Payments disruption in real time

The Medicis in the 15th century (‘God’s Bankers’) were constrained by the Catholic Church’s ban on usury - the charging of interest - on loans.

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As a result, they were perhaps the first to prosper from ‘bills of exchange’, used by businesses to fund cross-border transactions. The bill, fully hand-written and signed by the remitting branch manager for secure identification, instructed the foreign Medici branch to pay the presenter of the bill in their local currency.

It was a payment innovation which has survived the centuries, relatively unchanged. The Medicis made a margin on the components of the transaction, pricing their risk. Yet much of that value derived from an inconvenience – time. Transactions could not be done instantaneously. But today instantaneous – “real time” – payments threaten to be a major disruption to the industry. 

Perhaps prescient about 'travel money’ prepaid cards today, the Medici exchange rate was locked in at the time of bill issue. So the presenter bore the foreign currency risk, gaining or losing money based on the exchange rate at time of collection, often several months later. 

Perhaps one of the first ‘market makers’ in currency dealing, the Medici bankers monitored exchange rates and corresponded frequently with each other to ensure their funds transfers were profitable. 

The Medici branches in important cities - Pisa, Milan, Venice, Geneva, Avignon, Bruges and London - and perhaps the first ‘mobile bank’, a branch that followed the Pope around on his travels, offered a network to facilitate commerce.  If they lacked a branch in a city, the Medicis would contract with a local bank to honour drafts and accept their bills of exchange. 

A few centuries later, the casual observer today may be forgiven for thinking not a lot has changed in the clubby world of banking. The global correspondent banks facilitate trade very similarly across borders and still very profitably. Sophisticated currency dealing and treasury management of currency inventories around the clock enables them to offer liquidity and manage prudential and compliance risks on behalf of domestic banks and their clients.

A quick primer: a ‘payment’ generally refers to the authorisation of the payment and the associated messaging to the recipient (remitter, beneficiary and associated business transaction details).  ‘Clearing’ refers to the directing of funds to the ultimate beneficiary, often across borders and via many hands (one or more correspondent banks).  ‘Settlement’ is the final receipt of usable funds by the beneficiary, free and clear.

Cross-border ‘settlement' of funds is now an arcane science in the back-offices of Treasury and Markets departments, little understood by precocious startups with the next cool user experience in mobile payment authorisation. 

All well-known payment service providers generally address only the ‘payment’ aspects of the service.  (PayPal with their ‘stored value’ accounts can offer instantaneous funds transfer within the PayPal system). 

Banks and their country-specific regulators still control the crucial ‘clearing’ and ‘settlement’ legs of each transaction into bank accounts within their jurisdictions.  Correspondent relationships are the only way to bridge countries and their regulatory constraints.  Anti-Money Laundering and Counter Terrorism Financing (AML/CTF) legislation is now de rigueur and compliance an essential capability in global banking services.

In the era of the Medicis, the time between when a bill was issued in one city and could be cashed in at another was set by long-standing custom, or at usance. The usance between Florence and London might have been 3 months!

Today’s commercial clients and multinationals are more demanding. Even small and medium businesses are exporting and importing in larger volumes and values, to and from more countries. Tourists are spending money, in various currencies, in several countries in a week or two as they vacation far from home. The internet and more recently mobile digital devices have redefined expectations. Consumers expect instant gratification of purchases made, faster than you can say ‘Yo!’. 

‘Real-time’ payments are now the glittering new prize for bankers, payment service providers and even regulators. 

‘Real-time’ can often refer to the payment authorisation and messaging component alone but to the pedantic, instantaneous settlement of cleared funds to the recipient is the real deal.  Even the US Federal Reserve is contemplating a real-time replacement for the Automated Clearing House system that powers a huge share of domestic transactions.  

In Australia, the Reserve Bank (RBA) has been instrumental in catalysing an industry-funded project to build a real-time domestic clearing and settlement service called the New Payments Platform (NPP).  The NPP is a wholesale utility for domestic banks to clear low value, high volume payments in real-time, using their accounts at the RBA to effect immediate settlement. 

Embracing principles of ‘openness’, the NPP should enable incumbent banks and new competitors to develop innovative services ‘overlaid’ on the utility infrastructure. Executed well, with oversight by a new Payments Council, this infrastructure should enable Australian consumers and businesses to engage in e-commerce more simply and conveniently by December 2016. 

Several countries now offer such capabilities within their borders and we can expect an ‘arm’s race’ driven by the exigencies of global trade. However, there are no industry moves to consider alternative systems that may offer the hope of real-time clearing and settlement for cross-border payments. 

The innovative Medici’s are credited with the invention of ‘double-entry’ book keeping - remnants of ledgers were found at their Bruges branch. To this day, ledgers that record transactions conducted by their own clients remain the cornerstone of banks: they are the single source of ‘truth’ relating to their client’s financial affairs.

A visiting Medici banker from the past, briefed on current technology and computer systems, would immediately recognise their traditional operating model and likely do very well in a senior global transaction banking role! 

For the first time since the Medici’s, however, a new model with supporting technology has emerged for the conduct of financial transactions across borders. This is the model of the ‘distributed, open ledger’ made possible by the ‘block-chain’ concept of crypto-currencies like Bitcoin.  A single ledger of transactions, shared by all banks across the globe, verified in a collaborative manner and secured by proven algorithms is a potentially transformative model for global transaction banking. 

Technology providers like Ripple (my client) are leveraging the underlying ‘blockchain’ technology but more efficient ‘validation by consensus’ algorithms to enable settlement within 10 seconds.  Being currency agnostic, banks can trade in fiat currencies without conversions into a crypto-currency. 

The Ripple ecosystem accommodates banks and currency traders in a regulator-friendly platform.  These industrial strength building blocks offer a truly global set of payment rails on an ‘open source’ basis (making the software free for commercial use). Banks remain free to build client-facing services. 

The atomic transactions between participating servers combine payment authorisation with instant settlement, removing the current ‘counter-party’ risks. It is simply not possible for just one leg of a transaction (remittance) to be completed with another leg (settlement) failing. 

There are other benefits. The increasing focus on ‘trace reporting’ by regulators to enable funds to be traced end-to-end and more stringent ‘Know Your Client’ burdens are escalating costs for banks. These costs could be reduced via one-to-one, trusted relationships and ‘straight- through’ transactions via the new platforms.  

The new technology and operating models offer prospects for both domestic and cross-border inter-bank clearing and settlements. So emerging economies have yet another opportunity to leap-frog developed economies in this new race.  Besides wholesale funds transfers between their own foreign branches and with close partners, banks can leverage this technology to reinvent the global remittances market in real-time. Small and medium importers and exporters, a growing and politically important constituent for most governments, can scale their commerce by orders of magnitude with the removal of historical financial constraints to cross-border trade. 

Licensed and prudentially sound financial institutions, whether banks, hedge funds or others, can remake their roles in this brave new world where transactions and relationships are exploding across the planet.  Doubtless a Medici would welcome and embrace such an opportunity for commercial gain and client satisfaction, as will innovative and thoughtful banks today.

Dilip Rao is a veteran in financial and banking technology innovation, currently based in Palo Alto.  His company Woomera Labs consults to startups and enterprises to incubate disruptive solutions that address enterprise challenges.

Disclosure: Woomera Labs consults to Ripple Labs, the creators and supporters of the Ripple protocol.

Photographer: Jennifer Farmer.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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