How Cross-Border Payments Work: Opportunities in a Fast-Moving Environment

Introduction

In our quest to demystify the world of payments, we take a deeper dive into cross-border payments, how they work and what opportunities this fast-evolving environment holds.

Domestic payments are usually subject to one legal system and one regulator, with settlement managed by one central bank. When payments move across borders, there is usually the need to engage at least two legal systems, two regulators, and potentially two or more central banks balancing liquidity. Most domestic payments systems are broadly similar, but many adopt slightly different technical standards and payment rules. So, any cross-border payment system joining them must be able to handle these different interfaces.

While the overall scale of cross-border payments is small compared to domestic transactions, they constitute a disproportionate amount of the revenue pool, with higher margins compensating for the operational and regulatory complexity of building and managing cross-border networks. Note that ‘small’ is very much relative here: FXC estimates that annual cross-border payments exceeded $190 trillion in 2023, of which $44 trillion was for retail payments by businesses and consumers remitting money and purchasing goods and services (see Figure 1). The report goes on to project that the market will grow above gross domestic product (GDP) at a 6.8% compound annual growth rate to >$290 trillion by 2030.

Domestic payments recap

The mechanism by which money is transmitted in a domestic payment transforms an originating bank’s liability to a sending customer into a receiving bank’s liability to a receiving customer (see Figure 2). This occurs in three steps:

1. The originating bank deducts funds from the sending customer’s account and credits its own liquidity account.
2. The central bank deducts funds from the originating bank’s settlement account and credits those funds to the receiving bank’s settlement account (often on a net settlement basis).
3. The receiving bank deducts funds from its own liquidity account and credits the receiving customer’s account.

Cross-border payments: Correspondent banking

The model is more complicated when it comes to international payments. The deposit-holding institutions operate in different markets, with different regulations, central banks and currencies. While several models exist, the most common way to make international payments (by volume of money transferred) is the traditional correspondent banking model (see Figure 3).

Correspondent banking involves banks in different geographies holding money on each other’s behalf. Funds are held in the currency of the deposit-taking institution, which refers to the liability as a ‘vostro account’. To keep us all on our toes, the bank which is the beneficiary refers to the same account as a ‘nostro account’.

For simplicity, we assume that the originating customer’s bank has a correspondent banking relationship with the receiving customer’s bank. The originating bank deducts funds from the originating customer’s account, crediting its liquidity account in its home market (in sending currency), and sends an instruction to the receiving bank to transfer money to the receiving customer. The receiving bank deducts funds from the sending bank’s vostro account and credits the receiving customer’s account (in receiving currency).

Here, the responsibility for the foreign exchange (FX) sits with the originating bank. A critical role for the originating bank’s treasury team involves managing its liquidity across all its nostro accounts around the world and balancing its FX exposures where necessary in the capital markets.

If the nostro/vostro relationship is reversed, the FX element may be managed by the receiving bank. 

The picture becomes more complicated when customers wanting to send and receive payments hold accounts with banks or other deposit institutions that don’t themselves have direct correspondent banking relationships. There are many possible routes for a payment to be made via one or more intermediary banks.

The simplest option to describe is for the sending and receiving banks to find an intermediary bank which holds accounts for each of those banks in their respective domestic currencies and provides FX services as well (see Figure 4).

It is common for multiple intermediaries to be engaged in facilitating correspondent banking payments, leveraging the intermediary banks’ nostro/vostro accounts in two or more jurisdictions. These may also leverage the domestic payments infrastructure to enable pay-ins and payouts at each end of the journey (see Figure 5).

Challenges with the correspondent banking model

While the correspondent banking model has generally been effective for managing international finance, it primarily serves the interests of the largest banks and big multinational corporate clients that transact very large trades, move money on a regular basis, and have developed systems and business processes around the available payments services.

A significant industry of FX brokers and money transition businesses grew up around the core model, aggregating demand from a longer tail of smaller customers — essentially breaking bulk on behalf of the banks and providing a wide range of pay-in and payout options (e.g. cash, card, account-to-account and mobile credits) tailored to particular use cases they serve.

