By Dima Kovalchuk, co-founder at InCrypto
The modern world economy is characterised not only by positive trends, such as globalisation and increasing population mobility in Western countries, but also by negative manifestations: there remains an existing economic imbalance in various regions of the world, as well as labour migration.
However, both of these positive and negative trends contribute to the continuous growth of the need for cross-border payments. What is the state of the industry now, how much does it meet modern realities and requirements and what technological innovations are emerging in the space?
Traditional international payment systems
Today, old technologies such as SWIFT and Western Union still dominate the market for cross-border payments.
SWIFT: the current industry standard
SWIFT (Society for Worldwide Interbank Financial Telecommunications) provides a network that allows financial institutions around the world to send and receive information about financial transactions in a safe, standardised and secure environment.
The society is an international cooperative founded in 1973 (almost half a century ago). Until now, the majority of international interbank communication has been carried out through SWIFT channels. Today, SWIFT links more than 10,000 financial institutions in more than 200 countries around the world. In fact, today the syntax of the interbank SWIFT messenger is the industry standard for financial communication, and the system itself is the main way for making cross-border payments by most financial institutions.
SWIFT transmits financial messages with a high degree of security, but does not keep money accounts of members nor conduct any clearing between them. Also, the system does not make the actual transfer of funds: it sends payment orders that must be repaid through correspondent accounts (nostro accounts) opened in each of the SWIFT members’ financial institutions. Thus, in order to exchange banking operations, every financial institution must have a banking relationship, either by being a bank itself or by linking itself with one or more of the banks.
Thus, every financial institution or bank that wants to be able to make payments in any country is forced to have nostro accounts in one or several banks and in the appropriate currency.
In the 2000s, SWIFT switched to an infrastructure based on IP technology, which replaced its old infrastructure based on the X.25 standard.
The main disadvantages of the SWIFT system are slow transfer speeds (usually up to several business days), high commissions (which can range from tens to thousands of dollars), and the likelihood of errors.
Feeling the increasing pressure of competitors, especially those like Ripple (see below), the organisation is attempting to address these problems. Recently, the introduction of new standards – SWIFT gpi – has begun, making the network faster, more transparent and allowing for somewhat lower cross-border transfer fees.
However, these new standards still rely on old infrastructure and principles, and are not as disrupting as the newer competitive systems. In particular, if SWIFT gpi allows one to reduce the speed of transactions from several business days to up to one day, then transactions in the Ripple network, for instance, take seconds.
Western Union: a dinosaur of cross-border payments
One of the oldest American communication and financial companies, which appeared in the 1850s. From the late 19th until the mid 20th century, Western Union was a monopolist in the American telegraph services market and the first communications business empire that had a huge impact on the whole telecom industry. The company also played a role in the early stages of creating computer networks, and of what later became the internet.
In the 1980s, due to falling profits and related financial problems, Western Union began the transition from telecommunications to the business of cross-border payments. This transition finally ended after 19 years, in the mid-2000s.
Since then, Western Union has been specialising in cross-border P2P payments. To do this, the sender must come to one of the WU offices and present the funds including a fee (which may vary depending on the urgency of the payment, as well as the location of the sender and recipient), state his/her name and address, as well as the name of the recipient and the destination of the payment.
Further, Western Union provides the sender with a 10-digit MTCN (Money Transfer Control Number), which the latter must give to the recipient. The recipient at the destination must come to the local WU office, provide the MTCN number as well as documents confirming his identity, after which he will be given cash. In some countries, to receive a payment MTCN is not required and it is enough to confirm the identity of the recipient.
One can also use the Western Union’s website to send funds.
Overall, Western Union’s cross-border payment service is fairly straightforward and traditional in form. This, plus the fact that the recipient in most cases can immediately obtain cash, is to WU’s credit.
At the same time, the service is characterised by a relatively slow transfer rate of funds, as well as high transfer fees. In addition, there have been many complaints about money laundering and fraudulent schemes using the service. Moreover, the WU system specialises only in the transfer of small P2P payments by individuals.
PayPal: a well-established new generation
This American company, founded in 1998, is the leader in the field of online payments and money transfers both between individuals and between customers and businesses. The service is massively used by vendors, online auctions and many other commercial users as one (and often the main) payment method.
According to one of the founders of PayPal, the initial mission of the company was to create a world currency independent of banks and governments (that is, something similar to what was later declared by the creators of cryptocurrencies). However, PayPal failed in this mission due to pressure from investors who demanded the early launch of a working product.
