.”
— – Bank for International Settlements
According to the Bank for International Settlements (BIS), banks are cutting back on correspondent relationships due to the rising costs of regulatory compliance, specifically in light of the Know Your Customers’ Customer (KYCC) rules, and the uncertainty about how far customer due diligence should go.
Correspondent banking risks can also soar due to compliance penalties, possible reputational damage, and high cost, so banks opt to cut back on the correspondent bank services, BIS explained in its report, by the Committee on Payments and Market Infrastructures.
Bob Werner, the global head of financial crime compliance at HSBC Holdings, states that more comprehensive customer due diligence is required, including more physical visits, examining bills of lading, and probing questions that are more intrusive.
According to SWIFT, the increasing cost of regulatory compliance is among every banker’s top concerns, having to comply with regulations such as Anti-Money Laundering (AML) and Know Your Customer (KYC), Basel III, Dodd-Frank, FINCEN, FACTA and the European Payments Council (SEPA).
In an independent industry report, global consulting and technology company Accenture estimates that AML compliance-related expenditures have risen by more than 50% over the last three years.
In an separate survey, from global audit and advisory firm KPMG in 2014, not only has the cost of AML compliance increased, but it shows no signs of slowing down in the near future.
“Seventy-eight percent of survey respondents reported increases in their total investment in AML activity, with 74 percent also predicting further increases in AML investment over the next three years.”
— – KPMG
These compliance efforts are clearly costly, which is why banks have scaled down certain lines of business where risks outweigh rewards, and correspondent banking often falls into that category. The cost is not the only problem, there is also rising competition among banks as well as non-bank establishments.
“Competition in the correspondent banking market is hotting up…There is also the possibility of large nonbank organisations deciding to offer cross-border payment services to companies, in competition with global and regional banks. The likes of PayPal, Apple, Amazon and Google have already entered the retail payments market. The corporate payments market could be next. Banks must be mindful of such emerging competition.”
— – Deutsche Bank
The Society for Worldwide Interbank Financial Telecommunication (SWIFT), is perhaps in the most precarious, although deeply entrenched, position. Banks around the world are able to communicate instructions to each other using the SWIFT money transfer network, an inherent part of correspondent banking market.
SWIFT codes are unique to each member bank, and are used by to send fund transfer instructions to each other. Once an instruction is loaded into the SWIFT system, and conveyed to the other institution, the funds are either transferred from a correspondent bank or, in the event that the sending bank has accounts at the receiving bank, it’s done through the institution’s own accounts.
Founded in 1973, the messaging network has reduced some of the risks involved with money transfers and has also increased the speed with which they can be performed.
Bitcoin, by its very nature, negates the need for payment networks like SWIFT. If everybody is using the blockchain to transmit money, common sense would dictate that there will be less demand for a slower and less-efficient system.
“The current SWIFT system will be replaced but it won’t be replaced with private blockchains in another SWIFT-like cartel nor will it be replaced with a SWIFT-administered blockchain.”
— – Jon Matonis, former Director of the Bitcoin Foundation
However, SWIFT has demonstrated some initiative on this point. The member owned payment network giant has been investigating blockchain technology, and even Bitcoin, for quite some time. The company has offered grants for blockchain research, as well as supporting Fintech startups through Innotribe.
Most recently, SWIFT announced a global payments innovation initiative “to dramatically improve the customer experience in correspondent banking by increasing the speed, transparency and predictability of cross-border payments.”
“This initiative is an important first step in driving cross-border payments innovation. As part of the initiative we will continue to develop new and enhanced services, utilising SWIFT’s Innotribe initiative to further engage the FinTech community and explore the application of innovations such as real time payment status tracking, the use of peer-to-peer messaging and blockchain technology.”
— – Wim Raymaekers, SWIFT Head of Banking Markets
According to the society, correspondent banking is the most important channel for cross-border payments. The latest published data revealed that 67% of the total volume of customer payments were settled bank-to-bank, through correspondent banking relationships.
“Correspondent banking serves the industry with millions of secure cross-border payments day in, day out; with this initiative we are building on those strengths, enabling banks to provide distinctive cross-border payments services and providing real benefits to end customers. This is a critical step in cross-border payments innovation.”
— – Gottfried Leibbrandt, SWIFT CEO
As the global leader, connecting more than 10,800 banking organizations, securities institutions, and corporate customers in more than 200 countries and territories, SWIFT is clearly in the best position to provide a blockchain solution to the correspondent banking problem.
“SWIFT’s role is two-fold. The company provides the proprietary communications platform, products and services that allow customers to connect and exchange financial information securely and reliably. They also act as the catalyst that brings the financial community together to work collaboratively to shape market practice, define standards and consider solutions to issues of mutual interest.”
— – SWIFT
With the new initiative, SWIFT sees the potential of using the blockchain to help the correspondent banking problem. According to an independent report by global management consulting firm the Boston Consulting Group (BCG), banks are unlikely to be able to establish a standardised blockchain network on their own.
Many large investment banks, such as Goldman Sachs, Credit Suisse, UBS, and JP Morgan, have tried to utilize the blockchain on their own, as well as supporting efforts of other independent startups such as R3CEV, in order to develop universal standards for the new technology.
However, BCG believes that a third party infrastructure player is better positioned to take advantage of this space, and deliver a new standard in cross-border payments.
SWIFT already works closely with the ISO standardization body and payments industry forums, such as the Payments Market Practice Group (PMPG) and SEPA, to define standards and best market practices in the payments business.
“This global payments innovation initiative is a reflection of the strength of the SWIFT community and its ability to collaborate and innovate, and deliver a new benchmark in cross-border payments.”
— – Yawar Shah, SWIFT Chairman
This new cross-border payments initiative will operate on SWIFT’s secure global platform. Financial institutions that are SWIFT members, and adhere to its business rules as outlined in multilateral service level agreements (SLAs), can participate. Initially, it will focus on business-to-business payments service supported by participating banks, starting in early 2016.
Designed to address end-customer needs, “the new service will help corporates grow their international business, improve supplier relationships, and achieve greater treasury efficiencies,” without compromising banks’ abilities to meet their compliance obligations, market, credit and liquidity risk requirements, according to SWIFT. Corporates will enjoy “enhanced payments service directly from their banks, with the following key features: Same day use of funds, Transparency and predictability of fees, End-to-end payments tracking, Transfer of rich payment information.”
In an interview with The Finanser, Leibbrandt revealed that cross-border transaction can be vastly improved. A consumer pays a bank between $5 to $50 for a cross-border transaction, but the SWIFT message costs only about $0.04. “I think there’s also room for the banks to look at the whole correspondent banking value chain, and see if there are ways to do that more efficiently,” which is one reason why SWIFT is looking into the blockchain for a solution.
“We’re looking at the blockchain technology, keeping a very close eye on it. If there is a way to improve the service we provide to the banks with that new technology, then we will use it. We are absolutely on it.”
— – Leibbrandt
Leibbrandt further indicated that SWIFT is not opposed to using the blockchain, if it can improve on the existing system, and more importantly SWIFT is working with banks to get them on board.
“Is there a way to change the business layers of correspondent banking with this technology [blockchain], and thereby reduce the cost and the friction to the consumer? That is something we are working with the banks to explore.”
— – Leibbrandt
The initial pilot will focus on cross-border payments for corporates. Then SWIFT plans to incorporate additional innovations and deploy new technologies as part of the global payments innovation initiative. SWIFT unveiled that it will work together with the industry to define additional service level agreements aimed at servicing other client groups. This will further reduce the costs and frictions arising from compliance, liquidity and processing efficiency for cross-border payments.