Nonetheless, the traditional correspondent banking model relied on slow and often manual processes by a series of banks, each of which would take fees — and the rates at which currencies were converted were not always transparent. So, customers would not always know how much would be paid out in the receiving market or when funds would be available.

There has been a significant collaborative effort to improve the correspondent banking model. The adoption of Swift GPI has improved both the transparency of fees and the speed of cross-border transactions.

The non-bank intermediary model

Intermediary platforms offer an alternative to correspondent banking. While these are usually regulated as payments institutions rather than banks, some banks offer similar functionality as a service.

Non-bank intermediaries are licensed in the markets they send money from. They manage a network of bank accounts (or wholesale lines of credit) across a range of banking partners in the receiving markets, providing liquidity to fulfil payouts on behalf of customers (see Figure 6). 

These intermediaries could be end-to-end platforms that manage customer acquisition and notify the receiving party when funds are available. Alternatively, an increasing number of specialist network operators provide background ‘rails’. These network operators tend to specialise in payment flows between country pairs (aka ‘corridors’) or regions and seek to gain advantage through scale, aggregating demand across their distribution networks of banks, agents and other money transfer organisations.

An important aspect of the more modern intermediary platform businesses has been the customer interfaces that provide ease of access, are transparent on costs and progress of payment fulfilment, and encourage repeat usage.

G20 initiative to improve global cross-border payments

At the lower end of the market, remittances have been a key focus area for the World Bank given that those from expat workers can account for a significant proportion of income in receiving markets.

In 2020, the G20 set out goals and agreed a roadmap to enhance cross-border payments by 2027. The roadmap aims to address four challenges: cost, speed, access (for enabling institutions and their end users) and transparency. It has identified 19 initiatives under three broad themes: payment systems interoperability; legal, regulatory and supervisory frameworks; and cross-border data exchange and messaging standards.

In particular, the roadmap promotes the adoption of ISO 20022 messaging and a model to interlink domestic payments systems, along with increased use of shared liquidity models, such as those operating under the TARGET2 system in Europe.

Investment considerations

Increasing global mobility, growing use of digital banking and greater transparency on costs have led to the rise of innovators seeking to address inefficiencies in international payments, developing new solutions which improve the experiences of the originating customer and the receiving customer and/or the efficiency of the platforms. A plethora of alternative options for making international payments now exists, with start-ups and innovators challenging specific niches, but there remains much work to be done.

As start-ups mature, those in complementary niches will consolidate, but given the complex and disparate nature of the cross-border payments market, we expect that opportunities for new innovators will continue to appear as well.

Despite financial markets’ concerns over the near-term economic outlook, we believe that this large, growing and innovative part of the payments market will remain attractive to investors for a long time to come.

Factors shaping cross-border payments and investors’ opportunities in the space include:

• Domestic and geopolitical concerns. In many markets, domestic politics and geopolitics are impacting growth in global trade and foreign direct investment. However, cross-border payment volumes continue to grow above GDP. Economic centres outside the US are looking to reduce dependence on entities and networks that rely on US dollar clearing, but we believe it will remain the de facto currency and reference for international payments for a long time yet, providing a reliable basis on which commercial opportunity can be assessed. The G20 push to improve cross-border payments is creating regulatory pressure for greater alignment of payments systems, which in turn encourages innovation and competition to better serve the market.
• Defensible moats in the cross-border payments market. The complexity of the use cases for cross-border transactions will ensure that defensible moats for investors will continue (e.g. in the remittance market, access to a cash-out branch in hard-to-reach communities will be critical). Advantaged access to certain communities and corridors can lower fulfilment costs for other providers of remittance solutions, and we expect to see more ‘coopetition’ between platforms that together provide a patchwork coverage model, potentially as a precursor to consolidation.
• Revenue growth from moving along the value chain. Greater transparency in pricing and access to real-time FX rates will continue to put pressure on prices. To defend margins, providers will continue seeking to enhance their offerings by providing value-added services like FX hedging, bridging different countries’ accounting regulations, or offering treasury or cash management solutions.

How L.E.K. can help

L.E.K. has deep expertise and experience working with clients across the payments value chain, and we continuously support our clients with growth strategies and commercial and operational excellence projects. We support investors in identifying credible targets and growing companies with value creation strategies.

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