In essence, therefore, PayPal has become little more than an electronic equivalent of the traditional paper means of payment – checks and payment orders. This largely determined the success of the company, but did not bring something fundamentally new to the sphere of payments and finance in general.
Stripe: a young competitor
A California company founded in 2010, Stripe is one of PayPal’s main competitors, and generally focuses on the same audience (e-commerce, small business, online merchants, end customers) while providing similar services. Stripe and PayPal fees are also broadly similar.
At the same time, Stripe is more customisable, which makes it more attractive for those who have a corresponding need, as well as resources for this.
Traditional P2P digital systems
When digital technologies took over the world and invaded our everyday life and business, many long-mooted ideas and systems got a chance to flourish in the form of their more efficient digital counterparts. For example, payment P2P systems.
TransferWise and others: classic ideas and modern technologies
An Estonian company (headquartered in the UK), founded in 2011 by financial consultant Kristo Käärmann and the first Skype employee Taavet Hinrikus. Skype at the dawn of its existence was one of the first P2P messengers, so TransferWise uses a similar principle for making cross-border payments between people.
Unlike the traditional method of transferring money from sender to recipient, TransferWise uses the process of matching the amount that a particular recipient wants to send with the amounts of other users wishing to send money in the opposite direction. After that, these pools of funds are used for payments to the appropriate recipients in local currency. Thus, money does not actually cross borders and is not subject to standard currency exchange.
In fact, TransferWise uses the principles of the hawala money transfer system known since the Middle Ages, but adding to it the network (P2P) component, which has the effect of making it less centralised.
The main advantage of this system is the savings for the user compared to conventional bank transfers, wherein people can lose up to 5% of the amount transferred, sometimes even more. First, the transaction fee is significantly less than ordinary bank fees (about 0.5% of the transfer amount). Second, users do not lose on currency exchange, because virtual exchange takes place at the average market rate, without a spread of buying and selling currencies on which banks usually earn extra money when making cross-border and trans-currency transfers.
Today, TransferWise is a relatively small network: 4 million users who transfer about 4 billion dollars a month. The network supports more than 750 currency routes around the world.
It should be noted that there are similar services with comparable functionality: CurrencyFair and TransferGo among them. There is also TransferMate, which uses a similar principle but for making B2B payments.
Cryptocurrencies (primarily Bitcoin) were originally created as a decentralised response to the contemporary banking system, with all its flaws (including high fees and slow transfer of value).
Bitcoin: a new hope?
Speaking about Bitcoin here, we can bear in mind many similar cryptocurrencies (altcoins) that do not have specific applications, except, in fact, being a currency itself (as opposed to currencies like ETH or XRP, which have their own utility within their own projects and/or ecosystems).
In fact, it can be argued that cross-border payments are precisely the main Bitcoin use case. However, over time we have learned that cryptocurrencies themselves are not immune to such shortcomings: due to the growing adoption of Bitcoin and its price surge, we faced a slowdown in transaction speed and an increase in transfer fees, which rendered Bitcoin poorly suited for micropayments.
In spite of this, cryptocurrencies remain a generally more attractive alternative for cross-border payments than traditional systems and services. Even the slowest Bitcoin payment at the peak of its network load is often much faster than most cross-border payments in the traditional banking system. Plus, cryptocurrencies and their ecosystems have a number of other advantages compared to fiat money and legacy finance.
Nevertheless, Bitcoin is increasingly losing the monetary function as a means of circulation, becoming a kind of “digital gold” (the store of value function). This, together with high transfer fees (that tend to climb even higher with an increase in the price of Bitcoin itself) and the limited scalability of blockchain-based systems, makes Bitcoin one of the possible, but less convenient, means for making cross-border payments.
Ripple: new challenger to the old throne
The original idea of Ripple was conceived in 2004-2005 by Ryan Fugger. The concept was to enable individuals and communities to create local money based on trust.
In 2011, Jed McCaleb from eDonkey – the peer-to-peer network – developed the idea, further embodied by Arthur Britto and David Schwartz, in the form of a payment system in which the validity of transactions was confirmed by general consensus of network members, and didn’t rely on mining as “classical” cryptocurrencies do, which made the system, among other things, more energy-efficient and speedy.
In 2012-13, Ripple Labs developed the Ripple payment protocol, which provides direct exchange between counterparties. This protocol was intended to eliminate bank fees and significantly increase transaction speed. It also launched its own cryptocurrency – XRP, which is today one of the top three cryptocurrencies by market capitalisation.
