The way people/Institutes send money from one country to another has not dramatically changed since the 1970s. Despite the advent of the internet and digital tools like Cryptography, Blockchain, sending money across the world is still complicated. For example, there is no still visibility on what occurs during the process, and settlements can take multiple days and are usually very costly. In this article, we will look into the pain points of the present day’s Cross-border transactions and how On-Demand Liquidity is becoming the sole savior.
What is Liquidity?
In general terms, Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. For instance: cash, trade debtors, trade creditors, and most bank loans. This takes into account the credibility and price of each instrument throughout a transaction. Country-specific regulations and currencies play a significant role while assessing liquidity for international or cross-border transactions. Exchanging one currency for another introduces a price and time variance that could impact pricing on each side of the exchange. This erodes the stability of the transaction, therefore, the liquidity and increases risk and cost. As a result, financial institutions must hold multiple pre-funded Nostro [1] accounts on each side of a transaction in that country’s native currency. The capital requirements for holding idle money in many countries would be prohibitively expensive. They also must be actively managed to ensure balances are commensurate with transaction volume. These account balances in a local currency improve liquidity by lowering the risk for the parties transacting. [1] a bank account held by a local bank with a foreign bank, usually in the currency of that country.
For banks to conduct cross-border transfers, a relationship between them needs to be established. Banks with direct relationships have pre-funded Nostro accounts set up at their partner banks overseas. Anytime a transfer occurs, the SWIFT system instructs the sending bank’s Nostro account to be debited and the receiving bank’s local account to be credited. A transaction between an Indian bank account to a US Bank account would involve the following:
1. The Indian bank receives the recipient and transfer information from the sender
2. The SWIFT system finds a link between the sending and receiving banks via their correspondent banks
3. A SWIFT message is sent with transfer details to the sender’s correspondent bank. The INR account of the sender’s bank is debited, and the correspondent’s account is credited – The INR correspondent bank takes a fee for facilitating the transfer
4. The sender’s correspondent bank exchanges the INR funds into USD at a fee
5. A SWIFT message is sent with the transfer details to the receiver’s correspondent bank who debits the receiver’s correspondent’s Nostro account and credits its own account – The US correspondent bank takes a fee for facilitating the transfer
6. A SWIFT message is sent to the receiving bank with the transfer details. The receiving bank debits its correspondent bank account and credits its own account
7. The funds are received in US
There are multiple issues with traditional Cross-Border Payments – Cost, Time, Transparency, and Errors. The average costs for a bank transfer are 11.18% [2] for low-value payments while typical business to business payments can cost up to $30USD. Transactions can take between 3-5 days to settle [3], and the error rate of international transfer is around 5%. [2] World Bank [3] Each step takes time and as most international banks operate different time zones; money can stay idle waiting for recipient banks’ business hours
What is wrong?
The cost and complexity of holding and maintaining Nostro accounts is one reason why only a handful of banks can process global transactions. Nostro accounts are simply unsustainable for most organizations, creating the need for correspondent banks. These banks act as intermediaries for smaller and medium-sized banks and have partnerships with multiple international banks. When a money transfer is requested, the SWIFT system links banks via correspondent banks and instructs each bank along the way of which transaction to fulfill. The capital requirements for holding idle money in many countries would be prohibitively expensive. They also must be actively managed to ensure balances are commensurate with transaction volume. Speed and volume are crucial considerations. The faster the transaction, the more a sender is protected from volatility risks and the faster the recipient receives fully settled funds. High throughput allows for a more stable volume of exchange for all market participants.
Is DIGITAL ASSET a Solution?
Digital assets are cryptographically secured tokens that store value and can be transferred between two parties without the need for central counterparty (corresponding banks). A digital asset use can take the place of Nostro accounts and offer on-demand liquidity. This is possible because the digital asset serves as a universal currency, and payments can be instantly made in any currency. This capability not only lowers the cost of the overall transaction, but it can speed up the exchange in real-time. Banks and payment providers can then free up the dormant Nostro accounts around the world. Even better, banks, and payment providers that would usually be locked out of transacting on their own, can now engage in international payments directly.
RIPPLE: Disrupting the Model
Targeting the money transfer pain points, Ripple is using a blockchain-based network to improve the way transfers are done. Ripple is a real-time gross settlement system (RTGS), currency exchange, and payment network, built specifically for the direct transfer of assets. Ripple introduced XRP as the digital token that can act as a bridge currency to facilitate direct asset transfers between parties. XRP transfers are instant, extremely inexpensive (fractions of a cent), and can be done to any entity on the RippleNet willing to accept the token. Ripple’s xRapid solution uniquely uses XRP to offer on-demand liquidity.
How On-Demand Liquidity Works?
RippleNet customers can use XRP to bridge two currencies in three seconds, ensuring payments are quickly sent and received in local currency on either side of a transaction.
- The sender requests a quote on pricing and FX
- Ripple’s technology calculates the pricing and FX across all parties and returns a quote to the sender
- The sender accepts the quote and submits payment instructions, initiating the payment
- The send-side exchange debits the sender’s account and converts that amount (fewer fees) into XRP
- XRP is sent across the XRP Ledger (settles in 3 seconds) from the send-side exchange to the receive-side exchange
- The receive-side exchange converts XRP into local currency and credits the sender’s account (fewer fees)
- Ripple’s technology confirms the amount received is accurate and will top up the sender’s account if needed
- The receive-side exchange forwards the payment to the receiver
- The receiver forwards the payment if necessary
- The sender and receiver confirm the transaction is complete
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