After that, the company began to move further away from Ryan Fugger’s initial idea and concentrate on providing cross-border payment services for the banking sector. Starting from 2015, the first financial institutions began to show a practical interest in the Ripple system, integrating it into their own systems, or experimenting with it.
Today Ripple provides banks with a more progressive alternative to the SWIFT system (see above). In fact, Ripple set itself the goal of essentially replacing SWIFT with its own services. To support this aim, the company had to make its system more centralised and controlled, which is clearer and more convenient for traditional financial institutions.
In this case, turning to the native Ripple’s cryptocurrency – XRP – is optional when using the Ripple banking services. However, its use may provide additional benefits, such as eliminating the need to use nostro accounts (thus saving on fees), as well as avoiding losses on intermediate currency exchanges.
It should be noted that most banks – even those that have integrated Ripple – are in no hurry to deploy XRP. The main concern for them is the significant volatility of cryptocurrencies (where XRP is no exception), because it can potentially lead to significant losses in the course of a single transaction.
Thus, Ripple today is in fact a more progressive alternative to the SWIFT cross-border payment system, which focuses primarily on banks and other traditional financial institutions.
Nevertheless, the question of whether Ripple will become an industrial (or at least a de facto) standard in this area remains open.
World Wire (Stellar + IBM): competition does not sleep
In March 2019, IBM announced the “limited launch” of World Wire, a global payment system uniting banks using the Stellar digital asset network. This announcement focused mainly on cross-border payments, and six international banks signed an agreement of intent to create “stablecoins” (digital currencies with volatility close to zero) for use in the system. Only two currencies are circulating on the World Wire network at the moment: Stellar Lumens (XLM) and Stronghold USD, which is a stablecoin backed by reserves in US dollars.
The World Wire functioning model is very similar to the current Ripple model (see above): this is a modern high-speed and more cost-effective alternative to SWIFT, which easily integrates with existing banking technologies, and where the cryptocurrency component performs the fiat exchange function for currencies.
That being said, there are a number of differences between World Wire and Ripple. If the latter relies on local crypto exchanges in each country for the exchange of crypto assets for fiat currencies, World Wire offers a real-time market making feature using Stellar’s built-in distributed currency market.
But an even more noteworthy difference is that World Wire offers traditional financial organisations a fairly convincing answer to their concerns about the price volatility of the cryptocurrency component of the system: namely, the use of a stablecoin (or even digital currencies that may be released by central banks in the future), which Ripple cannot yet offer.
Although cryptocurrencies are often labelled the future of the financial world, it should be said that this future is available already. But being based on distributed ledger technology (blockchain), they do have a number of disadvantages, such as limited scalability and difficulty (or missing) interoperability with other blockchain and non-blockchain systems. The answer to these problems could be off-chain solutions.
GEO Protocol: The future of the Internet of Value
GEO Protocol is a young but novel project that is only a few years old. In April 2019 it attracted its first international investments. The company is developing an open-source protocol solution for the future “Internet of Value” – a global financial analogue of the conventional Internet, which should unite all possible “local” networks for creation, transfer and exchange of value: banks, payment systems, exchanges, asset registries, cryptocurrencies, etc.
GEO Protocol develops Ryan Fugger’s original idea, from which Ripple pivoted in order to serve the traditional banking system (see above), but with certain technological differences.
In particular, the protocol is not based on blockchain and general consensus. It is an off-chain, blockchain-agnostic solution based onlocal consensus, which makes the GEO network much more decentralised than any blockchain-based system, not to mention the traditional super-centralised banking system.
This, in particular, allows it not only to overcome the natural limitations of blockchain systems (low scalability), but also to serve as a link between them, just as the IP protocol connects all possible digital systems into a single global network.
Thus, instant cross-border, multi-hop, multi-equivalent payments without bank charges is one of the main attractions of this innovative technology. Already today, there is GEO Pay – a small payment system which members can use to send fee-free payments to each other, thereby bypassing banks.
GEO Protocol also allows one to create and exchange equivalents of any asset (including non-digital), as well as create local currencies.
In all likelihood, the revolution of the global financial system – which many people have predicted and are eagerly anticipating – will start with cross-border payments. As we have demonstrated, there are already many solutions to this problem. Only time will tell which of them will become the catalyst that takes the world of finance to the next level.